Bifurcation of FX Exposure as Hedging of P&L Results
The purpose of hedging is to reduce the variability/volatility of profit and loss (P&L) results and not necessarily to generate profit. Of course, if someone had a crystal ball, they could substantially improve the results by buying currency at the lowest rate and selling it at the highest rate. However, even without a crystal ball, the foreign exchange (FX) manager can still substantially improve company results if they can reduce the impact from FX volatility.
Although a company seldom receives credit for FX gains, it will be always be penalised for FX losses. Analysts will never extrapolate past gains into the future but, in case of losses, they will assume that the company is acting in a risky manner and can generate FX losses into the future as well.
This asymmetric approach to the impact of FX promotes the heavy use of the FX options. However, an option does not come for free – buying options means paying option premiums, which increase with volatility and lack of market liquidity. They are particularly expensive when they are needed most, namely during crisis.
As option premiums reflect market volatility, buying them continuously will lead to detrimental results compared to hedging with forward contracts or doing nothing. However, hedging with forward contracts or not hedging at all can also generate losses. When these losses become substantial, the underlying strategy will be questioned. Therefore the correct strategy would be to reduce exposure without entering into any hedging with third parties.
Since FX gains and losses depend strongly on the applied accounting standard, the most prudent hedging would be a favourable accounting treatment or adequate interpretation of possible accounting procedures, for example the bifurcation of a transaction into P&L exposure and balance sheet exposure.
According to FAS 52, gains and losses on some types of foreign currency transactions are not included in P&L but are treated as translation adjustments. Translation adjustments are not included in determining net income for the period. They are reported as part of the comprehensive income and, ultimately, as a separate component of the shareholders’ equity accumulated with other comprehensive income. Such gains and losses include:
In a multinational corporation, a substantial amount of exposure results from intercompany transactions.
The adequate management of this exposure can substantially impact the results of the corporation. For example, a multinational company with selling subsidiaries in many countries, which obtain the majority of their products from other related parties, can avoid FX fluctuations without entering into hedging contracts.
The FX exposure is a result of the inability to settle the FX transaction immediately. So there is a discrepancy between the booking rate (the rate at which exposure is booked into the accounting system) and the settlement rate (the rate at which transaction is settled). If the booking and settlement rates are the same, then there is no accounting exposure and FX gains or losses do not appear in the accounting system. How can these rates be made to be the same or very similar?
Reducing the time between booking and settlement will have the strongest impact, and selling on consignment will reduce this timespan. The selling subsidiary will be billed at the time when it sells the products to the customers. However, if the customers do not pay immediately and the subsidiary does not have enough liquidity, it still cannot pay immediately – and the discrepancy between booking and settlement rate remains. The parent company could provide enough liquidity to the selling subsidiary to enable it to pay any intercompany payables immediately; then the booking and settlement rate would be the same and there would be no accounting exchange gains or losses.
The additional liquidity would change the net investment in a foreign entity. The potential gains and losses (also from providing additional liquidity), on the other hand, will not impact P&L. This exposure would also qualify for hedges of net investment which do not impact P&L but appear as translation adjustments. Some companies might not have the required liquidity, while others might not want to provide additional liquidity to the subsidiary. However, when multinational companies introduce the concept of an in-house bank, then they can achieve this without increasing liquidity at subsidiary level. In order not to increase the exposure of the in-house bank, it will be necessary to increase the net investment in the subsidiary to enable it to settle intercompany payables immediately, without incurring obligation versus the in-house bank.
Within the in-house bank concept, all intercompany payables and receivables are settled through book entries on the accounts of the in-house bank. To avoid any FX gains and losses, all intercompany obligations are settled immediately (at least during the same month) through the in-house bank. The booking and settlement rates are the same, so there is no accounting FX exposure.
The exposure arises at the level of the in-house bank. However, if the selling subsidiaries have enough capital to settle intercompany obligations without assuming new liability from in-house bank, then there is no additional exposure for the in-house bank as well.
There is no need to hedge intercompany exposures to avoid FX gains and losses using the in-house bank concept. With an appropriate structure of intercompany settlements through the in-house bank, the FX gains or losses will be avoided and hedging will be pointless.
Table 1 shows the exposure of a US subsidiary resulting from imports from a European affiliate. The subsidiary is purchasing monthly products totalling €1m. The exposure is booked with the monthly booking rates and is settled one month later with the prevailing rates at that time. The exchange rate differences lead to exchange gains and losses. From January to June, the subsidiary purchased goods for €6m, which at the booking rates equals US$8.48m. Due to exchange loss of US$50,000, the company had to pay €6m for US$ 8.48m. If the subsidiary had been able to settle the exposure immediately, the FX loss would not arise.
By applying the in-house bank concept, a procedure can be established where all the intercompany obligations are settled immediately. Then current monthly or daily rates can be used as booking and settlement rates avoiding any exchange gains or losses. Since all settlement transactions are executed through accounts of the in-house bank, the process can be very flexible. The in-house bank can also provide the necessary financing for the settlement, or the financing can come from the parent company as the increase of the net investment, and will enable the parent company to increase the hedging of the net investment.
The results of this hedging will not impact P&L but will be booked as a translation adjustment directly onto balance sheet. In the case above, it is easy, with equal monthly payments, to increase the net investment by the appropriate amount. With variable monthly amounts, the average amount needs to be estimated. The deviations from this amount will result in balances on accounts with the in-house bank and will create exposure for the in-house bank with the potential of generating FX gains or losses in the P&L.
These balances on the accounts of in-house bank may also require hedging. However, the potential exposure will be substantially smaller than potential exposure of all subsidiaries added together. The in-house bank structure allows the company to execute all netting possibilities and the exposure is much easier to manage at the level of the in-house bank. The in-house bank structure allows not only the use of all netting possibilities but also the ability to swap transaction exposure into translation exposure, thereby avoiding/reducing potential volatility of P&L results.