Tackling Balance Sheet FX

balance-act-1000x500.jpg

FX risk management is filled with nuances affecting how some exposures are commonly hedged versus others, but there is one crucial differentiator dividing two very different approaches – that of forecast versus balance sheet exposures. This is the first delineation to be made when we characterize FX exposures.

-       Balance sheet exposures are presently reflected on the company’s financial statements

-       Forecast exposures are items that will affect the company’s financial statements in future periods – but are not presently reflected 

Forecast exposures result in a more complex set of issues, principally because forecasts are estimates in both time and quantity, whereas balance sheet exposures are known with certainty at the present time.

Though balance sheet exposures are less dimensional, they nonetheless come with unique complications that cause imperfect – and sometimes bad – hedging results. Complications involve both the changes and recording of balance sheet exposures and the approaches used to hedge them. 

The scope of imperfect hedging results from balance sheet hedging is too broad for a single article. So, in this article, we frame the topic and take an initial look at the complexities of recording balance sheet exposures that impact hedging results. Then, we will address issues and strategies related to hedge execution and market rates in a subsequent article. 

  

Balance Sheet Exposures

Balance sheet exposures mostly consist of foreign currency denominated monetary assets and liabilities. Such accounts include cash, trade receivables and payables, notes, etc., and these balances are “remeasured” into functional currency amounts in each reporting period. Say your company reports its results in USD terms, but sells products to European customers in EUR, resulting in a EUR 1 million account receivable as of June 30. 

 The impact of these FX balances comes from changes in the FX spot rate used to convert oranges to apples. That is, in order to record EUR balances on a USD balance sheet – and be able to add them to other balances – they must be recorded in the same currency. To do so, the EUR balance will be converted at the EURUSD rate on June 30 … let’s say it was 1.1400. 


Date                   Balance (EUR)           Spot Rate        Balance (USD)

6/30/2019         1,000,000                 1.1400             1,140,000

7/31/2019         1,000,000                 1.1150             1,115,000

 

While the EUR balance was unchanged during July, the USD-equivalent value declined by $25,000. The reduction would be recorded in your company’s FX gain / loss during July, reducing your bottom line by $25,000. 

 

 

The Hedge

You might hedge against FX losses in July by selling EUR 1 million via a forward contract on June 30. While the spot rate was 1.1400, the rate on a forward contract to be cash settled based on the July 31 spot rate (date of the next FX remeasurement) would have been about 1.1430. The settlement value of the hedge would be as follows.

Date                   EUR notional            Direction         Rate          USD equiv.

6/30/19             1,000,000                 Sell                  1.1430             1,143,000 (received)

7/31/19             1,000,000                 Buy                  1.1150             1,115,000 (paid)

 

The EUR notional amount sold on June 30 and bought on July 31 offsets, but the USD settlement value nets to $28,000 in the company’s favor. This amount would be recorded as an FX gain as of July 31. 

 

Mismatches

Even our very simple example (above) of a balance sheet exposure and a hedge results in a mismatch between the FX gain / loss of the exposure and hedge. The exposure, because it is remeasured based on spot rates alone, incurs a loss of $25,000, while the forward contract’s value is affected by spot rates and forward points, and generates a gain of $28,000. 

Imperfect balance sheet hedging results occur when the FX gain / loss on the exposure and the hedge do not fully offset. Typically, much of the imperfection is caused by changes to the exposure during a reporting period, which are not matched by the hedge. In addition, companies’ methods for recording changes to exposures vary, so two companies with the same changes in exposure might experience different outcomes. Both the change in the exposure amount and how it is recorded are likely to result in imperfect balance sheet hedging results. 

For hedges, the rates affecting the hedges value can be different from the rates used to remeasure exposures – stemming from either: 1) slippage due to timing of execution, or 2) forward points on a forward contract rate (as we saw in the above example). 

  

Dynamic Balances 

Over a reporting period, a monetary balance will frequently change.[1]In our example, the beginning balance is EUR 1 million, and the ending balance is the same as the beginning. In reality, accounts receivable balances vary almost daily as old receivables are paid and new sales on credit are recorded. A more realistic example would show the original balance of EUR 1 million might increase to EUR 1.2 million or decrease to EUR 0.8 million by month end. But even if the balance is unchanged, it likely varied during the period, only to arrive near the same balance at period end. 

It is difficult to separate the issues of:

  • changing balances over a period, and

  • how a company records changes to balances within the period

So, we will illustrate them in combination to show how the tracking and measurement of exposures impacts FX gains / losses incurred. 

The most accurate method is for companies to use daily (or even continuous) rates to remeasure balances and generate FX gains / losses. 

blog-10-chart.png



Often, companies are too constrained for resources, or flows are too frequent to manage FX exposures and changes continually, and accounting practices vary for how intra-period rate changes are reflected. So, many companies settle for using monthly or average rates to record FX gains / losses. 


Despite recording exact flows in and out of the balance on the days they occurred, the FX gain / loss differs by $1,240 based on the FX rate method used to record the exposure. 

Summary

Imperfect balance sheet hedging results can be expected, but you should manage them to minimize FX gains and losses within the constraints of your company’s practices and resources. While it might be possible to eliminate FX gain / loss in some simple cases, in most cases, they cannot be eliminated – i.e., you will be unable to eliminate FX gains / losses. It is crucial to understand the sources of hedging imperfections and their potential impact. 




[1] A notable exception is for notes receivable or payable, where the notional amount of a note might remain the same for many period, while trade related balances will be impacted frequently by payments, receipts, and additional transactions. 


Need historical FX data? OANDA is the premier supplier of foreign exchange data rates and is trusted by the world’s largest audit firms. Compare up to 10 currencies at once. Start your Free trial today.