In some respects, Treasury has a dual burden where Balance Sheet hedging is concerned. Not only does the typical Treasury professional need to understand currency markets and derivatives, but he or she is often responsible for explaining the results of a hedge program – which are almost 100 percent dependent on the way in which transactions are recorded at their firm.
A “good” Treasury professional will try to gather the right exposures and exposure forecasts for Balance Sheet hedging. They might have a relatively solid understanding of the business model, seasonality and other aspects of the business. But to truly move from being an average to a great hedger of Balance Sheet risk, one needs to fully understand the subtle nuances impacting that exposure type.
We’ll start with a quick anecdote. A company once hedged a BRL-denominated tax liability on a U.S. set of books. This sounds reasonable since a tax liability is a monetary liability for which re-measurement should be applied and an FX gain/loss should have resulted. When analyzing the performance of that hedge, it was quickly realized that the derivative performed as expected, but there was no offset from the exposure. As they dug into the reasons why the liability had not been re-measured, it turned out that this particular exposure belonged to the Brazilian (local functional) subsidiary and the amount was accrued in the U.S. on its behalf. So what was thought to be a Balance Sheet exposure turned out not to be at all. We share this example as a reminder that even when you have identified the exposures for your company, a complete understanding of the risk profile is needed to become “great” at hedging it.
When hedging certain Balance Sheet exposures, there are several common pitfalls avoid. A good example of this is a foreign-denominated accrued liability. This is an exposure that needs to be hedged, but the reversing nature of an accrual can throw the hedge’s performance (or perception thereof) off. When an accrual is Balance Sheet hedged, the change in value of the derivative from the hedge rate to each month end’s balance sheet rate impacts the FX gain/loss line. The rules for the accrual should be the same. What we see happening, however, is that the accrual typically reverses out and is re-booked at a new rate in the following month. The result is that the change in rates on the accrual becomes pushed from FX into operating expense, while the offsetting derivative continues to impact the FX line. Treasury either needs to explain this “geography” miss (a difficult proposition) or work with Accounting to maintain an appropriate accrual exchange rate.
A ghost or shadow balance is another key miss. Nearly all companies encounter this at some point. A shadow balance is a balance in the ERP system, like a VAT payable in EUR that was cleared in another currency, such as USD. In this case, if one were to pull exposures by transaction currency, the EUR payable would look like it still existed. It might even be hedged by Treasury… but hopefully not, because that exposure would be gone and it would be a closed transaction.
The result of hedging a shadow balance is that the company begins risking real cash flows on closed transactions via derivative settlements. Even if the company doesn’t hedge the closed exposures, EPS is probably wrong due to unnecessary re-measurement. Performing an analysis of risky accounts is the best way to go from good to great. Accounts such as receivables, cash accounts and VAT accounts (among others) are susceptible to having a shadow balance. By running a trial balance by transaction currency, one can spot large credits in one direction and currency and large debits in another; a telltale sign of shadow balances. To be great, Treasury needs to understand this concept and help Accounting clear those old balances. For accounting to be a great partner, they should be reconciling account balances by currency.
Finally, to truly be exceptional, there needs to be a feedback loop in reporting on the hedge results. There also needs to be a solid understanding of the reasons for residual FX gain/loss when the risk was thought to have been hedged away. We suggest an attribution analysis to uncover the size and sources of any “misses” in the hedge program. Examples include forward points, under- or over-hedging and material un-managed currency conversions. There are two ways to achieve this level of performance reporting. The analysis can be processed by hand, which can be exhausting and time consuming, or technology, such as CapellaFX, can be leveraged to help quicken and ease the analysis. Either way, knowing exactly why there is residual FX gain/loss is a key driver to improving the hedge program in the next hedge cycle and beyond.