Cash flow hedging is the hedging method most widely associated with FX risk management programs that seek hedge accounting treatment.
Oddly, the term “cash flow hedging” is actually a bit of a misnomer; often, the maturity of a cash flow hedge will be before the date of any associated cash flows from the underlying hedged item.
Let’s dive into the basics of cash flow hedging to learn more about how it works, why it’s urgent to get it right, and how to make your cash flow hedging program more successful.
What is Cash Flow Hedging?
Cash flow hedging is aimed at managing the impact of currency fluctuations on future cash flows, such as those from exports, imports, or intercompany expenses or revenues. This type of hedging is typically focused on managing the FX risk of the income statement where the transaction currency differs from the functional currency of an entity. The goal of cash flow hedging is to minimize the impact of FX rate changes on the company’s income statement and earnings.
Unlike balance sheet hedging, the goal of cash flow hedging is to delay the mark-to-market impact of the hedges to match the timing of the underlying risk they are hedging.
Example: If FX revenue forecasted six months from now is the hedged item, the company will want to postpone the mark-to-market impact of the associated cash flow hedges for six months and ultimately have the entire gain or loss of those FX hedges impact the income statement during the same month that the FX revenue is recognized. During these six months, the mark-to-market gains/losses of cash flow hedges get parked in an equity account called other comprehensive income (OCI).
Cash flow hedging impacts are often allocated throughout the company by geography and/or business unit. Though there are a variety of corporate structures that can influence how or whether this is done, there is ultimately going to be someone responsible for the USD equivalent (post-hedge) results for the various FX exposures that permeate the company’s income statement.
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Don’t Wait to Address Cash Flow Hedging
FX risk management is a crucial piece of every multinational company’s financial results, so getting cash flow hedging correct is key.
When listing their top challenges while managing FX risks, Global Treasury Survey respondents cited issues that would hurt their ability to successfully execute cash flow hedging:
- Manual exposure identification and capture processes (71%)
- Hedge accounting compliance (32%)
- Non-standard FX management processes (31%)
- Informal or immature hedging practices (22%)
Overcoming these challenges may require outside assistance, as Treasury teams are typically very lean and may be lacking the necessary technology to overcome the top challenge in particular.
How to Achieve Cash Flow Hedging Success
When implementing the cash flow hedging strategy, it’s critical to focus on these best practices for continued success.
- Take a layered approach: Achieve the ultimate cash flow hedge percentage by hedging in layers for the consecutive quarters prior to the period in question, so the ultimate hedged rate will be a blend of prior period rates.
- Consider a broad set of perspectives and potential impacts: Cash flow FX risk management strategies must consider the potential pricing impacts on suppliers and customers, not just the company’s internal financial plan.
- Understand the company’s ability to respond to FX shocks: How far out to go and what percentage to hedge will depend on the company’s ability to respond to these FX shocks in other ways and may differ by business and/or geography.
- Deliver insightful analytics to those who are impacted by FX: For those that are measured on USD-based results, understanding the FX rate and volume-related impacts that build a bridge back to the plan they are measured against is crucial.
All of these best practices are made easier with a complete FX risk management technology solution. Implementing software solutions that offer FX exposure insights, automate hedging workflows, and provide risk reporting and analysis capabilities can streamline operations.
By addressing common balance sheet hedging challenges through technology solutions, companies can mitigate the impact of FX volatility and safeguard their bottom line.
