Doing business with other countries can be complicated, especially if you are dealing with a country for the first time. There are different rules, regulations, interest rates, and currencies which all need to be taken into consideration. The financial instruments available to businesses who are looking for new ways to manage their money are also different around the world. If a business has investments in another multinational entity then the fluctuations in interest and currency exchange rates, as well as swings in the value of relevant commodities, will affect the value of their investment at any given time.
Risk management refers to the strategy a business undertakes in order to reduce the risk on the investments that they make, as well as the assets that they hold. Most businesses will have a comprehensive set of goals that they hope to achieve, as well as realistic strategic proposals for achieving them. An increasingly popular tool in this battle for better risk management is hedge accounting.
Reducing a business’ exposure to volatility through hedging will show outside investors that the business is strong and able to withstand pressure – investors prefer a business which is built on solid foundations. Therefore any tool, such as hedge accounting, which can help a business to reduce their exposure to risk is one that is worth pursuing.
Protecting from Currency Fluctuations
As an example that might occur of potential hedge accounting in the UK, consider the following scenario. A firm based in London might enter into a contract to sell goods to an overseas business based in Helsinki. The agreement that both parties enter into stipulates that the firm in Helsinki will buy £850,000 worth of goods from the London business in three months time. Over the same period, the London business will undertake to purchase £100,000 worth of goods, in addition to a further £150,000 of equipment. This gives a total of £250,000, leaving a difference of £600,000.
By using this £600,000 to purchase a currency hedge which expires in three months, this protects both parties in the contract from any fluctuations in the currency exchange rate between the two countries involved. Businesses can therefore use hedge accounting to reduce their risk of entering into contracts with overseas businesses.
Reduce Exposure to Volatility
The primary function of any hedging instrument is to reduce a businesses exposure to volatility on an investment or asset. At its core, hedging is about mitigating the potential effects of the market moving in an unfavourable direction.
Corporate bookkeepers have increasingly turned to hedge accounting in relation to derivatives. Hedging is an effective tactic for offsetting the risks that are traditionally associated with the use of derivatives. The way by which hedge accounting is able to protect the investor in this regard is rather clever, since hedge accounting treats both the derivative and the corresponding reciprocal hedge as one item so that the larger fluctuations in value are balanced out.
It’s Simple to Do
Consider the potential returns and the mitigation of risk that you can achieve from making use of hedge accounting in offsetting the risks that your business portfolio is exposed to. Of course, as with any financial or accounting manoeuvre, you will want to consult with a qualified professional whose opinion you trust. Consulting with a firm that specialises in financial hedging is a worthwhile investment if you are looking to reduce risk as your portfolio expands.
Hedge accounting is a very effective financial instrument which allows a business to greatly reduce its exposure to risk on a number of different investment types, as well as on the risk they face of the volatility of currency and interest fluctuations across borders.