“Hedge Accounting and Beyond: Currency Volatility and Movements Aren’t Just Treasury’s Problem”

I came across this nice little article today from Jason Busch of Enterprise Irregulars on the need, during such volatile economic times, for a wider understanding of Hedge Accounting and its role in managing an organization’s currency exposure.

As Busch says, management right across businesses with currency exposure (whether through global sourcing or international sales) need to have a much better understanding of the tools at their disposal, and need to stop relying on their treasury team (if they are lucky enough to have one) to manage these “stormy waters”. It takes a collaborative effort between Treasury and “the business” to make sure that a business is qualifying for hedge accounting, and therefore minimising the impact of currency shifts on their profitability.

As Richard Eaddy commented in his latest article, for most businesses hedge accounting need not be the onerous process that it is perceived as and is a vital tool in helping to ensure that the market volatility doesn’t have to flow through to your company’s income statement. But to Jason Busch’s point, it needs to be a team effort.

Hedge Accounting – where to from here?

When hedge accounting under IAS39 was first introduced in 2005, many nay-sayers (including myself) thought that organisations would move away from worrying about it once the standard was well understood. This was especially so as it seemed overly complicated at the time and administratively a nightmare to comply with. I know of senior partners in accounting firms who decided that they were “too long in the tooth” to invest the time to learn such new concepts and promptly retired.

The reality has been somewhat different. Like many new things, hedge accounting was met with fear and distrust but what was new and scary more than seven years ago is now familiar and normal (albeit with some changes on the way). In fact not only is it now “normal” but where many thought that organisations would move away from worrying about it and would “mark-to-market” all their financial instruments through the Profit and Loss account, we have seen more and more moving towards adopting hedge accounting.

Why is that? For a couple of reasons probably, firstly because hedge accounting is not that difficult if you are reasonably conservative with your risk management. If you stick to plain vanilla type products such as foreign exchange forwards or interest rate swaps and you don’t try and restructure them or push them out too far, then you will easily comply with the standard. Yes you need to do the documentation but that is mostly a simple matter of copying a WordTM document and making a small number of changes. If you have access to independent mark-to-markets of the financial instruments then you can do the hedge effectiveness testing relatively simply, and if you don’t want to do it yourself you can always outsource to an 3rd party who will do it for you.

The other reason why hedge accounting has been more widely adopted (even by those who would prefer not to) is because of the volatility in the financial markets over the last few years that has caused significant movements in the valuations of financial instruments. Volatility in the financial statements is a CFO’s worst nightmare and even though we all know they are unrealised movements, the market still focuses on the bottom line that includes these movements. I am not a financial markets forecaster but I would suggest that volatility is here to stay for the foreseeable future and this alone will continue to drive more and more to hedge account.

The good news is that hedge accounting is going to become easier. IAS 39 is due to be replaced by IFRS 9 and this will mean that complying with the new standard will be simpler than it was under the old one. Gone will be the illogical requirement to split time value out from options which led many to abandon using this useful instrument. Gone also will be the hardline 80 to 125% rule for achieving hedge effectiveness. Now you will be effective for the portion which is effective, not effective if you were 80.1% and ineffective of you were 79.9%.

The final standard is still to be released with likely adoption in 2015 but with the unrelenting volatility in financial markets and a more practical approach to hedge accounting, there is little doubt that the trend we have seen since its original introduction of an increasing uptake is going to continue over the coming years.


Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at richard.eaddy@myhedgebook.com.

Five steps to more effective treasury management

I recently read an interesting report in the November 2011 McKinsey Quarterly that highlights the increasing complexities of managing the treasury function of a business and focuses on 5 key areas that should be given attention, no matter what size or type of business you are.

The article delivered a timely reminder that the costs of inadequate focus on this important function can be extremely costly for small and large businesses alike. “Companies pay incremental interest expenses when they overborrow as a result of inaccurate cash flow forecasting and often lose money when they don’t hedge exposures for currencies and for interest rates…”

Now clearly you don’t need to be a McKinsey analyst to work that out, however too many  businesses still take something of a laissez faire approach to the task of managing their currency and interest rate exposure.

The 5 areas the McKinsey report focuses on are:

  • Centralise the treasury function globally
  • Strengthen governance
  • Enhance treasury-management systems
  • Increase the accuracy of cash flow forecasting
  • Manage working capital in developing markets

Points 1 and 5 may only be relevant to organisations with a global footprint, however the other three are extremely pertinent to any business carrying currency and interest rate risk, and can all be improved through the introduction of a tool such as Hedgebook.

Hedgebook’s reporting module allows for stronger governance, enabling the implementation of robust procedures through the provision of good information, while bringing much greater visibility to policy management and adherance.

The same reporting gives decision makers much greater visibility of projected cashflows, while also modeling their sensitivity to market fluctuations, making forecasting much simpler and more accurate.

The McKinsey report was particularly harsh on organisations who still rely on spreadsheets to manage this mission-critical business function.  It found that a staggering number of businesses, including large multinationals, are still relying on error-prone spreadsheets.

“A single error in a single cell can ripple through an entire model, leading managers to borrow instead of invest, to hedge incorrectly, and to forget to fund operating accounts or make debt payments.”

The report identified cost as one of the most-stated barriers to investing in a treasury management solution, but went on to point out that the cost-benefit stacks up every time when you consider the potential cost of a single mistake.

“At one North American utility company a simple spreadsheet error for energy auction bids led managers to enter into nonreversible contracts the company didn’t need – a mistake that cost it half of its operating earning for the quarter.”

This may well be an egregious example, but with many businesses living and dying by their success in navigating a volatile currency market, a subscription to a tool like Hedgebook looks a small price to pay for confidence.

The original McKinsey article can be read here (note you have to register to view)

Interest Rate Swap Tutorial, Part 1 of 5

This is the first in a series of articles that will go from the basics about interest rate swaps, to how to value them and how to build a zero curve.

Introduction to Interest Rate Swaps

An interest rate swap is where one entity exchanges payment(s) in change for a different type of payment(s) from another entity. Typically, one party exchanges a series of fixed coupons for a series of floating coupons based on an index, in what is known as a vanilla interest rate swap.

The components of a typical interest rate swap would be defined in the swap confirmation which is a document that is used to contractually outline the agreement between the two parties. The components defined in this agreement would be:

Notional –  The fixed and floating coupons are paid out based on what is known as the notional principal or just notional. If you were hedging a loan with $1 million principal with a swap, then the swap would have a notional of $1 million as well. Generally the notional is never exchanged and is only used for calculating cashflow amounts.

Fixed Rate – This is the rate that will be used to calculate payments made by the fixed payer. This stream of payments is known as the fixed leg of the swap

Coupon Frequency – This is how often coupons would be exchanged between the two parties, common frequencies are annual, semi-annual, quarterly and monthly though others are used such as based on future expiry dates or every 28 days. In a vanilla swap the floating and fixed coupons would have the same frequency but it is possible for the streams to have different frequencies.

Business Day Convention – This defines how coupon dates are adjusted for weekends and holidays. Typical conventions are Following Business Day and Modified Following. These conventions are described in detail here.

Floating Index – This defines which index is used for setting the floating coupons. The most common index would be LIBOR. The term of the index will often match the frequency of the coupons. For example, 3 month LIBOR would be paid Quarterly while 6 month LIBOR would be paid Semi-Annually.

Daycount conventions – These are used for calculating the portions of the year when calculating coupon amounts. We’ll explore these in more detail in our discussions on fixed and floating legs. Details of different daycounts can be found here.

Effective Date – This is the start date of a swap and when interest will start accruing on the first coupon.

Maturity Date – The date of the last coupon and when the obligations between the two parties end.

Thanks to our sister company Resolution for providing us with this series of posts.

Next Article: Constructing fixed legs including calculating coupon amounts.

When to use zero-premium FX collar options as the method of hedging

For importers and exporters managing trade-related transactional FX exposures, the choice of hedging instrument is just as important to overall performance as tactical/strategic risk management decisions to position at the minimum or maximum of hedging policy limits. Increased volatility in many currency pairs over recent years has naturally increased option premium costs, however it is not wise to always hedge via zero-premium collar options and never consider paying premium to buy outright call and put currency options. The choice between these option instruments and straight forward exchange contracts normally comes down to the following considerations:

  • If the home currency spot rate is at an historical low point against the export receipt currency (say based on long-term average rates) and the lead-indicators point to a greater probability of appreciation of the home currency than further depreciation, the choice of hedge instrument is going to be heavily weighted to straight forwards.
  • If the home currency spot rate is at an historical high point against the export receipt currency (based on long-term average rates) and the lead-indicators point to a greater probability of depreciation of the home currency than further appreciation, the choice of hedge instrument is more likely to be buying outright call options on the home currency.
  • When the currency pairs are trading closer to long-term average levels and there is no clear indication on future direction either way, collar options fulfill the objective of being hedged at an acceptable rate (the cap), however leaving some opportunity to participate in favorable market rate movements at least down to the collar floor level.

In some respect, hedging with collars is akin to having permanent orders in the market to deal at more favourable exchange rate levels with protection on the other side along the way. Whilst zero-premium may appear attractive, FX risk managers should always examine the trade-off’s of paying some premium to widen the gap between the floor and cap strike rates to provide greater opportunity of participation in favourable rate movements. In a similar vein, opportunities should be taken to restructure collars over the course of their term by buying back the sold cap or floor, or alternatively converting the collar to a straight forward if original target hedged rates are achievable. An active mixture of hedging instruments within policy limits should provide greater opportunity to beat benchmark and budget exchange rates.

Roger Kerr is widely regarded as one of New Zealand’s leading professional advisers and commentators on local/international financial markets, the New Zealand economy and corporate treasury risk management. Roger has over 30 years merchant and investment banking industry experience, and has been closely associated with the changes and development of New Zealand’s financial markets since 1981. Roger advises many Australian and New Zealand companies in the specialist areas of foreign exchange risk, interest rate and funding risk and treasury management policy/governance matters.

Roger has provided daily market and economic commentary on the 6.40am slot at radio station NewstalkZB since 1994.