What Is a Balance Sheet Hedge?

The multinational nature of contemporary business creates currency risk.

A balance sheet hedge is the denomination of assets or liabilities designed to reduce or eliminate the impact that unanticipated changes in exchange rates could otherwise have upon the balance sheet of a multinational company.

The Free Float of Currencies

Since the early 1970s, currencies have in essence floated freely against one another. As a consequence, businesses are exposed to currency risk, sometimes called "translation exposure."

A North American Example

The Canadian dollar is fondly called the loonie.

Consider a U.S. based company with some operations in Canada. It may hold on its books assets and liabilities denominated in the Canadian dollar, known as the loonie.

Assets Offset Liabilities

A company might hedge translation risk by balancing loonie-denominated assets against loonie-denominated liabilities. If this can be completely executed so that there is exactly as much liability as assets in that currency, the translation exposure will be zero.

Translation by Current Exchange Rate

One very common method of translation is use of the current exchange rate for all assets and liabilities.

Translation Using Historical Exchange Rates

Another possible approach would be to keep assets and liabilities on the books at the "historical rate"—the exchange rate that was in effect when the assets or liability was first entered onto the books. Nobody uses the historical rate exclusively, but there are several methods that mix the historical method for some items with the current exchange rate for others.

References

• Blackwell Publishing Company: Translation Exposure Management
• University of Alabama at Huntsville: Accounting Exposure
• Forex Theory: Forex History
• Slide Share: Foreign Currency Transactions
• University of Kentucky, Gatton: Management of Translation Exposure