The idea of hedging a debt issue as described last month isn’t new, but we saw how changes to US GAAP greatly simplify the accounting. Hedge accounting can now produce a P&L outcome more palatable to management and easier to follow for investors.
I want to take the concept of an issuance window and think about it in the context of hedging the cost of an overseas construction project.
In this situation, the company has forecasted foreign currency outflows and may be very confident that that those flows will occur in a certain timeframe. That said, forecasting the exact date on which the flows will occur is very difficult, large capital projects are often subject to delays beyond the company’s control (weather, inspections, regulatory approvals, contractor schedules).
Under prior accounting rules, ineffectiveness would be recognised in earnings whenever the forecasted timing of cash flows changed. Companies could use the spot method to tighten the effectiveness of the hedge; this would still result in some volatility hitting P&L due to the fair value changes in the forward differential. While the spot method under new rules allows amortisation of forward points, this would result in accelerated recognition of hedging costs.
For Companies who have historically avoided certain types of hedges or even chose not to hedge at all, it may be time to reconsider
New accounting rules may allow companies to apply a similar designation method as under the pre-issue hedge of debt we previously looked at.
Hedge accounting changes
1. Hedge effectiveness assessments:
a. Initially assess the hedge quantitatively under the forward method
under the following:
i. Worst case hedge performance – depending on the structure may
need to consider multiple points during the window (using a
ii. Best case hedge performance (again, versus a hypothetical
b. Ongoing assessments may be done qualitatively
2. As discussed above, so long as the hedge is highly effective, there is no separate recognition of ineffectiveness in P&L
Considering the designation of FX flows occurring in a designated window, let’s look at the added flexibility in the types of hedging instruments that can be used.
Flexible forwards are forwards that can be settled at a fixed rate during a specified timeframe. This will give the hedger more flexibility on when the forward can be settled, but adding this flexibility may cost more in forward points.
When structuring these instruments, the pricing is typically based on the highest cost of hedging when looking at the forward curve over the course of the window. Therefore, the worst hedge performance would be expected versus a plain vanilla forward priced to the date in the window with the lowest cost of hedging (highest level of ineffectiveness). As the other extreme would be regressing versus a plain vanilla forward to the same date on which the flexible forward is also priced on, it seems reasonable to say that the full range of ineffectiveness within the window has been captured by testing these scenarios.
If the flexible forward is proven to be highly effective versus the worst case, then hedge accounting could allow for all mark to market changes to be deferred in OCI and only released when the hedged cash flow(s) impact earnings. Further, ongoing assessments may be done qualitatively so long as the original forecast(s) hold true. While the cost of the hedge is higher, the company would get the flexibility needed to better align the flows of the hedge with the project they are funding – the accounting can now follow the strategy.
Many things changed under ASU 2017-12, but just highlighting two key changes (the ability to perform ongoing assessment qualitatively and removing accounting for ineffectiveness), we see how companies can achieve better alignment of accounting and risk management objectives. Companies may find themselves now able to consider different product structures which better align to the exposures they face and still get a reasonable accounting outcome. For companies who have historically avoided certain types of hedges or even chose not to hedge at all, it may be time to reconsider.
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