Accounting Rate Approaches
Practical Corporate FX Risk Management Series, Part 2
This article is part two of an eight-part series on FX risk management.
As mentioned in part one of the series, there are two approaches to setting the accounting rate for foreign currency (non-functional currency) transactions: the prior month end rate and the daily rate. We will look at each of these approaches and the implications that they have for the balance sheet hedging program.
Prior Month End Rate
Using the prior month end rate approach, all new transactions booked during the period are booked at the prior month end rate. The transactions are therefore remeasured from the prior month end rate to the next month end rate.
In the example above, we have a USD functional entity with an opening balance exposure of EUR100 and further activity during the period of EUR50. Using the month end approach the total (EUR150) is remeasured from the prior month end rate of 1.20 to the next month end rate of 1.15, USD180 versus USD172.50, resulting in a remeasurement loss of USD7.50.
Daily Rate Approach
Under this approach new transactions are booked at the daily rate in place on the day that the transaction is booked to the ERP.
In the example below, we see a USD functional entity with an opening balance exposure of EUR100 and new activity booked during the period of EUR50. The difference on this occasion is that the EUR50 activity is booked at different daily rates: [email protected], [email protected], and [email protected]. When it comes to remeasurement of the exposure, we now have to look at each of these transactions separately.
Here is a more detailed breakdown of the remeasurement calculation:
Rate Method Implications for the Balance Sheet Hedging Program
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Month End Rate
At the end of the month when the new accounting rate is set, it is possible to hedge the exposure for the next month end (the end of January exposure is hedged at the end of December). This is possible because the rate at which the activity for the next month is hedged is the same as the rate at which activity for next month is booked to the balance sheet.
The company needs to forecast the balance sheet exposure for the next month end close. There are many approaches to forecasting the balance sheet exposure and we will explore this topic in a later post.
Daily Rate
In contrast to the month end rate approach, the rate at which the activity will be booked to the balance sheet in the coming month is not known so hedging that activity in advance at the prior month end would not lead to effective hedging.
Transactions are booked to the balance sheet daily and at the daily rate, to hedge these exposures the company reviews the exposures as frequently as daily and places a hedge for the incremental exposure.
As hedges are placed after the transactions have been booked there will always be slippage between the rate at which transactions are booked and the rate transactions are hedged (at least a one-day lag depending on the frequency that new hedges are executed).
The daily rate approach generates more trades as new activity during the month is hedged, this can lead to additional hedging costs plus more operational costs (booking and settling trades, etc.).
The daily approach makes the month end analytics more difficult as there are 20+ additional rates in calculations.
One further issue with the daily rate approach is that manual journals booked during the month end close process can be backdated to a date during the month and will attract the rate from that booking date, these transactions would be therefore unhedged.
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Global Treasury Operations - Halliburton
11 个月Literal gold in terms of keeping a potentially complex topic simple and easy to understand.
Driving Financial Performance Improvement - FX Hedging, Global Payments & Treasury.
11 个月Very insightful piece. The daily rate methodology can be hugely onerous with lots of downstream implications on reporting/operations/execution of hedges. We have some AP/Invoice automation technology that automatically hedges individual transactions as soon as they hit the AP ledger. That sort of solution isn't for everyone, often it also needs to be integrated into the procurement process which is separate from reporting/treasury. If you haven't built or bought something like that a already it can be really challenging to set up a balance sheet hedging program with daily or average rate valuations of transactions.
Those who have experienced working at different companies that utilize different AR methodologies quickly realize how big of an impact that has on the FX risk management process!