Don’t Hedge Lightly
Citic Pacific recently announced it faced a near $2 billion loss on a contract thanks to trading write-downs due to its "currency exposure to an iron ore mining project in Western Australia, for which supplies were obtained using Australian dollars and euros." The problem -- as Southwest recently found out in a surprising quarterly loss thanks to underwater hedges is that some contracts "do not qualify for hedge accounting … and must be marked to market at the end of each financial period." Citic's hedging cock-up should serve as a lesson to all companies that consider taking commodity price exposure off the table that not all commodity price mitigation strategies are created equal. It's also a reminder that GAAP and related treatment of hedged contracts can negatively impact earnings performance in the near-term.
Given these accounting standards, options contracts -- as opposed to futures -- where I'm guessing the only accounting hit would be for the risk premium which is factored into the cost of the contract price, might be a better bet because with options there is no requirement to take delivery. But before running out and investing in options -- where they're available, which is not everywhere -- organizations should seek specific advice from trading and accounting experts in the area under consideration.
- Jason Busch
Given these accounting standards, options contracts -- as opposed to futures -- where I'm guessing the only accounting hit would be for the risk premium which is factored into the cost of the contract price, might be a better bet because with options there is no requirement to take delivery. But before running out and investing in options -- where they're available, which is not everywhere -- organizations should seek specific advice from trading and accounting experts in the area under consideration.
- Jason Busch
Hedging is defined as "the practice by which a business or investor limits risk by taking positions that tend to offset each other." That means if you have an exposure to an increased cost when your supplier's currency strengthens, you buy something that gains equally in value when the supplier's currency strengthens. Usually that's a forward currrency contract.
GAAP allows hedge gains or losses to be taken in the same period as the item they are offsetting. However if you are speculating (one indication is that your hedge contracts are much larger than the item you're offsetting) then the contract must be "marked to market" at the end of each accounting period. That isn't hedging.
You wrote:
"But before running out and investing in options -- where they're available, which is not everywhere -- organizations should seek specific advice from trading and accounting experts in the area under consideration."
If I could indulge in some shameless but brief self-promotion to accompany the above lesson, you could also sign up for Next Level Purchasing's "Basics of Smart International Procurement" where I cover these issues from a purchasing perspective.
Hedging good. Speculation bad.
Dick Locke