Forex risk management is an important aspect of every multinational company’s business and having the right forex risk management strategies is crucial in order to achieve financial targets.  Forex risk management can be very complex, and according to a recent Global Treasury Survey conducted by Deloitte, forex volatility ranks as the top challenge facing Treasurers today.

The big-picture objectives for most companies are usually the same when it comes to forex risk management.  They want to minimize the impact of forex volatility on their EPS and meet all their financial targets and external guidance regardless of the forex environment.  No CFO wants to have to discuss currency volatility as a reason for missing their objectives on a quarterly earnings call.

While primary responsibility for achieving this objective may fall on the Treasurer and his or her forex risk management team, there really needs to an understanding throughout the organization of how forex can impact everything from a long-term strategic plan to the smallest of transactions.  While it’s not realistic to have everyone in the company become an expert in forex risk management, it is crucial to properly integrate forex impacts into the metrics that drive behavior in the company. After all, you can’t manage what you don’t measure.

To isolate the forex risk management challenges a bit, we’ll separate the process of balance sheet (or “fair value”) hedging from cash flow hedging, as they require different approaches and typically have different levels of involvement and accountability within the company.

Balance Sheet Hedging

The forex risk that is typically the first that companies focus on is balance sheet risk.  This is because there are no longer any internal mechanisms a company can use to protect itself from the forex volatility of items that are already on the balance sheet.  While future non-USD revenues and expenses may be influenced by local currency pricing changes, negotiated discounts, or other mechanisms, once a receivable or payable is on the balance sheet, the volatility of that asset or liability will have a direct impact on the bottom line, if not hedged.

Specifically, when there are assets and liabilities in currencies that differ from the functional currency of the entity where they reside, their value must be remeasured (back into functional currency terms) at the end of every month.  This remeasurement gain or loss can be substantial, and the goal of a balance sheet hedging program should be to offset this remeasurement impact as much as possible.

The net impact of currency remeasurement combined with an offsetting balance sheet forex hedging program provides the company feedback each month on how well they are managing this risk.  Without the ability to break down the potential sources of variance, however, the company is just left with an unexplained delta between the underlying balance sheet exposure and the balance sheet hedge.  The forex risk manager hopes this delta is not large, and that they will not have to scramble to try and explain where the noise is coming from during a tight month-end close window. Hope, however, is not a strategy.

To move past hope as a strategy, it is crucial to understand the potential sources of hedging variance and have the right technology and processes in place to capture and understand this information in a timely manner.  The sources of variance in a balance sheet hedging program include the following:

Balance Sheet Hedging Sources of Variance

  1. Forward point cost or benefit This will be part of the hedge while there is no offset on the remeasurement side.  This is purely a function of the interest rate differential between the currencies being hedged, reflecting the difference between the spot rate and the relevant forward rate to the hedged date.  This may be a cost or a benefit to the company, depending on whether they are sellers or buyers of the higher interest rate currency to a future date.
  2. Spot trading impact This is the difference between the spot rate of any hedges and the relevant accounting rate they are meant to protect.  A hedging program that is properly timed should have minimal variance based on their initial trades, but there may be larger variance from adjustment trades done later in the month, or any potential liquidity trades that are executed as forex spot trades instead of forex swaps.  This impact could be favorable or unfavorable.
  3. Forecast deviation Ultimately there will be a difference between a forecast that a hedge is based upon, and the actual exposure that is remeasured.  This impact can also either be favorable or unfavorable. For companies that use a daily accounting rate, calculating and tracking this impact can be very complex without the right technology.
  4. Remeasurement inconsistencies Identifying the inconsistencies between the theoretical remeasurement impact and the actual remeasurement impact is often a major pain point in forex risk management.  These inconsistencies may arise from manual booking adjustments (of which Treasury is often not notified) or from forex rate booking errors or transaction currency reporting errors that are difficult to locate without the right technology to assist.

There are several challenges that companies face that keep them from being able to put together this kind of analysis of variances for their balance sheet forex risk management programs, which often lead to poor hedging results.  These challenges include the following:

Balance Sheet Hedging Challenges

  1. Complex ERP environment The ERP environment can vary quite broadly between companies.  Ideally, the entire company uses the same modern instance of a single ERP platform for all their entities.  Some companies, perhaps due to numerous acquisitions, have an environment of several different ERP platforms and potentially different charts of accounts throughout the company.
  2. ERP data lacking transactional currency detail The out-of-the-box reports that are typically available from the ERP systems often contain information that is missing the transactional currency detail needed to understand the exposures on the balance sheet.  The data in the reports has already been converted to the functional currency of the entity or the reporting currency of the company.
  3. Poor forecasting processes Many companies rely on forecasts that are not particularly well thought out and do not take into consideration the main drivers of balance sheet fluctuations.  Too often the latest known balance sheet actuals are used as a forward forecast, or perhaps a simplistic trend analysis is utilized for some larger items. Companies often fail to leverage existing income statement forecasts that can help forecast the future balance sheet in a predictable and more accountable manner.
  4. Poor liquidity management Many companies create unnecessary spot trading volatility through their cash conversion process.  Whether they are converting excess local currency to USD or needing to purchase local currency for funding needs, these spot conversions typically have an offsetting impact on the balance sheet.  Therefore, the spot trade should have an equal and opposite forward trade (balance sheet hedge adjustment) to reflect the reduction of the asset or liability, eliminating the “spot noise” from this activity.
  5. Inability to interrogate remeasurement data Since the goal of the balance sheet hedging program is to offset the remeasurement impact, not being able to find discrepancies in the remeasurement data is a problem.  Discrepancies can show up from manual entries into the remeasurement account, rate errors, or other reasons. Being able to find these “needles in the haystack” during a tight window of the month-end close process is almost impossible without help from the right technology solution.

Cash Flow Hedging

“Cash Flow Hedging” is the term most widely associated with forex risk management programs that seek a different accounting treatment than balance sheet hedging (balance sheet hedges are also known as “fair value” hedges).  A quick summary of the difference between cash flow and fair value hedge accounting is as follows:

With balance sheet hedging, there is no need to delay the mark-to-market gains or losses of the balance sheet hedges from impacting the income statement at the end of the month, since the remeasurement of the balance sheet (the underlying risk they are hedging) is also impacting the income statement immediately.

With cash flow hedging, there is a desire to delay the impact of the hedges to match the timing of the underlying risk they are hedging.  If forex revenue forecasted six months from now is the hedged item, for example, the desire is 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 forex hedges impact the income statement during the same month that the forex revenue is recognized.  During the six months, the mark-to-market gains/losses of cash flow hedges gets parked in an equity account, called Other Comprehensive Income (OCI).

The term cash flow hedging is a bit of a misnomer, since often the maturity of a cash flow hedge will be before the date of any associated cash flows from the underlying hedged item.  In the revenue hedging example, the maturity may go to the revenue date, while the receivable associated with the revenue may not get paid for another few months (and potentially be covered by a balance sheet hedge).

The same dynamic may occur if expenses are covered with a cash flow hedge, and the associated payables are covered with a balance sheet hedge.  In these cases, the “cash flow hedge” is really more of an “income statement hedge.” Some companies, however, will hedge the entire risk timeline with a single hedge, and de-designate the hedge from a cash flow hedge to a balance sheet hedge at the appropriate time.  Either method can work fine, just as long as there is an efficient handoff from one hedging program to another.

Cash Flow Hedging Forex Risk Management Strategies

Coming up with the proper forex risk management strategies for cash flow hedging can be challenging.  Most companies have a once per year financial planning exercise that can be made more complicated by the desire to lock down the USD equivalent value of forecasted revenues and expenses for the following year.  This annual plan often becomes the basis for key performance metrics throughout the company.

Because of this, it may be tempting to hedge the following year’s revenues and/or expenses all at once, when the company needs to put a “line in the sand” about what forex rate assumptions to use for their internal plan.  While this may be the easiest approach from an internally focused administrative perspective, it’s not the best way hedge against forex volatility when considering the potential impacts on your suppliers and customers.

The proper cash flow forex risk management strategies must take into consideration a broad set of perspectives and potential impacts.  Hedging an entire year’s worth of exposures at once and repeating the process one year later will likely distort the financial picture from one year to the next if the forex exposure is at all significant.  That approach would create a “staircase” effect on the forex risk, as the forex rates locked in for one year would often make a dramatic step to the rates locked in for the following year.

The goal of cash flow hedging should really be to buy enough time to adapt to new forex environments as they evolve, and this is not accomplished with a once a year “set it and forget it” strategy.  “Buying enough time” is usually accomplished best with a layered hedging approach, covering a certain percentage of future exposures several quarters in advance, steadily increasing the percentage covered as the quarter approaches.

For example, a company may target an ultimate cash flow hedge percent of 80% but achieve that by hedging in 20% layers for the four consecutive quarters prior to the period in question.  That way the ultimate hedged rate will be a blend of prior period rates, and more steadily increase or decrease over time in response to currency shocks. How far out to go and what percentage to hedge will relate to the company’s ability to respond to these forex shocks in other ways and may differ by business and/or geography.

As opposed to balance sheet hedging results, which are often kept centralized and not allocated to various business units, 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 forex exposures that permeate the company’s income statement.

Having effective cash flow forex risk management strategies from the perspective of all impacted parties is a difficult goal to achieve, and success requires overcoming numerous challenges.

Cash Flow Hedging Challenges

  1. Merely providing constant currency guidance First of all, some companies decide to not hedge their cash flow exposures at all, and instead provide their investors with information on how their financials would have looked based on the prior year rates (i.e. in “constant currency”).  While this data point might be somewhat interesting in trying to figure out underlying growth rates, not hedging material forex risks does a disservice to your investors, as they are not able to manage this risk themselves.
  2. Poor forecasting This was a challenge for balance sheet hedging, and not surprisingly, one for cash flow hedging as well.  Forecasting future revenues and expenses in total is difficult enough but determining the necessary forex breakdown in order to hedge makes it even tougher.  Because of this, the percentage of forecasted exposures hedged will often be less than 100%, as frequent over-hedging may jeopardize the desired hedge accounting treatment.
  3. Dealing with attempted “market timers” or those with “20/20 hindsight” If the forex risk manager is allocating cash flow hedging gains and losses to the business units, they may receive unwanted feedback on when or whether to hedge certain currencies.  Attempting to time the market based on an individual’s guess, or even a “bank consensus” estimate is a bad idea. In fact, if most banks agree on a direction for a currency, this is more likely to be a contrary signal, as it is likely an indicator of how the majority are already positioned in the market!  A cash flow hedging process needs to have specific parameters for percentages hedged, and the window when the hedging will take place, removing subjectivity.
  4. Trying to maximize upside This is somewhat related to the point above but is important enough to call out separately.  The goal of a cash flow hedging program should be to minimize the downside, not to maximize the upside.  How to do this can be very specific to the nature of the exposures and requires an in depth understanding of how your business can respond to various currency shock scenarios (price changes, changing location of certain activities, etc.).  Besides, those that may occasionally succeed in maximizing the upside may find themselves with a very difficult year over year comparison the following year!
  5. Poor cash flow hedging metrics It is difficult for a cash flow forex risk management program to be successful if the results don’t help tie back to a plan that is meaningful to the people who are getting allocated the gains and losses.  The sources of variance need to be understood, and where they are significant, a feedback loop needs to exist to make well understood adjustments when necessary.

Cash Flow Hedging Metrics

When it comes to any performance metrics, you get what you measure, and cash flow hedging is no different.  It can be challenging to bridge the results of a layered cash flow hedging program back to metrics that may be based on a single forex rate assumption for the entire year for any given currency.  The potential sources of variance that the cash flow hedging analytics need to explain include all the potential volume drivers (where hedged volume differs from the actuals) and rate drivers (where the hedged rates differ from the relevant planning rates).

  1. AvP impact on the business In order to understand the results of the cash flow hedging, the forex risk manager needs to first identify the impact on the business before incorporating the hedging results.  This requires calculations of how the related forex revenues and expenses convert to USD at the actual accounting rates during the period in question, compared to how they would have converted to USD using the planning rates (or budget rates) for the period in question.  This essentially quantifies the impact (either positive or negative) of the actual rate environment in which the business had to operate compared to the planning assumptions.To the extent that the cash flow hedge does not perfectly offset this impact (essentially bringing these results back to the planning or budget rate), the variance should be broken out and explained:
  2. Volume drivers This is the mismatch between the hedge (based on a forecast) and the actual.  This will usually have two components, one based on policy (target hedge percentage) and the accuracy of the forecast itself.  If, for example, the target hedge only gets to 80%, the “policy impact” of deciding not to hedge 20% of the exposure needs to be isolated from the true forecast deviation.Feedback on the accuracy of the forecasts needs to be provided back to the individuals providing the forecast, preferable in a dashboard that highlights large percentage misses (the “name and shame” approach).
  3. Rate drivers This reflects the difference between the hedged rate and the planning rate for the period in question.  If the company only uses a single planning or budget rate for the year, this may differ significantly from the ultimate hedged rates realized with a layered approach, especially late in the year.  The forex risk manager should work with the planning team as closely as possible to eliminate any unnecessary variance here.This can be accomplished by helping to determine the planning rates used each year, which should ideally be a weighted average of the hedges that are already in place for that period, combined with the most up to date forward rates to use as an estimate for what is unhedged at the time of planning.Ideally, the forex risk manager also introduces more frequent planning rates throughout the year (quarterly is better than annually) that more closely mirror the hedges as they are layered on, which need to be reflected in the metrics for those responsible for the USD equivalent results.
    While this may be administratively more difficult, it more closely ties the company to the forex market realities, and keeps certain plans form either becoming too difficult or too easy to achieve, based on forex headwinds or tailwinds compared to a single planning rate for the year.


It should be evident that successful communication and partnering beyond the Treasury organization is critical in successfully implementing your forex risk management strategies.  There are many things that can go wrong when it comes to forex risk management, and we’ve only touched on some of them in this paper. Even with the right processes in place, the data involved can overwhelm an “Excel only” solution and requires the right technology solution as well.

For a more comprehensive discussion on the issues and pain points that are most relevant for your company, please contact us or email us at [email protected].