By Anne Friberg and Ted Howard
Twenty years later the question of whether to hedge remains.
Twenty years ago balance-sheet hedging was still in its infancy and many wondered if it was necessary. In June 1994, International Treasurer wrote, “Deciding whether or not to hedge balance sheet translation exposure involves an analysis of the nature of the business and the level of earnings repatriated to the parent.” (“Is it Real…or is it Paper?” IT, June 11, 1994).
The story went on to state some of the reluctance of why companies might choose not to hedge, mainly that the benefits of doing so can be opaque. “Discussions about the economic impact of balance sheet translation exposure are often confusing. Each participant has different assumptions about reality. The situation is further confused by FAS 52 [the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 52, which deals with foreign currency translation].”
Not a lot has changed in this regard as the problem is the same today. FAS 52/functional currency choice is still a factor in deciding whether to hedge or not.
Another question treasurers needed to ask themselves: how liquid are the assets? “Economically,” IT wrote back then, “the ultimate owner of any foreign currency denominated monetary assets [are] exposed to exchange rate risk. For this reason firms that have mostly financial assets abroad should be concerned about the dollar value of their subsidiary equity. After all, if the overseas balance sheet is the equivalent of a…time deposit, there is a real change in the value of those assets as the…exchange rate moves. At the other extreme, a heavy industrial operation with a balance sheet composed largely of inventory and PP&E funded locally will not have the same economic exposure.”
Again, the concept still holds today. If a company has cash or receivables sitting offshore, those are a more immediate exposure than property and equipment, because cash is cash and receivables will soon turn into cash and presumably it wants to get that cash home as soon as possible. So the value is sensitive to FX fluctuations.
And whether to hedge at all is still open to question. In 1994, IT wrote: “Some treasurers will argue that the balance sheet should not be hedged. Stock market analysts, they claim, do not have to understand translation losses and therefore tend to ignore them.” However, “such a view can be dangerous for companies where equity ratios are important, such as those with covenant restrictions or those highly leveraged.”
Once again, this is still true. To equity analysts’ ears, hedge cost and the impact of FX on foreign assets is unwanted noise that skews their models. They would prefer not to understand how it comes about and what it means. Still, because EPS is such an important reporting number and not hitting the guidance or Street expectations can dent the stock price, most treasuries only have a penny in EPS per quarter (up or down) to play with on FX (cash-flow and balance-sheet). For that reason, they hedge to keep any impact (good or bad) on earnings as low as possible. In addition to the penny a quarter, highly leveraged companies always have to be very cognizant of covenant and related ratios. The same is true of a highly rated company with little debt: to keep the rating they also need to make sure ratios stay within certain ranges.
What has changed are the tools available to be able to analyze the underlying exposures on the balance sheet through better systems and more real-time accessible information. This can be better ERPs and/or add-ons like FiREapps, which provides FX exposure-management systems. Companies have also had two decades since 1994 to refine their processes for identifying exposures and how the systems-generated exposures need to be adjusted and tweaked for things that are not yet reflected in the systems. Also, while it is true that some companies do and some don’t do balance sheet hedging, if they do, it’s not all or nothing. Some currencies get hedged and some don’t, depending on the cost of hedging (forward points, for example) and the materiality of the exposure.