Forecasting Balance Sheet Exposures

In order to mitigate foreign currency gains and losses, companies routinely hedge away currency risk associated with balance sheet exposures. Companies need to identify all monetary accounts on the balance sheet and aggregate the foreign amounts in those accounts.

A balance sheet exposure is a monetary account balance denominated in a currency other than an entity’s functional currency. Typical accounts (among others) that create balance sheet exposure include: foreign cash, accounts receivable/payable, tax receivable/payable and inter-company accounts.

When exchange rates change from one accounting rate to another for these types of balances, they generate unwanted gains and losses in company financials. These gains and losses are impacting earnings reflecting an expectation of their impact to future cash flows and are not merely a result of accounting practices.

We will discuss three key elements for balance sheet exposure forecasting: why you need to forecast balance sheet exposures, understanding transaction rate impacts when forecasting balance sheet exposures and how to better forecast balance sheet exposures.

Why Forecast Balance Sheet Exposures? 

Balance sheet exposure management is comprised of two key elements: Knowing how much to hedge and hedging it at a rate the hedged item is recorded.

Knowing how much to hedge starts with identifying “existing” exposures. The next step in balance sheet exposure management is to forecast “changes” in exposures. These are transactions related to monetary accounts that will occur in the current/upcoming month. Hedging existing assets and liabilities will frequently help a company substantially offset gains and losses, but additional precision requires insight into changing balances, the rates used to change the balances and control over substantial foreign currency conversions of the company. Increased precision further protects a firm’s cash flows and income statement from foreign exchange volatility.

If a forecast is not used, then changes to the total balance sheet exposure will be missed. The “miss” creates either an over- or under-hedged position, as the exposure balance has likely changed from the prior period-end balance. Any over- or under-hedged amount results in additional currency volatility. In an over-hedged position, treasury is actually creating risk for the organization, rather than mitigating it.

Understanding Rate Impacts When Forecasting Balance Sheet Exposures

Another important factor in managing exposures is to match the exchange rate on hedges with the rate at which new exposures come onto the books. Timely collection of data is critical to adjusting the hedge at an appropriate rate to offset the gains and losses on new transactions.

Forecasting the timing of exposure changes is an important part of the forecast, but it’s also sometimes overlooked. Timing in this case means the relationship between the new activity and the accounting rate that will be used to record the transaction.

For example, let’s assume a company uses a monthly average exchange rate to record new foreign currency transactions. Treasury would be wise to enter into forward currency hedges that approximate those transaction rates. That could mean hedging four times a month to approximate the average.

Now, let’s assume that the tax department records transfer pricing via inter-company at the end of the month, and accounting uses the last day of the month exchange rate to record inter-company. In this case, treasury could hedge inter-company on the last day of the month to approximate the inter-company exchange rate.

Overall, there could be one or more exchange rates for which the forecast needs to be allocated in order to match both the amount to hedge and the correct rate. Any timing or volume mismatches will result in ineffectiveness in the hedge program.

How to Forecast Balance Sheet Exposures Better

Capturing the change in monetary assets and liabilities can be difficult.

More often than not, many companies fail to accurately capture this change by asking entities to forecast the ending non-monetary balances of cash, AR, AP, Inter-co, tax and so on. Why? Because this is asking busy people to step away from their priorities and provide and forecast data that no one else in the company needs.

Treasury should align their data collection needs with the important information that’s already being forecast in the organization, such as sales, expenses and capital purchases. Changes to the exposure balances will likely result from a subset of this widely distributed data. For example, new foreign revenues will increase the net asset position and increase AR, and foreign currency expenses or capital purchases will increase the new liabilities and increase AP. This data is more likely to be higher quality, reviewed inputs of C-level decision makers.

The other key source of changes in exposure arises from conversions of currency. This anticipated conversion should not be part of the forecast, unless the conversion is executed at the same time as the Balance Sheet hedge execution. Hedges need to be closed out at the conversion rate — or as close as possible — to minimize FX noise. By leaving currency conversions out of the forecast, treasury can swap out hedges at the conversion date and rate.

Forecasting foreign denominated balances is both an art and a science.

The science portion of the forecast relies on transactions to derive new balances. For example, companies can use foreign revenue forecasts impacting accounts receivable changes to capture increases in asset positions. Inter-company transactions can be forecasted (or even known in advance) since the company controls these transactions. It is best practice to start with income statement activity to derive balance sheet exposure changes.

The artistic portion of the forecast includes taking seasonality, current economic conditions and institutional experience into account to formulate a forecast. For example, if the company is impacted by regulatory changes or an economic downturn, those factors may lead to a reduced forecast, versus the base case where all other factors are equal. Forecasting, therefore, becomes an iterative process that continuously narrows forecast errors over time.

Summary

Forecasting balance sheet exposures is essential to providing a good balance sheet hedge to offset currency risk. The best hedgers utilize income statement activity to forecast new monetary account balance changes. Good forecasters use both “facts” (FP&A forecasts and other sources, like the tax department) as well as “feel” (trending, seasonality or economic changes) to arrive at a final forecast. Matching both the amount of the hedge and the timing of the exchange rate provides the best chance to offset currency implications of balance sheet exposures.

You’ve gathered and forecasted your balance sheet exposures. Now it’s time to implement a comprehensive hedge program to mitigate FX risk — and secure your margins. Contact us today.