Hedging a USD receivable and a debt covenant
Nordwind Exports AG, based in the eurozone, expects to receive USD 2,000,000 from a US customer in 90 days. The current spot rate is USD 1.10 per EUR. A 90-day forward contract is quoted at USD 1.08 per EUR. USD 90-day interest rates are 4% per annum and EUR rates are 2% per annum, using a 360-day money-market convention. The treasurer is considering either a forward hedge or a money-market hedge. A euro-denominated bank loan is available at 5% per annum. Nordwind has a covenant requiring net debt/EBITDA below 3.0; the ratio is currently 2.8. Under IFRS 9, the treasurer would like to apply cash-flow hedge accounting, but the risk manager doubts that the hedge is highly effective because the receivable is not a firm commitment and the customer can vary the order quantity by 10%. The CFO wants to know the hedged euro amount and whether the covenant could be breached if the euro strengthens.
1. Calculate the euro proceeds under the forward hedge and the money-market hedge. Which is more favourable on the stated assumptions?
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Forward hedge: sell USD 2,000,000 forward at USD 1.08/EUR. Proceeds = 2,000,000 ÷ 1.08 = EUR 1,851,851.85 in 90 days. Money-market hedge: borrow USD today, convert to EUR, invest EUR for 90 days, and repay the USD loan with the receivable. USD borrowing = 2,000,000 ÷ (1 + 0.04 × 90/360) = 2,000,000 ÷ 1.01 = USD 1,980,198.02. Convert at spot 1.10 = EUR 1,800,180.02. Invest at 2% for 90 days: EUR 1,800,180.02 × (1 + 0.02 × 90/360) = EUR 1,800,180.02 × 1.005 = EUR 1,809,180.92. The forward produces EUR 1,851,851.85, which is EUR 42,670.93 more than the money-market hedge. The forward is more favourable on these rates. The money-market hedge does, however, create euros today rather than in 90 days, so liquidity timing and transaction costs must also be considered.
2. Assess whether Nordwind can apply cash-flow hedge accounting under IFRS 9 given the 10% order-quantity variability.
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Cash-flow hedge accounting requires a highly probable forecast transaction, identification of the hedged risk, an economic relationship between the hedged item and the hedging instrument, and a hedge ratio that does not create ineffectiveness. A expected receivable from a repeat customer can be highly probable even if it is not a firm commitment, but the 10% quantity variability must be assessed. If Nordwind hedges USD 2,000,000 but the actual receipt may be USD 1,800,000 to USD 2,200,000, the hedge is over-hedged at the lower end; the excess derivative is not offset by the hedged item and creates ineffectiveness. The entity should designate only the highly probable portion, document the risk management objective, and test effectiveness prospectively. If the quantity cannot be estimated reliably, hedge accounting may not be available, or a lower hedge ratio or an option may be more appropriate. The risk manager's doubt is not automatically fatal, but it must be resolved with evidence and documentation.
3. Explain how the hedge and the covenant could interact if the euro strengthens, and state what further information is needed before concluding on covenant compliance.
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If the euro strengthens from USD 1.10 to, say, USD 1.20, the unhedged USD 2,000,000 receivable would translate to EUR 1,666,667 instead of EUR 1,818,182 at spot, a loss of EUR 151,515. The forward locks in EUR 1,851,852, so the forward gain largely offsets the receivable loss. Under cash-flow hedge accounting, the effective portion of the forward gain is recognised in OCI, not in profit or loss, which stabilises EBITDA but creates a derivative asset or liability on the balance sheet. Covenant definitions matter: net debt may or may not include derivative balances, and EBITDA may exclude hedge gains or losses. Nordwind cannot conclude on breach from the 2.8 ratio alone; it needs the absolute EBITDA figure, the covenant's definition of net debt and EBITDA, the hedging documentation, and a stress test at plausible exchange rates. If the derivative becomes a liability, or if hedge accounting is not applied, the covenant could be affected. The treasurer should align the hedge ratio with the highly probable receipt and disclose the sensitivity to lenders.