How currency hedging works
/A business creates a currency hedge when it has current or expected cash holdings or obligations involving foreign currencies. Doing so allows it to mitigate the firm’s potential losses arising from exchange rate fluctuations in future periods. Foreign exchange hedging works as follows:
Step 1. 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.
Step 2. Examine the 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
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Step 3. Begin the Hedge
Enter into the hedging transaction with a third party.
Step 4. 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
Step 5. 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 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.
Step 6. 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.