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Selecting hedge ratio on future cash flows

Moderator

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All companies with some sort of international activity are exposed to currency risk. This risk might be on future income or expenses in a foreign currency from international trade, or future investments in manufacturing equipment produced in a foreign country. Currency risk can also arise from investments in subsidiaries, financial investments in foreign countries or from debt nominated in a foreign currency.

 

All these risk exposures might lead to value changes on future cash flows. The value changes can also influence the financial statements, depending on the type of risk and the corresponding accounting rules.

 

The currency risk factors should be monitored by the treasury team. If the risk is material to the company, it must be managed.

 

Other risk factors linked to the currency exposure should also be evaluated. As an example, next year’s income will be generated from USD with an 80% share of the turnover in a company with NOK as home currency (and expense currency). This USD risk is probably material to this company. But the nature of the income might develop in to different hedging strategies.

 

If the USD income is deriving from one or several contracts, where the amount of income is fixed, the currency risk is well known. The few things that might change the risk profile are linked to delays in delivery or breach of contract clauses. Currency risk on contracted income is normally hedged with a high hedge ratio (close to 100%) to avoid currency risk ruining the contract profitability. The financial statements at Norwegian company Aker Solutions, a company with material share USD income, shows that they are “hedging currency risk for all significant project exposures”. Note 22 in their 2017 financial statements shows that the net amount of payment from customers, payments to vendors and balance sheet exposure are hedged 100% with currency forward contracts.

 

On the others hand, if the USD income is deriving from expected, non-contract sales, the risk profile on the income is very different. Price changes on the product we are selling (in USD) might occur through the coming year. In addition, there might be a risk that we do not reach the expected sales volume in product sales. Changes in these two risk factors can lead to significantly lower income in USD than we expect. A hedge ratio which is close to 100% for the coming year might end up with being over hedged if USD sales expectations are not met. Expected sales in foreign currency can be hedged, but with a lower hedge ratio than contracted sales. The hedge ratio on expected sales should be set based on evaluating the price and volume risk. Hedge ratios on expected sales for the coming year are normally set in between zero and 70%.

 

Swedish company Volvo Group is a producer of trucks and has 95% of its sales in currencies other than SEK. The group also has some production costs in other currencies than SEK. “The Volvo Group only hedge the part of the forecasted portfolio that is considered highly probable to occur, i.e. firm flows, where the main parts will be realized within six months. The Volvo Group uses forward contracts and currency options to hedge the portion of the value of forecasted future payment flows in foreign currency.” The Volvo Group USD hedge ratio is calculated (by DNB Markets) to be 35% for the coming year.

  

Ståle Johansen, Risk Advisory, DNB Markets

 

 

Information regarding Volvo Group and Aker Solutions is based on Financial Statements for 2017.