How to manage a short-term currency fluctuation risk
Strategies that mitigate short-term currency fluctuations are routinely part of a multinational company’s enterprise risk management plan. Events such as changes in interest rate policies in countries where the company does business usually trigger these ERM strategies.
Thursday’s referendum on the UK’s membership in the EU, commonly known as the Brexit vote, has been a highly unusual and powerful trigger. With a majority of voters deciding to leave the EU, uncertainties abound, and foreign exchange markets hate uncertainty. Just hours after the vote, the British pound had plummeted to a 30-year low against the US dollar.
Management accountants the world over are preparing for more uncertainty as talk of referendums similar to the Brexit pop up throughout the world.
The runup to the Brexit vote helps provide a road map, illustrating how a shifting currency landscape, if unmanaged in advance, could wreak havoc on a balance sheet. It also illustrates that, despite uncertainty, actions can be taken to defend against currency swings.
Firstly, it is difficult to make contingency plans for an unprecedented event, raising questions about the workforce, access to trade, as well as travel, legal, and import costs. Secondly, the time frame in which changes can take effect is often unknown.
How can a company protect itself?
Hedging is a best practice to manage the two types of foreign currency risk – transaction risk and translation risk. The US Financial Accounting Standards Board governs accounting for transactions and translation through Accounting Standards Codification Topic 830, Foreign Currency Matters. IAS 21, The Effects of Changes in Foreign Exchange Rates, provides guidance for foreign currency accounting under IFRS.
Risk from translations results when companies convert foreign subsidiaries’ assets and liabilities from a foreign currency into the domestic currency. In the US, for instance, according to Topic 830, the impact of fluctuating foreign currency exchange rates does not impact current income (assuming the functional currency is the local currency, which occurs in most instances). Instead, it impacts other comprehensive income on the income statement and accumulated other comprehensive income on the balance sheet. The impact of changing foreign currency rates would not impact income until the foreign investment is disposed of, and the impact would be in gain or loss.
Because there is no current income impact, most companies may not take action to mitigate foreign currency translation risk. This would be determined by a company’s risk-management strategy approved by the board of directors. If a company does take action, it is generally a natural hedge.
A natural hedge offsets a net asset denominated in the foreign currency by creating a liability in the same currency. This is the typical case where an investment in a foreign subsidiary is financed with debt by borrowing in the same currency. These risk-management actions, to be effective, need to be initiated at the inception of the investment because they hedge long-term structural risks. Thus, because of the long-term structural nature, taking action related to Brexit would not be effective.
Risk from transactions in a foreign currency results from selling goods and services in a foreign currency, which creates accounts receivable, or buying goods and services in the foreign currency, which creates accounts payable. Topic 830 requires revaluing receivables and payables denominated in a foreign currency at each balance sheet date, with the change impacting current earnings.
Companies can take immediate risk-management action by hedging transaction-based assets and liabilities for foreign currency exchange rate fluctuations. A forward contract is a common financial investment vehicle available to accomplish this hedge. A forward contract is an agreement to exchange currencies at a specified future price (exchange rate) with delivery at a specified future time.
While there are some specific differences between US GAAP and IFRS, both require entities to remeasure assets, liabilities, income, and expenses into the entities’ functional currency, which is the currency of the primary economic environment in which it operates. Assets and liabilities are translated at period-end rates, and income statement amounts are generally converted at the average rate.
How forward contracts work
If, for example, a US company purchased raw material inventory denominated in British pounds from a UK firm with terms of net 60, then the US company would need to purchase British pounds in 60 days to settle its accounts payable. Unhedged, the US company has foreign currency exchange risk until the accounts payable are settled, and today’s uncertainty due to the Brexit vote has elevated this risk.
The US company can, on the date it buys the raw material inventory, reduce this risk by entering into a forward currency contract to buy British pounds in 60 days.
Here’s how it works:
Assume the following £/$ foreign currency rates:
|Date||Spot rate||Forward rate|
1. On June 23rd, the US company buys inventory from the UK company with payment due in 90 days in the amount of £100,000 when the spot rate is $1.48/£1.
2. Also on June 23rd, the US company enters into a forward contract to buy £100,000 on September 23rd at a forward rate of $1.486/£1, assuming no transaction costs.
3. The U.K. votes to leave the EU, resulting in a decrease in the pound’s value.
|Date||Accounts payable value||Hedge value|
|June 23rd||£100,000 × $1.48/£1|
|£100,000 × $1.486/£1|
|September 23rd||£100,000 × $1.33/£1|
|£100,000 × $1.33/£1|
The $600 net expense is the cost of reducing foreign currency exchange rate risk.
By establishing a risk-management policy that locks in foreign currency exchange rates at the transaction date through hedging, the company becomes financially indifferent about foreign currency exchange rate fluctuations because it has mitigated the risk.
Case study: Hedging at Isogenica
The volatility in the currency markets generated by the prospect of a referendum had been on the radar of Carolyn Rand, FCMA, CGMA, the chief executive of UK-based biotech company Isogenica, since the end of last year.
The UK-based workforce is Isogenica’s main cost, while the majority of its income comes from overseas. This makes Isogenica vulnerable to currency variations and leaves little opportunity to naturally hedge.
“We have been trading at €1.3 to the pound for a long, long time, and that’s what you based your original forecasts and budgets on. But then, when it plummets down to €1.25, that makes the purchasing of the euro very expensive. If you want to get … equipment in from Europe, that suddenly becomes massively more expensive.”
Isogenica’s strategy has been to reduce the external risk of currency movement by ensuring that current contracts with clients are hedged.
“Hedging is something that a lot of companies don’t do enough of,” Rand said.
“We tend to hedge fixed currency. If we know the customer is going to pay us at a certain rate or over a certain period – say, a year – then we forward hedge those [elements] in advance.”
The company also hedges when it knows approximately what the difference will be between its expenditure in the EU (or in any country outside the UK) and what the receipts will be. “You can hedge values so you can draw off at that fixed rate over a period of time,” Rand said.
When it comes to planning in an uncertain business environment, Rand advised: Don’t panic, and keep scanning the environment.
“You’ve really got to watch your cash flow,” regardless of whether your company trades directly with the affected region, she said.
It’s also essential to keep listening and for board members to make sure that they are very close to their companies. In the months following a major event (such as the result of the referendum), strategic plans have to be reviewed outside of the normal, possibly once-a-year, cycle.
“This is a time where you’re definitely going to have to review your horizon and ask, ‘Have we put our funds in the right place?’ You’ve got to think about your capital investment.”
A lot of companies have stopped recruitment and capital expenditures, which could damage their long-term prospects. Now is not the time for that, Rand said. Instead, ask, “ ‘What opportunity is there that I can take hold of?’
Source : GCMA