Commercial Bank

FX Review: FX Balance Sheet Hedging — A Starter Guide

Businesses need appropriate strategies to manage their exposure to fluctuating foreign exchange rates. However, deciding how best to implement a FX hedging program is challenging for treasuries. While there is no one-size-fits-all solution given companies’ varying needs and circumstances, a balance sheet hedging program is often a good starting point and can provide immediate benefit to companies.

Figure 1: Market Data

S&P 500 DJIA EUR per USD JPY per USD MXN per USD

Q1 2021 3,959 33,067 0.8536 110.36 20.58

QoQ Change 5.39% 8.04% 4.28% 6.89% 3.36%

*Arrows indicate direction of dollar performance | *Data as of 3/30/2021 | Source: Bloomberg, Citi 2 Commercial Bank | FX Review

Why a Balance Sheet Program Makes Sense Corporate FX hedging programs are highly individual. Companies make specific choices about the types of exposures they manage in order to protect key metrics, such as margin or cash flow, against market volatility. That said, balance sheet hedging programs that protect recognized foreign currency transactions are a common strategy among companies that manage FX.

When companies make sales and/or purchases in non-functional currencies, they must recognize these transactions on their books once the transaction is invoiced. Commercial flows, such as receivables, payables, and intercompany balances (as well as other monetary assets or liabilities) are recorded on the balance sheet until settlement. While they do not have any impact on margin, these balances are subject to market re-measurement for changes in spot FX rates and gains/losses are reported in income. Due to the eventual cash impact, there is an economic rationale to hedge the functional currency-equivalent value of these FX balances.

For companies that are new to FX, balance sheet programs are often an ideal starting point given that the item being hedged is already recognized on the balance sheet. They may even help pave the way for cash flow (forecasted transaction) hedging, since both involve the same transactions but at different stages in the transaction flow. A balance sheet program hedges exposures whenrecognized while a cash flow program hedges them when forecasted. The same critical elements that make a balance sheet hedging strategy effective will drive successful forecasted transaction hedging.

How Does a Balance Sheet Hedging Program Work? To understand the important elements of an effective balance sheet program, it is helpful to describe the work flow involved. For most companies, once the process is set, it is often run on ‘auto-pilot’ from one hedging cycle to the next, typically month to month.

Generally speaking, the process kicks off with exposure gathering and consolidation before the desired hedging date. Exposures consist of actuals (or amounts outstanding) as well as forecasts of transactions to be booked or paid in the next accounting period. Next, treasury prepares to execute hedges in order to cover the identified FX exposure from outstanding foreign currency items and/or any new items to be booked. Hedges are generally executed at the beginning of the monthly period but, in some cases, companies may decide to delay hedging until the transactions come on the books, intra-month. Further hedge adjustments may also be required intra-month when previously booked transactions are settled. Finally, at month-end, companies need to report FX gains and losses along with offsetting settlements from hedges. The cycle then re-starts with exposure gathering.

Figure 2 below illustrates a typical workflow. It highlights the important roles that the finance and treasury functions must play throughout the process to make the hedging program effective. Beyond treasury, other business areas such as financial planning & analysis and receivables/payables teams will also be required to provide information to support the process. Finally, accounting support will be needed to properly identify exposures, reporting of FX, general ledger, and trading activities. FX Balance Sheet Hedging — A Starter Guide 3

THE SAME CRITICAL ELEMENTS THAT MAKE A BALANCE SHEET HEDGING STRATEGY EFFECTIVE WILL DRIVE SUCCESSFUL FORECASTED TRANSACTION HEDGING.

Figure 2 – Example of Balance Sheet Hedging Process

Gather exposures Hedges confirmed Hedges executed (FP&A, cash, by email, settlements FX rates set based on forecasts collection/payments, instructed (Treasury) accounting, treasury) (Back-office)

Invoices prepared Swaps executed FX gains/losses and distributed as needed recorded (Receivables/ (Treasury) (Accounting & Trsy) Payables team)

Source: Citi

Given that this is a continuous process of exposure gathering, hedging and reporting, a well-run balance sheet program requires a streamlined policy and process that can be followed month-to-month.

Setting-up the Program entity, or via back-to-back transactions? Is the program managed regionally or on a centralized basis? Treasury is well Figure 3 shows the inter-related nature of people and positioned to drive these discussions during the construction organizations, the treasury processes, and technology of the program and also conduct regular reviews to ensure systems needed to stand up a well-functioning balance sheet the program is functioning as intended. hedging program. Next, companies need to consider various treasury work In terms of people decisions, treasury would need to clearly streams and establish the monthly process. For example, define roles and responsibilities to carry out the hedging to minimize the variance between the FX rate at which an process. Internal support from senior management is critical exposure is booked and hedged, treasury needs to have as the program involves cross-functional finance teams’ an understanding of both the exposure gathering process, expertise and time. During the initial set-up of exposure in addition to the accounting rate setting mechanism. If capture, treasury requires accounting and possibly tax done correctly, this variance can be effectively minimized. partners to properly identify which exposures pose FX In relation to executing hedges, companies need to define re-measurement risk. These exposures must be monetary how trading decisions will be made. This involves an balances and should be reviewed periodically to ensure internal assessment of risk tolerance, hedge cost, financial that all exposures are properly captured (certain items instruments, and deciding when intra-month adjustments are such as leases may require special accounting treatment). warranted. Furthermore, to ensure transparency, companies Organizationally, there are other key decisions that must be should put in place a reporting practice that periodically made in terms of the scope of the program: does the program reviews the effectiveness of the program, to determine include exposures from all legal entities or only operating whether improvements are required. subs? Is hedging done at the entity level, on behalf-of an 4 Commercial Bank | FX Review

Figure 3 – People, Process, and Technology for a Balance Sheet Program

Treasury Processes

• Exposure gathering/ • Risk & strategy reporting • Trading set-up • Exposure reconciliation • Intra-month adjustments • Netting processes • Reporting • Rate setting/settlement • Hedge result review

System Policy Configuration

System and Technology Organization Structure

• ERP and TMS • Location (centralized/by-entity) Execution • Exposure capture • Approval/Execution decisions • FX calculations • Finance functions; FP&A, tax, • Trading and derivative reporting accounting/audit, treasury • Netting • Management support

Technology People

Source: Citi

Finally, systems technology is needed to support hedging activity in order to minimize the use of manual processes and procedures. Specifically, a treasury management system (TMS) – connected to the company’s ERP – that supports exposure capture and booking of hedging transactions, including inter-company transactions, is an essential component of a streamlined and efficient FX risk management program.

Bringing It Together People, treasury processes and technology are necessary to support the implementation of a balance sheet hedging program. Each of these are inter-related and collectively act as a strong foundation on which an effective risk management program can be built. Given considerable uncertainty about the economic outlook and business environment in the post-pandemic period, FX volatility needs to be taken seriously by all companies: a balance sheet hedging program can be a valuable addition to the treasury toolkit.

Please contact your Citi salesperson for more details.

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