Hedge Schedule Development: Best practices for aligning exposures with financial planning and analysis
Hedge Schedule Development:
Best practices for aligning exposures with financial planning and analysis
Rolling hedges and layered hedges are two structures that can be used to help temper the effects of FX volatility on the balance sheet. The flexibility they offer can help enhance a business’s ability to adapt its hedging tactics to market events as they unfold.
Rolling hedges can help ‘net out’ exposures in the balance sheet. Setting the hedge for a specific tenor, then adjusting and rolling the hedge at expiry for the next accounting period, can help protect the balance sheet from FX gains or losses.
Some business-customers of Corpay seeking to hedge currency risk find layered hedges to be a useful tool. A layered hedge can help build to a targeted average ratio over time. Longer-dated exposures are typically hedged at a higher ratio than nearer-dated exposures, which can help ‘smooth out’ the effects of volatility over time.
These structures are not without drawbacks, and require a more active approach than the static hedge, but they can also offer other potential benefits to a business with dynamic needs.
As we mentioned in our earlier post, the hedge schedule framework can often be the biggest driver of a hedge program’s effectiveness. Optimizing the framework involves aligning the hedge scheduleto the underlying FX exposure; to how the business actually operates; and to how it conducts its financial planning.We explored the static hedge in our earlier piece; we will now look at some other structures, including rolling and layered hedges, for context and contrast.
Addressing Balance Sheet Exposures – The Rolling Hedge
In multicurrency environments, businesses’ balance sheets often carry transactional FX exposures that might increase the risk of volatility in earnings and profitability. When looking to ‘net out’ these impacts with currency hedges, a rolling FX hedge strategy is often employed.
The key distinction between a rolling strategy versus a static one is that rolling hedges are continuously executed as the firm moves from one accounting period into the next.
A rolling hedge could also be used for a balance sheet hedge by aligning the tenor of the currency hedge to the reporting period. On the first day of the reporting period, the hedge is executed with an expiry on the last day of the reporting period. The gain or loss at expiry on the hedge will offset the gain or loss on the underlying accounting entry. This tool shields the balance sheet from gains and losses on revaluation, thus mitigating or eliminating the FX gains / losses line item on the income statement. To be clear, this type of hedge does not impact the FX gains or losses seen in Other Comprehensive Income (OCI) line items, as those originate from an entirely different sort of FX exposure. (We will address that concept in another post.)
Forecasted FX exposures & layered hedge strategies – approaching best practices
While rolling FX hedge programs are often used for forecasted hedge exposures as well as for balance sheet exposures, they have considerable drawbacks. Namely they often simply result in delaying FX risk, and not in an actual material reduction in the variability of realized FX rates. Layered hedge programs are often considered helpful for corporate FX risk management when used prudently in appropriate circumstances, as they address some of these shortcomings. Layered strategies might be considered by businesses which have the requisite cash flows, financial planning capacity, and a lack of variability in both, or by businesses that use both traditional and rolling forecasts. Layered strategies build to a targeted average hedge ratio over time, with long-dated exposures hedged at lower ratios than near-dated exposures.
In terms of performance, layered hedge strategies can help to effectively temper the highs and lows often seen in spot FX prices. Statistically speaking, this drives a sharp reduction in the volatility of realized FX rates and can help provide a more consistent basis for forecasting and planning.
Beyond the potential improvements in ‘forecastablity’, layered strategies can also help reduce cashflow volatility. This can result in an improvement in the management of working capital, the lifeblood of any organization.
Given the variation in hedging ratios across the hedging period, businesses are less likely to find themselves in a position of hedging highly uncertain cashflows far into the future. Pushing the tenor of hedges out also can help soften realized volatility in FX rates: some businesses may see advantages of employing layered hedging over longer-dated tenors, even as far out as 18 and 36 months.
The following is an example of a hypothetical layered hedging structure, showing the desired percentage of exposures hedged month by month.
This next example details the layering of the hedges, month to month. After the first three months, the fourth month (April) is ‘topped up’ to 80% of exposures. The chart below illustrates the T+1 hedge, with the first month expired and new hedges added.
To further illustrate and anchor our discussion, this graph below compares hedged vs unhedged USDEUR exposures (from 2018 to 2023), using the same 80/60/40/20 structure above. Please note the reduction of the impact of volatility over time.
Of course, actual outcomes can vary widely – shaped by considerations such as your risk appetite, your strategy, and the currency pairs you are hedging. The foregoing charts are hypothetical illustrations.
Again, while layered hedge schedules may be a personal favourite of mine, there are a multitude of potential drawbacks to this approach. Many businesses have difficulty constructing the forecasts that are a pre-requisite to employing these schedules; building that FP&A function is an undertaking on its own. High-growth businesses may have exposures that increase so rapidly that they need to constantly update both their forecasts and their hedge schedule, making this sort of program an additional burden. Further, extreme seasonality in business cycles can yield inconsistencies in exposure over time, and make it imprudent or impossible to employ such an approach. In those situations, another of the three general approaches we have discussed may be more suitable.
Developing and implementing a disciplined hedging strategy, aligned to the business goals and considerations, is a complex undertaking. It is important that you conduct your own research and consult third parties for a perspective on what best practices may look like for your organization. Which brings us to the next point.
Alignment is a critical driver
We now see why one particular hedge schedule may be selected over another, due to factors unique to specific firms and their underlying FX exposure. The reality is hedging is not a one-size-fits-all venture and the ultimate performance of a hedge program is often largely shaped by the degree of proper integration of FP&A with FX hedging.
Helping businesses navigate these issues is Corpay’s competitive advantage. We’d welcome the opportunity to learn about your business.
Opinions expressed in this article are those of the author. Please consider contacting an independent advisor of your choosing – an advisor completely independent of Corpay – to help you ensure that solutions discussed here are right for your business’ needs.
The hedging products described in this document can be useful but are also associated with significant added complexity; obtaining a thorough understanding of each such product's trade-offs/pros-and-cons (fully describing these is beyond the scope of this article) is important before choosing to use any of these products.
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