A user's guide to currency hedging.

• Author: Beier, Raymond J.
• Position: Risk Management

Stop losing sleep over your foreign-currency transactions. Once you know how to qualify them for hedge accounting, you can cut the risk of losses substantially.

Have you been taking care of your hedges lately? If not, now's a good time to shape up your risk-management and accounting strategies. The Financial Accounting Standards Board, as part of a project to develop consistent rules on hedge accounting, has issued an exposure draft requiring more complete disclosure on derivatives activities (see Financial Executive, July/August 1993, p. 42). And the highly publicized losses several companies incurred from their foreign-currency and fixed-income derivatives instruments have thrown more fuel on the fire. Add in continuing market volatility, and it's easy to see that change is undeniably on the way, even if it isn't around the comer yet.

Given the stepped-up regulatory, public and media scrutiny, it's crucial for you to evaluate which risks your company hedges and how you account for your hedging activities. As a financial risk manager, you need to know which techniques you can use to hedge your difficult existing or anticipated foreign-currency exposures and qualify for hedge accounting under current generally accepted accounting principles.

The accounting principles for foreign-currency transactions are defined in Statement of Financial Accounting Standards No. 52, "Foreign-Currency Translation," in addition to several Emerging Issues Task Force papers, including EITF 90-17, "Hedging Foreign-Currency Risks with Purchased Options"; EITF 91-1, "Hedging Intercompany Foreign-Currency Risks"; and EITF 91-4, "Hedging Foreign-Currency Risks with Complex Options and Similar Transactions." Keep in mind that economically prudent hedging transactions don't always qualify for the hedge accounting prescribed in SFAS 52. SFAS 52 allows for hedge accounting when the hedged item exposes the company to risk, the hedging transaction reduces the exposure to risk and the company designates the hedging transaction as a hedge.

Plus, hedge accounting generally recognizes gains and losses from the hedge position in the same accounting period as gains or losses on the hedged item, thus eliminating a source of reported-earnings volatility. While certain hedging strategies and the mathematical analyses supporting them can quickly become exceedingly complex, the exposures that create accounting difficulties and the strategies you can use to correct them fall into only a few broad, recognizable categories.

Existing assets and liabilities -- Accounting for hedges of existing foreign-currency denominated assets and liabilities is usually straightforward. Market-value changes caused by exchange-rate fluctuations should be included in your determination of current-period income and should offset the economic effects of changes in the exchange rates on the hedged asset or liability. Companies use virtually all types of foreign-currency hedging instruments to hedge existing assets or liabilities, including forwards, swaps and other similar contracts. They also use options, although not as frequently because of their up-front cost.

Foreign-currency commitments -- When you're dealing with strategies for hedging firmly committed foreign-currency transactions, such as purchase or sale commitments, it's usually simple to qualify them for hedge accounting, and the entire range of hedging instruments is available. A firm commitment is defined in SFAS 80, "Accounting for Futures Contracts," as "an agreement, usually...