What is cash flow hedging?
Cash flow hedging helps both corporate treasurers and fund managers to reduce VaR (Value at Risk) of their future expected earnings or distributions. Reducing earnings volatility brings a host of benefits. While there are many cash flow hedging protocols (rolling, layering, fire and forget, ad hoc), our adaptive layered hedging program implements the best components of each.
Reduced VaR and Earnings Volatilty
Layered hedging operates much like dollar-cost averaging. Each forecast is hedged with a series of prior hedges placed in the preceding 12-24 months. The effective rate is the weighted average of those hedges. This reduces the volatility of the effective rate by 70-80% (depending on ccy pair).
Whether it's local currency earnings or liabilities being hedged, layering reduces earnings volatility.
Increase Sharpe Ratio and Investor interest
When volatility is reduced, the Sharpe ratio increases. This in turn increases the corporate valuation.
The benefits of Cash Flow Hedging are:
Improves the ability for a firm to raise capital through Cash Flow hedging because an increased Sharpe ratio enhances equity raising.
In the debt market, a firm's ability to borrow is increased when it hedges. A key metric of corporate credit is net foreign exchange exposure, which again, Cash Flow hedging reduces.
FASB’s Conceptual Framework emphasizes earnings quality, which includes earnings stability, persistence and lack of variability. Hedging clearly increases earnings quality.
Enables Durable Planning/Budget Rates
Budgets are set using the expected years net revenues. CFOs use a budget or planning spot rate to convert forecast foreign earnings to the firm's reporting currency. Every department’s budget is dependent on the planning rate remaining constant. Yet often they are changed multiple times during the year.
Utilizing a layered cash flow protocol stabilizes foreign earnings. This makes for a more durable planning rate, and makes it far easier for departments to manage their budgets.
Enhance Local Currency Price Stability
Cash flow hedging creates price stability. For goods that are imported, it lowers COGS. For goods that are exported, hedging enables a stable price in local currency. This enhances competitiveness, brand reputation, and local distributor relationships.
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