Treasury Risks and Hedging: IRS, Cross-Currency Swaps, and FX Forwards

Types of Treasury Risks

Corporate treasury manages three main categories of financial risks:

1. Foreign Exchange Risk (FX Risk) — the risk of losses due to changes in exchange rates
2. Interest Rate Risk — the risk arising from changes in interest rates
3. Commodity Risk — the risk resulting from changes in commodity prices (for resource-dependent companies)

Foreign Exchange Risk

Types of Foreign Exchange Risk

Transaction Risk: The risk of exchange rate changes between the date a deal is concluded and the settlement date. The most tangible and manageable type.

Translation Risk: The risk encountered when consolidating financial statements of subsidiaries operating in different currencies. Affects the reported P&L and balance sheet.

Economic Risk: The long-term impact of currency fluctuations on a company’s competitiveness.

FX Forwards

A forward is a contract to buy or sell currency in the future at a rate fixed today.

Formula for the forward rate: Forward Rate = Spot Rate × (1 + r_d)^n / (1 + r_f)^n

Where r_d is the rate in the domestic currency, r_f is the rate in the foreign currency, and n is the term in fractions of a year.

Example: A UAE company will receive $5 million in 3 months. Spot AED/USD = 3.673. In 3 months, the company wants to convert to AED. It enters into a forward contract to sell $5 million at a fixed rate → pricing certainty ensured.

Note: AED is pegged to USD (pegged at 3.6725), so USD/AED hedging is not critical for UAE companies. However, EUR/USD and GBP/USD risks are relevant for international operations.

FX Options

Call/Put options: The right (not the obligation) to buy or sell currency at a strike price. Provide protection while preserving upside potential (unlike a forward). Used when there is uncertainty regarding dates or amounts.

Zero-cost collar: Purchase of a protective put and sale of a call. Downside protection with limited upside. Zero cost (the cost of the put is offset by the premium received from selling the call).

Interest Rate Risk

Interest Rate Swap (IRS)

An IRS is an agreement between two parties to exchange interest payments: one party pays a fixed rate, the other a floating rate (LIBOR/SOFR).

Typical application:

• The company has taken a loan at a floating rate (SOFR + 2%)
• Fears an increase in rates → wants to convert to a fixed payment
• Enters into an IRS: pays a fixed rate to the bank, receives SOFR → net effect: fixed-rate loan

IRS mechanics:

• Notional: $100 million
• The company pays: 4.5% fixed (annual rate)
• The company receives: SOFR (let's say, 5.2% today)
• Net payment: the company receives 0.7% (in this scenario, gains)
• If SOFR falls to 3%: the company pays an extra 1.5%

IRS accounting (IFRS 9):

• Fair value hedge: hedges a balance sheet item → changes in the fair value of the IRS are reflected in P&L
• Cash flow hedge: hedges future flows → changes in fair value are reflected in OCI (other comprehensive income)

Cross-Currency Swap (CCS)

A CCS is an agreement to exchange principal and interest payments in different currencies.

Application:

• The company has taken a EUR loan, but operates in USD → CCS converts EUR liabilities to USD
• The company issues USD bonds, but main costs are in JPY → CCS provides JPY funding
• Arbitrage: a company with a USD rating can borrow more cheaply in EUR and convert through a CCS to USD

Mechanics:

1. At inception: the parties exchange principals (e.g., $100 million ↔ €90 million)
2. Periodically: exchange of interest payments (USD rate ↔ EUR rate)
3. At maturity: reverse exchange of principals at the original rate

Building Treasury Policy

Hedge Ratio: Corporations typically hedge 50–80% of transactional risk (on forecasted flows).

Hedging horizon: Generally, 12 months for operational flows, up to 5–7 years for long-term debt.

Mark-to-market: Derivative instruments are reflected at fair value on the balance sheet (IFRS 9, ASC 815).

Hedge accounting: Allows companies to avoid P&L volatility from derivative revaluation. Requires formal documentation and a hedge effectiveness test (the 80–125% rule).

Example: Treasury Program of an International Retailer

A company operating in 20 countries:

• Operational cash flows in 15 currencies
• Long-term debt in EUR and USD
• Commodity risks (cotton, oil for logistics)

Measures:

1. Cash pooling with a master account in USD in Zurich
2. FX forwards for operational flows (12-month rolling horizon)
3. IRS: converting floating-rate debt to fixed
4. CCS: converting EUR bonds to USD
5. Commodity forwards on cotton (6 months)