Earnings Volatility and FX Risk Management in a Post-IAS39 World
In theory, the debate over implementation of IAS 39 should be coming to an
end. The International Accounting Standards Board is expected to produce a set
of revised standards by the end of March. Those companies that are then required
to adopt it will have until the end of the year to ready themselves, provided
of course that the standard is endorsed by relevant bodies such as the European
Commission. This is by no means certain, as certain groups, particularly French
banks, are continuing to actively lobby against the introduction of IAS 39.
Even though standards such as IAS 39 were proposed back in 2002 as a move towards
a common set of harmonised global accounting standards, it seems that many European
companies and perhaps their auditors are still struggling to come to terms with
Clearly, there has been a great deal of confusion about what compliance with
IAS 39 entails. Few would disagree that the standard is a well-intentioned measure
that has been poorly designed. But introducing transparency into the process
of how derivatives are revalued can only be applauded. If nothing else, IAS
39 will force derivative users to finally address what is currently the biggest
issue facing the financial markets. That is, how to revalue derivative portfolios
accurately. For that reason alone, IAS 39 should be welcomed.
However, even if companies do have some serious hurdles to overcome, it is
important that they do not hide behind IAS 39 and use it as a reason not to
hedge their exposure to financial markets properly. Unfortunately, this appears
to be happening in some cases, especially when the asset class concerned is
foreign exchange (FX).
Several high profile companies have gone on the record and admitted they have
been prevented from using derivatives because of uncertainty how resulting positions
will be accounted for on the balance sheet under IAS 39. In private, there are
many other treasurers who have moaned that their auditors have prevented them
from hedging their FX exposure prudently and conservatively.
There is no doubt that IAS 39 is a challenging standard. But it must be remembered
that it does not prevent any company from using derivatives. According to recent
research published by Lehman Brothers, the main criticism about IAS 39 is that,
“the IASB’s criteria for a derivative to qualify as a hedge are too restrictive.”
If a derivative position does not get hedge accounting status, the fear is that
it will lead to potential volatility on reported earnings.
Is that a problem? Earnings volatility may be a very small price to pay if
it means assets are managed properly. Would shareholders prefer not to have
earnings volatility but see money thrown away because an asset is mismanaged?
It seems that many companies are more concerned with avoiding press headlines
stating that they use derivatives, than with actually managing their shareholder’s
assets most effectively.
So instead we have the ludicrous situation where company after company can
report reduced earnings because of an adverse currency move. In fact, it still
appears that there are many companies who do not seem to even realise that foreign
exchange is a recognisable asset that can generate alpha ? the extra return
awarded for taking or managing a risk.
Over the last 18-months to two years, there has been a real return of volatility
to the FX markets leading to some very strong moves in certain currencies. For
companies that have not managed their FX risk properly, the currency markets
have clearly not been a potential source of alpha but a source of red ink on
the balance sheet.
Numerous companies have blithely reported that adverse currency moves have
reduced earnings. Obviously, hindsight is wonderful, but even if hedging can
never be an exact science, there are numerous strategies they could have been
used to prevent them pouring their shareholders money down the drain.
If a company managed its debt the same way and reported to its shareholders
that its borrowing costs had doubled because it had not swapped from fixed debt
to floating or vice versa, we could expect a serious enquiry. But a multi-million
pound loss because the dollar weakened, even when that move had been predicted
by almost every analyst and commentator in the market, barely raises a whisper.
This will change, although the introduction of IAS 39 is unfortunately providing
some companies with a convenient excuse not to hedge their currency risk. But
the FX market has never been so accessible and many do now see it as an important
asset class in its right. Yes, FX options may trade primarily over-the-counter,
but the market is mature, liquid and very commoditised.
Also, advances in systems means that anyone can actually mark-to-market any
option position they have using independent rates. IAS 39 has caused problems,
but it should not be used as an excuse not to hedge. The standard will introduce
transparency, which should prevent the sudden discovery of an unexpected loss
in any derivatives book.
Companies can use independent option pricing systems for their initial pricing
and risk management needs, confident in the fact that the mark-to-market rates
produced will pass muster with their auditors. So the requirement under IAS
39 that derivative positions are regularly marked to market is not a hindrance,
at least to those who have systems that are up to the task.
Some education may be required before IAS 39 is no longer seen as a problem.
New systems and technology can play a part by introducing a level of transparency
into the FX options market that simply did not exist even three years ago. But
companies have to accept their own responsibility and teach their shareholders
about why they have used derivatives. If they do not accept this and continue
to mismanage their assets, investors will ultimately look for alternative companies
within the same sector that do not.