“It often happens that a player performs a deep and complicated calculation, but does not realize anything fundamental on the first move.” — Alexander KotovChess grandmaster
introduction
The impact of exchange rates on corporate earnings and forecasts needs to be top of mind for each firms and the analyst community. In fact, greater than 45% of S&P 500 firms’ revenue comes from abroad. But last yr, the hedging performance of many U.S. multinational corporations (MNCs) was significantly off, and few CFOs explained their hedging decisions in earnings announcements.
Why such poor hedging performance? Finally, treasury management system (TMS) providers claim to supply “at your fingertips” capabilities to limit the impact on exchange rates to $0.01 of earnings per share (EPS). The answer will not be as elusive as a few of us might think. Although there are challenges to hedging earnings, including risk assessments and accounting-related issues, only a few firms actually hedge earnings risks to corporate profits.
According to a Citibank survey, around 60% of firms cite reducing profit volatility as a key risk management goal, but fewer than 15% actually hedge their profit conversion risk. This raises an interesting query in the sphere of behavioral finance: could different treatments in financial accounting for hedging transaction risk on the subsidiary level and translation risk on the consolidated income level unduly influence prudent decision making and result in a transfer from financial accounting to mental Do the accounting?
Key questions to contemplate include: Are CFOs and company treasurers making effective hedging decisions? Do they replace practicality with substance and make decisions based on financial accounting considerations? Is the profession risk of fair value hedging too high?
On a broader level, how helpful is it to categorize FX risk? Is it counterproductive to place FX exposures into clear boxes – transactional, translational or structural?
The Fungibility of FX: One Risk, Three Forms
The fungibility of FX is definitely underestimated. For example, to raised align customers’ revenues with production costs, EU-based firms can reduce their costs structural risk by relocating production facilities to the USA. But they may simply replace one core risk with one other: transactional for translational.
Furthermore, if a subsidiary reinvests its profits moderately than passing on dividends to its parent, then the unrealized transaction risk is aggregated against the corresponding dividends to match the interpretation risk to the consolidated profit. The difference between transaction and translation risks just isn’t fundamental, but a matter of timing.
Hedging vs. accounting
Accounting standards provide for 3 kinds of hedges: fair value hedges, money flow hedges, and net investment hedges. Fair value hedges lead to gains or losses from derivatives being recognized in the present period’s income statement. For money flow and net investment hedges, current period derivative gains or losses are deferred through other comprehensive income (OCI), which is recorded within the equity section of the balance sheet.
According to IFRS, intercompany dividends can only be transaction secured once they’re declared. This protects the period between declaration and payment, which is normally too short to significantly reduce the danger. If firms are more inclined to undertake money flow hedges moderately than fair value hedges – which might cover longer periods given an estimated risk but should be recognized within the income statement – negative exchange rate effects shouldn’t be surprising as macroeconomic conditions change Conditions worsen or during times of rapid USD appreciation.
Accounting hacks exist: One way for firms to counteract opposed accounting treatment related to profit hedges is to categorise them as net investment hedges each time possible, since they’ve similar detection mechanisms to money flow hedges. Through holding firms or regional treasury centers, some multinational firms are deploying such accounting-friendly solutions to handle real timing issues, which can also include economic and structural safeguards.
Despite these methods, the broader questions remain: Why are listed firms “routinely” surprised by exchange rate volatility? Do financial accounting rules influence hedging decisions? Do corporate treasurers and CFOs are likely to avoid fair value hedges while overlooking earnings risks? Does the tail wag the dog? While the subject may receive limited academic attention, sell-side professionals who address firms know that accounting considerations often have an outsized influence on the sort of “accounting risks” which can be hedged.
Boardroom Dynamics: Holding the CFO Accountable
Boards have to do a greater job of holding CFOs accountable. All too often, discussions in regards to the impact of FX on earnings per share are likely to trade the prosaic for the poetic. No asset class is best than forex for waxing lyrical about all things macroeconomics – from fundamentals, flows, institutional credibility to geopolitical dynamics – but the elemental questions that underlie the rationale behind what’s insured (or not insured) are rarely, if ever, asked.
Likewise, debates about technology can turn out to be a hoax that distracts from the underlying issues. While firms need systems that “talk to each other” and supply gross and net exposures across the organization, impeccable transparency in itself just isn’t a panacea. As Laurie Anderson put it“If you think technology will solve your problems, you don’t understand technology – and you don’t understand your problems.”
Smart hedging measures take into consideration an organization’s level of risk aversion in relation to its market risks. An organization’s selection of risk metrics and benchmarks is closely related to its specific circumstances: shareholder preferences, corporate objectives, business model, financial position and peer group evaluation. “Know thyself” is a useful principle on this regard. For example, if a multinational company within the fast-moving consumer goods (FMCG) industry wants to maximise profits while maintaining its investment grade rating, consolidated earnings in danger (EaR) needs to be amongst the suitable risk-based measures . Regardless of accounting considerations, it will be significant that the proper risk measures and benchmarks are pursued.
Diploma
In summary, effective corporate hedging begins with understanding the fungibility of FX: risks can’t be “categorized away.” Additionally, there isn’t any substitute for thoughtful hedging policies and collection of performance indicators that outline success to make sure consistent interpretation and pricing of risk across the organization. These policies must also address the strain between core hedging objectives and financial accounting considerations.
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