What is cash flow risk?
Summary
Most operational foreign exchange (FX) risk falls into two broad buckets, cash flow risk and balance sheet risk. Cash flow risk (occasionally referred to as margin risk) refers to volatility in an organization’s revenue and expense line items if left unhedged.
Cash flow risk
Cash flow risk is generally driven by forecasted revenue and expenses for both the parent and the subsidiary that are external to the organization and occur in currencies other than the parent’s functional currency. Cash flow risk has a few more nuances than balance sheet risk though. Following are some typical characteristics of cash flow risk and how it differs from balance sheet risk:
Risk is typically longer term (12 months or more) because programs extend throughout at least the budget year for most companies.
The parent entity and the subsidiaries do not always have the same point of view regarding FX risk. For the parent, any transaction not happening in the reporting currency is a risk, while for the subsidiary, any transaction outside their functional currency would impact their local financials. Ensuring that goals and incentives align across the organization is crucial.
Most corporations want to apply hedge accounting treatment to these programs, which carries more burdens than accounting for a balance sheet hedging program.
Cash flow hedging requires forecasted data by transaction currency at the entity level, something that is not readily available at most corporations. It can be a challenging exercise to start from scratch or to use historical data as a proxy for forecasts.
Before deciding whether to implement a cash flow hedging program, it is important to conduct an analysis to determine the amount of risk, discuss the organization’s risk appetite, create a sustainable strategy, and ensure the proper resources exist to run such a program.
Chatham Financial corporate treasury advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Want to learn more?
Contact our team to discuss how Chatham can help with your treasury and risk management needs.
Contact usDisclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit cf.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
