Balance Sheet Hedging: What to Know About Hedging Risk

Updated: Jun 9

Balance Sheet Hedging Image

The Treasury department serves two main functions: the obvious, which is to consider the financial position of a business and make sure that it can pay its creditors and other expenses, and the less obvious, which is to make sure that the outcome of a hedging program reflects reality.

A good Treasury professional will typically try to gather the correct exposures for Balance Sheet hedging. They might have a solid understanding of what the business does, its seasonality, and how other aspects of its business model interact with the exposure it’s trying to hedge. To truly become a great hedger of Balance Sheet risk, one must understand the subtle nuances of how exposures are recorded at the firm. This effort pays off.

These nuances are the building blocks of exposure because the accounting treatment of exposure determines the sensitivity of the exposure to the price of the underlying asset. For example, a business’s cost of goods sold is a balance sheet item recorded as an expense on the income statement, but it also has tax implications.

If the business’s tax rate is higher than in previous years, then the cost of goods sold will significantly impact its profit than last year. By getting a firm’s tax rate, the Treasury can determine the sensitivity of the business’s profit to the underlying asset price.

This sensitivity analysis is a core tool for building the optimal hedge for a business and is based on how the company reports its results to its shareholders.

A deeper understanding of the accounting nuances can also help an individual firm understand how its executives view the business’s performance. For example, a cost-cutting drive from management might show up in a company's profit and loss account as an increased cost of goods sold (an expense).

However, this same cost-cutting initiative might also have a positive impact on future profit by allowing the firm to lower its tax rate for future years, thus reducing its future cost of goods sold (again, an expense). Knowing how a business records its results can give a Treasury expert a better understanding of how its executives view the firm’s performance.

In today's article, we will be exploring hedging balance sheet risk and what you should know about it.

If you're curious to learn more, keep reading.

What is Balance Sheet Hedging?

Balance sheet hedging refers to financial engineering designed to neutralise the risk from a company’s assets and liabilities or a company’s asset and liability groups. The term is most commonly used in banking and financial markets. It describes a strategy for managing certain risks, either by transferring assets and liabilities to reduce balance sheet risk or by creating synthetic assets and liabilities to minimise risk exposure.

In a banking context, balance sheet hedging is used to reduce a bank's exposure to movements in the value of various assets and liabilities that it holds. By transferring the assets and liabilities to other parties, the bank can reduce its balance sheet risk while simultaneously allowing the parties that take on the assets and liabilities to manage their risk exposure.

How Does a Balance Sheet Hedge Work?

There are two main ways a hedge can work when it comes to Balance Sheet Hedging. Without getting into technical details, let’s say a firm has an asset with a value of $100 at an initial date and then has a liability of $100 6 months later.

One way for the firm to reduce its balance sheet risk would be to borrow $100 six months in advance and pay it back at the end of the six months. This way, the firm would have an asset worth $100 at the initial date and a liability worth $100 6 months later, but no exposure at the end of the six months.

Another way for the firm to reduce its balance sheet risk would be to have a borrower buy the asset at the initial date and pay the lender of the asset £100 six months later when the liability is due.

Top 6 Balance Sheet Hedges That Create Risky Positions

There are different ways to enter positions in the financial markets that don't fully hedge off the risk that an underlying asset might decline in value. Here are five common balance sheet hedges that introduce risk into positions.

1. Hedging U.S. Dollars

Many investors hedge U.S. dollars against the risk of a decline in U.S. dollar value by shorting currencies like the British pound, the Australian dollar, and the Danish krone. These currencies are often referred to as "risk currencies." This strategy makes sense since the U.S. dollar is generally considered a haven currency, meaning it typically rises in value during market turmoil.

This position is a risk hedge since we assume U.S. dollars will decline in value and that the risk currencies will appreciate. Thus the U.S. dollar should understand.

However, if the U.S. dollar were allowed to trade freely, meaning there were no currency trading restrictions, investors would likely not be short U.S. dollars. If there were no restrictions, the U.S. dollar would probably appreciate since investors would buy the U.S. dollar to hedge against risk elsewhere in the world.

This is why restrictions on U.S. dollar trading are in place. If U.S. dollars were free to trade, there would be an enormous amount of U.S. dollars traded by investors and speculators each day. Speculators would likely drive the currency up in value with large trading volumes and be able to take large positions in futures, options and other derivatives markets with relative ease.

2. Hedging Certain "Tax" Liabilities

The balance sheet hedge of a tax liability works by a hedge fund, creating a hedged fund that owns the tax liability. If the hedge fund makes a hedge for a corporate tax liability, then the hedge fund owns the corporate income tax liability.

The hedge fund buys the tax liability at the present value of taxes and then sells a call option on the tax liability to an investor. A call option on a tax liability has the same value as a forward contract. The hedge fund can charge a fee for the hedge and still be at a zero net refund on the tax liability plus the option.

The hedge fund simply owns a derivative that pays off in future years and can use credit default swaps or options on the cash flow of the tax liability in the future to hedge its position. The hedge fund can also create a structured credit or equity tranche, of loan tranche for the tax liability.

3. Hedging Foreign Currency Exposure in the United States

When a U.S. company purchases foreign currency-denominated assets, it creates a liability on its balance sheet denominated in foreign currency and valued in U.S. dollars.

This means that if the dollar falls in value against the foreign currency, then the dollar value of the liability will fall, meaning the company will have to pay more foreign currency to liquidate the liability.

A company may hedge the currency risk of a foreign currency-denominated liability by obtaining a currency swap or by entering into an interest rate swap, a currency option or a forward contract. The company may also obtain a credit default swap on the foreign currency-denominated asset to cover the foreign currency exposure of the liability.

4. Hedging a Long Dated Contingent Liability

A contingent liability is a liability that depends on a future event to occur. A business may have a contingent liability if a future event, such as a lawsuit or an environmental cleanup, could cost the business money.

The cost of the contingent liability is typically estimated today. If a future event occurs, the business has to pay the cost of the liability. However, if the future event does not happen, then the business does not have to pay for the cost of the penalty.

For a business, the main concern with contingent liability is its impact on the business's earnings power. A contingent liability could have a negative effect on the business's earnings if it is significant and is not insured.

For example, if a company is sued for $1 billion and has a contingency fund or insurance that covers the liability, the company would not have to pay out of pocket to satisfy the lawsuit.

However, if the company does not have $1 billion to pay out of pocket, it would have to pay the $1 billion out of pocket, which would hurt its earnings. A company can hedge a long-dated contingent liability by entering a swap on the liability.

5. Hedging Cash Pooling Inter-company Transactions

Hedging cash pooling intercompany transactions can be done in several ways. One way to hedge is through a "Non-Deliverable Forwards" (NDF). An NDF is a non-deliverable forward contract typically used to hedge a non-deliverable foreign currency (NDF) swap.

In a typical foreign currency swap, a company that does business in multiple countries may wish to have its local subsidiary match local currency for local currency (i.e. Japan for Japan and USA for the USA). This way, a company doesn't need to use expensive inter-company borrowing instead of saving on transaction costs.

However, if the company uses the NDF method, the company can still end up with a foreign currency exposure between the countries if the cross-currency swap rate is not the same.

Hedging cash pooling inter-company transactions can also be done through a cross-currency interest rate or a cross currency IRD swap. An IRD swap is an interest rate derivative involving multiple currencies, while an IRD swap involves multiple interest rates.

6. Hedging Non-Monetary Account Balances

Hedging non-monetary account balances is an example of a balance sheet hedge. A swap is a type of hedge that involves non-monetary positions on a balance sheet.

A swap is a combination of a derivative and a cash account. A company can enter into a trade by first entering into a derivative, then offsetting the derivative with a market position or another derivative. This is done very commonly in the foreign exchange and interest rate markets.

A company may enter into a non-deliverable forward contract in the foreign exchange market. Then, the company can use a cross-currency interest rate swap to hedge the non-deliverable forward position. The interest rate swap can be set up in any shape or size to offset the risks of the non-deliverable forward.

Best Practices for Hedging Programs

Although a hedge is designed to reduce the risk of the underlying position, some hedges will cause more risk. Some hedge strategies are better than others, depending on the risk in the underlying asset. Some strategies will increase the risk of the underlying position during some market conditions.

For example, if an investor has a long position in a foreign currency, the investor might hedge against currency risk by buying a financial product that offsets the long position. However, if the financial product is a currency option, the investor will increase the risk of the long position during the call period.

The investor will be betting on the currency's value increased during the call period. If the underlying currency declines in value, then the investor will increase the overall risk of the position, as the money decreases in value but the option increases in value.

The following best practices should be followed when operating a hedging program:

Limit the Number of Hedge Positions

It is essential to limit the number of hedge positions to manage the risk of the overall hedge program. It is easy to buy hedge positions and forget about them. Assuming the hedge position will offset the risk of the underlying position.

However, having too many hedge positions can increase the overall risk of the hedge program and may even cancel out the risk of the underlying position. For example, if an investor has an extensive portfolio fully hedged in a portfolio, then the investor doesn’t have any actual risk in the portfolio.

Be Careful of Hedging Multiple Underlying Risks

It is essential to understand that hedging multiple underlying risks can increase the risk of the underlying position. For example, if an investor has a portfolio of 10 bonds and hedges against the interest rate risk and inflation risk, the investor has cancelled out all risks in the portfolio.

While this may seem like a good idea, if the underlying bonds are not perfectly correlated, the investor will have increased the position's risk.

Don’t Use VaR to Measure Hedge Performance

VaR can be a good metric to use when measuring the risk of a portfolio, but it is not a good metric to use when measuring hedge effectiveness. VaR does not consider the offsetting dangers of the hedge, which can increase the overall risk of a position. For example, if an investor buys a put option and the underlying position goes up in price, then the put option will lose value, which will make the risk of the underlying position increase.

The Bottom Line

A hedge is a portfolio designed to reduce the risk of another portfolio. A hedge does not eliminate the risk of an overall position, but it does help to reduce the risk by taking on a different market position. The effectiveness of a hedge depends on the effectiveness of the hedging strategy.

Hedge strategies are most effective when they are well-diversified and designed to offset a market risk similar to the market risk of the underlying position. The best hedge strategies have no cost and can be fully automated.

A good hedge program will reduce the risk of an overall position. The best hedge programs are long-term and are based on market data. It is important to limit the number of hedge positions a portfolio has, as it is easy to forget about a hedge position and end up with a poorly-diversified portfolio.

Bound is an auto hedging platform dedicated to making currency protection better for businesses. It's a great software program to help you look at your risk in any one currency. Watch a demo today to learn more, and contact us for more information!


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