Finding the right balance in a hedge program can be challenging. Will critical terms match work or is your program better suited to the long-haul approach?
Hedging FX transactions of an operational nature (i.e., ongoing forecasted revenues and expenses) can present a number of key challenges. Specifically, these challenges include dealing with the timing uncertainty of hedged transactions, and the closely related concept of asserting the probability of hedged transactions. In addressing these considerations, companies often seek the right balance between the complexity of their hedge accounting program and preserving flexibility.
Most apply hedge accounting
In late 2013, Chatham Financial conducted an extensive research study of the annual filings of 1,075 publicly listed corporations to gain insight into risk management practices. While the results provide intriguing insights across many risk classes, one particular finding is especially relevant to this discussion. Amol Dhargalkar, who leads Chatham’s risk management practice serving the corporate sector, said the results were very telling when it came to the application of hedge accounting for FX hedging programs. In short, “over 80 percent of companies hedging forecasted revenue and expenses are applying hedge accounting,” he said. This finding certainly affirms the importance and desire for companies to apply hedge accounting to their FX hedging portfolios.
Finding the sweet spot
Finding the right balance between complexity and flexibility is difficult to achieve. For example, one way to simplify a hedging program is to use the critical terms match (CTM) approach to assessing effectiveness, where a hedge is deemed to be perfectly effective as long as the critical terms of the hedging instrument match the underlying exposure being hedged. While a CTM approach can be significantly less complex to apply, it can also significantly limit the application and flexibility of a company’s hedge accounting program. Alternatively, a long haul approach to assessing effectiveness can be a more rigorous test to perform to qualify for hedge accounting (usually a regression test) and also requires any resulting ineffectiveness to be measured and recorded, but provides more flexibility.
Seeking simplicity
In seeking a simple solution for FX hedge accounting, the appeal of the CTM approach is hard to deny. Despite its appeal, there are a few important considerations before jumping into this method, including:
- What do we give up to utilize this approach?
- What risks exist in using CTM from an accounting perspective?
- What are the potential pitfalls a company could experience down the road?
Timing flexibility with earnings volatility
While CTM can be an effective approach to apply to hedge accounting, it’s best used in limited circumstances. One such circumstance would be when a company intends to hedge only the changes in the spot rate over a period of time—otherwise known as the spot method. Under this method, as long as the critical terms match then changes in value due to spot rate changes can be deferred to equity (i.e., the hedge is considered perfectly effective—no earnings impact).
This approach alleviates problems a company can run into if the timing of hedged transactions should change or are inherently uncertain (e.g., if a forward rate method were applied and the timing were to change, then the critical terms would no longer match and the trade would no longer qualify for hedge accounting under CTM). However, one of the main shortcomings of this approach is that changes in value due to forward points are not eligible for deferral to equity and must be recognized in current period earnings, resulting in earnings volatility.
The chart below provides an indication of what that volatility could look like by showing the historical volatility of forward points from October 1, 2014, through March 31, 2015, for a 12-month EUR-USD forward contract as it progresses toward a maturity date of September 30, 2015. Consequently, this approach may be most appropriate for companies with a shorter duration hedging program of relatively stable currencies where any earnings volatility from forward-point movement would not cancel out the benefits of simplicity and timing flexibility.
Another circumstance where CTM may be utilized is when a company wishes to hedge changes in the forward rate (rather than simply changes in the spot rate) and the hedged transactions are defined within a narrow range of time (i.e., one month). Under this scenario, differences in the timing of the derivative’s maturity date compared to the timing of the hedged transactions would need to be analyzed.
As such, the CTM approach would need to be supplemented with an analysis showing that the timing differences within the defined window are so small they can be ignored for accounting purposes (this type of analysis is often referred to as a “de minimis” analysis as it seeks to prove the impact would be de minimis in nature). With this additional analysis (and assuming changes in forward rates are truly insignificant), CTM can be applied without the drawback of forward point movement being recorded through earnings. However, some may determine that this required quantitative analysis detracts from the goal of simplicity—one of the main purposes of applying CTM in the first place. Those in this camp would suggest that if any quantitative analysis is required for CTM, then the company may as well select a long-haul approach and reap the full benefits of doing so.
This, combined with the limited flexibility of a relatively small window (only one month) can significantly reduce the benefits of CTM for some companies. Nevertheless, this approach may be appropriate for companies where monthly cash flows are highly predictable or where a lower percentage of total exposures are being hedged, but where the potential earnings volatility from the spot method is unacceptable.
Ultimately, CTM can provide simplicity when seeking to apply hedge accounting. However, that simplicity can come at the cost of limited application and potential shortcomings down the road should circumstances and forecasts change.
Preserving Flexibility
As some companies seek the simplicity of a CTM approach they become dissatisfied with choosing between timing flexibility but experiencing earnings volatility and eliminating earnings volatility but limiting timing flexibility. When companies reach this point, they rightly evaluate whether using a long-haul approach can strike the right balance for their FX hedging program.
Under a long-haul approach a company can use a regression analysis to qualify for hedge accounting. Using a regression approach can allow a company to define a larger window of time in which the hedged transactions may occur (e.g. a three-month window) without increasing earnings volatility to the level that would often be recorded from forward-point movement in a spot method CTM approach.
An additional benefit of this approach may be that a company could actually increase the notional amount being hedged. Aaron Cowan, the leader of Chatham Financial’s corporate hedge accounting practice explains, “A company may be very comfortable with its quarterly forecasts, but far less comfortable with its monthly forecasts. By defining a larger window a company could hedge a greater percentage of its quarterly forecast because it isn’t constrained by the fear of over-hedging in any given month.” This concept is further depicted in the chart below by showing hedge accounting capacity being limited by a company’s minimum monthly volume, but increased when considering quarterly averages or a three-month rolling period.
Companies seeking greater flexibility in the application of hedge accounting can greatly benefit from applying a long-haul approach. This type of approach can allow for more timing flexibility without a corresponding increase in earnings volatility, and in many cases may even support an increase in a company’s hedging levels. While a long-haul approach does involve some quantitative complexity in order to perform regression analyses as well as model hypothetical derivatives that are used as a benchmark for assessing and measuring the performance of a hedge, these complexities can largely be mitigated through specialist systems and integration with a company’s TMS.
Like many strategic decisions, the proper balance in applying FX hedge accounting requires a careful evaluation of the costs and benefits. In some circumstances, using the CTM approach may be the right method. However, for many companies, using a long-haul approach with regression analysis will likely provide the right fit by mitigating the impact of earnings volatility and providing the desired flexibility in timing. In most cases, these benefits can be obtained without an unmanageable amount of effort being required, especially when specialty systems are leveraged to perform the required quantitative analyses.