Over-Hedged Forward After a Contract Reduction
On 10 January, Calder Engineering Ltd, a UK exporter, sold a machine to a US buyer for USD 6,000,000 payable in six months. Calder sold USD 6,000,000 forward at GBP/USD 1.2700 with its bank, value 10 July. On 10 April the buyer cut the order by 30% and postponed shipment to November, with payment expected in May the following year. Spot is now 1.3300 and six-month forward points are 150 pips, giving a new six-month rate of 1.3450. Calder's bank has an unsettled-FX credit limit of GBP 500,000 and current utilisation of GBP 320,000. The client asks the bank to 'move the whole forward to next May, reduce it to the new amount and keep the 1.2700 rate'. The bank's treasury estimates USD funding at SOFR plus 40 bp and charges 20 bp for restructuring. Calder applies IFRS 9 and had designated the forward as a cash-flow hedge of the highly probable sale.
1. Calculate the over-hedge and the mark-to-market cost, and assess the credit limit.
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The original forward sold USD 6,000,000 at 1.2700, producing GBP 4,724,409. The revised exposure is 70% of the original, or USD 4,200,000. The over-hedged amount is therefore USD 1,800,000.
At spot 1.3300, closing the over-hedge costs: USD 1.8m / 1.2700 = GBP 1,417,323 received under the original forward; USD 1.8m / 1.3300 = GBP 1,353,383 paid to buy back; loss = GBP 63,940. If the close-out is priced at the new six-month forward of 1.3450, the loss is GBP 79,033. The total mark-to-market on the full USD 6m at spot is USD 6m / 1.2700 minus USD 6m / 1.3300 = GBP 213,131.
On the credit limit, if the GBP 320,000 utilisation already includes the existing forward's mark-to-market, adding the restructuring cost may not breach GBP 500,000 immediately. If it does not, GBP 320,000 plus GBP 213,000 = GBP 533,000, which exceeds the limit. The bank should revalue the whole portfolio, add the new forward's potential exposure and decide whether to require collateral or a limit increase. The 20 bp restructuring fee also needs to be disclosed.
2. Recommend how to restructure the forward and explain why the 1.2700 rate cannot be preserved.
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A forward is a binding contract. The bank cannot simply amend the rate to 1.2700 for a new maturity without absorbing the market cost, and it should not do so. The client's request should be reframed as a close-out and rebooking at market.
A clean structure is: (i) close USD 1,800,000 of the original forward at the prevailing rate, crystallising a loss of about GBP 64,000 at spot or GBP 79,000 at the six-month forward; (ii) for the remaining USD 4,200,000, close the original forward and rebook a new forward to May next year at 1.3450. The loss on the remaining portion is about GBP 149,000 at spot or GBP 184,000 at the new forward. The client receives a new all-in rate near 1.3450 and pays the close-out cost. Alternatively, the bank can arrange a forward-forward roll that moves the July value to May, but the economics will be similar and the documentation must be clear.
The bank should show the client the gross and net figures, the 20 bp fee and the new settlement date. It should also check that the client understands the new forward is a fresh commitment and that further changes will crystallise further costs. If the client cannot pay the close-out cost, the bank should treat it as a credit event and consider collateral.
3. What are the IFRS 9 and hedge-accounting consequences of the reduction and postponement?
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Under IFRS 9, the forward was designated as a cash-flow hedge of a highly probable forecast sale of USD 6m. A 30% reduction means the hedged item is no longer highly probable to the original extent. The hedging relationship is discontinued prospectively for the over-hedged 30%. The cumulative gain or loss in other comprehensive income attributable to that portion is reclassified to profit or loss when the forecast transaction affects profit or loss, or immediately if the transaction is no longer expected to occur.
The remaining 70% can remain in the hedging relationship if it is still highly probable and the hedge remains effective. The postponement to May next year changes the timing of the forecast transaction; the bank should obtain the client's updated cash-flow forecast and formally document the change. Effectiveness testing should be updated, and any ineffectiveness recognised in profit or loss.
The realised loss on closing the over-hedge is a derivative loss. It is not automatically a basis adjustment unless the entity applies the hedge accounting rules to defer it. The client's finance team should be warned that the accounting result may differ from the cash cost, and that the bank's confirmation of the close-out is needed for the hedge documentation.