How to increase FX hedging capacity while maintaining hedge accounting

In volatile markets, companies face various challenges as they look to expand in foreign markets and diversify supply chains, all while managing financial risk. Senior leadership continues to call on treasury teams to come up with creative risk management solutions to mitigate volatility in earnings due to currency risk.

Senior leaders commonly ask treasury teams to either hedge higher volumes or more currencies. At the same time, achieving hedge accounting remains a priority to shield the income statement from unwanted volatility and align economic objectives with financial reporting. Several accounting strategies exist, many made popular as a result of the revised hedge accounting guidance (ASU 2017-12), which may enable your organization to hedge more economically while still achieving the benefits of hedge accounting.

Intentional over-hedging

One strategy seen in practice that allows for increased hedge volumes is intentional over-hedging. With this strategy, your organization enters into a derivative contract for a notional amount in excess of the amount of the underlying hedged transaction. For example, consider a U.S. firm with a sales forecast of 15 million EUR per month. Due to the current economic environment, the firm does not have a great deal of certainty around its sales forecasts. Therefore, it decides only to hedge 60% or 9 million EUR per month of its forecast considering this is the amount that is probable of occurring and the amount that can qualify for hedge accounting. Unfortunately, this does not get the firm to its desired level of economic risk reduction. If applying the intentional over-hedging strategy, the firm may hedge, for example, 10.5 million EUR per month which is now 70% of its forecast, and designate the trade against 9 million EUR of exposure while still qualifying for hedge accounting, unlocking 10% of additional capacity for the organization.

A company can intentionally over-hedge so long as the hedge relationship will still be highly effective at offsetting the hedged risk, which in practice is between 80% and 125% effective. ASU 2017-12 changes the timing of the recognition of the earnings impact of cash flow over-hedges. The effects of cash flow over-hedges were previously deemed ineffective and were recognized in earnings immediately. Now, given that ineffectiveness is no longer separately measured or presented, what was previously ineffectiveness is now initially recognized in Other Comprehensive Income (“OCI”). Therefore, it is reclassified to earnings at the same time as the underlying hedged transaction.

Accounting implications

Of course, like many favorable strategies, this one also comes with an additional layer of complexity in that a simplified method of applying hedge accounting is not appropriate. Critical terms match is a method of hedge accounting that, in certain circumstances, simplifies the hedge effectiveness assessment. When the critical terms of the hedging instrument and the hedged transactions are the same, the changes in cash flows from the derivative can be viewed as a proxy for the change in cash flows of the hedged transactions, thus eliminating the need to perform an assessment of effectiveness quantitatively. This method is intended for hedges considered “perfectly effective.” Given that, when utilizing the intentional over-hedging strategy, the derivative notional is more than the amount of the underlying hedged transaction, this method is inappropriate and you must utilize a long-haul method.

The most common long-haul method utilizes regression analysis to assess effectiveness. A company utilizing the intentional over-hedging strategy can use regression analysis as a statistical method of assessing effectiveness, proving out each quarter quantitatively that the hedge relationship remains highly effective. Consider employing technology to perform regression analysis, which can serve to make this strategy scalable. This typically lowers the overall audit risk of applying hedge accounting as the quantitative test is easily determinable and does not require judgment or documentation of qualitative assumptions.

Flexibility and increased hedge accounting capacity were important to Nike, and they found it with Chatham. Ryan Boos, Director of Treasury Accounting at Nike, said, "Utilizing a strategy that designates an entire trade against a lower exposure has allowed us to increase our overall hedge percent while still maintaining the same level of risk of being over-hedged. Moving from critical terms match to a long-haul effectiveness testing approach, however, we realized that our current system was unable to fully support the necessary regression analyses. Thus, in order to quickly implement this strategy, we partnered with Chatham who performs the required regression analyses and provides us the results of such tests. Increasing our hedging percentage has, and will continue to have, a significant impact on our ability to mitigate an even greater amount of risk."

Documentation

Another critical factor in ensuring this strategy’s success is proper documentation. Documentation at inception of the hedging relationship is paramount and serves as a playbook for your company’s risk management objective and strategy, along with how you will assess effectiveness at inception and on an ongoing basis. Documenting your organization’s intention to over-hedge is important. It serves to avoid the potential assumption that your organization does not exhibit the ability to accurately forecast, which may preclude the application of hedge accounting.

Although complexities exist in setting up and administering this strategy, the benefit of intentionally over-hedging is clear: hedge to greater economic levels while still achieving the benefit of hedge accounting.

Additional strategies

Additional strategies are available to help your organization hedge more economically despite seasonality and other forecasting issues. These include utilizing the spot method or rolling exposure windows. With both strategies, rather than over-hedging a given month’s forecast, your company can look to expanded time horizons for hedged transactions to occur so long as you document the strategy and test the timing difference appropriately. With proper education and tools, these methods serve as beneficial alternatives to the more traditional hedging programs utilizing a critical terms match approach.

Making informed decisions

These strategies require time to understand and implement, but the benefits they provide may allow your organization to mitigate additional risk during this global crisis and far beyond. As the world’s largest and most experienced independent financial risk management advisor, Chatham Financial can empower your team to make informed hedging and hedge accounting decisions that achieve your objectives.

Chatham Financial corporate treasury advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.