Currency overlay management

Currency overlay management

Challenges with regard to accounting treatment pursuant to German GAAP [HGB]

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In the search for flexible solutions in currency risk management, currency overlay management is considered a possible alternative by many companies. When selecting and developing strategies, the accounting treatment of programmes should also be considered in addition to examining the suitability of a risk management method and the costs associated with that strategy. There are a number of pitfalls that should be avoided in doing so, which could undermine the desired hedging effect on the accounts. This newsletter discusses the accounting treatment in accordance with the German Commercial Code [HGB].

Currency overlay management is an active currency management strategy, in which hedging decisions are taken based on expected trends derived from forecast models. In most cases, companies delegate this type of hedging of their foreign currency exposures completely (or for particular currencies) to an external third party, usually a bank. Trading decisions are then – depending on the company's requirements and limits – taken by the bank on behalf of and for the account of the company. This active strategy is designed to hedge currency positions against negative movements in exchange rates while at the same time safeguarding the opportunity to take advantage of positive changes in exchange rates. The hedge ratio – with regard to exposure – decreases with a positive trend in exchange rates while it increases with a negative trend, making this strategy particularly effective in the case of significant changes in exchange rates.

Derivatives under the currency overlay model first have to be accounted for in accordance with general commercial law principles. In most cases, the objective is to designate these transactions as a hedge pursuant to German GAAP [HGB] in order to reduce fluctuations in profit or loss.

For such accounting treatment, the following issues should generally be considered:

Accounting treatment of hedges:

  • If the hedges are based on individually agreed legal transactions, they must be separately valued pursuant to HGB on a regular basis and treated in accordance with the recognition-of-loss principle. Transfer of the portfolio approach from risk management to accounting must be examined on a case-by-case basis.
  • In the case of designation as a hedge, the transactions concluded for the client can be considered on an aggregate basis in most cases. However, this requires compliance with extensive documentation and verification requirements applicable to hedge accounting.

Adjustment of the hedge ratio:

An active risk management strategy requires frequent adjustments of the hedge ratio, which is associated with concluding new and closing out existing hedges:

  • To create an effective hedge with the established hedged items, only the spot element is usually designated. Companies then have to determine the forward elements separately in a subledger and recognise them independently of the hedge in accordance with general accounting principles.
  • It is also important to ensure that the hedge is adjusted in line with the adjustment of the hedge ratio. If there already is a reportable hedged item, the unhedged element has to be recognised in accordance with general principles. In this regard, the intention to hold them to maturity (which is relevant under HGB) also has to be assessed.
  • In the case of forecast transactions it is important to keep in mind that the realised effects from the settlement of maturing or closed out hedges must be recognised outside profit or loss if the net hedge presentation method is used. Otherwise, the objective of compensatory valuation cannot be achieved with the as yet unrecognised hedged item.

In conclusion, it should be pointed out with regard to a general evaluation of risk that intentionally creating open positions from active foreign currency management must be regarded as speculative. Companies should prepare themselves with scenario analyses or similar, so that possible negative effects due to market volatility can be absorbed. To implement effective currency overlay management, companies should include risk management and cost factors, along with an analysis of the effects on accounting, in the decision-making process.

Source: KPMG Corporate Treasury News, Edition 62, December 2016
Author: Christian Pfeiffer, Manager, Finance Advisory, christianpfeiffer@kpmg.com

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