abc medical - fx management
TRANSCRIPT
RECOMMENDATIONS REPORT:
ABC Medical Company
Prepared for:
ABC’s Treasury Department
Prepared by:
Michael Harris
August 4th, 2015
EXECUTIVE SUMMARY
Recommendations Report for ABC Medical Company
Prepared by Michael Harris
Volatile and unpredictable currency markets have caused unnecessary noise to ABC Medical
Company’s financial statements. The recently strengthening United States Dollar (USD) has
caused losses to net income for ABC and has decreased the earnings per share of its
shareholders. Although this effect has been, and continues to be, relatively immaterial to its net
income and earnings per share, it is important to consider in a company’s FX policies.
Additionally, with ABC’s active international expansion, it is becoming subject increasingly to
new and larger foreign currency exposures on a corporate and subsidiary level. The proper
foreign currency (FX) policies and practices will help mitigate exchange rate risk and cost, while
neglecting these practices will result in swings in ABC’s financial statements. A proper FX
program will allow ABC to actively manage its core business practices without worrying about
the effects of the FX market.
A major strength of ABC is its choice in subsidiary location. With recent acquisitions it has a
large presence in China whose currency is not volatile. This allows it to transact in a country
with promising opportunities for business expansion that also has little FX risks. ABC’s large
quantity of transactions, and the size of those transactions, allow it to get competitive pricing that
rivals corporations much larger than ABC. Additionally, its centralized treasury allows it to save
not only on its transactions, but in management costs. This strong centralized treasury will
provide a base for the execution of additional FX practices that will bring additional benefits to
the firm.
The largest weakness keeping ABC from mirroring its larger competitor’s FX practices is its
absence of a hedging program. To start a hedging program it will need to be comfortable with its
visibility into its exposures. It can do this through an automatic report from its Enterprise
Resource Planning (ERP) system, or through its subsidiaries reporting its individual exposures.
With both an automatic report and with each entity reporting its exposures, great care should go
into verifying the integrity of the data on an ongoing basis including verifying the rate exposures
were posted at.
ABC will needed to ensure the costs of the hedge are minimized. The cost of the hedge is
measured by the forward points, market spread and minimizing the volume traded. Similar to
pricing is the timing of the hedge. ABC will need to check for changes in its FX exposures on
daily basis to ensure its hedge is capturing all of its exposure. It should only hedge if the net
change in its exposures are above predetermined threshold. If ABC does not do this, it can expect
larger inefficiencies in remeasurement.
In addition to maximizing the trading portion of its exposures, it will need to utilize hedge
accounting treatment to properly reduce the noise on its financial statements. For forecasted
transactions and firm unrecognized commitments above 2 million United States Dollars (USD),
it should hedge those items and classify it as a cash flow hedge. For all other exposures, ABC
will hedge it once it is stated on the financial statements. By following this model, ABC will
reduce gains and losses due to forward points and to posting and trading at different spot rates.
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Recommendations Report for: ABC Medical Company Prepared by Michael Harris
INTRODUCTION
Since its inception, ABC Medical Company1 has emerged as a global leader in diversified
medical technologies. A key component to its growth has been its merger and acquisitions
practices, especially in international markets. This has allowed it to effectively enter into new
global markets and obtain new product offerings. Growth in international markets introduces
new risks for companies, primarily FX risk. FX risk management will primarily effect both the
accounting and treasury functions of a company, but will reach into purchasing, sales, and the
finance functions of a company. How companies manage the risks that are associated with
international growth greatly influences profitability, efficiency and ability to continue expansion.
Since 2011, ABC’s main acquisitions that have exposed it to FX markets have been International
Subsidiary Co., and Beijing Subsidiary Company in China, and the multinational corporation
International Subsidiary, Inc. based out of San Diego.2 The two Chinese acquisitions has given
ABC a considerable market share in the Chinese market, which market share is a core strength.3
The acquisition of International Subsidiary, Inc. not only increased its product offerings, but it
also increased the sales basis and distribution network for the company worldwide. ABC has
subsidiaries throughout the world, with functional currencies of the Great British Pound (GBP),
Euro (EUR), Swedish Kroner (SEK), Australian Dollar (AUD), Chinese Yuan (CNY) and
Japanese Yen (JPY).4 It also has manufacturing facilities in Germany, England, Canada, and
China, leading to additional exposures in EUR, GBP, Canadian Dollars (CAD) and CNY.5
During fiscal year 2014 twenty-five percent of all sales were outside of the United States.
The company has a central treasury function that moves trades through the market. Since its
treasury is strongly centralized it is able to net exposures together and reduce volume out of the
market. The ability to net like currency pair exposures gives ABC a cost advantage when trading
currencies. Once it starts a hedging program it can expect is earnings to stabilize and the firm’s
value to increase.
1 This report was originally written for a writing class I attended during the summer of 2015. The subject of this paper was a multinational company whose treasurer, after reviewing the paper, asked that I remove content that put the company’s foreign currency practices in a negative light. Additionally, she asked that I make the company, and its subsidiaries anonymous. To comply with her wishes I made the changes and as such some of the references are inaccurate. If the reader wishes to have the original references, or has any questions and comments, please contact me at [email protected]. References to ABC Medical Company, and its subsidiaries, are now purely fiction and any existing companies with the same names are purely incidental. 2 MarketLine, “ABC Medical Company MarketLine Company Profile”, February 2015, Business Source Premier,
EBSCOhost, accessed on July 12, 2015 3 MarketLine, “ABC Medical Company SWOT Analysis”, February 2015, Business Source Premier, EBSCOhost,
accessed on July 12, 2015 4 MarketLine, “ABC Medical Company MarketLine Company Profile” 5 ABC Medical Company 2014 10-K, <http://investors.ABCMedical.com/index.php?s=127&year=2015&cat=2>,
accessed on July 12, 2015
2
STRENGTHS
Subsidiary Locations
One of the strengths of ABC’s FX portfolio is its large exposure to the CNY. For decades
leading up to 2010 China pegged its currency’s exchange rate to the USD, at which time it has
then pegged its currency to an undisclosed basket of currencies. Even though the CNY is no
longer pegged to the USD, China still maintains a “dirty float” and there is very little movement
in the exchange rate when compared to other major currencies.6 This beneficial for ABC because
it has a lower risk of price movements, meaning if it has an exposure to CNY on its balance
sheet, there is little risk of it drastically changing its value.
This “dirty float” has manipulated the USD/CNY exchange rate so that the CNY is highly
undervalued. Some estimates have the CNY undervalued by 30% - 40% within the last two
decades.7 An undervalued CNY will result in a general increase in sales in China due to
increased exports, however, it will also reduce the amount of profits repatriated back to ABC’s
headquarters. This is because it will take more CNY to purchase the same amount of USD. For
ABC specifically, an undervalued CNY is both positive and negative. For expansion in China it
is very beneficial because it becomes cheaper to invest into new companies or expand existing
operations. This is negative, however, for repatriating funds back to headquarters.
From a risk management perspective, having a Chinese presence is an advantage because the
currency is not very volatile against the USD (see Figure 1) but ABC still is able to increase its
foreign market share. Although the company is still exposed to FX risk, including laws making it
difficult to move money in and out of the country, the low volatility smooths out transaction
gains and losses, and makes FX gains and losses more predictable. Part of any sophisticated
corporate FX policy is the consideration of which countries will increase earnings while keeping
risk at a minimum.
6 Heikki Oksanen, “Re-pegging the renminbi to a basket: issues and implications”, Asian-Pacific Economic
Literature, Vol. 26 Issue 1, May 2012, p18-33, Business Source Premier, EBSCOhost, accessed on July 13, 2015 7 Bob Davis, “Undervalue/Overvalue: The Great Yuan Debate Continues”, The Wall Street Journal, May 13th, 2014, <http://blogs.wsj.com/chinarealtime/2014/05/13/undervalueovervalue-the-great-yuan-debate-continues/>, accessed on July 31st, 2015
3
Figure 1:8
The USD/CNY exchange rate’s volatility (orange) is compared to the EUR/USD exchange rate’s volatility (blue)
China’s laws that restrict movement of money into and out of China have been lessened with the
recent introduction of a new offshore currency, the CNH. The introduction of the CNH allows
foreign companies to actively buy, sell and hedge the CNY though the CNH. The two currencies
are highly correlated, and transactions between the CNY and CNH are easier than between the
USD and CNY. Because the CNY is often a “Non-Deliverable Currency” for hedging purposes
and the CNH is not many companies are utilizing the ability to hedge CNH and then converting
directly into CNY. With the introduction of the CNH ABC is better able to manage its risk and
cash flows into and out of China.
Large Volumes Traded
Another strength to ABC’s FX policies is the volume it transacts on an annual basis. The
company uses a platform in which it competitively bid its transactions between multiple
counterparties. Through this trading platform it is able to competitively bid its exposure to its
different providers. When a company bids out its exposures it usually receives very tight pricing
from its counterparties.
Its current practice is for the corporate treasury to transact all exposures over a nominal amount.
This is beneficial from a practical standpoint because it allows the corporate treasury to net
exposures together and bring larger trades to the market. Because it is able to trade these large
exposures, its counterparties will give better rates. Having a nominal threshold also reduces the
amount of work required for the central treasury. If the treasury were to manage all of its
subsidiaries’ exposures, regardless of size, it would then start to over work itself. The cost for the
central treasury to trade small nominal amounts is not worth the price savings.
Additionally, with larger volumes companies will usually have the ability to net like currency
pair exposures together. This allows a company with a subsidiary that needs to buy EUR and a
subsidiary that needs to sell EUR to reduce volume by combining the inflow and outflow of EUR
together and only trading the difference. This practice will take unnecessary volume out of the
market so that the company is not paying the bid/ask spread on the smaller amount.
Historically ABC has had large cash reserves which is beneficial for many different reasons. It is
particularly beneficial for firms who are actively trading amongst many different counterparties
and for firms that are hedging. Typically when a firm is trading among many different
counterparties it can require large outflows and inflows of cash to settle various spot and forward
contracts. Additionally, if the company is hedging exposures, and swaps the contracts to a later
date, it can expect large settlements with each bank. If ABC pursues a hedging program its large
cash reserves will provide the crucial liquidity required to settle with its counterparties.
Centralized Treasury Management
8 “USDCNY Spot Exchange Rate,” Bloomberg Business, Five Year Graph,
<http://www.bloomberg.com/quote/USDCNY:CUR>, accessed on July 29, 2015
4
Another strength of ABC’s FX management practices is its strong centralized treasury program
that manages all of its and its subsidiary’s FX exposures. One of the world’s best examples of a
properly functioning centralized treasury programs is that of one of ABC’s competitors, GE
Heathcare. GE Healthcare’s FX exposures are all managed by its parent, General Electric (GE).
GE has an award willing team of treasury professionals that manage FX exposures for every
subsidiary with an annualized cost savings of roughly $10 million.9,10 GE even bought several
banks to more fully utilize its treasury function.
GE’s centralized treasury manages all cash balances and risk that each of the subsidiaries are
exposed to. The benefits are twofold. Not only does it allow for cost savings by consolidating the
practice in one location, but it allows a single group to become experts and implement best
practices amongst the firm’s subsidiaries. The risk of having a decentralized treasury is that
subsidiaries might not implement best practices. ABC’s corporate treasury function currently
manages all of its subsidiary’s FX exposures.
Centralizing the use of derivatives is important if ABC pursues a hedging program. In his
research, Håkan Jankensgård finds that centralizing the use of derivative contacts will increase
firm value by 15% over those who have a decentralized hedging policy.11 This is due to the gain
in scale of pricing power and natural hedges inherent in the company’s exposures. Hedge
accounting treatment allows a centralized treasury to trade the net exposure with a counterparty
and issue internal derivatives for each of its subsidiaries. This allows for a strong centralized
treasury while allowing each subsidiary to have specific hedges to properly offset its exposures.
If ABC can aggregate all derivatives and trade the contracts at one location it can negotiate
smaller spreads from its counterparties. Additionally, if each subsidiary location enters into spot
or derivative contracts separately, it will book offsetting contracts, thus putting the company on
both sides of the bid/ask spread.
WEAKNESSES
Hedging
ABC does not engage in any hedging activities,12 although it has done so it the past.13 Recently
with a strengthening dollar many US corporations, including ABC, have blamed “currency
headwinds” as the cause of diminishing profits.14 Hedging those exposures would have protected
its earnings and resulted in minimal FX gains and losses. All FX exposures can be mitigated
9 Treasury and Risk Management, “GE’s Treasury Strategy”, April 2001, Business Source Premier, EBSCOhost,
accessed on July 12, 2015 10 Treasury and Risk Management, “FX Power: General Electric Co.”, November 2008, Business Source Premier,
EBSCOhost, accessed on July 12, 2015 11 Håkan Jankensgård, “Does Centralisation of FX Derivative Usage Impact Firm Value?”, European Financial
Management, Vol. 21 Issue 2, March 2015, p309-332. 24p., Business Source Premier, EBSCOhost, accessed on
July 13, 2015 12 ABC Medical Company 2014 10-K, <http://investors.ABCMedical.com/index.php?s=127&year=2015&cat=2>,
Page 26, accessed on July 12, 2015Ibid. 13 ABC Medical Company 2006 10-K, <http://investors.ABCMedical.com/index.php?s=127&year=2015&cat=2>, Page 46, accessed on August 5, 2015. 14 ABC Medical Company, “ABC Medical 1QFY15 Financial Results Conference Call Prepared Remarks”, January
28th, 2015, accessed on July 30, 2015
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through a hedge resulting in reduced earnings volatility. Losses to do “currency headwinds”
result in actual losses to net income and earnings per share, which losses are completely
manageable.
The goal of hedging is to reduce risk and is never speculative in nature. Firms that use
derivatives for speculative purposes loose the confidence of its investors and can quickly accrue
large losses. A firm should have rules in its FX policy as to when to hedge, which hedges are
appropriate and when to stop hedging. A firm may use option contracts to reduce losses and
maximize gains, however, it should be within the guidelines set forth in the FX policy.
A perfect hedge will protect ABC from all losses and allow for unlimited upside potential in
gains. Option contracts are ideal hedges, although sometimes it is expensive and requires a
capital exchange upfront. Future contracts are poor hedges because it requires continual capital
adjustments into and out of margin accounts. Forward contracts produce the same results as
future contracts but without the constant capital adjustments. Additionally, currency swaps are
another viable option to hedge currency exposures, but are “a series of forward contracts
packaged together.”15 A viable strategy is to use forward contracts to initialize a hedging
program and when ABC receives a large settlement from swapping out of its exposures, to use
that settlement to purchase option contracts. This would provide a transition for ABC to hedge its
exposures through option contracts through additional capital it has received from favorable
market positions. It would also allow it to lock in a more favorable rate while still allowing for
upside potential.
Multiple sources have found that hedging FX exposures will reduce exchange rate risk,16 and
will tend to increase firm value.17,18 Similar research also finds that “firms with strong corporate
governance use derivatives in a way that is beneficial to firm value and therefore adds to the
nascent literature on the channels by which corporate governance increases firm value.”19
Research outlines that “derivative use… is beneficial to firm value,” not when a firm speculates
or pursue management’s self-interests, but when it hedges known exposures.20 When hedges are
focused on known exposures it tends to reduce earnings and cash flow volatility.
ABC’s top competitors hedge its exposures. Phillips Heathcare, a direct competitor based out of
Europe, hedges just over 93% of all its foreign currency exposures.21 More specifically, Phillips
15 TCX The Currency Exchange Fund, “Fx Forwards and Cross Currency Swaps”, <https://www.tcxfund.com/products/fx-forwards-cross-currency-swaps>, accessed on August 4th, 2015 16 Feng-Yi Chang, Chin-Wen Hsin, Shin-Rong Shiah-Hou,“ A re-examination of exposure to exchange rate risk:
The impact of earnings management and currency derivative usage”, Journal of International Economics, Vol. 87
Issue 1, May 2012, p65-79. 15p., Business Source Premier, EBSCOhost, accessed on July 13, 2015 17 Håkan Jankensgård, “Does Centralisation of FX Derivative Usage Impact Firm Value?”, European Financial
Management, Vol. 21 Issue 2, March 2015, p309-332. 24p., Business Source Premier, EBSCOhost, accessed on
July 13, 2015 18 Francisco Pérez-González, Hayong Yun, “Risk Management and Firm Value: Evidence from Weather
Derivatives”, Journal of Finance, Vol. 68 Issue 5, October 2013, p2143-2176, Business Source Premier,
EBSCOhost, accessed on July 13, 2015 19 George Allayannis, Ugur Lel, Darius Miller, “The use of foreign currency derivatives, corporate governance, and
firm value around the world”, Journal of International Economics, Vol. 87 Issue 1, May2012, p65-79. 15p., Business
Source Premier, EBSCOhost, accessed on July 13, 2015 20 Ibid. 21 Phillips Heathcare. 2014 20-F,
<http://www.philips.com/about/investor/financialresults/annualreports/index.page>, accessed on July 14, 2015
6
utilizes hedge accounting under IFRS 9 which allows it to put unrecognized gains and losses in
other comprehensive income to smooth out earnings, and to gain visibility into future gains and
losses at the onset of the hedge.22
Companies like ABC cannot limit its business dealings in only one currency. Not only does ABC
have subsidiaries around the globe, it has many business partners and clients who transact in
different currencies than ABC. Having the ability to competently transact in multiple currencies
establishes credibility in international markets, and can increase a company’s customer base.
Offering clients the ease of use to transact in its functional currency is important to any
multinational company wishing to satisfy its foreign customers. Hedging these exposures is
critical towards maintaining a global presence.
With increased visibility through an ERP report, ABC will know what exposures it needs to
hedge, both on a corporate and subsidiary level. Typically intercompany exposures are
reasonably visible to a company’s headquarters and are typically one of the first items hedged.
This is also beneficial because hedging intercompany FX exposures receives special hedge
accounting treatment that is not afforded to other derivatives and their underlying exposures.
RECOMMENDATION - Implement a Hedging Program
Background and Rationale
In this recommendation section, when hedging is referenced to it is in the form of forward
contracts. ABC may also hedge with option contracts, however, option contracts are less
traditional to hedge balance sheet exposures. Additionally, option contract usually require an
exchange of cash on the onset of a hedge, which would become burdensome to manage with a
comprehensive hedging program, as is described here. Option contracts are a viable option if it is
used to hedge a balance that will not change and ABC is willing to pay a premium for the option
contract.
The two areas ABC will protect with a hedging program are its earnings and its cash flows. Its
earnings will be protected because its assets and liability will have offsetting exposures that will
reduce the impact of rate movements. If ABC hedges its exposures, it will protect its cash flows
because ABC can plan with certainty what rate it will use when it settle its contracts.
Hedging will affect many areas of ABC’s practices, including banking relationships and
accounting. Creating a FX policy that covers its FX hedging practices is completely achievable
at minimum costs. Typically, the biggest obstacle for a company obtaining an efficient FX
hedging program is the lack of knowledge and experience and a corporate culture that is averse
to change.
There are four distinct categories for hedging purposes and each one can receive different
accounting treatment: 1) Payables and receivables denominated in a foreign currency, 2) firm
unrecognized commitments in other currencies, 3) highly probable, or forecasted, transactions
denominated in a foreign currency, and 4) net investments in foreign subsidiaries.
22 Robert G. Rambo, Daphne Main, Louis Beaubien, “Reducing reporting risk Designating foreign currency forward
contracts as cash flow hedges”, Journal of Accounting Education, Vol. 29 Issue 4, December 2011, p284-294. 11p.,
Business Source Premier, EBSCOhost, accessed on July 13, 2015
7
Payables and receivables denominated in a foreign currency are items that are recorded on the
balance sheet. This includes cash, payables, receivables, and available for sale securities. Firm
unrecognized commitments are transactions that are highly probable to occur and if the
transaction fails there is an option for legal recourse. This is usually when there is a purchase
order and sales invoice, but revenue or expenses are not recognized on the entity’s financial
statements.
Highly probable transactions are transactions that are expected to happen. This includes
transactions that are in the closing stages of negotiation or future sales and expenses that are
projected to happen. It is important to note that if ABC hedges highly probable transactions and
the underlying fails to happen the hedge will cease to receive hedge accounting treatment. Net
investments in foreign subsidiaries allows a firm to hedge, in the functional currency of its
subsidiary, the net asset or liability of the same subsidiary. Because the gains and losses from
currency movements against a foreign subsidiary are captured in translation gains and losses, and
that is recorded in other comprehensive income, it is immaterial for ABC to hedge.
There are three pillars to any successful hedging program: 1) Obtaining and using correct data, 2)
Timing, and 3) Pricing. Correct data includes using both correct financial data that is free from
errors and using appropriate conversion rates. Timing is the frequency at which an entity adjusts
its hedges; the time between posting exposures and putting on hedges. This includes utilizing the
ability to hedge firm unrecognized commitments and forecasted transactions. Pricing is perhaps
the most subjective, but includes the forward points, the market spread, and minimizing volume
traded.
Visibility into Exposures
There are primarily two different ways to gain visibility, which is the first step in establishing an
effective hedging program. The first option is to use a report in ABC’s ERP system, Oracle,23
and the other is to have each subsidiary report its exposures. If ABC does not have a report that
shows its treasury its exposures, it will need to create one. For some companies creating a
custom report is costly and time consuming; these reports have been known to take up to a year
to create and verify for accuracy, although most companies can create the report relatively
quickly. The advantage of having a custom report is that, once created, it can significantly reduce
the amount of time to gather information.
Although there are several different types of reports ABC can use, it is best to use, and create, if
applicable, one that will provide as much information as possible. Maximum visibility through
this report is beneficial when testing for data integrity. The report should include both items that
have been posted to the general ledger, and items that have been entered and approved in Oracle
but have not been posted due to revenue recognition requirements. The advantage of this will
become apparent latter on in this recommendation. At the minimum, the report will need to
include the entity, account number and foreign exposure amount and currency for each account
and entity in the company. This report will allow ABC to start placing and updating its hedges
daily. For purposes of testing the accuracy of data, ABC will need to either include in the report,
23 Kerrie Jordan, “ABC Medical Speeds Launch of Innovative, Life-Saving Technology”, Oracle Webpage, <https://blogs.oracle.com/PLM/entry/ABC_speeds_launch_of_innovative>, October 9th, 2015, accessed on August 5, 2015
8
or have easy access to, each entry that makes up the account amount and the functional amount
that each item was posted at.
Although it is typically slower, having each entity report its exposures is a viable alternative and
is usually a preferred approach until an entity can reliably use an accurate report. If each entity
reports its exposures to a central location, usually the corporate treasury, ABC should have an
approval process to ensure each entity is reporting correct data. Since data entry is highly subject
to error, the approval process will help mitigate input inaccuracies. As tracking these exposures
through Microsoft Excel, Access or similar software products is difficult to manage, there are
different software providers that ABC should consider that offer the ability to facilitate both
processes to different levels, such as FiREapps, Hedge Trackers and GPS Capital Markets.
Once ABC is hedging its balance sheet items with its ERP report, it will still need to have each
subsidiary report unrecognized firm commitments that have not been inputted and approved in
Oracle. Additionally, each entity will need to report forecasted transactions, as these exposures
are not captured in the Oracle report. To hedge the items that are not recorded in Oracle, the best
approach is to set a USD threshold, 2 million USD being recommended, and have each entity
report that firm commitment or forecast. This threshold is calculated by taking roughly 0.05% of
the average of the last three years cash balances, net receivables and current liability amounts.
These accounts typically have foreign currency exposures, and ABC should adjust the 0.05%
number until it gains comfort that it is capturing all material exposures.
Forecasted transactions can develop into a large portion of ABC’s hedging program, but initially
it should only include transactions that are likely to close. Eventually, depending on its appetite
to stabilize cash flows, ABC can expand its forecasted hedges to include a broader range of
potential exposures, but that is beyond the scope of this recommendation.
Data Integrity
ABC should periodically review its reports and manual inputs for accuracy. A method for
verifying data is by looking for large fluxuations in GL accounts from period over period.
Fluxuations over a certain USD amount and percentage will require further investigation; in
ABC’s case, 250,000 USD and 10% are recommended. These amounts are calculated by taking
0.01% of the average total revenue amounts for the last three years. Again, ABC can adjust these
numbers until it has a material number it is comfortable with. For any fluxuations above these
limits, ABC should obtain an explanations and if an error is found ABC should correct it.
Another integral element to having correct data is ensuring exposures have been posted at correct
rates. This is done by checking that known exposures have been posted at a rate that is within the
trading range of the day. Forecasted and firm unrecognized exposures that have been hedged
should post at the spot rate the offsetting hedge was entered into, in addition to any gains or
losses due to market fluxuations. This concept is covered in depth in the “Accounting” section of
this recommendation. Without visibility into correct data any hedging program, no matter its
virtues, is worthless.
Timing
Ideally as each exposure comes on and off the balance sheet the hedge is adjusted. It is not
practical to capture all changes because some exposures are so small that any gain or loss is
immaterial and is not worth the effort that goes into a hedge. To effectively take care of this,
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ABC should only trade a balance if its net exposure’s USD amount is over a certain threshold,
250,000 USD being the recommended amount for the same reasons explained above.
Additionally, it will only adjust its hedge if the change in exposures is greater than 250,000
USD. This threshold will also prevent immaterial trades from being entered into.
The change in exposure is measured by taking the exposure amount for each currency amount
and subtracting the amount of hedges outstanding with the same currency pair. Debit balances
are positive whereas credit balances are negative for calculations. Additionally, ABC will need
to include the exposures of all subsidiaries for an effective hedge. This will sometimes require
assigning an arbitrary rate if two entities have the same currency pair exposure but opposite
functional currencies.
This rate should match the rate it uses to hedge the contract, or a best estimate of what rate ABC
will hedge at, as that will exactly represent the hedge. If the remaining amount is a net debit, or
positive, exposure then ABC will enter into a contract to sell that amount. If the remaining
amount is a credit, or negative, balance then ABC will enter into a contract to buy that amount.
When placing the hedge with ABC’s counterparties it is important that it trades the net exposure,
to save volume. ABC is then able to enter into its own internal derivative contracts with its
subsidiaries so that its subsidiaries gains and losses are offset. During consolidation ABC will
need to eliminate all intercompany hedging contracts from its financial statements.
ABC should take great care to include exposures that have not yet been recorded on ABC’s
balance sheet: firm unrecognized commitments and forecasted transactions. When ABC utilizes
hedge accounting, ASC 830 allows firms to use the forward rate when recording the hedged
exposures that are firm unrecognized commitments or forecasted transactions.24 Any changes to
the value of the underlying exposure is not recognized until the exposure has been recorded and
settled as long as ABC records the hedge as a cash flow hedge. This is important because if ABC
waits to hedge the exposure once it is on its balance sheet, it will have already posted the
exposure at a different rate than what it hedged at, and will immediately have to post a gain or
loss. When ABC posts its exposures it will do so at the rate it was hedged at.
ABC should check for changes in exposure every day. Although this can become tedious,
especially if ABC is submitting its exposures manually, it is crucial as changes in ABC’s
exposure are unprotected until it adjusts its hedge. This is important especially with instances
where there are larger changes in exposure in ABC’s balances and when there are large gains and
losses in the market between hedge adjustment intervals. It is common for currency markets to
move over 1% in a day, and in the recent case of the Swiss Franc (CHF) removing its tie to the
EUR, the CHF strengthened 17.62% against the USD on January 15th, 2015 alone.25 A
theoretical 17% loss on a 10 million CHF exposure would result in a 1.7 million CHF loss, or
roughly 1.75 million USD.
Although some exposures will not change daily, it is beneficial to check for changes.
Additionally, doing this program daily will help bring to the central treasury’s attention the
changing exposures. When ABC is calculating all of its exposures manually, moving to a bi-
24 Financial Accounting Standard Board, “ASC 830”, Generally Accepted Accounting Principles, <https://asc.fasb.org/subtopic&trid=2175826>, accessed on July 12, 2015 25 “USDCHF Spot Exchange Rate,” Bloomberg Business, January 15th, 2015,
<http://www.bloomberg.com/quote/USDCHF:CUR>, accessed on July 29, 2015
10
weekly schedule, every Tuesday and Thursday, is appropriate. There are several software
providers that will help facilitate the calculation of changes in net exposure to one extent or
another such as FiREapps, GPS Capital Markets and Hedge Trackers.
Cost
The cost of the hedge in regards to the forward points is the effect of interest being paid or
received. The forward points are a result of the interest rate differential between the two
currencies. The forward points are traded with the interest rate desk at the bank. ASC 815-30-55-
108 through 55-112 instructs companies to amortize the forward points over the life of the
derivative.26
An additional costs to consider is the spread between the market and the rate ABC receives on its
derivative. Although this cost is offset by using the same spot rate to post ABC’s exposures at,
and hence not recognize it in its income statement, it will still reduce the cash balances of the
company as it is paying out more money at each settlement. It is important to know that
counterparties will tend to take its spread in the forward points when swapping the hedges for
even or roughly even amounts, and it will take its markup in the spot rate when entering into or
adjusting the hedges.
Counterparties take the markup in the forward points because even swaps, or near even swaps,
do not allow for profit between both settlements; whatever ABC would pay or receive on the first
settlement is offset by the second settlement. ABC’s advantage in this instance is that it has
seven counterparties to consider when placing hedges, and it has a Bloomberg portal to use to
verify rates are close to market.
Perhaps one of the most efficient ways to reduce unnecessary costs is by reducing volume traded
in the market. The most efficient way to do this is by recognizing natural hedges; if Subsidiary A
has a 1,000 EUR payable and reports in USD and Subsidiary B has a 1,000 EUR receivable and
reports in USD, the gains and losses on both contracts will completely eliminate each other
during consolidation as long as each entity is using the same rate. In the example above, ABC
would save 2,000 EUR worth of trade out of the market by netting similar exposures together,
and would not have to pay the bid ask spread. Positions can net within each subsidiaries balance
sheet into one net debit or credit amount. Additionally, ABC can net subsidiary exposures into
one corporate debit or credit amount. Each time ABC updates its hedges it should only trade the
change in net exposures.
Similar to netting exposures together is the practice of swapping the outstanding hedge balances
to a further date. Some companies, when the value date of its hedges come due, will enter into an
offsetting hedge and then after the settlement will enter into new hedges. This is very costly and
is not best practice. Counterparties will typically take a spread on the onset and the offset of the
hedge, thereby effectively doubling the spread that company pays. Best practice is, when the
hedges value date is coming due, swap out of the contract to a further date. ABC should try to
swap out of its hedges for spot value so it does not have forward points on its offsetting
contracts.
26 Financial Accounting Standard Board, “ASC 815”, Generally Accepted Accounting Principles, <https://asc.fasb.org/subtopic&trid=2175826>, accessed on July 12, 2015
11
When swapping a contract, the rate used to exit the existing contracts will determine the
settlement. If the swap is for an even amount, the settlement on the offsetting contract will match
what is received or paid on the new contract. If amounts are uneven, ABC’s counterparty will
mark up the net amount to make additional profits. Whenever swapping a contract, ABC should
strive to obtain a rate that is in-between the market bid and ask prices.
Another example of reducing exposure is by triangulating net debit and credit exposures
together. The triangulated method will always reduce the volume traded over additional hedges,
and will usually produce greater gains and reduce losses on hedges depending on the forward
points. ABC should not initially enter into a triangulated hedge because it is a relatively new an
unproven method. Through the triangulated method ABC would transact in currency pairs that it
has not exposure in, although it will use currencies that it transacts in.
A factor to consider with regards to price is the labor cost to enter into hedges. If ABC traded
every change in exposure individually, and not netted, the volume of contracts would become
bothersome and costly to enter into and keep record of. Additionally, the wire fees might cost
more than the potential benefit the hedge provides if the amounts traded are small enough.
Usually when a company trades high volumes of contracts for low amounts its counterparty will
increase the spread it makes on the transactions.
By setting trading thresholds ABC will reduces unnecessary trades from the market, save on wire
fees and maintain a tight market spread on its trades. As was mentioned before, the appropriate
trading threshold is anything above a 250,000 USD equivalent. Additional labor costs include the
effort to confirm contracts, and to send and receive payments when the contracts come due.
Fewer contracts will result in reduced labor costs and time savings because it takes the same
effort to enter into, manage and settle a large trade as it does for a small trade.
Theoretically the duration the ABC’s hedges should not matter because it will amortize the same
amount in forward points each month. This is untrue because counterparties will take a spread in
the forward points to make profits on the trades, especially on swaps. Because of this, it is
typically better to have longer durations on ABC’s hedges. However, after a month of hedging
ABC will have a difficult time managing the volume of contracts outstanding. Because ABC
receives such tight pricing from its counterparties it can have shorter durations with minimal
consequences. It is recommended that ABC enter into hedges with durations of one month to
avoid unnecessarily large amounts of outstanding contracts.
Because ABC has large cash balances it has the required liquidity to run a hedging program.
With each settlement, ABC should expected that it will either receive or send several million
dollars to its trading counterparties. This can become compounded when ABC updates its hedges
with multiple counterparties each hedging period. The ability to switch counterparties is crucial
when trying to maintain low pricing, however, it requires a lot of liquidity. As long as ABC
maintains large cash balances it should meet the restraints of its hedging program.
Accounting
The first item to consider when setting a hedging program is to ensure ABC is using appropriate
rates to post its exposures at, and how often it is updating those rates. ABC should update its
rates daily so that items are being posted at rates that are as close as possible to the rates ABC
enters into hedging contracts at. There are several different rate providers that ABC can choose
12
from, including Oanda, GPS Capital Markets and Yahoo Finance. ABC should use a rate service
so that it can both receive a rate file and upload it into Oracle, or so that it can feed directly into
ABC’s Oracle application. Additionally, ABC should give attention so that the rates are posted
within the high and low of the day, thereby verifying rate integrity.
When recording hedges ASC 830 allows for two different methods for treating gains and losses
on derivative contacts: the fair value method and the cash flow method.27 The journal entry
details are shown in Figure 2 for the fair value method, and Figure 3 for the cash flow method.
Figure 2:28
Note, this image is
from a website
explaining hedge
accounting in IFRS.
The principles are
the same for US
GAAP, however,
“FP” (Statement of
Financial Positions)
synonymous with
Balance Sheet.
Additionally, “P/L”
is an acronym for
Profit and Loss
Statement, or
Income Statement.
27 Financial Accounting Standard Board, “ASC 830” 28 Silvia M., “Difference Between Fair Value Hedge and Cash Flow Hedge”, IFRS Box, May 29th, 2014, <http://www.ifrsbox.com/difference-fair-value-hedge-cash-flow-hedge/>, accessed on July 30th, 5015
13
Figure 3:29
Note, this image is
from a website
explaining hedge
accounting in IFRS.
The principles are the
same for US GAAP,
however, “FP”
(Statement of
Financial Positions)
is synonymous with
Balance Sheet, and
“P/L” is synonymous
with Profit and Loss
Statement, or Income
Statement. “OCI” is
an acronym for Other
Comprehensive
Income.
For FX purposes, if the hedged item is a recognized asset or liability or if the hedged item is a
firm unrecognized commitment ABC can treat it as a fair value hedge. ABC can treat a
derivative as a cash flow hedge if the underlying item is a recognized asset or liability, a firm
unrecognized commitment or a forecasted transaction. For firm unrecognized commitments and
forecasted transactions above the threshold mentioned earlier, designating the hedge as a cash
flow hedge is preferable. Designating those items as a cash flow hedge is beneficial because
instead of posting the gain or loss on the hedge in the income statement, ABC should post it in
other comprehensive income which will not affect net income. Each of these forecasted
transactions or firm commitments being hedged will require separate documentation. Since there
is an increased amount of work to document each exposure, although the threshold will reduce
the amount of exposures hedged and hence the manual costs to track each exposure.
Once the unrecognized firm commitment, or the forecasted transaction, is recognized on ABC’s
balance sheet, ASC 815-20-25-34, ASC 815-30-35-9 and ASC 815-30-55-106 through 55-112
allows ABC to use the same derivative to continue hedging the exposure amount. 30 ABC will
able to record the exposure on its books at the spot rate, adjust the hedge to its fair market value
in accumulated other comprehensive income and move the entire gain or loss, less a portion of
the forward points, into the sales or expense account. ABC is allowed to bring the forward points
for the portion it was a forecasted and firm commitment into the sales or expense account. Once
the hedged item is settled, ABC will have perfectly offset the entire exposure, and with a
remaining gain or loss in other comprehensive income. This remaining gain or loss reflects the
forward points for the duration the exposure was on ABC’s financial statements, and will go into
an expense or income account. This reduces the gain or loss that results from the delay in posting
29 Ibid. 30 Financial Accounting Standard Board, “ASC 815”
14
and hedging the contract. Additionally, this method only records a gain or loss due to the forward
points for the time the exposure has been recorded instead of for the duration of the hedge.
For all forecasted transactions and firm unrecognized commitments that were not above the
threshold, it will eventually come onto ABC’s financial statements unhedged. For these
recognized assets or liabilities, it is recommended that ABC treats the hedge as a fair value
hedge. The gain or loss on the hedging instrument is directly offset by the gain or loss on the
hedged item. The exposure will have the same effect on ABC’s net income whether it is recorded
as a cash flow hedge or a fair value hedge, although treating it as a fair value hedge will require
documentation for only the net hedge and not each individual exposure. See Figure 4 for a
diagram for how ABC should capture all exposures in its hedge.
In order to receive hedge accounting treatment, ABC must document, and test for effectiveness,
every hedge. For cash flow hedges, it must document a hedge for each exposure, whereas a fair
value hedge ABC may document the net exposure. Additionally, ABC may enter into one hedge
to offset the entire exposure of all of its subsidiaries, but must subsequently issue internal hedge
contracts where appropriate. ABC should trade all exposures together, cash flow or fair value,
but should issue internal hedge contracts via its central treasury for each entity and for each
relevant exposure.
Documentation must occur at
the inception of the hedge,
and ABC should state which
type of hedge it will
categorized it as, methods for
testing effectiveness, the
credit worthiness of its trading
counterparties, and general
rationale for hedging. For
purposes of testing, a hedge
must meet the 80%-125%
rule, or must offset 80% to
125% of the hedged item. At
the onset of the hedge, the
issuance of financials and at
the conclusion of a hedge
ABC is required to test
effectiveness both
retrospectively and
prospectively. Additionally,
ABC may test either
quantitatively and
qualitatively depending on a
few criteria. ABC will use
qualitative methods to test
prospectively and quantitative
methods to test
retrospectively. Qualitative
15
test will require ensuring the hedge meets all requirements set forth during the initial
documentation. Quantitative test will require ensuring the actual gain or loss on the hedged item
is offset by the hedge using the 80%-125% rule.
For cash flow hedges, ABC needs to document each exposure separately. Because this adds
additional work to ABC’s treasury function, ABC should enforce the threshold amount of 2
million USD. Additionally, cash flow hedges require an estimate that is accurate within thirty
days of when the transaction will happen, and when it the transaction will settle. ABC should
record these estimates on the initial documentation. The failure to create documentation and
perform effectiveness tests will result in the reissuance of financial statements. However, if a
specific hedge does not meet effectiveness tests, then ABC will need to reclassify the hedge and
will lose the benefits ASC 815 and ASC 830 provides.
Execution
To make ABC’s hedging program successful, ABC will require additional resources to initiate
and maintain its hedges. ABC should accomplish this through its treasury and accounting teams
and can reasonably take up to a year to establish a successful program. This program will run
indefinitely.
ABC’s central treasury will download its FX exposure report daily and each subsidiary must
report any firm unrecognized commitment or highly probable forecasted transaction over 2
million USD. The corporate treasury will need to verify each submitted firm unrecognized
commitment or forecasted transaction so that items are not hedged which are not supposed to be.
ABC will need to include in its report, if possible, data about firm commitments entered into and
forecasted transactions that are highly probable to happen. For firm commitments and forecasted
transactions, ABC might need to pull this data from the company’s Customer Relationship
Management (CRM) system. If this is not possible, it will need its subsidiaries to report these
numbers to the central treasury. Periodically ABC will also need to validate the data it is using to
hedge its exposures through the methods mentioned earlier in this section.
Every day ABC’s treasury will check for updates in its FX exposures. It will continue to bid out
its exposure amongst its counterparties so that it may obtain optimal pricing. Wherever possible,
it will urge its counterparties to take its spread in the spot rate, which will allow for minimal
gains and losses in net income. Additionally, ABC will hedge its positions out towards month
end. Two business days before the value date of all existing hedges, it will swap out of its
positions for the end of the next month. Here it will strive for optimal pricing as was described in
the “Cost” section of this recommendation.
When each item is added to the overall hedge, ABC’s corporate treasury will issue an internal
forward contract to offset the underlying exposure. Even though ABC is swapping its exposures
each month, the internal forward contracts are for the duration of when the forecast or
commitment was estimated to the settlement of the transaction. ABC should use its Bloomberg
service and best judgment to price the forward points for its subsidiaries, and should use the
same spot rate it received from its counterparties.
The treasury team will document each internal hedge, and perform subsequent testing. This
might require additional staff to manage all the documentation and testing, and should be
considered when setting its trading thresholds. The treasury team will work closely with the
16
accounting function to ensure proper treatment of each underlying exposure; ABC should
designate forecasted transactions and firm commitments over 2 million USD as cash flow hedges
and recognized exposures accounts with changes over 250,000 USD as fair value hedges. This is
vital because improper treatment can result in restatements or wasted resources in producing the
hedges in a manner that is compliance with ASC 815 and ASC 830.
On the onset of each hedge, each time ABC issues financial statements and at the settlement of
each transaction, ABC will issue accounting entries to properly reflect the transactions’ values.
As each entry is diverse because of a number of factors, it is encouraged that ABC references
PricewaterhouseCoopers’ (PwC) “Guide to Accounting for Derivative Instruments and Hedging
Activities (2013)” and “Foreign Currency (2014)” manuals that are downloadable from PwC’s
webpage.31,32
Additionally, the more counterparties ABC transacts with in a hedging period the more diligence
accounts payable and receivable needs to take to ensure settlements are happening correctly.
Accounts payable and receivable will need to verify hedge amounts with the bank after each
transaction. Additionally, accounts payable and receivable will need to need to meticulously
verify settlement amounts with each provider each month end. Failure to verify amounts can
result in settlement errors, and incorrect hedges being transacted.
Opportunities and Threats
The threats pertaining to this new hedging program lie almost exclusively with ABC’s foreign
exchange providers. Its providers can take an additional spread in the rates issued, but this is
negated by spreading the volume out to multiple providers. Additionally, its counterparties will
have credit risk. A foreign currency provider with sub-par credit usually is more inclined to
default on its hedge which puts ABC at risk. ABC should take into consideration the credit rating
of its trading counterparties.
Additional threats may come from incorrect data, user error and future changes to hedge
accounting requirements. ABC can do little to mitigate the risk of future changes to hedge
accounting codification, but ABC can mitigate the risk of these other items by following the
procedures specified in this recommendation section.
Future opportunities for improvements may come when ABC has a successful and established
hedging program. These may include hedging with option contracts, trading the triangulated
exposure based off of the total debit and credit amounts and expanding what exposures it
includes in its forecasted transactions. Hedging with option contracts will have capital
requirements at the onset of the hedge, but will allow ABC to offset all the risks that it might
have losses on the derivative but still allow for gains in its exposure amounts. Trading the
triangulated exposure will require additional comfort from ABC’s executives and investors as it
is still a new practice. Additionally, it will require additional sophistication when issuing internal
hedge contracts as amounts, exposures and rates will not directly match. However, this method
31 PricewaterhouseCoopers’, “Guide to Accounting for Derivative Instruments and Hedging Activities”, August 23rd, 2013, PwC Guide Library, <http://www.pwc.com/us/en/cfodirect/publications/accounting-guides/guide-to-accounting-for-derivative-instruments-and-hedging-activities-2013-edition.jhtml>, accessed on July 12, 2015 32 PricewaterhouseCoopers’, “Foreign Currency”, December 8th, 2014, PwC Guide Library, <http://www.pwc.com/us/en/cfodirect/publications/accounting-guides/foreign-currency-reporting.jhtml?display=/us/en/cfodirect/publications/accounting-guides>, accessed on July 12, 2015
17
does tend to allow for greater gains and mitigated losses and always mitigates volumes traded,
which is favorable for debt covenants and credit agreements.
Another opportunity for improvements is to allow highly correlated exposures to hedge each
other, but that requires an increase in ABC’s risk appetite, and it may not want to pursue that
option. This practice would drastically reduce the amount of volume being traded, although ABC
would need to give strict attention so that it still meets hedge accounting criteria.
Increasing the criteria of what constitutes a forecasted transaction will allow for more stable cash
flows, but it runs the risk of being ineffective when during hedge testing. This could include
forecasting quarterly and yearly revenues and expenses. Typically to maintain an effective
forecast, firms will spend great resources into managing its forecasted numbers and updating its
hedges when new information becomes available.
When the initial hedging program is efficient, ABC should reduce all thresholds so that its
hedges are more effective. With these thresholds ABC will not have the ability to capture every
exposure, but it will capture most exposures. Generally, capturing large exposures will help a
hedging program become effective but capture all small exposures will help a hedging program
become most effective.
CONCLUSION
ABC is a dynamic company with an impressive treasury function. As it continues to make the
changes and improvements it needs, it should to focus its efforts on creating a hedging program.
Great care should go into making sure its exposures and rates are accurate, the timing of its
hedges are frequent to capture all exposures, and that its pricing is competitive. Additionally, it
should strive to utilize hedge accounting so that any unrecognized gains and losses are reported
in Other Comprehensive Income, thereby smoothing out period over period earnings. By
establishing a successful hedging program, ABC can expect to increase firm value by
minimizing FX risk, stabilizing profits and securing cash flows.
18
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