The Exporter Who Sold Forward and Then Won a Contract
A European capital-goods manufacturer expects to invoice a U.S. customer €120 million equivalent (about $130 million) in six months, and in March sells $130 million forward at EUR/USD 1.0850 to lock the euro value. In May, the customer exercises a contract option to double the order, adding another €120 million, but with payment terms extended to 12 months. The CFO is pleased: 'We're hedged and the euro has weakened, so the forward is in the money.' The treasury analyst notes the forward is now only covering about half the exposure and that the new tranche has a different maturity. The company uses cash flow hedge accounting under IFRS 9 and designates the forward as a cash flow hedge of the highly probable forecast sale. The euro has moved to 1.0450. The analyst must decide whether to layer a second hedge and how to treat the original one.
1. Assess the hedge's effectiveness and the accounting status of the original forward after the contract option is exercised.
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The original forward remains effective for the originally designated €120M tranche: the hedged item (the first order) is still highly probable and matches the forward's notional and timing. The forward's intrinsic value change (favorable, since EUR/USD fell) is accumulated in OCI and will be recycled when the sale occurs.
However, the new tranche is a separate exposure that is not hedged by the original forward. Key points:
- The doubled order does not retroactively make the original forward 'more effective'; it simply leaves €120M of additional exposure unhedged.
- The extended 12-month payment terms on the new tranche mean a hedge for it must have a matching maturity; the original forward matures in six months and cannot cover it.
- Under IFRS 9, the hedge relationship is assessed against the designated hedged item only. The existence of additional unhedged exposure does not create ineffectiveness in the designated relationship, but it does mean the CFO's 'we're hedged' statement is wrong at the portfolio level.
- The forward's time value must be accounted for separately (either in OCI as a cost of hedging or through P&L, depending on the entity's policy).
So: original hedge → still effective, OCI accumulates. New tranche → unhedged unless a new designation is made.
2. Recommend how to hedge the incremental exposure and what documentation is required.
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Recommendation:
- Layer a second forward for the incremental €120M with a 12-month maturity to match the extended payment terms. Do not extend or resize the original forward - that would break the existing designation and force recycling of accumulated OCI.
- Designate the new forward separately as a cash flow hedge of the new, highly probable forecast transaction. Document: the hedged item (the incremental order, its amount, maturity, and probability assessment), the hedging instrument, the risk being hedged (EUR/USD), and the effectiveness method.
- Effectiveness testing on the new relationship prospectively and retrospectively. Because notional and timing now match, dollar-offset should be close to 100%; any mismatch (e.g., if the order is partially cancelled) is ineffectiveness.
- Time value treatment - elect the cost-of-hedging approach for the forward points so only spot changes go to OCI, or accept P&L volatility for time value; be consistent with the original forward's policy.
- Disclosure - the additional hedge and the changed exposure should be reflected in the hedging note.
The CFO's 'in the money' comment is a distraction: being in the money on the original forward says nothing about covering the new exposure, which remains open until a second hedge is executed.