Actively Managing Your Balance Sheet Exposure Cycle

At a high level, an FX Balance Sheet Exposure Management program seems simple enough. You pull your exposures from one or more places, tally them up and hedge 100%. When your short-dated hedges approach maturity, you update the exposures and settle/roll your hedges to the next period-end date. Done! Or is it? What happens if you have to roll your hedges forward before you get updated exposures? What if your updated exposure amounts show changes that are suspect (sudden rises or drops)? How should you handle currencies that can be very expensive to hedge – and how do you weigh the trade-offs between paying that cost and leaving the exposure unhedged? What if you are hedging 100% but still getting FX noise at the end of the month? To overcome these devilish details requires a firm understanding of your exposure process, the players and systems involved and your approach to educating your stakeholders.  

The ideal balance sheet hedging program would eliminate all FX gain/(loss) flowing through to your P&L, but such a goal is nearly impossible to achieve. Instead, an effective strategy aims to significantly reduce FX noise while being able to explain any gain/(loss) that does occur. Getting there involves having clear direction in five key areas:

1. Hedging the right amount of your exposures.

Knowing that you’re hedging the appropriate amount of foreign currency exposure means starting with accurate current balances from all of your subsidiaries and the various ERPs your company uses. If you are trying to consolidate data across multiple ERPs (typical companies that we work with have two to four but some have 20 or more) and combine this with spreadsheets to determine your current remeasurable balances then getting an accurate picture of your existing balance sheet exposure can be a significant challenge. On top of this, if you run a monthly balance sheet hedging program as many companies do, you know that your current accounts payable and accounts receivable balances are going to change dynamically over the month, as will many of your other monetary assets and liabilities. If you follow the practices of roughly 40% of the firms we have spoken with and supplement your known balances with forecasted changes during the hedging period, your second step requires having confidence in the balance forecasts about how those exposures will evolve during the period. Finally, if you face exposure to emerging market currencies on your balance sheet, you have to weigh the costs and benefits of hedging exposures to less liquid currencies in addition to determining how to hedge your exposures to non-deliverable currencies. 

2. Hedging at the right time.

The way you manage your regular balance sheet hedging process makes a difference. If you wait until you have actual exposures at the beginning of the month before putting on balance sheet hedges, you are likely to be unhedged for the first several business days of the month until final bookings from all of your subsidiaries have been entered and confirmed. But if you hedge before verifying the current balances, you know that you will be either over- or under-hedged for a few days waiting for up-to-date information. Many companies choose to offset and roll their current balance sheet hedges at the end of the month and then enter new hedges several days later to true up the amounts once the starting period balances have been confirmed. Some corporations also choose to hedge based on anticipated changes to their balances during the month or even to conduct multiple mid-month adjustments. Decisions around how frequently to adjust hedges during the period are often influenced by whether balance sheet activity during the period will be booked using the beginning of period rate, the end of period rate, or some activity rate. Timing these initial hedges and any mid-period true up hedges requires careful consideration because it impacts the amount and the source of FX gain/ (loss) from the balance sheet hedging program.

3. Planning appropriately for cash conversions.

Even with your other balance sheet risks hedged, you still have to think about cash conversions expected during the period. If you have a cash balance in one currency that you’ve been carrying and remeasuring over time, when that cash converts to functional currency that will happen at the spot rate on the day of the conversion. Any difference between that day’s spot rate and the rate at which you’ve hedged that cash will result in some FX gain/(loss).

4. Thinking about balance sheet risk both locally and globally.

Are local subsidiaries charged with mitigating FX gain/(loss) on their books or do you focus on the consolidated results?

5. Understanding other sources of FX gain/(loss).

The rates used to record and remeasure your monetary assets and liabilities – your starting and ending period rates and your activity rate – likely differ from the rates used to value your derivatives – the market spot rates and forward rates as well as any impact from credit value adjustments.

Effectively managing FX risk on your balance sheet can be challenging, especially because the results show up directly on your financial statements and, therefore, have to be explained when there are significant swings in FX gain/(loss). The right combination of a sound process and an effective system can help remove some of the stress and guess work from this process.

ChathamDirect is a groundbreaking Treasury Risk Management and hedge accounting platform that supports foreign exchange, interest rate and commodity hedging programs. ChathamDirect provides a clear view of your entire hedging program, including cash flow forecasts, balance sheet exposures and hedge requests—all securely available on a leading SaaS platform. ChathamDirect is backed by Chatham Financial, an employee-owned, independent market leader with a global team of capital markets experts, risk management advisors, CPAs, lawyers, quantitative analysts and technology developers who serve more than 2,500 clients annually.

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