The hidden FX balance sheet exposure

Inter-company transactions are sometimes a source of exposure to currency risk. I have come across cases where associated companies lend loans to one another with the idea that "the consolidated balance sheet exposure is canceled-out." This is not always true, especially when the loan is denominated in a currency other than the functional currency of one of the parties to the loan.

Such a loan will create exchange rate differences that will be recorded as financing income or as financing expenses in the consolidated statement of profit and loss.  therefore a source of balance sheet exposure.

These loans are not visible in the consolidated balance sheet in which the mutual balances are offset, but the exchange rate differences that such loans create reflect real economic exposure and cause undesirable fluctuations in the finance cost section of the profit and loss statement. Although this exposure is a hidden balance sheet exposure, it is not exactly off balance sheet exposure because the loans are recognized in the solo's reports.

In this post, I will demonstrate a case as described and will examine a range of hedging solutions that may be appropriate in different scenarios.

Hidden balance sheet exposure example:

A parent company whose functional currency is the US dollar grants a loan in Euros to a subsidiary whose functional currency is the Euro.

Parent Company: The loan in Euro which it granted is an asset in its solo balance sheet. Therefore, the appreciation of the Dollar against the Euro creates a loss as a result of exchange rate differences recorded as financing expenses in the P&L statement.

Subsidiary: Since the subsidiary received a loan in its functional currency (Euro), the change in the EUR / USD exchange rate has no effect on its solo financial statements.

When consolidating the parent company’s financial statements with that of the subsidiary, the financing expenses recorded in the parent company's "solo" statement are consolidated. But, they are not offset by financing income from exchange rate differences in the subsidiary's solo report.

Hedging balance sheet exposure methods

The manner of handling this exposure should be related to the likelihood that the loan will be repaid and be manifest as cash flow on known dates. Hedging a loan that is not expected to be repaid in the foreseeable future by using a hedging instrument, that on the day it expires generates a cash flow, may create unnecessary liquidity problems. On the other hand, a loan that is expected to be repaid accurately according to a defined repayment schedule enables the use of hedging tools that will generate specific cash flow when they expire and will serve the currency conversion action that is supposed to take place anyway during the debt service. 

Cross Currency Swap (CC Swap):

This transaction is best suited to hedge this exposure, provided that the payments from the subsidiary are expected with high certainty. This transaction effectively replaces, from the parent company's perspective in our example, the granted Euro loan into a  Dollar denominated loan (the Dollar is the parent company’s functional currency). The transaction is built to exactly match the existing repayment schedule ("Tailor Made") until full repayment of the loan - several years ahead. Most banks agree to enter this kind of deal only if the loan and the repayment of the funds are above a minimum threshold that varies from bank to bank and usually amounts to several million Dollars.

A series of forward transactions and / or options:

When the loan is supposed to be repaid at intervals that are difficult to predict accurately, or when the loan's principal amount does not meet the minimum threshold required for a CC SWAP transaction, then another viable hedging alternative is the execution of a series of forward transactions and / or options. These transactions should be spread over a timeline that reflects the loan's projected repayment dates. In the future, if and when necessary, these transactions can be "rolled on" to create a more exact match to the now-known loan flow.

Taking credit in Euros:

In a scenario where the subsidiary is expected to repay the loan, but the repayments are due to begin only in a few years, the parent company in our example can use credit in Euros to create a "natural hedge". The credit should be taken as a "bullet" loan type (where the principal is repaid at the end) or as a line of credit in Euros (instead of Dollars), which, although defined as short-term credit, is essentially a fixed part of the debt structure of most companies.

Accounting treatment only: If the company is only concerned with the accounting ramifications of this exposure, then the use of “hedge accounting” is in order. Classify the loan as a "net investment in a foreign operation", provided that conditions specified in the accounting standard are met. This does not resolve the economic exposure However the advantage of this alternative is that the loan exchange rate differentials will be recorded in the capital fund, thereby preventing the company from unwanted volatility in the P&L.

This case study is general and schematically describes a series of solutions. It is very important to analyze each case and adopt a basket of solutions that is specific to the relevant company in a manner that is consistent with its risk perception, its financial capabilities, and its technical constraints, such as minimum thresholds for executing transactions. The formulation of a hedging strategy and technical methods of transaction execution is only one important layer. However, attention should also be given to executing efficient hedging transactions at their fair value.