Accounting Best Practices, Fifth Edition

11–24. Use Natural Hedging for Transaction Risks

When a company engages in transactions that involve another currency, it incurs a transaction risk that currency fluctuations will adversely impact its cash flows. They frequently purchase derivatives to hedge against these transaction risks. However, some organizations are reluctant to follow this path, because (1) derivatives can be expensive, and (2) FAS Statement 133 requires a company to charge fluctuations in the value of a derivative to the current reporting period if it cannot prove that the derivative effectively hedges an exposure. The latter issue also requires a considerable amount of documentation work.

To avoid the use of derivatives, some companies have centralized their treasury operations, which gives the treasurer sufficient information about companywide transaction flows to determine where transactions can offset each other. This information allows treasurers to create natural hedges, which require no FAS 133 documentation and are free. When using natural hedges, there will still be some residual exposure if revenues and costs do not exactly offset each other, but the remaining exposure is greatly reduced.

This technique is possible only if treasury operations are centralized, or if the information needed to construct natural hedges can be obtained by other means, such as through a data warehouse that accumulates information from multiple sources.

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