CASH FLOW HEDGING

Hedging foreign currency cash flows can yield significant benefits. Because a firm’s valuation is the present value of all of its future cash flows, reducing earnings volatility improves a company's valuation and access to capital. Conversely, the downside of not doing so can be significant. It is not uncommon to hear a CEO or CFO blame currency volatility for a quarterly earnings miss, and examples - even among the largest corporations- can easily be found. By implementing an effective cash flow risk management program that works with its balance sheet hedging program, a firm will greatly reduce the probability of ever having an earnings miss due to FX.

Implementing a practical and effective cash flow program has three main elements:

  1. Managing the effects of exchange rate variations over an extended time period.
  2. Managing volume variation - that is, how to hedge an estimated quantity (net local currency revenues). It's very easy to over or under-hedge, and the FX team needs to incorporate its company forecasting models and cycles, accruals, and the timing of significant tax bookings.
  3. Integrating the cash flow program with the balance sheet program. This includes recognizing and addressing potential accounting effects, and achieving the ultimate goal of converting the FX currency into the functional currency of the company.

Currency Risk Management has proven strategies for meeting each of these challenges. We present here a high-level view of some of our processes. For a more detailed discussion, please refer to our article in Treasury & Risk on "Cash Flow Hedging Best Practices".

Layered Hedging

Common practice is often to initiate hedges for the four quarters of the coming fiscal year during the final quarter of the previous fiscal year. This "fire and forget" approach, while simple to execute, has several drawbacks. The spot rate at inception may be disadvantageous or anomalous, and the approach does very little to reduce volatility of results.

CRM can design and implement a hedge layering program for your company which creates an effective hedge rate equal to the average spot of multiple prior periods. This dramatically smooths the effective rate for each period, reducing volatility. The average can be over 6 to 12 months - the longer the period, the smoother the results (see chart at right). In addition, CRM will also ensure that this cash flow hedging strategy integrates seamlessly with our balance sheet hedging strategy. (2)

(2) For additional insight: Layering Hedges and Extending the Hedge Horizon Through Rolling Hedge Programs, John Bird, Atlas Risk Advisory LLC

CRM's layered hedging dramatically reduces volatility (Std Deviation) and average cost.

 

Using Options

Net revenues/expenses in the future are difficult to predict and therefore to hedge accurately. Many companies hedge smaller fractions of revenues/expenses in the more distant future. This reduces the average hedge ratio and raises Value-at-Risk (VaR), since the furthest revenues have the highest volatility. This is not an optimum risk management strategy.

CRM determines the optimum combination of forwards and options for each hedging period using a mean variance approach. This strategy achieves a 100% hedging ratio without over- or under-hedging net revenues.

 

Time period
Hedged with
forwards
Hedged with
options
0-3 mo
90%
10%
3-6 mo
80%
20%
6-9 mo
70%
30%
9-12 mo
60%
40%

Example forward / option combinations for different forecast periods