Not All Hedge Accounting is Created Equal

Transcription

1 Not All Hedge Accounting is Created Equal April 26, :00 am to 10:00 am Ryan Bergstrom 1

2 Disclaimer TRANSACTIONS IN OVER-THE-COUNTER DERIVATIVES (OR SWAPS ) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS. THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS. 2

3 The Chatham Difference Technology and Advisory from independent experts leading the derivatives and debt markets Hedge Accounting Advisory Interest Rate Hedging FX Hedging Commodity Hedging Regulatory Advisory Debt & Capital Advisory ChathamDirect, our SaaS platform Financial risk management modules Debt management module Covered by SSAE 16 audit Serving clients Trading > $300 billion annually 5 locations globally in U.S., Europe, and Asia 3

4 Today s Agenda 1 Balancing Competing Factors in Your FX Program 2 Case Study: ABC Chemical 3 Why Hedge Accounting? 4 Identifying Hedge Accounting Capacity 5 Managing Forecasting Challenges 6 Documentation Considerations 7 Questions 4

5 Running a Great FX Program is a Balancing Act Questions that every treasurer should ask: ❶ ❷ ❸ ❹ ❺ ❻ Which Currencies cause material risks? Am I managing Economic and Accounting risks equally well? Are my Cash Flow and Balance Sheet programs working together? How do I resolve conflicts between Parent s and Susidiaries risks? How do I identify more Hedgeable Exposures? How do I avoid losing hedge accounting capacity from Forecast Uncertainty? Hedgable Risks 5

6 Advanced Techniques that Every Treasurer Should Know ❺ ❻ Identify hedgeable exposures utilizing Advanced Hedge Accounting Techniques Overcome forecast uncertainty with Rolling Exposure Buckets to identify more Hedgable Risks 6

7 Case Study: Multi-National Chemical Company EMEA $6.4bn Americas $3.6bn APAC $.5bn [2014 Projections] 7

8 Case Study USD Reporting ABC Chemical Corp is a US-based company, reporting in USD Global Business Units Subsidiaries with operations across a variety of currencies Net Income & FX Programs Key metric is consolidated USD net income Running both B/S and C/F programs Hedging Program Focus Limit cost of hedging through optimized program exposures present greatest risk reduction 8

9 Targeted Hedging to Efficiently Reduce Risk Greatest contribution to risk is from exposure 9

10 Why Hedge Accounting? Without it, all MTM changes on hedges flow directly into earnings Changes in MTM Everything flows immediately into earnings Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 10

11 Why Hedge Accounting? With hedge accounting, recognition of gains / losses on hedges is initially deferred in equity (other comprehensive income or OCI ) and subsequently reclassified to earnings to align with the recognition of the associated hedged transactions Equity Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Hedge Accounting Effective portion of MTM changes flow to equity, equity reclassified to earnings as hedged transactions occur Ineffective portion of MTM changes flow to earnings 11

12 Why Can t I Just Hedge my Exposure Directly at the USD Parent? Hedge Accounting Qualification Criteria Party to the derivative Trxn ccy functional ccy The entity with the currency exposure must be a party to the hedging instrument (in certain instances, another member of the consolidated group may qualify) The hedged transaction must be denominated in a different currency than the hedging unit s functional currency 12

13 Hedge Accounting Designation Approaches Hedge accounting exposures can be identified at multiple levels, some easier to locate than others Level one is the simplest hedge accounting structure to achieve. Level three additional exposures can be identified, but will require further analysis and implementation work. Level ❶ Level ❷ Level ❸ Direct Designation Indirect Designation Split Designation Bring in your auditors early and keep them informed. Level two additional hedge accounting exposures are identified by looking across the organization. This requires a bit more effort and hedge accounting setup. 13

14 Hedge Accounting Levels Hedge accounting exposures can be identified at multiple levels, some easier to locate than others Level one is the simplest hedge accounting structure to achieve. Level three additional exposures can be identified, but will require further analysis and implementation work. Level ❶ Level ❷ Level ❸ Direct Designation Indirect Designation Split Designation Level two additional hedge accounting exposures are identified by looking across the organization. This requires a bit more effort and hedge accounting setup. 14

15 Direct Designation Approach ($) USD Parent USD ($) USD Sub Counterparty Hedge may be designated against third party revenues in a USD functional entity. 50mm 15

16 How Does Hedging Revenues Help Achieve the Company s Objectives? Direct offset in Revenues: Variability in Gross Margin and Net Income attributable to variability in the USD: exchange rate is offset by gains and losses on ABC Chemical s FX hedges ($) USD Parent INCOME STATEMENT Revenue 10,000,000 Cost of Sales 7,000,000 Gross Margin 3,000,000 Other Inc/Ex 800,000 NI 3,800,000 USD ($) USD Sub Counterparty 16

17 Hedge Accounting Levels Hedge accounting exposures can be identified at multiple levels, some easier to locate than others Level one is the simplest hedge accounting structure to achieve. Level three additional exposures can be identified, but will require further analysis and implementation work. Level ❶ Level ❷ Level ❸ Direct Designation Indirect Designation Split Designation Level two additional hedge accounting exposures are identified by looking across the organization. This requires a bit more effort and hedge accounting setup. 17

18 Indirect Designation Approach ($) USD Parent USD ( ) Sub Counterparty 18

19 Indirect Designation Approach ($) USD Parent USD ( ) Sub USD Counterparty 50mm + 20mm 19

20 How Does Hedging USD Expense Help Achieve the Company s Objectives? INCOME STATEMENT Indirect offset in COS: Variability in Gross Margin and Net Income attributable to variability in the USD: exchange rate is offset by gains and losses on ABC Chemical s FX hedges ($) USD Parent Revenue 10,000,000 Cost of Sales 7,000,000 Gross Margin 3,000,000 Other Inc/Ex 800,000 NI 3,800,000 USD ( ) Sub USD Counterparty 20

21 Hedge Accounting Levels Hedge accounting exposures can be identified at multiple levels, some easier to locate than others Level one is the simplest hedge accounting structure to achieve. Level three additional exposures can be identified, but will require further analysis and implementation work. Level ❶ Level ❷ Level ❸ Direct Designation Indirect Designation Split Designation Level two additional hedge accounting exposures are identified by looking across the organization. This requires a bit more effort and hedge accounting setup. 21

22 Split Designation Approach ($) USD Parent USD ( ) EUR Sub Counterparty Hedged risk has to be GPB to EUR so our economic hedge will not be the appropriate accounting hedge. 22

23 Split Designation Approach ($) USD Parent Counterparty USD EUR EUR ( ) EUR Sub USD USD:EUR leg of hedge may be designated against USD expenses. EUR: leg of hedge may be designated against revenues. 23

24 Split Designation Approach ($) USD Parent Counterparty USD EUR EUR ( ) EUR Sub USD 50mm + 20mm + 15mm 24

25 How Does Hedging Split Exposures Help Achieve the Company s Objectives? INCOME STATEMENT Split offset in Revenues and COS: Variability in Gross Margin and Net Income attributable to variability in the USD: exchange rate is offset by gains and losses on ABC Chemical s FX hedges ($) USD Parent Revenue 10,000,000 Cost of Sales 7,000,000 Gross Margin 3,000,000 Other Inc/Ex 800,000 NI 3,800,000 USD USD EUR EUR ( ) EUR Sub Counterparty 25

26 Identifying Exposure at an Organizational Level Allowed for More Hedging Capacity Parent Sub Sub Sub Sub Sub Sub Sub Sub Sub 50mm + 20mm+ 15mm 26

27 Forecast Uncertainty Can Constrain H.A. Capacity Examples: Unpredictable plant shutdowns; seasonality in core business; delays in supply chain A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Millions Historical Volume

28 Forecast Uncertainty Can Constrain H.A. Capacity Examples: Unpredictable plant shutdowns; seasonality in core business; delays in supply chain A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Millions Historical Volume H.A. Capacity (without Rolling Bucket)

29 Forecast Uncertainty Can Constrain H.A. Capacity Examples: Unpredictable plant shutdowns; seasonality in core business; delays in supply chain A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Millions Untapped Potential Hedge Accounting Capacity

30 Rolling Exposure Buckets: How do they work? A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 CF hedge A s exposure period CF hedge B s exposure period CF hedge C s exposure period CF hedge D s exposure period Excess hedge notional is spilled-over into the following exposure period. Hedges cascade into the future. 30

31 Rolling Exposure Buckets Can Alleviate Capacity Constraints Stemming from Forecast Uncertainty A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Millions Historical Volume H.A. Capacity (without Rolling Bucket) Rolling 3 Month Average Volume mm + 20mm + 15mm + 18mm 31

32 Rolling Exposure Buckets Can Alleviate Capacity Constraints Stemming from Forecast Uncertainty A B C D TODAY Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Millions Historical Volume Rolling 3 Month Average Volume H.A. Capacity (without Rolling Bucket) H.A. Capacity (with Rolling Bucket) Unleashed Hedge Accounting Capacity from Rolling Buckets 17 50mm + 20mm + 15mm + 18mm 32

33 Spill-Over Tracking 33

34 Increasing Capacity Without Adding Significantly More Admin. Hedge Accounting Qualification Improving hedge capacity through exploring advanced hedge accounting techniques and implementing a hedging strategy using rolling exposure buckets may complicate the administration of the program. Administration may be alleviated through consideration and implementation of a bestin-class FX policy framework and appropriate hedge accounting documentation. 34

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