Hedging Basics

All forex hedges are recorded on the balance sheet at their fair market value (FMV).

The items recorded on the other side of the journal entry depend on whether a forex hedge was designated for special accounting treatment (provided it met applicable criteria).

If your company has more assets than liabilities in a foreign currency, then your company is exposed to a potential drop in that currency’s exchange rate. Each 1% drop lowers the value of the assets by 1%, when you convert the net assets to the reporting currency on your balance sheet. This loss would be recorded as an expense to the profit and loss statement.

Unless the amount is small, you do not want to be exposed to currency fluctuations—foreign currency gains and losses on the income statement are difficult to justify. Furthermore, there is no need to be exposed to currency fluctuations because you have the ability to manage this risk through hedging.

To counteract currency risk, you can lock in the exchange rate used in your company’s foreign currency transactions by hedging. Consider an example where you have a net foreign currency asset exposure on your balance sheet. To effect the forex hedge, you will enter into an offsetting sale agreement (hedge) for that foreign currency in an amount equal to the net asset position on your balance sheet. Through the hedge, you would sell the foreign currency and purchase the reporting currency. This hedge balances out any unfavorable rate changes on your existing net foreign currency asset position on the balance sheet, as shown below:

Recorded Foreign Currency Amount

Our Hedging Scenario gives a full example, including a discussion of costs and margin requirements.