Can a money-losing hedge actually fulfill part of your hedging program and be viewed as successful? (Webinar Attendee Question)

In almost every case a money-losing hedge is “successful”. Hedge programs are not designed to “make money” for a company. They should be perceived as insurance. When the company experiences a loss, they are happy to have the insurance in place, but they still need to deal with the devastation. Most of us prefer not to use the insurance. We are not confident enough to fly naked, but don’t consider our risk management tools failure in the years there are no claims. Hedges lock in (forwards) or insure (options) the future value of cash flows. When you lose money on the forward contract that means that you received precisely the exchange rate you locked in, and the unhedged exchanges will be at a better rate. For folks who locked in a floor on the revenue values or a cap on the cost side using options, not having to exercise means you recognized revenue at values higher than you insured or costs at values lower than you insured. If either the options or forwards had expired “in-the-money” that would mean that the hedged values came in at the insured/locked rate, any unhedged values came in at worse rates (lower revenue/higher expenses) and the next hedge to lock in future revenues/expenses will be at current, less advantageous rates.

So when is losing money on a hedge bad news? If you don’t have an underlying exposure (a speculative position) or if your exposure evaporates then losing money on a hedge is bad. In addition, if you are hedging balance sheet exposures that are not economic (never will result in conversions) you have a bad exposure and therefore a bad hedge. Also, when the losses represent forward point costs that reflect speculative expectations that the currency will move against you (most frequently NDFs/controlled/illiquid currency contracts) but the spot rate hasn’t moved this can feel very negative if not built into the margin on the hedged transactions.
For those that are locking in a one-off specific transaction, you would be neutral to a gain or a loss as the forward contract would deliver the exact cash flows expected. If you lost money on the option, your margin should be better than planned (you would have assumed the premium loss and you will get part or all of that back and perhaps more).

In general losing money on hedges is not always bad. My preference is to manage hedges to convert currency at delivery therefore avoiding the bad taste that comes with writing a check. It seems to feel better when we get the currency we contracted for at the rate we contracted rather than getting a lot more currency, and then having to pay some of it back—or even worse, paying some of it back in advance of getting the higher value.

Critical to ANY hedging program is a systematic set of metrics that track how effective the hedging activity is against its stated goal(s). For FASB 52 hedging, the remeasurement process easily provides a measurable exposure to use for comparison the hedging gains and losses. For FASB 133 / Cash Flow hedging, it is imperative to set up your program at the *start* with some type of underlying business metric that will capture the underlying currency dynamics of the business.

To simply present your CFO with a $x million dollar loss with no appropriate metrics for the offsetting gain is a recipe for failure.