Due Diligence & Distinguishing FX Derivatives

Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions.

At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives.

The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows:

1) Forward Contracts

• Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges.
• Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate.

2) Option Contracts

• Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures.
• Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity.

3) Zero Cost Collars

• Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium.
• Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate.

Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives.

To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative!

Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples!

Cheers,

The FX Initiative Team
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Identify the 5 Stages of the FX Trade Lifecycle

Foreign exchange trading is a critical element of currency risk management, and understanding the trade lifecycle can help organizations plan their hedging activities more efficiently and effectively. The foreign exchange trade lifecycle, as discussed in the FX Risk Management course, can be enhanced with automated resources and typically includes the following 5 stages:

1. The first stage involves identifying and evaluating exposures. To aid in the exposure identification and evaluation process, best practices relate to investment in quality automated resources such as an enterprise resource planning (ERP) system or treasury software application that can be set up to extract data across the enterprise to identify and evaluate foreign exchange exposures rather than manual analysis, which can be time consuming and limited in scope.
2. The second stage involves collecting and quantifying exposure details. These tasks can be automated through software modules such as a netting system for matching foreign currency inflows and outflows or a cash flow forecasting module for determining future exposures based on historical trends in comparison to manual collection and quantification processes through spreadsheets, which can be vulnerable to human errors and oversight.
3. The third stage involves developing and analyzing hedging strategies. This analysis process can be streamlined and structured with automated software that performs value at risk analyses and simulates hedge strategies such that scenarios can be modeled prior to trading in order to save significant time and costs down the road, whereas performing this analysis manually can limit the ability to compare economic and accounting strategies in a comparable format and in a time efficient manner.
4. The fourth stage involves the administration and execution of hedge strategies. This is increasingly facilitated through the integration of electronic trading platforms, where multi-provider execution platforms can be integrated for optimal rate bidding across numerous FX service providers in real time, coupled with automated straight though processing of trades with back office systems to handle transaction reporting, confirmation matching, and payments between counterparties rather than manually performing these critical tasks.
5. The fifth and final stage of the foreign exchange trade lifecycle is financial & managerial reporting. This communication and recordkeeping can be automated through the integration of accounting systems to enable seamless financial reporting for both internal and external audiences rather than manual reporting and compliance processes.

Overall, the 5 stages of the foreign exchange trade lifecycle include (1) identifying and evaluating exposures, (2) collecting and quantifying exposure details, (3) developing and analyzing hedging strategies, (4) administering and executing hedging strategies, and (5) financial accounting & managerial reporting. Each of these stages is essential when implementing foreign exchange trading best practices, and understanding the lifecylce can help organizations plan their hedging activities more efficiently and effectively.

To learn more about foreign exchange best practices and to observe how world class organizations such as Apple employ each stage of the FX trade lifecycle, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples and webinar events can help you and your team better mitigate FX risk and deliver measurable results to the bottom line, so get started today by taking the FX Initiative!

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The FX Initiative Team
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How to Implement Internal Controls for FX Risk Management

Internal control (IC) involves everything that controls risks to an organization. IC relates to operational effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations and policies. When it comes to hedging foreign exchange risk and Sarbanes-Oxley (SOX), management should be able to understand, assess, and conclude on the adequacy of internal controls over financial reporting as it relates to currency risk management.

In general, a minimum of three personnel are required for sufficient internal controls since the trading, accounting, and confirmation duties should be segregated. For example, the Chief Financial Officer (CFO) could be responsible for confirmation and authorization, the controller could be responsible for accounting and record keeping, the treasurer could be responsible for trading and custody. Furthermore, the Board of Directors could be responsible for oversight and approval, and in the event that an exception to the Policy is warranted, the CFO could be responsible for approving any exceptions.

While specific internal controls will need to be tailored to the specific needs of an organization, some key questions that should be addressed include:

1. Who has the authority to execute trades?
2. How will trades be executed and what process should be followed?
3. How and when are trades confirmed and compared?
4. Are the trading, accounting, and confirmation duties segregated sufficiently?
5. Who has the authority to authorize policy exceptions, and trade ticket or accounting discrepancies?

It is critical to include internal controls as an essential component of an effective Foreign Exchange Risk Management Policy because it outlines in detail the specific processes to be followed. The Internal Controls section of a Policy should address the key questions above by stating internal controls have been set forth to segregate the trading, accounting, and confirmation processes. Continuing the example using the CFO, controller, and treasurer, internal controls could apply to the following FX Risk Management related tasks:

• The Treasurer will be responsible for recommending hedging strategies, and the Controller and Chief Financial Officer will be responsible for approving the proposed strategies prior to trade execution.
• The Treasurer will be responsible for selecting counterparty foreign exchange service providers in accordance with 'Counterparty Guidelines', and the Controller is responsible for approving the selected counterparty prior to trade execution.
• The Treasurer is responsible for executing approved hedging strategies and subsequently recording the transaction in the appropriate general ledger account within 24 hours. The Controller is responsible for confirming that the financial reporting surrounding trade execution matches the trade confirmation received by the counterparty service provider within 72 hours. If a trade confirmation is not received within 72 hours, the Controller is responsible for obtaining the confirmation directly from the counterparty service provider, mediating any disputes between the Treasurer and the counterparty service provider, and alerting the Chief Financial Officer of any pertinent issues.
• The Treasurer will prepare a cash reconciliation at each month end related to all underlying positions and derivative transactions, both inflows and outflows, that occurred throughout the period. The Controller will cross check the cash reconciliation with all trade confirmations to ensure cash balances reflected on the accounting records match the economics of the underlying positions and derivative transactions settled throughout the period.

These are just some of the many ways organizations engaged in foreign exchange risk management should be considering internal controls as part of their currency hedging program and formal Policy. Keep in mind that policies and procedures are never perfect, and should be viewed as a process that is responsive to change and capable of continuous enhancement. By starting sooner rather than later, practice, experience, and results will contribute better information to the internal control process allowing for changes to be made to the foreign exchange risk management program in the future.

If you are interested in learning how internal controls are integrated into a foreign exchange risk management policy, FX Initiative's currency risk management training has a course on FX Risk Management that walks you through a real-world scenario using the Foreign Exchange Risk Policy Drafter to illustrate step-by-step the process of segregation of duties and how it relates to personnel and reporting. World class organizations know that proactive prevention is the best approach to long-term compliance and sustainability, so take the FX Initiative and improve your internal control process by subscribing today!

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Cheers,

The FX Initiative Team
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Discover the Details of FX Hedge Documentation

When accounting for FX derivatives, firms have a choice between the “default” and “elective” accounting treatment. Elective accounting treatment is not required and involves extra preparation and utilization of resources, but for forecasted transactions and hedges of net investments in foreign operations, the benefits can outweigh the costs particularly for publicly traded firms most concerned with mitigating periodic earnings volatility.

The “elective” accounting treatment permits special accounting for items designated as being hedged and offers 2 main financial reporting benefits; Timing & Geography: (1) timing refers to reducing periodic earnings volatility by deferring derivative mark-to-market gains and losses in equity and (2) geography refers to accounting for the derivative gain or loss in the same geographic area of the financial statements as the hedged exposure.

It is important to emphasize that elective hedge accounting never changes the economics of a hedge, only the financial reporting. The choice of whether or not to use “elective” accounting treatment will depend on the foreign exchange risk management objectives of each organization, and part of the strategic decision making process involves determining if the financial reporting benefits outweigh the administrative and compliance costs.

To satisfy the requirement for elective accounting treatment, companies must prepare formal contemporaneous hedge documentation at the inception of the hedge. The hedge documentation outlines the hedging relationship, and the entity's risk management objective and strategy for undertaking the hedge, including identification of following 5 components:

1. The hedging instrument
2. The hedged item or transaction
3. The nature of the risk being hedged
4. The method that will be used to retrospectively and prospectively assess the hedging instrument's effectiveness
5. The method that will be used to measure ineffectiveness

Effectiveness is an assessment of the degree by which the derivative offsets the hedged transactions changes in cash flows that are attributable to foreign exchange risk. While hedge documentation and effectiveness testing can range significantly in detail and complexity, two simplified examples of hedge documentation are addressed in FX Initiative’s currency risk management training.

Our Hedging FX Transactions and Hedging Foreign Subsidiaries courses walk you through real world scenarios using Apple, Inc. as an example, and show you the required documentation as well as the timing and geography benefits using our FX Transaction Simulator and Foreign Subsidiary Consolidator. Hedging documentation can be daunting, but our training makes preparation practical so you can achieve for your foreign exchange risk management goals.

Are you interested in discovering the details of FX hedge documentation? Take the FX Initiative by subscribing today!

Cheers,

The FX Initiative Team
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Learn Best Practice Accounting for FX Derivatives

Foreign exchange accounting is a complex area of financial reporting that many global organizations struggle with. Adding to that complexity, companies engaged in foreign exchange risk management must also learn how to account for currency derivatives. While the specific accounting rules differ between generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), the fundamental concepts are essential to understand when implementing foreign exchange risk management best practices for your international business.

Companies that hedge foreign exchange risk often have two main objectives: (1) To minimize the Income Statement impact of fluctuating foreign exchange rates, and (2) to reduce the variability in functional currency equivalent cash flows resulting from foreign currency transactions. In order to achieve the objective of minimizing the Income Statement impact of fluctuating foreign exchange rates, it is important to first consider the accounting treatment for the underlying position, and then to align the accounting treatment for the FX derivative accordingly.

At the highest level, companies can account for FX derivatives using “default” accounting treatment or “elective” accounting treatment. The “default accounting treatment requires that derivative gains and losses should be recorded in earnings on a current basis based on changes in their fair market value. The “elective” accounting treatment permits special accounting that results in changes in the fair value of the derivative to be recorded in the equity section of the balance sheet (rather than earnings) as part of other comprehensive income and then reclassified from the balance sheet to the income statement in the period or periods in which the underlying hedged item impacts consolidated earnings.

While the rules of elective accounting treatment can get quite complex, the key take away is that elective accounting treatment provides financial reporting benefits when hedging underlying exposures that do not impact the income statement on a current basis, such as forecasted transactions. Therefore, firms have a choice between the “default” and “elective” accounting treatment. FX Initiative’s currency risk management training addresses several variables to consider when choosing the most appropriate course of action for FX derivative accounting.

If you are interested in learning more about accounting for FX derivatives, FX Initiative’s currency risk management training walks you through real-world scenarios using Apple as an example. Specifically, we cover hedging forecasted revenue transactions, booked receivable transactions, and net investments in foreign subsidiaries using both elective and default accounting treatment. Learning how to account for FX derivatives is critical in order to achieve your foreign exchange risk management objectives. Start learning today by taking the FX Initiative!

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Cheers,

The FX Initiative Team
support@fxinitiative.com