John Chen, product specialist, treasury advisory, Asia-Pacific for J.P. Morgan Treasury Services, explores key approaches to managing FX risk and examines the objectives behind each approach.

The uncertainty riling global currency markets during the second half of 2011 added an additional consideration to Asian treasurers’ efforts in managing FX risk. With companies in Asia taking an increasingly global view to growing their business, any increase in volatility prompts a re-look at how that risk is managed. A robust, ground-up approach is often one of the most effective ways of managing that risk, and ensuring that the bottom line remains on track. 

The first steps

A company’s core strategic objectives are imperative when it comes to defining and implementing an appropriate FX hedging strategy. To ensure the effective deployment of any FX hedging strategy, a treasurer should evaluate factors such as which functional currency should be adopted, how should they offset the resulting FX footprint and what sort of resources are required – and available – to implement the program.

Having an appropriate functional currency will significantly decrease the levels of FX exposure that need to be managed. Neutralizing the outstanding FX footprint, which typically involves re-negotiating sales and purchasing contracts to naturally balance FX exposure, is another important consideration. The residual FX exposure will then need to be managed through the purchase of contracts and the adoption of a suitable hedging strategy.

The ‘do nothing’ approach

With this approach, businesses typically take the view that over time, movement across currency pairs cancel each other out, and that hedging such FX exposures will just mean incurring additional and unnecessary costs. This strategy is often utilized by domestic corporates without a significant offshore business focus, along with multinationals and investors which are looking to capitalize on favourable currency movements.

Such an approach also tends to be adopted by companies operating within industries where FX movements can be priced out to their customers and/or suppliers. It is worth noting however, that companies employing this approach will often hedge large capital expenditures, acquisitions and divestures to gain certainty around one-off costs and revenue, effectively leaving currency flows from normal business flows unhedged.

Hedging cashflow items

A company looking to lock down projected cash payments and receipts can consider implementing an FX strategy that hedges committed and forecast non-functional cash flows over a specific period of time – generally between three to 12 months. In this approach, calculated monthly net flows are hedged through FX contracts, with maturities coinciding with payment dates.

With the amended IAS39,  companies now have the flexibility of adopting hedge accounting, allocating period-end gains and losses arising from the hedging contracts into ‘Other Comprehensive Income’, thus reducing profit and loss volatility. Some companies however, may be deterred by the amount of time and resource required to perform effectiveness testing, as required under hedge accounting treatment, especially when it does not address translational volatility.

Hedging balance sheet items

Many listed companies operating in low margin industries often look to an FX hedging strategy with a view to protecting their earnings per share (EPS), as translational gains and losses directly affect a company’s net income and EPS.  For those companies where the primary objective is to protect the company from translational FX gains and losses, treasurers will often look to hedge balance sheet monetary items.

By adopting such an approach, a company can ensure that at least by one measure, it passes muster with equity analysts, who while using discounted cash flows as an important valuation method, will often use EPS as a primary benchmark in determining a company’s attractiveness. It is worth noting however, that analysts will also question the company’s overall FX exposure and what that company is doing to manage that exposure within the larger macro-economic environment.

Hedge balance sheet and cash flow items

Companies which are not resource-constrained may look to hedge both their translational and transactional exposures by hedging balance sheet items as well as their forecast cash flows. Hedge accounting is adopted on FX contracts covering the forecast cashflows, while shorter-dated contracts are translated together with the underlying balance sheet monetary items at each period-end reporting.

The last word

Whatever the eventual strategy adopted, there is no best practice when it comes to hedging a company’s FX exposure. It is contingent on a company’s objectives, requirements, resources, risk appetite and the competitive landscape.

What is important is for a company to have a formal FX hedging policy that objectively prescribes the identification of FX exposure and the approach and instruments through which such identified exposures are to be managed. This will eliminate subjectivity, and allow the corporate treasury team to perform its primary function of managing the FX exposure.

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