Should Companies Hedge Translation Risk?

In 2007, gtnews published a guide series from Zanders presenting the company’s corporate risk management framework. In this framework, corporate risks are managed based on a systematic, integrated five-step approach, aimed to enhance shareholder value.

Figure 1: Five-step Approach to Managing Corporate Risk

The first step in managing foreign exchange (FX) risk is to acknowledge that this risk exists and that managing it is in the interest of the firm and its shareholders. The next step, however, is much more difficult: the quantification of the nature and magnitude of FX exposure. In other words, assessing what is at risk, and in what way. Therefore a thorough understanding of the different FX exposures is key to identify and measure the actual FX exposures. In our advisory projects on FX risk management we use the following classification in identifying the FX exposures.

Transaction exposure

This is the risk of value changes of a transaction executed in foreign currency measured in the functional currency as a result of FX fluctuations:

  • Transaction exposures can be split into ‘recognised transaction exposures’ and ‘unrecognised transaction exposures’.
  • Unrecognised transaction exposures can be split into either a ‘contractual/committed exposure’ or an ‘anticipated exposure’.
Figure 2: An Overview of Transaction Exposure

Economic exposure

This is the future impact on cash flows and earnings of a company as a result of long-term changes in FX rates which impact competitiveness and other strategic factors of the company:

  • Very wide ranging type of risk and broadly links into a company’s competitive and strategic position (long-term structural changes of FX flows and rates) within an industry, its relationship with customers, suppliers or competing companies.
Translation exposures

These are typical for holding companies and arise when a company has subsidiaries with assets or liabilities denominated in a functional currency other than the reporting currency of the holding company:

  • Translation gains or losses reflect a change in the way values are measured by the accounting process and do not per se reflect actual economic losses.
  • Most multinational companies (MNCs) are heavily exposed to translation risk.
  • Translation exposures are often split in profit translation exposures and (net) asset translation exposures.

Translation Risk Hedging

Net asset translation exposures arise when the value of non-functional currency assets and liabilities are to be translated into the functional currency of the company. The fluctuations of the exchange rate between the functional and non-functional currency could generate significant gains or losses. Consider a company with a wholly-owned subsidiary whose assets are denominated in US dollars and the reporting currency of the company is in euros. If the euro appreciates against the dollar, the value of the assets will be lower when translated into euros. The result will be a loss in the value of the group’s assets, which will be recognised in the company’s foreign currency translation reserve as part of equity on the balance sheet. However, this gain or loss will only materialise in the profit and loss (P&L) when the asset is sold.

Profit translation exposure arises as the results of foreign subsidiaries are consolidated from the reporting currency of the subsidiary into the reporting currency of the group. Therefore the consolidated P&L will be subject to the strength of the reporting currencies of the subsidiary. As long as the earnings or the retained earnings respectively are kept in the non-functional currency entity, it is a translation risk exposure from a group perspective.

As soon as a part of the profit of the foreign subsidiary is paid out as a dividend disbursement to the attention of the group, it turns into a transaction risk.

Protecting FX denominated net asset values (net asset translation)

Changes in exchange rates result in a change in the MNCs reported capital base as the subsidiary’s foreign currency denominated balance sheet is restated in the consolidation currency. Translation gains or losses impact the reserves of the company.

The majority of companies who decide to hedge net asset value translation risk actively use foreign currency loans. Derivatives could also be used to hedge this risk. However, the biggest disadvantage of derivatives to hedge translation risk is that it could lead to liquidity issues due to cash settlements of derivatives. Also, companies seek to keep net investments as low as possible by leveraging subsidiaries in local external debt and regular capital repatriation.

In order to avoid FX results of revaluation of the foreign currency loans in the P&L, net investment hedge accounting is applied. The FX gains or losses on the borrowing are deferred in equity (other comprehensive income) to offset the exchange differences on the net assets in the translation reserve.

A number of situations can be observed in which companies decide to actively hedge net asset value translations risk, e.g. when a company has balance sheet ratio covenants in financing or a public credit rating or to protect the divesture asset value of the foreign subsidiary. Deteriorating ratios may lead to an increase in the cost of debt financing. Consider a company with a credit facility in which it ensures to maintain a minimal net worth on consolidated level. The actual value of this net worth on reporting dates determines the credit spread the company has to pay on its funding. In case this company has a number of wholly-owned subsidiaries with assets denominated in a currency different than the reporting currency, an appreciation of the reporting currency against the foreign currency would lead to a loss on its assets denominated in the foreign currencies. This will impact the net worth and could end with the company having to pay a higher credit spread or even worse a breach of its net worth covenant.

However, there are also situations in which the hedging of the net asset value is less relevant. Especially when the equity book value of the foreign subsidiary deviates strongly from the economic value. In such situations the hedging of the equity book value becomes less relevant from an economic point of view. Also, when the foreign subsidiary is considered strategic and the assets are part of the core assets of the company, net asset value hedging is in this instance of dubious value.

Therefore the decision to hedge this risk should be considered in relation to the potential impact of net asset value translation on the capital base of the company. If in practice the cost of borrowing foreign currency debt is higher than the borrowing in the group’s consolidation currency, balance sheet hedging can come at a cost.

Protecting FX denominated Profits (net profit translation)

Generally speaking there are two opposing views on hedging profit translation risk, which are the following:

  1. Profit translation gains or losses reflect a change in the way that values are measured in accounting terms and do not reflect actual economic losses (cash flows) to the extent that profits are not declared to be distributed to the parent company; it is seen as undesirable to hedge accounting (paper) gains or losses.
  2. Profit translation gains or losses impact the reported profit of the company and as such are real risks in a number of situations, e.g. when:
    • Investors are focusing on real earnings metrics such as net profit, dividend yield, earnings per share, etc.
    • The company is financed with loans/bonds with a strict covenant package, e.g. balance sheet and P&L ratios that are impacted by changes in earnings and subsequently reserves.
    • Subsidiary earnings may be remitted to the parent company or when there is a possibility of a sale of the subsidiary (these cases are actually transaction exposures).
    • Management compensation is based on post-translation results.

A small but increasing number of companies are hedging profit translation risk, most prominent at the level of EBITDA, by using derivatives like forward contracts. However, when a company decides to hedge the foreign currency denominated EBITDA, it will still be subject to FX volatility in its P&L. The reason for this is that, under IFRS, you are not allowed to apply hedge accounting for net profit translation risk. Therefore, if the main objective of the company is to hedge this translation risk due to its strict covenants, it will be difficult to manage in practice.

However, companies continue to prefer offsetting exposures naturally, e.g. by matching revenues with costs in the same currency, in order to avoid the cost of hedging with derivatives or to avoid the risks of inaccurate forecasting. It is also possible to manage translation risk by changing the reporting currency under certain conditions.

Conclusion

In our opinion, the above-mentioned reasons are sensible rationales that support the decision to hedge translation risks. However, it could also be argued whether it would be worthwhile to hedge future profits and infinitely paying the forward points. Transaction costs of such a strategy would certainly not to be neglected. A more fundamental question is whether a company hedging this net profit translation risk would serve its shareholders by adopting such a strategy. Also the application of hedge accounting under IFRS for net profit translation risk is not possible and thus unrealised FX results of outstanding derivative contracts create undesired P&L impact, which leads to a rather peculiar situation.

However, what we see in practice is that many MNCs refrain from hedging profit translation risk, and this decision is not supported by factual reasons and clearly communicated. From a best practice perspective, a clear communication of the adopted strategy towards shareholders is required.

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