Source: KPMG Corporate Treasury News, Edition 49, November 2015
Inexplicable foreign exchange effects despite currency hedging frequently trigger queries by management. The main reasons, apart from incomplete recognition of risk exposures, are their changing characteristics over time which are not sufficiently taken into consideration.
Exposure life cycle and evidence of foreign exchange effects
Foreign exchange exposures follow life cycles, which, if taken into account, are of major sig-nificance for the strategy taken to hedge risk. Their life cycle is determined by allocating risk exposures to various process phases at different points in time: budgeting, order placement, balance sheet recognition of the transaction (usually upon delivery or invoicing) and payment. These phases are also referred to as planned exposure, firm commitment and balance sheet exposure.
While the economic effect of changes in exchange rates on the underlying transaction continues throughout the exposure's life cycle, only part of this effect is evident in accounting. This is because the underlying transaction can only affect the balance sheet or the income statement once it has been recognized in the balance sheet. Therefore, if, for example, the exchange rate drops between costing an export transaction and entry of the receivable in the accounts, this is not yet reflected as a loss in the accounts. Instead, a lower receivable compared to the budgeted amount is recognized as revenue. These effects of movements in exchange rates therefore are not evident from the entered data, but only by means of final costing based on the development of exchange rates. Therefore, foreign exchange risk during the exposure's life cycle until recognition of the transaction in the balance sheet is also referred to as valuation risk, which affects cash flows when the exposure matures.
Once the transaction is recognized in the balance sheet, for example upon invoicing, it may affect profit or loss as of that date in the course of subsequent foreign currency valuation, which becomes evident in the accounts as a currency gain or loss (for more information on the issue of currency gain or loss, see Newsletter 48 of October 2015). If, for example, after entry of the receivable in the accounts, the exchange rate declines further, a foreign exchange loss is incurred on the next valuation date, which needs to be recognized in the income statement. Therefore, the accounts are exposed to valuation risk until the date of payment when the foreign exchange effects are fully recognized.
But how can balance sheet exposure be managed and what are the different requirements for hedging planned or contracted transactions?
Hedging approach for balance sheet exposure
Usually, the probability of occurrence of risk exposures changes as they progress through their life cycle. While there is a relatively high degree of uncertainty during the budgeting and planning phase, the occurrence of recognized transactions is virtually certain. This circumstance is taken into account for example by using various hedge ratios or ranges. While longerterm planned transactions are hedged at a lower ratio – of 25 or 50% for example, depending on probability – in order to take account of uncertainty, recognized exposures can be hedged at very high hedge ratios of up to 100%. This can only be accomplished if risk exposures are structured accordingly in the treasury system based on the life cycle model, in order to be able to distinguish balance sheet exposures from other exposures. Moreover, the hedging strategy should take account of any adjustments to the hedge ratio once the transaction has been recognized on the balance sheet.
In addition to increasing probability of occurrence, it also becomes easier in many cases to predict the maturity date of recognized transactions, which by then has been sufficiently specified during invoicing for example. Therefore, in addition to having to increase the hedge ratio, the maturity of the hedge may also need to be adjusted. Insufficient adjustment of hedges with regard to the specific maturity dates of exposures results in disparities, which frequently give rise to unexpected currency gains or losses.
Rolling approach within the meaning of 'net currency exposure'
As the foregoing requirement of adjusting hedges ties up considerable front office resources, another approach to controlling balance sheet exposure to foreign exchange risk is currently under discussion in practice: control by determining net currency exposure.
In this approach, similarly to a balance sheet, asset-side and liabilities-side currency positions are netted for each currency pair on a particular date. The resulting net exposure is used as a basis for a short-term rolling hedging approach, with a hedging horizon of 1-2 months for example – regardless of the specific maturities of individual recognized risk exposures. Hedge positions are adjusted on a rolling basis by means of regular recalculation of net currency exposure as of each review date by taking account of existing hedges. This can reduce the above-mentioned effort required to adjust individual transactions due to the uncertainty of maturity dates, as only the net currency exposure is hedged. On the other hand, the hedging effect is reduced usually with regard to the hedged exchange rate and so the effectiveness of currency management, as exchange rates are not hedged in accordance with their maturities because the focus is on offsetting the effects of valuation as of the balance sheet date.
It should be noted that it is usually not sufficient to exclusively hedge planned transactions at the outset because of the increase in information available on risk exposures as they progress through their life cycle. Likewise, merely hedging balance sheet exposure would not fully cover the potential currency exposure of the underlying transaction. Exposure needs to be analyzed and managed throughout its entire life cycle. The right approach to balance sheet exposure to foreign exchange risk is a crucial component to reducing undesirable currency gains and losses.
Author: Stephan Plein, Senior Manager, firstname.lastname@example.org
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