Corporate Foreign Exchange Risk Management

Chapter 6Hedge Accounting Explained

Most people like the idea behind derivatives, recognizing that they hold the potential to let firms flexibly fine‐tune their risk–return profile. Derivative usage in practice, however, is beset by various complicating factors. One of these has to do with the way they are accounted for. Derivatives are fair value accounted, meaning, among other things, that firms need to recognize changes in the fair value of derivatives in net income. This is generally viewed as problematic. Managers worry that analysts do not like the excess volatility in profits caused by these fair value changes. The fluctuations in the value of derivative contracts can indeed be large, and the firm is not allowed to apply the same fair value accounting to the business transaction that they have hedged.

The conundrum is therefore that while the exposure may be perfectly hedged in the sense of protecting the cash flow in a commercial transaction, net income may in fact become more, not less, volatile because of these accounting conventions.

The solution on offer is called hedge accounting, which is regulated by the standards IFRS 9 and ASC 815 in US Generally US GAAP. Hedge accounting is a technique for keeping the unrealized GLs out of net income until the hedge contract is realized (i.e. cash‐settled at maturity). It lets firms achieve the desired outcome of stabilizing cash flow by hedging without having to worry about any unpredictable swings in net income as a side‐effect. ...