How can I hedge margin on the P&L when we are a multinational company with operations in the EU - thus Euro revenue and Euro sales? (Webinar Attendee Question)

Hi Kurt,

The best way to hedge is definitely "natural hedge". Meaning, you match your revenues and costs in Euros. The unmatched position has to be hedge with a traditionnal hedging product (forward, option...) or a corporate-to-corporate solution which make it possible to create a natural hedge with a third party.

Regards

The election of functional currency is pivotal to responding to this question. If you are local currency functional, your margin hedging must be done via proxy. Generally intercompany transactions will serve as the proxy. It becomes a 2-part process. Step 1 – identify the amount you want to hedge. Step 2 – identify hedge-able exposures to determining how much you can hedge. In this case you would identify the 3rd party EUR denominated revenues and 3rd party EUR denominated costs. That is your exposure to EUR. Now identify “long EUR/short USD” qualifying exposures. This could be EUR denominated sales from parent to EUR sub, or USD denominated sales from parent to EUR sub, or USD denominated costs of EUR sub to 3rd parties. Then these proxy exposures can be hedged to protect the company margin using special hedge accounting applications under ASC815. If a company has transferred IP to a EUR headquarters unit that is designated as EUR functional, it can be extremely difficult to identify qualifying exposures. The management fees and other small intercompany transactions are rarely large enough to adequately hedge the exposure. This highlights the critical nature of the functional currency decision in key subsidiaries. I would be happy to elaborate further on any details.

Please note, if you hedge net through the interco, you protect net income not necessarily margin percent as the effective portion will skew the top line (or costs if net short). Margin % is protected when, for example, USD interco inventory is hedged by the sub into EURO. Then EUR rev and EUR CoGS will be protected to a margin % (but not a dollar value). One additional caveat is when hedging at the USD level, there may be a timing mismatch if the hedged item stays in inventory or deferred revenue at the foreign functional subsidiary.