Rethink Rolling those Remeasurement Hedges

By Helen Kane

By aligning the remeasurement hedging program with currency conversion requirements, treasury can reap benefits.

All across the country corporate treasuries are establishing one-month hedges for exposures that are not expected to convert for two or three or six months in the future.

Why? Because that’s the way they’ve always done it.

Many existing programs were designed to avoid accrual accounting in favor of cash accounting by having all forward contracts mature at month end. But now it is time to rethink your remeasurement hedge program by shifting the focus of the instruments to the cash conversion event.

By aligning the remeasurement hedging program with currency conversion requirements treasury organizations can begin reaping benefits including:

• Reduced total notional amount traded (and associated spreads)
• Improved cash forecasting
• Identification of uneconomic hedges
• Improved remeasurement hedge results.

So here are the operational steps to switch a rolling hedge program to a cash conversion program—for those bold enough to try.

Reducing Notional Amounts

Corporate treasurers may associate the annual volume of trades executed with the importance of the hedge program to the company overall. But the hope is that the hedge program is perceived by senior management as directly correlated to their experience and prowess rather than hedge volume.

Regardless, because disclosure requirements now call for registrants to detail volume-related information associated with the hedge program, many remeasurement hedge programs are looking bloated and out of touch with corporate exposure activity.

Example:
A corporate reporting a quarterly volume of EUR90M notional on remeasurement hedges is protecting EUR30mn of exposure. If the corporation sells/buys $10mn of goods per month with 3-month terms, a monthly hedge program would “roll” EUR30mn of forward contracts each month or EUR90mn per quarter (see table below).

One can see in the above example how easy it can be to accumulate a “trading” notional of EUR90mn in a quarter when the incremental exposure was only EUR10mn per month. The solution to the bloated hedging in this example is to execute a EUR10mn three-month forward each month: the result at quarter end would be three forwards outstanding for a total of EUR30mn notional for EUR30mn in exposure. Subsequently, at each maturity date in future periods the euros would be delivered to the bank and US dollars would be delivered to the corporate. Extending this concept out a year the corporation would execute EUR120mn in hedges for EUR120mn in exposure, rather than the EUR360mn (EUR30mn a month) that the current program trades.

An added benefit is that this exchange at maturity does not require any additional trading with the bank. This is most apparent for those corporations that have negotiated spreads over market on their trades—two-thirds of current costs would be redirected to income due to the lowered notional upon which the spread is calculated.

Better Cash-Flow Forecasting

Another advantage of hedging to the expected cash-conversion date is the improvement to USD cash forecasting. Admittedly, there still are no silver bullets to help the corporate treasury team magically foresee exactly how much cash will be available for conversion in three month’s time.

Generally the three-month forward contract executed in the above example will be over or under the actual cash conversion requirements; bankruptcy automatic stay however, the amount of adjustment should be relatively small. Therefore, the actual USD cash inflow/outflow will be easy to forecast by looking to the forward notional amount.

Another added benefit to the forecast model is that there will be no need to estimate the gain or loss to be exchanged with the counterparty every month end to compensate for the large rolled positions. This is crucial for the perceived performance of new hedge programs where management may be unfamiliar with the mechanics of using derivative instruments. It is not unusual for new hedge programs to be terminated after the first very large cash transfer to the counterparty used to compensate a rolled hedge. Had the same amount been characterized as an unrealized gain/loss as the result of the mark-to-market process at month end it would be better matched with the offsetting unrealized loss/gain on the hedged item, and the program effectiveness would have been more obvious. Unfortunately, the large net settlement transfers associated with realized derivative losses has been the death of many a fledgling hedge program.

Uneconomic Hedges ID

If hedging to cash flow doesn’t make sense for your company because there are no “cash conversions” associated with the hedge program, there’s a bigger problem than just rolling your hedges.

Consider the following case of a client that never delivered funds on one of the currencies in its remeasurement hedge program. Upon review of the balance sheet of the related subsidiary we noted a substantial inconsistency between the accounting exposure and the economic exposure. The subsidiary’s balance sheet without intercompany balances was $2mn long (USD equivalent) local currency. The related intercompany payable balance for the same subsidiary on the parent’s balance sheet was $20mn short (USD equivalent).

Therefore the hedge of the intercompany payable at the parent added $20mn to the $2mn long position in local currency (SGD) at the subsidiary. The hedges never ended in conversions because the intercompany balance was not being paid down and as a result actually exacerbated rather than mitigated the economic exposure to those currencies.

The parent admitted it had no intention of paying off the intercompany balance—but if it did the funds would be immediately returned to the parent as a dividend. There would never be a need for a currency exchange of USD for SGD, ever. However, every month cash flowed in or out associated with forward contract gains or losses that had no third-party substance. The good news is there are processes and strategies to address similar situations and avoid executing hedges that have no relevance outside of intercompany accounting transactions.

Improved Hedge Results

Converting from a rolling hedge program to a cash-focused hedge program requires an increased understanding of the economic nature and timing of transactions that drive your currency positions.

Analyzing the details of these transactions through the financial statements is the best way to improve your understanding of exposures and thereby improve hedge effectiveness. Better quality information will save your program losses associated with spreads that are paid again and again over a transaction’s multi-month life. Disclosures about derivative activity will no longer highlight unnecessarily high notional trading activity. The greatest benefit however of a cash- focused derivative hedge program will serve as the canary in the mine, detecting uneconomic hedge positions created by intercompany or tax strategies.

The key to hedging to cash flow date is information. Not necessarily a crystal ball (we’ve all been hoping in vain for the perfect forecast for years!) but a solid understanding of the inflows and outflows that drive those balances. If your program is asking subsidiaries to forecast non-functional currency balances at month end, your forecasts and therefore hedge program is likely doomed to failure.

The currency risk management team needs to understand what transactions are driving growth in the exposures, and the business terms (days payable and receivable outstanding) impacting conversions. Dust off the FP&A skills and model the flows driving your currency inflows, outflows and conversions. Most of your systems now have years or even decades of actuals to support your program. The negotiated (or unnegotiated) basis point spread on the extra hundreds of millions of hedges you no longer swap should readily pay for the additional analysis.