Balance-sheet forecasting remains a challenge for FX practitioners. Here’s one way of doing it.
Balance-sheet forecasting continues to vex many FX practitioners, particularly those with numerous subsidiaries, a great deal of cash in a number of different currencies and locations, and a lack of centralization.
Recently at a NeuGroup’s FX Managers’ Peer Group 2 (FXMPG2) meeting, one member gave a view into his company’s forecasting process, the results of which he said are more accurate than rolling 12-month or six-month averages. In fact, this member said that the company was stretching the bounds of its program, and becoming less inclined to “hedge the hedge” as forecasting has proved to be correct.
Some details. The ultimate objective is to hedge the re-measured gains/losses on local currency net monetary assets (NMA) with offsetting gains/losses on foreign exchange contracts. The net exposure is then hedged (assets – liabilities) on material exposures – in this company’s case those greater than a several million dollar equivalent.
The company transacts in 200 currencies and hedges 30 of them. The most significant un-hedged position at the moment is in China, where the company is currently long the RMB, an expensive scenario. “The higher the forward points, the bigger the exposure we seem to have,” said the FX director. “It’s like Murphy’s law.”
Hedging is done using deliverable and non-deliverable forwards—options are not a part of this company’s balance-sheet hedging program at the moment. Tenors are typically short (about a month), but they do regularly go out as far as three months. And because the company is sizeable, it can be a problem to roll all hedges out at once. If that is the case, the company will extend longer than three months.
The Forecasting Process. The company’s balance-sheet forecast is driven by the income statement forecast and cash settlement. The forecasting process consists of two stages, followed by a netting day.
In the first stage, FX contracts are executed on the last day of the month, and the following month is hedged by adjusting the existing contract positions. At this stage, the company analyzes the prior and current months’ positions (effectively two months’ worth of exposures). The initial hedges are executed to the monthly accounting rate, which is also set now.
In the second stage, balance-sheet actuals for the previous month are known by approximately the fourth business day of the month. Deviations between balance sheet forecast and balance sheet actuals, which are known on the seventh or eighth business day of the month, require an adjustment trade. Changes to the P&L forecast of the current month will also have an impact. This is when the “hedging of the hedges” typically occurs, which the manager said is happening with less frequency than before, due to better initial forecasting. However, the company won’t hedge the whole amount to make sure it’s not on both sides of the market.
Finally on netting day, maturing contract amounts (in local currency) get rolled to the next netting day. All contracts are valued on the same day and include two adjustments: (1) the maturing contract amounts are adjusted by additional cash settlement requests made by regional treasury service centers. The company does a swap to true up the position on about the 20th work day of the month and (2) “true ups” are based on new revenue and expense actuals. The rolled amount to the next netting day becomes the “existing contracts position” for the balance-sheet forecast.
For the sake of convenience, everything expires on the same day at the end of the month, although some things must be marked to market later, which leaves the company open to basis risk (e.g., when contracts expire 20 days after the cash deliveries). But the problem has not been quantified and does not seem material enough to address at this point.