FX risk management has in the last year moved to the top of treasurers’ agendas, and especially so after the reversal of the long dollar-weakening trend last year and more recently, the yuan devaluation. As a result, the earnings-smoothing effect of a well-executed hedge program takes on heightened urgency, as well as the ability to articulate how FX impacts the company and how the underlying business is performing.
To address the former, several members in The NeuGroup universe are conducting reviews and back-testing to determine which hedge strategy produces the most effective earnings smoothing. If you haven’t already, this may be the right time to conduct your own, especially if the uptick in currency volatility leaves you vulnerable to larger-than-desired swings in reported results, or if you don’t qualify for hedge accounting for as many exposures as possible.
But one thing is certain: cash-flow hedging doesn’t always hit the mark, as members of The NeuGoup’s FX Managers’ Peer Group discussed at their last meeting. Cash-flow exposure used to be the guiding star for one member’s hedge program, until it was discovered that cash-flow hedging in some cases conflicted with profit exposure for certain businesses, depending on their location and market specifics.
The member told the group that his company is now in the process of transitioning from a hedge program that focuses on affiliate cash flow to one with a corporate profit focus, while leveraging diversification benefits, reducing hedging to those key exposures that pose “significant risk” to the total company and using a simpler hedge strategy, i.e., lower cost and fewer derivatives, to obtain the same results. For example, if an affiliate’s net costs are in EUR and net revenues are in GBP, with profit hedging they largely offset each other against the dollar.
Also discussed by the presenting company were alternatives to the widely value-at-risk (VaR) models, cashflow-at-risk (CFaR) and earnings-at-risk (EaR) — and going from one to the other. Going forward, the member company will base its hedge program on earnings-at-risk instead of cash-flow-at-risk. The exposure profile will change—instead of loading all cash-flow exposures (e.g., the EUR and GBP above), it will now load FX exposures against USD. But it will be the “same buttons, same reports.”
Also discussed, hedge accounting and how it can sometimes be the tail that wags the dog. One of the challenges is that while cashflow hedging qualifies, some of the profit hedging may not. If profit hedging does not qualify, the hedges need to be designated against certain cash flows, which means those cash-flow exposures still need to be tracked for hedge accounting purposes. This can be non-transparent and counter-intuitive for outside stakeholders like investors, and it needs buy-in from auditors.