When a business has current or expected cash holdings or obligations involving foreign currencies, it may be prudent to create a hedging transaction to mitigate the company’s potential losses arising from exchange rate fluctuations in future periods.
A foreign exchange hedging procedure involves the following steps:
- Calculate hedge requirements. Based on the company’s forecast of foreign currency holdings or obligations, determine the amount and duration of the hedging transaction needed to offset these holdings or obligations in each future period.
- Examine preliminary hedge. Obtain information about the prospective hedge, and address the following issues:
- Determine the extent to which the hedging instrument must be rounded up or down from the hedging requirement, and how closely its timing matches the company's needs for the hedge
- Verify the sufficiency of the counterparty’s credit rating
- Determine the level of effectiveness of the hedging strategy
- Review the proposed contract for legal issues
- Obtain approval of the hedge
- Begin hedge. Enter into the hedging transaction with a third party.
- Document the hedge. Create all hedging documentation required under the applicable accounting standards. This includes documentation of:
- How the company plans to measure the effectiveness of the hedging transaction
- The relationship between the foreign exchange position and the hedging instrument
- The risk management objectives of the company
- The specifics of the hedging strategy
- Account for the hedge. At the end of each reporting period, charge to comprehensive income the effective portion of a hedge for any gains or losses resulting from having marked the hedge to market. Also, charge to profit or loss any ineffective portion of a hedge that is caused by having marked to market. If any hedge losses are considered to be non-recoverable and they have previously been recorded in other comprehensive income, shift them to earnings.
- Close out the hedge. Once the hedging transaction has been completed and settled, move all gains and losses initially recorded in the other comprehensive income account to earnings.