Key Points:
- The FX impact on corporate earnings and guidance is a crucial consideration for both companies and analysts.
- Many US multinational corporations (MNCs) had poor hedging performance last year, raising questions about effective hedging decisions.
- Behavioral finance and financial accounting treatments may influence hedging decisions.
- There is a need to understand the fungibility of FX risk and the different forms it takes.
- Hedging decisions should focus on risk management objectives, rather than solely on financial accounting considerations.
- Boardrooms should hold CFOs accountable for effective hedging strategies.
- Thoughtful hedging policies and selecting appropriate performance indicators are essential for successful hedging.
“It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move.” — Alexander Kotov, Chess Grandmaster
Introduction
The impact of foreign exchange (FX) on corporate earnings and guidance is a critical consideration for companies and analysts. With a significant portion of revenues in S&P 500 companies originating internationally, the performance of hedging strategies is crucial. However, many US MNCs struggled with their hedging performance last year, and few CFOs explained their decisions on earnings calls.
Why did these companies perform poorly in hedging? Despite claims from treasury management system (TMS) providers about the capabilities of their systems in limiting the FX impact on earnings per share (EPS), very few companies actually hedge earnings risk. While there are challenges in hedging earnings, including exposure estimation and accounting-driven issues, the Citibank survey reveals that less than 15% of companies hedge their earnings translation exposure.
This raises a behavioral finance question about the influence of financial accounting treatments on hedging decisions and whether it leads to a transference of financial accounting to mental accounting.
The Fungibility of FX: One Risk, Three Forms
It is important to recognize the fungibility of FX risk, which can be underestimated. For example, EU-based companies can reduce their structural risk by relocating production facilities to the United States, aligning client revenue with production costs. However, this substitution of risk results in transactional risk being replaced by translational risk.
Timing plays a crucial role in distinguishing between transactional and translational risks. If a subsidiary reinvests its earnings instead of upstreaming dividends to its parent, the unrealized transactional risk will accumulate and match the translational risk to the consolidated income. Thus, the difference between these two forms of risks is a matter of timing rather than fundamental distinction.
Hedging vs. Accounting
Accounting rules allow for three types of hedges: fair value, cash flow, and net investment hedges. Fair value hedges recognize derivatives gains or losses in the current-period income statement. Cash flow and net investment hedges defer derivatives gains or losses through other comprehensive income (OCI), recorded on the shareholders’ equity section of the balance sheet.
Under IFRS, intercompany dividends can only be transactionally hedged once they are declared. This provides protection for the period between declaration and payment, but it is too short to significantly reduce the risk. If companies prefer cash flow hedges over fair value hedges, adverse FX impacts may arise when macro conditions deteriorate or during periods of rapid USD appreciation.
Companies have found accounting hacks to address unfavorable accounting treatment around earnings hedges, such as classifying them as net investment hedges when possible. Some MNCs use holding companies or regional treasury centers to manage timing issues and incorporate economic and structural hedges.
Despite these methods, questions remain about why publicly traded companies are often caught off guard by FX volatility. Financial accounting rules may influence hedging decisions, with treasurers and CFOs potentially avoiding fair value hedges and overlooking earnings exposures. It is crucial to examine whether accounting considerations dominate hedging decisions.
Boardroom Dynamics: Holding the CFO Accountable
Boardrooms play a critical role in holding CFOs accountable for hedging strategies. However, discussions regarding FX’s impact on EPS often focus on broader macro issues rather than the fundamental questions underlying the rationale for hedging decisions.
Technology is often seen as a solution, but flawless visibility alone cannot address the underlying issues. Smart hedging policies consider a firm’s risk aversion in relation to market risks and the specific circumstances of the company. Factors such as shareholder preferences, corporate objectives, business model, financial standing, and peer group analysis shape a firm’s choice of risk measures and benchmarks. Regardless of accounting considerations, it is important to pursue the right risk measures and benchmarks.
Conclusion
In conclusion, effective corporate hedging requires an understanding of the fungibility of FX risk and thoughtful hedging policies. Risk cannot be categorized away, and hedging decisions should focus on risk management objectives rather than financial accounting considerations alone. Boardrooms play a crucial role in holding CFOs accountable for effective hedging strategies, and the selection of appropriate performance indicators is essential for successful hedging. It is important to prioritize risk measures and benchmarks that align with a company’s specific circumstances to ensure consistent interpretation and pricing of risk.
