Amid Greece’s woes and the possibility of a Grexit, time to get “rolling.”
Currency volatility has ebbed for now, after a turbulent autumn and spring, but the impact of Greece’s potential withdrawal from the euro is still unfolding. Indeed, numerous other currencies, including the US dollar (USD), Russian ruble, and Chinese renminbi could again take wild swings as government policies and geo-political events transpire.
The extreme volatility in the foreign-exchange markets over the last year has served to heighten awareness among corporates of their currency hedging strategies. To their dismay, however, they may have found that hedges serving a definitive economic purpose – mitigating very real FX risks – are not eligible for hedge accounting treatment, and so swings in the price of the hedging instrument must be recognized currently in the company’s earnings rather than when their hedged exposure impacts earnings. This timing mismatch leads to undesirable earnings volatility.
Aaron Cowan, who heads up the corporate accounting advisory team at Chatham Financial, said his firm has actively worked with clients to maximize the capacity of their hedge accounting programs over the last four years, seeking to reduce that volatility. The techniques have sparked heightened interest recently, given the FX unknowns corporates now face.
Corporate forecasts of foreign transactions often involve some level of uncertainty. To apply hedge accounting, generally accepted accounting principles (GAAP) require the hedged transactions to be highly likely to occur. And given GAAP can be very punitive if those expectations are not met, Mr. Cowan said, companies tend to conservatively estimate the occurrence of transactions as they determine how much of each exposure to hedge. Such conservative estimates can reduce the application of hedge accounting and even the ultimate amount of hedge cover in place, suboptimal outcomes from risk management and earnings volatility perspectives.
A commonly used corporate FX hedging strategy involves using a currency forward contract to hedge the forecasted purchases or sales expected to occur in a month. However, the uncertainty around the amount of purchases or sales that are expected to occur in that period can complicate the application of hedge accounting. An alternative strategy for hedge accounting purposes is to extend the forecast period from one month to a rolling three months, creating a three-month window that enables “higher hedge cover to qualify for hedge accounting,” as Chatham describes it. The greater assurance that hedging transactions will occur over the longer time period encourages companies to take more advantage of hedge accounting treatment.
“It’s a way to increase the amount for which a company can get hedge accounting on FX exposures, looking at the longer range of time, because it increases confidence that level will be hit,” Mr. Cowan said. “This approach resonates well with companies that have been constrained by a lack of forecasting accuracy, or an inherent uncertainty in the past about forecasts. Companies then have to weigh that benefit against the cost.
“The tradeoff there is that you’re giving yourself more flexibility to qualify for hedge accounting at the cost of having a hedge accounting program that is a bit more complex with some incremental administrative work,” Mr. Cowan said. He added that extending that window requires more detailed hedge documentation, quantitative effectiveness testing, and a spill-over monitoring process to demonstrate the likelihood of hedged transactions occur over three months compared to one.
Another approach to increasing hedge-accounting capacity is to optimize the use of designated hedges. Mr. Cowan said USD-functional companies, using USD as their functional currency, may want to hedge euro-denominated revenues, and to do that they can directly designate a sell euros/buy USD forward contract for hedge accounting purposes. Oftentimes, however, companies don’t have that “direct capacity,” in the form of euro-denominated revenues at a USD functional entity, so they can look for “indirect” and “split” exposures within their corporate structure.
In the case of indirect exposure, a USD-functional company may want to hedge its exposure to euros, but it doesn’t have any euro-denominated revenues. However, it has a euro-functional subsidiary that has USD expenses. Those expenses provide the same FX exposure as the USD-functional corporate entity’s euro revenues, and so the USD entity can accomplish its corporate hedging objectives by having the euro-functional subsidiary hedge its exposure to USD expenses instead.
“So that’s what we mean by ‘indirect.’ A company can search throughout its organizational chart to find any euro-functional subsidiaries, and then find out whether any of those subsidiaries have expenses in USD that can be hedged,” Mr. Cowan said.
And for more complicated situations, such as a company that has a significant operating entity in Switzerland that is Swiss franc (CHF) functional but nevertheless wants to hedge a net long euro exposure back to USD, aggregating portions of more than one hedge can pump up capacity. If the company’s main operating entity in Switzerland has USD expenses and EUR revenues then it can hedge those revenues back to CHF and the USD expenses back to CHF.
“The CHF legs of those two hedges cancel out and leave the company with a sell-euro/buy-USD trade, meaning you get back economically to the hedge you want, but you do it in two pieces, where the legs of each piece cancel each other out,” explained Mr. Cowan.
He added that a company can start with the easiest direct designation, then look to indirect and split designations as ways to increase hedge accounting capacity further.
“What this really does is allow a company to focus on what it wants to do economically and then look through its entire organizational structure and search for these three types of exposures that they can use to increase hedge accounting capacity,” Mr. Cowan said.
Mr. Cowan noted that taking such steps may impact how certain items are classified in the financial statements, but they won’t impact net income, earnings per share or EBITDA. From the perspective of treasury, he added, “These are some tools that can be used to achieve the desired economic hedges and as much hedge accounting as possible, so achieving hedge accounting doesn’t become a constraint on the hedging program you want to use.”