Mapping Currencies Across Countries

Mapping Currencies Across Countries: It is evident that no one single world currency exists. There are over 180 currencies recognized as legal tender in circulation throughout the world. The most widely used list of currencies is known as ISO 4217, which is a standard published by the International Organization for Standardization or the ISO. The ISO is an international standard-setting body composed of representatives from various national standards organizations, and the ISO 4217 currency codes shown in this interactive map are used in banking and business globally.

While many of us are familiar with the “Major” currencies, which include the euro, British pound sterling, Australian dollar, New Zealand dollar, United States dollar, Canadian dollar, Swiss franc, and Japanese yen, there are so many more currencies to explore. This interactive map helps you explore the world through the lens of currency. All 180 currencies in circulation are mapped using geographic coordinates and ISO 4217 currency codes. Simply click on the dots on the map to reveal the ISO 4217 currency code, currency name, country.

To learn more about conquering currency risk, start your FX risk management training today, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples & events at FXCPE.com.

Explore the Zero Sum Game of FX Gains & Losses

Hedging foreign exchange risk can be viewed as a zero sum game, meaning that when one side of the hedge gains the other side loses. The degree by which those gains and losses do or do not perfectly offset depends on the derivative instrument, hedge coverage level, and strategy used. The FX hedge game isn't about winning or losing, it's about making the outcome more certain.

Balance sheet hedging is the most common practice among multinational corporations, and the goal is often to reduce foreign exchange gains and losses on the income statement to zero. The most effective way to largely achieve this goal is to hedge using a forward contract, which has a symmetrical payoff profile relative to the spot exchange rate, and to hedge 100% of the underlying exposure. However, even under this perfect scenario, there will still be residual FX gains and losses reported in earnings.

When companies hedge near 100% of their balance sheet exposures using forward contracts, controllers and treasurers often wonder why they are never able to achieve that zero sum outcome entirely. This is due to the forward point component of the forward rate on the derivative contract, and the fact that forward contracts are revalued based on forward rates compared to the underlying spot exposure, which is revalued based on spot exchange rates.

As a result, there will almost always be a difference in the "mark-to-market" accounting of a forward contract hedge and an underlying spot exposure. The only time this would not be the case is if interest rates were exactly equal for the countries or regions associated with the two currencies in the pair, which is highly uncommon. This is a typical area of frustration global corporations struggle with, and it highlights that understanding the accounting for underlying exposures and derivatives can clarify why there is a residual impact in earnings. Furthermore, it helps set realistic expectations as to what can be achieved when trying to play the zero sum game of FX hedging.

FX Initiative's Currency Risk Management Training covers balance sheet hedging in detail using Apple as an example to show how multinational corporations can hedge common exposures such as receivables and payables with forward contracts to mitigate foreign exchange gains and losses on the income statement. Our focus is on both the cash flow and financial reporting aspects of the hedge strategy, and we reinforce our teaching with visual displays of the economic and accounting ramifications.

If you are interested in learning how to hedge FX balance sheet exposures, forecasted transactions, and net investments in foreign subsidiaries, start your training today and explore our real world examples of all three scenarios. Furthermore, you can use our FX Transaction Simulator and Foreign Subsidiary Consolidator to customize your own risk model using company specific variables that reflect your actual exposures. Our video based curriculum puts academic theory into practice, and can help you and your team deliver more effective bottom line results in a time efficient manner. Take the FX Initiative for your organization by subscribing here.

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Cheers,

The FX Initiative Team
support@fxinitiative.com

Explore the powerful impact of professional development

Professional development in the workplace often refers to required employee training in areas such as workplace safety, corporate policies, and industry specific rules and regulations. While this training is commonplace in the corporate setting, it rarely provides value add to the employee or organization in terms of job performance and customer success.

FX Initiative's approach to professional development focuses on the employee first, and makes results personal and meaningful. We start by identifying knowledge gaps using our Pre-Test Evaluation, then we close those knowledge gaps with our on-demand educational videos, and we reinforce our learning concepts using real-world examples.

Professionals tasked with foreign exchange risk management often know their goals and objectives, but struggle with how to achieve them due to lack of training. Without dedicating time to the learning process and practicing what you've learned, it seems unrealistic to expect positive bottom line results and achievement of plans.

The organizations FX Initiative works with recognize that investing in quality training that directly relates to employee job responsibilities benefits both the employee and the bottom line. Not only are employees more knowledgeable and capable after completing our training, but they are able to apply their knowledge for the benefit of their customers and the firm.

FX training is a win-win outcome. FX sales teams are able to have deeper conversations with clients, gain a better understanding of problems and available solutions, and secure long-term relationships that are mutually beneficial to both parties. Treasury professionals are able to significantly reduce FX gains and losses, preserve cash flows from FX transactions, and articulate their results more clearly and confidently to senior management.

FX Initiative's Currency Risk Management Training provides an actionable and valuable plan for learning foreign exchange that helps FX sales teams collaborate more effectively with treasury professionals. FX service providers and global firms can take full advantage of our unique training opportunity by proactively investing in their employees and organizations. Professional development is no longer something to simply check off the list, it is now a necessity for global companies and their employees to remain competitive and profitable.

Ready to invest in professional development for your organization? Click here to take the FX Initiative!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Attend the FX Risk Management webinar!

Program Overview This FX Risk Management webinar will address the fundamentals of corporate foreign exchange (FX) risk management. We begin with an overview of how leading multinational corporations manage foreign exchange risk. We will then address how FX risk impacts a corporation’s financial statements, including the Income Statement and Balance Sheet, and we will also highlight common disclosures found in annual reports (10-K). Furthermore, we’ll examine key terminology related to FX risk management, and define terms such as FX transaction, translation and economic risk. Finally, we will look at the essential elements of a world class corporate FX risk management program, with a focus on personnel, operations, resources, and policy. The goal of this program is to help global corporations understand the importance of FX risk management and how to assess their foreign exchange risk profile using a structured analysis framework. Learning Objectives Discover how leading multinational corporations manage foreign exchange (FX) risk. Explore FX risks on the Income Statement, Balance Sheet, and in annual reports (10-K). Recognize common FX terminology such as transaction, translation and economic risk. Identify essential elements of a world class corporate FX risk management program.   Who Should Attend? New and seasoned finance, accounting, treasury, and related professionals (CPA, CIA, CRMA, CFE, etc.) interested in international business. We look forward to your participation in this live program on Thursday, April 26 2018. Simply click here to register for the presentation! Register

Identify the Top Two FX Hedge Objectives

Companies that hedge foreign exchange must establish clear objectives in order to gauge the efficacy of their FX risk management program. While the priority of hedge objectives can vary between public and private companies, the same two overarching goals apply: (1) minimizing earnings volatility and (2) preserving cash flows. Gaining a better understanding of these two objectives can help organizations better decide how to allocate resources to achieve their desired economic and accounting results.

First, minimizing earnings volatility means neutralizing to the greatest extent possible the Income Statement impact of fluctuating foreign exchange rates. At the highest level, this requires aligning the accounting treatment for the derivative with the accounting treatment for the underlying exposure to achieve equal and offsetting gains and losses at the same time and in the same geographic area of the financial statements.

When hedging forecasted transactions that do not impact the Income Statement on a current basis, minimizing earning volatility often involves the use of elective “cash flow” hedge accounting treatment, which provides the timing benefit of deferring derivative mark-to-market gains and losses in equity during the forecast period and the geography benefit of accounting for the derivative gain or loss in the same financial statement line item as the forecasted exposure.

When hedging booked transactions that do impact the Income Statement on a current basis, neutralizing earning volatility refers to using the "default" accounting treatment, whereby the highly visible foreign exchange gains and losses related to the underlying exposure and the derivative hedging instrument work in tandem to create a largely equal offset in earnings that mitigates Income Statement volatility automatically at the end of each reporting period.

When hedging net investments in foreign subsidiaries that are accounted for in equity, reducing earning volatility means using elective "net investment" hedge accounting treatment, which allows for derivative gains and losses to be recorded in other comprehensive income (OCI), which is a component of equity, as part of the cumulative translation adjustment (CTA) until the point in time that a sale or liquidation event of the net investment occurs.

Second, preserving cash flows means reducing the variability in functional currency equivalent cash flows resulting from foreign currency transactions. When hedging booked and forecasted transactions, this means hedging to stabilize the amount of cash received or paid upon conversion of the foreign currency at a later date. When hedging net investments in foreign subsidiaries, preserving cash flows can involve a variety of strategies depending on the short and long term goals of the organization. For example, 3 different cash flow strategies include, (1) hedging excess cash balances that are held by foreign subsidiaries and that may eventually be remitted back to the parent, (2) hedging the value of a net investment position to preserve cash flows related to an anticipated sale or liquidation event of the foreign operation in the short or medium term, or (3) not hedging the position in a long term foreign subsidiary that may require cash settlement upon expiration of the derivative instrument.

While these concepts can get quite technical in detail, the overarching theme is that both public and private companies are focusing on the same two foreign exchange risk management hedging objectives: (1) minimizing earning volatility and (2) preserving cash flows. Public companies are often most concerned with mitigating periodic earnings volatility, which suggests they prioritize goal number 1 of minimizing earnings volatility over preserving cash flows. In contrast, private companies are usually more concerned about the economics over the accounting implications, which implies they focus more on preserving cash flows first and foremost. The key highlight is that public and private companies usually have different priorities between the same two FX hedge objectives.

To learn how your organization can prioritize and achieve your company’s specific hedging objectives, sign up for FX Initiative's currency risk management training to start learning best practices. We offer a complete continuing professional education (CPE) curriculum for controlling currency risk consisting of on-demand educational videos, interactive real-world examples, and live webinar events that can be customized to your organization’s particular needs. Take the FX Initiative today to learn how we help both Fortune 500 companies and small and medium-sized enterprises (SMEs) understand, identify, assess and mitigate foreign exchange risk.

Ready to achieve your FX Risk Management objectives? Click here to get started >

The FX Initiative Team
support@fxinitiative.com

Comparing Cryptocurrency to Foreign Currency

Cryptocurrencies such as Bitcoin have captured headlines in 2017, and the question of how modern cryptocurrencies compare to traditional foreign currencies is often raised. FX Initiative helps global businesses manage foreign exchange (FX) risk, and this article will explore some of the key differences between cryptocurrency and foreign currency from a corporate foreign exchange risk management perspective.

It is clear that cryptocurrencies are still in their infancy, but the debate in the financial community over the future growth of this digital asset class remains open. While many articles have focused on areas such as monetary authorities, regulation, costs, timing, and transparency, this article will offer a unique focus specifically on the areas of acceptance, exchange, utilization, obsolescence, and risk management.

Acceptance
A small but growing number of brand name companies promote their acceptance of Bitcoin, such as Overstock.com, DISH Network, Expedia, Microsoft, and others. In fact, Coinbase claims that 47,000 businesses integrate Bitcoin with their service. However, companies such as Dell and Fiverr announced their acceptance of Bitcoin in 2014 but have since updated their policies to no longer accept Bitcoin. As it stands today, cryptocurrency, unlike foreign currency, is not a universally acceptable medium of exchange for procuring goods and services.

Exchange
It is important to note that most major corporations who accept cryptocurrency are partnered with digital asset intermediaries such as BitPay and Coinbase to instantly exchange Bitcoin for fiat money such as U.S. dollars or euros. By doing so, the companies minimize their holding period and financial exposure to the heightened volatility of a cryptocurrency. Unlike foreign currency, which is not always immediately exchanged, a company’s acceptance of cryptocurrency largely depends on their partnership with intermediaries to transfer the financial risk immediately.

Utilization
While Bitcoin is increasingly used by investors and consumers, businesses still lack widespread utility for the cryptocurrency. For example, when a company earns foreign currency denominated revenue, they may also have foreign currency denominated expenses (i.e. payroll, suppliers, vendors, cost of goods, etc.), which creates a natural utility for the foreign currency. In contrast, most corporations that earn Bitcoin denominated revenue lack Bitcoin denominated expenses, which reduces the utility of the cryptocurrency for funding ongoing business operations.

Obsolescence
Although Bitcoin is perhaps the most well known cryptocurrency, there were over 200 initial coin offerings (ICO) in 2017, which collectively raised more than $3.2 billion. The following white papers on Bitcoin, Ethereum, Zcash, Monero, Bancor, Tezos, and EOS explain the pros and cons of each project, and there remains a high degree of uncertainty as to which cryptocurrency will emerge as the long term market leader. Unlike foreign currency, specific cryptocurrencies have the potential to become obsolete as newer and better technology evolves over time.

Risk Management
The Consumer Financial Protection Bureau (CFPB) warned about the potential issues with virtual currencies such as unclear costs, volatile exchange rates, the threat of hacking and scams, and companies not offering help or refunds for lost or stolen funds. Additionally, the most viable current means of managing Bitcoin's financial risk is simply transferring ownership though intermediaries. If and when firms such as the Chicago Board Options Exchange launch bitcoin derivatives trading products, foreign currencies have superior risk management products & services.

Overall, foreign currencies are widely accepted, easily exchanged, naturally utilized, lack obsolescence, and offer a range of risk management tools to mitigate risk such as over the counter (OTC) and exchange traded derivatives including forwards, swaps, options and futures. As we approach the 10 year anniversary of Bitcoin’s introduction, the adaptation of cryptocurrency in the business world will continue to be notable and newsworthy. Join the ongoing discussion and share your comments and stories on cryptocurrency and its impact on business.

FX Initiative is collaborating with cryptocurrency experts to help educate the business community. We’re creating compelling content and interactive risk modeling tools for simulating Bitcoin denominated transactions, hypothetical hedging instruments, and policies and procedures to facilitate a wider understanding of the practical application and potential of cryptocurrency. To learn more about foreign exchange risk management or to participate in our cryptocurrency collaborations, contact us here, email support@fxinitiative.com or visit FX Initiative at https://fxcpe.com.

Commemorating Forty-One (41) Years of Fiat Currency

This week marks 41 years since the definition of the U.S. dollar was officially changed through Public Law 94-564 on October 19, 1976. The result was a shift in U.S. monetary policy where the gold standard, which pegged all currencies to the U.S. dollar (USD) and fixed value in terms of gold, was replaced by our current system of freely floating fiat currencies, where currency no longer holds intrinsic value and is established as money by government regulation or law. This was the most notable event during the Nixon Shock, which was a series of economic measures undertaken by United States President Richard Nixon beginning in 1971, and shaped the nature of the foreign exchange market as it exists today.

Source: http://uscode.house.gov/statutes/pl/94/564.pdf

The free floating system of fiat currencies is best illustrated by the U.S. dollar Index (DXY) that was introduced in March of 1973. The DXY is a measure of the value of the United States dollar (USD) relative to a basket of foreign currencies, which include the euro (EUR), Japanese yen (JPY), Pound Sterling (GBP), Canadian dollar (CAD), Swedish Krona (SEK) and Swiss franc (CHF). At its start, the value of the U.S. Dollar Index was 100.000, and it has since traded as high as 164.7200 in February 1985, and as low as 70.698 on March 16, 2008. The DXY goes up when the U.S. dollar gains value when compared to other currencies, and goes down when the U.S. dollar loses value. The following graph shows the volatility in the value of the U.S. dollar over the last 50 years in relation to various political, economic and other major global events.

Source: US Dollar Index from Stooq.com

Free floating exchange rates are determined by the balance between supply and demand factors that influence a particular currency, and the intersection point where supply meets demand establishes what is known as the price equilibrium or exchange rate. The graph below of supply and demand shows that when there is an increase in demand and a corresponding shift of the demand curve to the right, a new intersection point where supply meets demand is established, and a new price equilibrium or exchange rate is set. In this case, as demand increases, the value or price of the currency also increases from Exchange Rate 1 to Exchange Rate 2. These fluctuations in currency values underscore the concept of exchange rate risk, or currency risk, which arises from the change in price of one currency against another.

Source: FX Initiative FX Market Overview Course

Supply and demand with respect to foreign currency valuations is a simple idea in theory. If at a particular exchange rate, demand exceeds supply, the price will rise, and if supply exceeds demand, the price will fall. Supply is influenced by a central bank’s monetary authority through monetary policy, and depending on the specific circumstances and economic goals of a country or region, a monetary authority will influence the money supply through interest rates and other market mechanisms. Demand, on the other hand, comes from a multitude of market forces including, but not limited to, (1) economic business cycles and economic data releases (2) international investment patterns and foreign direct investment (3) the balance of payments as it relates to tradable goods and services (4) government fiscal, monetary, or other policies and political developments and (5) speculation based on any or all of these factors.

Source: FX Initiative FX Market Overview Course

Over the last 40 years, governments have played a significant role in defining and driving the value of free floating fiat currencies. Since the financial crisis of 2007–2008, exchange rates have been impacted by several major foreign exchange interventions as follows:

• Venezuela’s introduction of a two-tier official exchange rate system for the Venezuelan bolívar in January 2010
• The Bank of Japan’s devaluation of the Japanese yen though quantitative easing and “Abenomics” in April of 2013
• The Central Bank of Russia allowing the Russian ruble to float freely in an attempt to stabilize value in November of 2014
• The Swiss National Bank (SNB) no longer holding the Swiss franc at a fixed exchange rate with the euro in January 2015
• Brexit’s impact on the British pound following the United Kingdom’s referendum to withdraw from the European Union in June 2016

In commemoration of the week that changed the foreign exchange market as we know it, we can look at free floating exchange rates through the lens of history and see how the events of the 1970’s are still impacting the value of more than 180 currencies recognized as legal tender in circulation throughout the world.

To learn more about the foreign exchange market and how to manage currency risk, explore FX Initiative’s educational videos, interactive examples, and webinar events. Our currency risk management training illustrates best practices from leading organizations such as Apple to help you efficiently and effectively mitigate foreign exchange risk for your international business. Learn how to assess and optimize your firm's foreign exchange risk profile by taking the FX Initiative today!

Ready to conquer currency risk? Click here to get started!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Morningstar's Missing FX Risk Management

FX Initiative is fascinated with how global companies manage foreign exchange (FX) risk. This analysis focuses on Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia. Founded by Joe Manseuto in Chicago in 1984, Morningstar’s timeline outlines their expansion into Japan in 1998, Australia, New Zealand and Canada in 1999, and the opening of Morningstar Europe, Morningstar Asia, and Morningstar Korea in 2000. Today, the company has operations in 27 countries as outlined in their 2016 annual report (10-K):

The company’s Securities and Exchange Commission (SEC) filings offer 3 interesting highlights from a FX perspective:

1. Morningstar has direct exposure to 23+ currencies through their wholly owned or majority-owned operating subsidiaries.
2. 26% of Morningstar’s 2016 consolidated revenue was generated from operations outside of the United States.
3. Their most recent 10-Q for the second quarter of 2017 states that "approximately 69% of their cash, cash equivalents, and investments balance as of June 30, 2017 was held by their operations outside the United States."

The two main goals of a FX risk management program are to (1) minimize earnings volatility on the Income Statement and (2) preserve cash flows on the Balance Sheet. Hedging involves taking an offsetting position in a specific currency in order to reduce the impact of unfavorable foreign exchange rate fluctuations, whereby when the underlying position incurs a loss, the hedge incurs a gain, and vice versa. The goal of hedging currency risk is not to gain or lose, it’s to make the financial outcome more certain and predictable. Let’s examine Morningstar’s FX risk profile with a simple year over year comparison between 2015 and 2016 by examining their revenue, operating expense, and other income highlights.

First, let’s explore the impact to the Income Statement from a gross margin perspective (i.e. revenue minus operating expenses). In 2016, “foreign currency translations reduced revenue by about $9.5 million” and their “operating expense by $11.5 million”, for a $2.0 million favorable variance. In 2015, “foreign currency translations reduced revenue by about $26.9 million” and “operating expense by $23.9 million”, for a $3.0 million unfavorable variance.

Second, the impact to “Other income, net primarily includes foreign currency exchange gains and losses arising from the ordinary course of our business operations.” In 2016, “Other income, net” was a positive $6.1 million compared to a positive $1.2 million in 2015. This volatility comes from the “mark-to-market” revaluation of booked receivables and payables each period that is reported in earnings on a current basis. These exposures are booked and known, and serve as the foundation of foreign exchange “balance sheet hedge” programs that are employed by many companies.

As it relates to Morningstar’s discussion of their FX risk management strategy, they state “Our operations outside of the United States involve additional challenges that we may not be able to meet. There are risks inherent in doing business outside the United States, including challenges in currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.” They also state they “do not expect to repatriate earnings from our international subsidiaries in the foreseeable future.”

While Morningstar clearly discloses their substantial currency risk, the company surprisingly states that "We don't engage in currency hedging or have any positions in derivative instruments to hedge our currency risk." Their 2016 annual report also goes on to state that “Foreign currency movements were a factor in our 2016 results, although to a lesser extent than in 2015, as continued strength in the U.S. dollar reduced revenue from our international operations when translated into U.S. dollars. This has been an ongoing trend for several years and reduced revenue by $9.5 million in 2016 and $26.9 million in 2015.”

Morningstar.com’s articles offer various investor perspectives on hedging FX risk. For example, the article “Hedge Your Currency Risk When Investing Abroad” mentions that “Investors should definitely invest globally and they should hedge out at least part of their foreign risk.” Another example from the article titled “The Impact of Foreign-Currency Movements on Equity Portfolios” is that “Betting on currency movements is generally a fool’s game and should be avoided by the average investor.” Applying this advice, it appears that Morningstar is invested globally but doesn’t hedge any part of their currency risk, and their decision not to hedge is a bet on FX.

Finding the right balance between risk and reward is a classic tradeoff for any investor or organization. Morningstar is a highly respected global thought leader when it comes to investing, and they have clearly analyzed their corporate exposure to FX risk as it relates to revenue, operating income and net investments (as shown in the screenshots below). Additionally, Morningstar has an array of publications on currency such as their Currency Category Handbook, and offers data services such as their Morningstar Foreign Exchange Feeds. The company seems to have the personnel, operations, and resources to manage FX risk.

From an enterprise risk management perspective, foreign exchange risk is a non-core business risk that often poses more of a threat than an opportunity, whereas core business risks are related the strengths that a company is rewarded for taking on, such as investing in new products and research and development. Therefore, hedging foreign exchange risk allows firms like Morningstar to budget more reliably when engaging in international business in order to focus on their core strategic initiatives more effectively.

What are your thoughts on Morningstar’s approach to FX risk management? Each market participant must define their own risk appetite, and there is no “standard" protocol. However, in closing this analysis, a quote from Gary Cohn, the Director of the National Economic Council and former president and chief operating officer of Goldman Sachs, comes to mind: “If you don't invest in risk management, it doesn't matter what business you're in, it's a risky business.” Join the conversation and share your thoughts on FX risk management in the comments section.

To learn more about FX risk management, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples, and webinar events help simplify complex currency risk management issues using real-world scenarios from leading organizations such as Apple. Our mission is to help banking and corporate treasury professionals deliver effective currency risk management results in a time efficient manner. Start learning best practices for mitigating FX risk by taking the FX Initiative today! Click here to for more information >

Image Sources: Morningstar Inc. 2016 Annual Report (10-K)

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
support@fxinitiative.com

Balancing Brexit & FX Balance Sheet Hedging

As Brexit continues to capture news headlines, FX Initiative is increasingly helping North American companies manage the currency risk associated with doing business in the United Kingdom (UK). Brexit refers to the prospective withdrawal of the United Kingdom from the European Union (EU), which was voted on in June of 2016. Since the referendum, the value of the British pound (GBP) versus the US dollar (USD) has fluctuated from highs near 1.4500 levels in June of 2016 to lows near 1.2000 levels in January of 2017. This approximate 15% decline in value has prompted many international companies to adapt their foreign exchange (FX) hedging programs to better stabilize earnings and preserve cash flows.

American companies exporting to the United Kingdom have seen significant fluctuations in their GBP denominated revenues and accounts receivables (A/R), which are translated into USD in their financial statements for accounting purposes. To state the obvious, the 15% fluctuation in GBP/USD exchange rates over a 15 month period has created sizable swings in earnings and cash flows for firms that operate with a non-GBP functional currency. To mitigate this volatility, one major US pharmaceutical company needed to reconsider their FX balance sheet hedge program to better respond to the changing political landscape and unpredictable currency market prices.

Balance sheet hedging is by far the most common approach among multinational corporations when hedging foreign exchange risk, and in the context of Brexit, refers to hedging GBP denominated receivables and payables on the balance sheet as part of a systematic hedge program at each period or month end, or upon booking a material foreign currency denominated transaction. This US pharmaceutical company was previously hedging at each month end to adjust and match the amount of the their underlying GBP receivables with the amount of their GBP forward contract hedges. However, the majority of their monthly receivable bookings occurred on the 15th of each month, and their mid-month A/R bookings were largely unhedged from the middle of the month through month end.

To address this problem, FX Initiative helped assess the mechanics of their balance sheet hedge program by looking at their financial reporting process and specifically at their accounting booking convention. An accounting booking convention refers to the foreign exchange rate used to record a transaction on the financial statements. In this case, they were using the daily spot rate, which meant they were exposed to changes in exchange rates for each mid-month booking of a material GBP receivable transaction. By probing all the way down to the accounting booking convention, this US company was able to quickly and effectively enhance their balance sheet hedge program by adding one additional “true-up” hedge mid-month.

Their revised approach meant that rather than only hedging at the end of each month, the company was now adjusting the amounts on their forward contract hedge both mid-month and at month end. The result of this fundamental fix was that the company is now hedging over 90% of their GBP exposure for the entire month, and the FX swings in their monthly and quarterly earnings have declined by over 50%. Regardless of whether you are a FX risk management expert or novice, knowing where to diagnose a FX exposure is critical and having the ability to drill down to a technical level of detail such as an accounting booking convention can help companies conquer currency market challenges more efficiently and effectively.

FX Initiative’s training and consulting services can help your global organization establish and improve your foreign exchange balance sheet hedge program. We use real-world examples from Apple to demonstrate how a balance sheet hedge works in practice, and our risk modeling tools enable you to practice your approach prior to implementation to get comfortable with the economics and accounting. While events like Brexit are hard to predict, a consistent and ongoing foreign exchange risk management program can proactively protect against changing political, regulatory, and economic environments. FX hedging is about making the outcome more certain, so give your company the FX certainty and predictably it needs to succeed abroad by taking the FX Initiative!

Ready to build a better FX balance sheet hedge program? Click here to start your Currency Risk Management training!

Cheers,

The FX Initiative Team
support@fxinitiative.com