3.4 Hedging foreign currency risk

Foreign currency hedging strategies are crucial for companies dealing with international transactions. These strategies aim to protect against exchange rate fluctuations, using tools like forward contracts, futures, options, and swaps to minimize potential losses.

Hedge accounting principles play a key role in financial reporting for these strategies. Fair value hedges and cash flow hedges are two main types, each with specific accounting treatments that impact financial statements differently. Understanding these concepts is essential for managing currency risk effectively.

Foreign Currency Hedging Strategies

Purpose and Types of Hedging

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• Foreign currency hedging strategies mitigate risk of adverse exchange rate movements on company's financial position and performance
• Primary purpose reduces or eliminates potential losses from currency fluctuations in international business transactions
• Forward contracts exchange specific currency amount at predetermined future rate (provides certainty in future cash flows)
• Currency futures offer standardized contracts traded on exchanges (more liquid and easier to exit than forwards, but less flexible)
• Currency options grant right to buy or sell currency at specified rate (protects against adverse movements while allowing potential gains)
• Currency swaps exchange principal and interest payments in different currencies (typically used for longer-term hedging)
• Money market hedges involve borrowing in one currency and converting to another (creates synthetic forward contract)

Advanced Hedging Techniques

• Cross-currency swaps combine interest rate and currency swaps (manage both currency and interest rate risk simultaneously)
• Participating forwards provide downside protection while allowing partial upside potential (blend of forward contract and option)
• Compound options involve options on options (provide flexibility in uncertain market conditions)
• Natural hedging utilizes offsetting cash flows in different currencies (reduces need for financial instruments)
  • Example: Company with Euro revenues and Dollar expenses
• Dynamic hedging strategies adjust hedge ratios based on market conditions (optimizes hedge effectiveness over time)
  • Example: Adjusting hedge ratio as exchange rate volatility changes

Fair Value vs Cash Flow Hedges

Characteristics and Applications

• Fair value hedges protect against changes in recognized assets, liabilities, or firm commitments due to foreign exchange risk
• Cash flow hedges mitigate risk of variability in future cash flows attributable to particular risk in recognized asset/liability or highly probable forecast transaction
• Fair value hedges typically involve existing balance sheet items (inventory, fixed assets)
• Cash flow hedges often relate to future transactions or cash flows (forecasted sales, purchases)
• Fair value hedges measure both hedged item and hedging instrument at fair value with changes recognized in profit or loss
• Cash flow hedges recognize effective portion of hedging instrument gain/loss in other comprehensive income, ineffective portion in profit or loss
  • Example: Hedging forecasted foreign currency sales (cash flow hedge)
  • Example: Hedging foreign currency denominated debt (fair value hedge)

Accounting Treatment and Impact

• Fair value hedges affect income statement directly (changes in both hedged item and hedging instrument recognized in profit or loss)
• Cash flow hedges primarily impact other comprehensive income until hedged transaction occurs
• Choice between fair value and cash flow hedges depends on nature of risk being hedged and company's risk management objectives
• Fair value hedges require adjustment of hedged item's carrying amount for hedged risk changes
• Cash flow hedges accumulate gains/losses in equity, later reclassified to profit or loss when hedged transaction affects earnings
  • Example: Gain on cash flow hedge of forecasted sales reclassified when sale occurs

Hedge Accounting Principles

Qualification and Documentation

• Hedge accounting matches timing of gain/loss recognition on hedging instrument with hedged item (reduces income statement volatility)
• Strict criteria for hedge accounting qualification include formal designation and documentation of hedging relationship at inception
• Documentation requirements include risk management objective, hedging strategy, and method for assessing hedge effectiveness
• Hedging relationship must demonstrate high effectiveness both prospectively and retrospectively
• Effectiveness typically measured using statistical methods (regression analysis, dollar offset)
• Ongoing assessment of hedge effectiveness required throughout hedging relationship
• Discontinuation of hedge accounting if effectiveness criteria no longer met

Accounting Treatment and Disclosure

• Fair value hedges adjust carrying amount of hedged item for hedged risk changes
• Changes in both hedged item and hedging instrument recorded in profit or loss for fair value hedges
• Cash flow hedges record effective portion of hedging instrument gain/loss in other comprehensive income
• Ineffective portion of cash flow hedges recognized immediately in profit or loss
• Reclassification of gains/losses from equity to profit or loss when hedged transaction affects earnings
• Disclosures required in financial statements regarding types of hedges, hedged risks, and impact on financial position and performance
  • Example: Disclosure of fair value hedge of foreign currency denominated debt
  • Example: Disclosure of cash flow hedge of highly probable forecast transaction

Effectiveness of Hedging Strategies

Measurement Methods

• Hedge effectiveness measures degree to which fair value or cash flow changes of hedged item offset changes in hedging instrument
• Dollar offset method compares changes in fair value or cash flows of hedging instrument with hedged item over time
  • Example: Comparing $100 change in forward contract to$95 change in hedged receivable
• Regression analysis examines statistical relationship between hedged item and hedging instrument
  • Example: R-squared value of 0.8 indicating strong correlation between variables
• Value-at-Risk (VaR) approaches assess potential loss in hedged position
• Prospective effectiveness testing performed at hedge inception and ongoing basis
• Retrospective effectiveness testing conducted periodically to assess actual effectiveness during reporting period

Factors Affecting Effectiveness

• Basis risk arises from differences between hedged item and hedging instrument (different underlying assets or indices)
  • Example: Hedging Brent crude oil exposure with WTI crude oil futures
• Timing differences between hedged item and hedging instrument impact effectiveness
  • Example: Hedging 3-month forward sale with 1-month forward contract
• Credit risk of counterparties involved affects hedge effectiveness
  • Example: Deteriorating credit quality of swap counterparty
• Over-hedging or under-hedging can reduce effectiveness
  • Example: Hedging $1.2 million of exposure with$1 million forward contract
• Changes in market conditions or volatility may impact hedge effectiveness over time
  • Example: Sudden increase in exchange rate volatility affecting option hedge