This is the fifth in a series of posts designed to give a top-line overview of the steps to establishing and maintaining a balance sheet hedge program. Today, we’ll focus on ongoing performance reporting and analytics. You can see past entries at hedgetrackers.com/blog.
Above all else, a balance sheet hedge program is about risk mitigation – minimizing the volatility that foreign currency exposure can drive into a corporation’s P&L. Ideally, a highly effective balance sheet hedge program would make this number zero while only hedging the true economic risk of the company. Unfortunately, however, we don’t live in an ideal world; realistically, P&L volatility due to FX will never be zero, no matter how well-planned and executed the hedge program.
As such, performance reporting efforts should be focused on identifying the reason volatility is not zero, with twin goals:
- Providing robust answers to performance-related questions posed by executives
- Driving future improvements to the program by identifying the need for strategic shifts or transactional changes
At Hedge Trackers, we refer to this reductive analysis as “reconciling to zero” – why is the FX Gain/Loss not zero if we have a hedging program? Depending on the tools used to manage the hedge program, the data used for this process can come from a variety of sources – scraped from spreadsheets, exported from ERP/MRP systems or curated by automated tools.
Regardless of where the data comes from (or the effort required to acquire it), several key sources of hedge ineffectiveness should be examined. These include:
- Unhedged exposures
- Unhedged conversions
- Over/under hedging
- Hedge timing mismatch
- Forward points/premiums
- Residuals from special hedge accounting (ineffectiveness, excluded time value)
- Accounting errors (shadow balances, credit memos, etc.)
While a limited amount of FX-driven P&L volatility will be based on other factors, the listed sources account for the lion’s share of the difference from zero. As such, a thorough analysis of them – generated on a monthly basis – provides the heart of an effective balance sheet hedge program performance reporting strategy … one that provides usable insights, rather than simply numbers. Even more important, the analysis can be acted upon both organizationally (leading or lagging payments, adjusting transaction denominations, etc.) and through the use of financial instruments, providing maximum benefit for minimum cash outlay.
Understanding these sources of hedge ineffectiveness are key to responding to questions and maintaining program credibility. “Why did we have a gain (or loss) this period due to FX?” “Why weren’t we 100 percent hedged?” All are readily answerable with the right performance reporting package in place.
When it comes to understanding a balance sheet hedge program’s effectiveness, remember this: Zero is impossible. Striving for it alone is not the best use of Treasury’s time. Rather, the key is understanding what makes the number not zero and being able to generate the data and insights necessary to deliver maximum FX risk mitigation in future periods.