To Hedge or Not to Hedge?

FX hedging is on the rise with more and more businesses in Asia doing business beyond domestic borders. With multiple strategies at their disposal for managing foreign exchange (FX) risks, what works best for businesses? John Chen of J.P. Morgan Treasury Services explores key approaches to managing FX risk and examines the objectives behind each approach.

Companies in Asia are increasingly pursuing a global agenda. As they do, a key consideration in taking their businesses beyond borders is how to effectively manage their currency exposures. The strategies that a business with global operations adopts depend on a number of factors. These include a company’s FX footprint and resulting exposure, their objectives in managing FX risks, the way competitors are managing their currency risks and the corporate view on future currency movements. But what are the main drivers behind popular FX strategies?

Different strokes for different folks

The best FX hedging strategies tend to be closely linked to the company’s overarching objectives. In formulating an FX philosophy, each business should consider the purpose of the program, as well as how it will be implemented and executed. The skill lies in the choice of a functional currency, in neutralizing the FX footprint and in allocating appropriate resources to minimize the FX risk.

The first step in creating an effective hedging strategy is to select a functional currency for the company. Many companies choose the currency in which they do most of their business. Some multi-entity companies have a number of different functional currencies, while other businesses decide to use the currency of the parent company’s domicile. The idea is to choose the option that most effectively reduces the level of exposure that ultimately needs to be managed.

Neutralizing the FX footprint

At the core of every company’s FX hedging strategy should lie a desire to achieve balance in its FX footprint. Purchasing contracts to hedge FX exposures should occur only after attention has been paid to balancing receipts, payments, assets and liabilities to reduce the currency risk. This might require additional contract negotiation as well as a review of regional and global operations to aggregate cash flows to reduce the FX program’s costs.

Allocating appropriate resources to minimize FX risk

Even after naturally balancing the FX footprint, most companies require a certain level of FX hedging. They need to take a comprehensive and incisive view of their FX exposures to identify which are relevant to the economic substance of the company. Importantly, there needs to be a distinction made between paper gains and losses versus actual gains and losses when determining the right FX strategy for the business, taking into consideration the amount of resources required to administer the relevant strategy.

How to hedge

So how should a business best manage its FX risks? The approach a company takes will depend on its objectives and the view it has on the currency or currencies to which it is exposed. Let’s take a look at four common strategies, the objectives of each strategy and why a company would adopt them.

1. The ‘do nothing’ approach

   As the title suggests, companies adopting a do nothing strategy leave their FX exposures unhedged. Some businesses take the view that over time, currency pairs’ movements cancel each other out and buying FX contracts means incurring unnecessary costs.

   One category of company – for example a Chinese business with exposure to the relatively weaker US dollar – on the right side of a currency pair might leave its positions unhedged. But this is an opportunistic stance, and may not serve as a sound fundamental platform for the formulation of a longer-term strategy, as this position has to be continuously monitored and re-evaluated based on currency movements.

   This is also a strategy employed by some multinational companies with global business operations, and investors who want to be exposed to the potential upside of the currency movements to which the business is exposed. To hedge away the FX exposure effectively caps this upside. An FX hedging program for businesses in this position can reduce investor appeal.

   Some businesses that can pass on the effect of currency movements on their operations to their consumers also choose not to hedge. In addition, companies in industries where hedging is uncommon might also be competitively disadvantaged by hedging FX exposures.

   However, companies with a ‘do nothing’ philosophy often hedge large capital expenditures, transactions around acquisitions and proceeds from divestitures to lock in one-off costs and revenue, but leave currency flows from normal business activities unhedged.

2. Hedging cashflow items

   In this approach, a company hedges committed and forecast non-functional cash flows over a particular time horizon, typically three, six or 12 months or longer. Companies adopting this strategy view their non-functional cash flow as the primary FX exposure that will have an economic impact on the business.

   The overall objective of this FX strategy is to lock down projected cash payments and receipts. FX contracts are purchased to hedge calculated monthly net flows, with maturities coinciding with payment dates. FX exposures arising from receivables are harder to manage because usually the business does not know when it will be paid.

   Under previous accounting rules (FAS 133 issued in June 1998 and the IAS39 which was amended on 16 June 2005 to allow for Hedge Accounting) some companies prefer to hedge only the committed or confirmed cash flows that appear on the balance sheets and are reluctant to hedge forecasted cash flows over a longer period because they will impact the balance sheet and lead to income volatility.

   Since the amended IAS39 accounting standard has been accepted by numerous countries, accounting standards have provided companies with the flexibility to book the period-end gains and losses on the hedging contracts into the ‘Other Comprehensive Income’ section of the balance sheet rather than to net income to reduce the profit and loss volatility caused by the period end translation of the hedging contract. Such flexibility is provided through the adoption of commitment hedge accounting, which will require considerable resources to administer. However, this still will not solve translational gains and losses arising from a revaluation of monetary items as a result of hedging.

3. Hedging balance sheet items

   Companies that hedge balance sheet items are concerned with hedging the translation of their balance sheet monetary items. The primary objective is to protect the company from translational FX gains and losses.

   Some companies that use a balance sheet hedging strategy are concerned about protecting their reported earnings per share (EPS), with translational gains and losses directly affecting a company’s net income and, therefore, its EPS. With this in mind, hedging balance sheet items is an approach sometimes used by listed companies operating in low margin industries.

   While most equity analysts will value a company using discounted cash flow, EPS is widely quoted and used as a ‘first cut’ to determine a company’s attractiveness. Having said that, analysts will also question the overall FX footprint of the business, and what a company is doing to manage the economic substance of exposures. Such scrutiny is more pointed when a company is caught in an FX footprint that is unfavorable in the context of point-in-time market conditions.

4. Hedge balance sheet and cash flow items

   Companies adopting this strategy will hedge balance sheet items as well as forecasted cash flows. In this approach, the company will attempt to lock down both its translational and transactional exposures.

   Companies that adopt this strategy will most probably adopt the new accounting standard that provides for commitment hedge accounting or be at risk of income statement volatility resulting from having to re-evaluate contracts.

   To use commitment hedge accounting, companies will have to undertake regular effectiveness testing, which will require considerable effort and resources. Together with the formulation of strategies to hedge the translational and transactional exposures, the amount of dedicated resources to administer such a program will be substantial.

Conclusion

There is no single ‘best practice’ FX strategy and the same company may use different strategies across different parts of the business. But there are numerous ways to streamline FX management. Many banks, like J.P. Morgan, offer auto FX conversion via online banking platforms to automate clients’ transactional flows and allow them to gain better visibility and control while moving funds around the world. It’s always prudent for corporates to talk to their banking partners to formulate an FX hedging strategy that best suits their unique requirements.

Contact information
John Chen
Vice President, Solution and Advisory
J.P. Morgan Treasury Services
Tel: +65 68827656
john.d.chen@jpmchase.com