Foreign exchange is a complex subject matter which impacts spending, cash repatriation, and perception. The important thing is to distinguish between foreign exchange issues that can have a real cash impact versus ones that impact reporting and accounting metrics.
Transactional exposures are those that occur as a result of a cash outflow or inflow in a foreign currency that are measurable and known. Hedging transactional exposures is beneficial and recommended, as knowing the cash inflow or outflow will assist in budgeting, pricing and cash flow estimation.
However, prior to hedging, the company should assess the following:
(1) Can the exposure be naturally hedged?
Naturally hedging the exposure means matching the outflow with an inflow in the same currency and vice versa. When doing this, timing of the expected outflows and inflows must be considered. Any amount that can be naturally hedged avoids the implicit costs associated with hedging such as having to set up a hedge facility with a bank and avoids the explicit costs of having to pay for the bank’s spread on the spot rate, and the forward points.
Frequently divisions of the same company will transact using different currencies, but often the divisions will not speak to one another. As such, although revenue is received by division A in a currency that division B could use for purchases, the natural movement of currency from one division to the other does not happen. This leads to unnecessary explicit and implicit costs for each division as they each attempt to mitigate their exposures by hedging them externally. These costs can be removed completely if the company’s treasury department acts as the bank and issues forward contracts for the divisions.
(2) If the exposure cannot be naturally hedged, then hedge the exposure with a counterparty. However, first assess:
a. What is the size of the hedge?
Prior to hedging, the company must determine if the benefits of hedging outweigh the costs. For an amount that is considered immaterial the costs will always outweigh the benefits.
b. What is the timing of the hedge?
For exposures that are maturing quickly, the volatility of the foreign currency must be considered. The benefits of hedging an involatile currency pairing for a 1-week, may not outweigh the costs.
Translational exposures are those that occur as a result of having foreign currency on the balance sheet, which when translated, impact the company’s income statement. Although these exposures are easy to identify and hedge, they will be reversed at the beginning of the next period and have no economic impact to the company.
Let us take an example of a company that must, for lender purposes, create quarterly financial statements. For simplicity, let us assume the following:
The company’s functional currency is USD.
The company has cash of 1,000,000 CAD.
The exchange rate when the cash was deposited was 1.20 USD/CAD.
The balance of the company’s cash on the balance sheet is $833,333 USD.
A the end of the next quarter, the exchange rate is 1.25 USD/CAD
The result of the assumptions is the following journal entry at the quarter end:
Dr. Foreign Exchange Loss $33,333
Cr. Cash $33,333
If the cash is not converted into USD at the end of the quarter, then this foreign exchange loss that was created has no economic impact to the company. However, covenants, shareholder requirements and bonuses often rely on net income as a measure of performance, which will be skewed negatively or positively by foreign exchange gains/losses. As such, companies who use net income as a metric for their performance, will seek to remove any losses associated with foreign exchange by entering into hedges that reduce these translational losses.
However, not only are there are explicit and implicit costs of hedging, but a company must generate a real loss to offset a paper gain and vice versa. Incurring costs to hedge an exposure that has no economic impact to the company is penny wise, and pound foolish. Thus, it is recommended that trades used to hedge the balance sheet should never be entered into.
Hedging and optics
One must be cognizant of management’s sensitivity to movements in the income statement as a result of foreign exchange.
To manage this sensitivity, one must first establish a hedging policy for the company, and then educate management on the goals of the hedging policy which is to reduce real transactional exposure while minimizing costs.
"Once there is a decoupling of performance-based compensation and foreign exchange gains and losses, management's buy-in will be swift."
Educating management will be easier if there is buy-in of the hedging policy from the company's investors and lenders.
This can be done by moving away from using metrics such as net income to ones that sit above “foreign exchange gains and losses” such as: EBITDA, adjusted EBITDA, Gross Margin etc. In addition, once there is a decoupling of performance-based compensation and foreign exchange gains and losses, management’s buy-in will be swift.
Keep in in mind the following when hedging:
No hedge is perfect – some hedges will result in losses, and some in gains. Once a hedge is entered into, do not look back at how it performed. The main objective is to lock in a cash inflow/outflow for certainty. Set it and forget it.
Revisit your hedge policy frequently. As the company changes, the hedging requirements will also change.
Do not be afraid to tell a trader to slow-down. Traders talk fast and trade faster. Take your time.
The cost of hedging is real – do not be tempted to pay for a hedge that has no real economic benefit.
Move away from metrics that include translational gains/losses – these will only lead to quarter by quarter movements that are not indicative of the company’s true performance.