Foreign Exchange Exposure Netting

Foreign exchange exposure netting is the practice of offsetting opposite exposures to the same currency, within one company or across a group, before deciding how much to hedge. If one subsidiary expects to receive 10 million euros and another expects to pay 7 million euros in the same period, the group as a whole is exposed to only 3 million euros. Hedging that net amount, rather than each gross position, reduces the number and cost of trades.

Exposure netting is a core technique of central treasury and is related to, but distinct from, payment netting, in which intercompany invoices are settled by paying only net balances. Exposure netting concerns risk measurement and hedging; payment netting concerns cash movements. The two are often run together, and both reduce the group's foreign exchange risk management costs.

Two cousins are about to travel. One will be paid in dollars and wants to swap them for pounds; the other needs dollars and has pounds. Rather than each going to a currency booth and paying its fees, they swap with each other, and only the leftover amount goes to the booth.

Large companies do this inside the group. Before buying protection against currency swings, the treasury adds up all the money the group expects to receive and pay in each currency. Much of it cancels out, so the company only needs to protect the remainder. That saves fees and avoids buying protection that the business never needed.

1. Each business unit reports forecast and committed receipts and payments by currency and date, often through a treasury management system.
2. The central treasury converts the data into exposures from the point of view of the group's functional or reporting currency.
3. Exposures in the same currency and period are offset to find a net position.
4. The treasury decides how much of each net position to hedge under its policy, usually with forward contracts or options with banks.
5. Internal contracts may be booked between the treasury and each unit so that local results are protected while only net trades go to the market.

For each currency $c$ and period, the net exposure is:

Suppose a UK group's German unit expects euro receipts of €12 million next quarter, its Spanish unit expects euro supplier payments of €5 million and the UK parent owes €4 million on a euro loan. The net euro exposure is €12 million − €5 million − €4 million = €3 million. Hedging 80 per cent of the net would mean selling €2.4 million forward, instead of €9.6 million in sales and €7.2 million in purchases if each gross exposure were hedged separately at the same ratio.

• Lower costs. Fewer and smaller trades reduce bid-offer spreads, bank fees and use of credit lines.
• Better control. Centralising exposures gives one view of group risk and stops units hedging against each other.
• Recognition of natural offsets. Netting formalises a natural hedge, such as costs and revenues in the same currency.
• Smaller cash and collateral needs. Smaller hedges mean less margin or collateral and fewer settlements.

Netting only works if forecasts are reliable and timings match; a receipt in March does not truly offset a payment in September. Some treasuries also offset exposures in closely correlated currencies, which is riskier because correlations can break down. Exposures recorded in different entities may affect different financial statements, so a group-level offset can still leave volatility in a subsidiary's local accounts. Where currencies are subject to exchange controls, local rules may prevent intercompany offsetting or require gross settlement. Reliable data also depends on careful intercompany reconciliation.

Hedging a net position can complicate hedge accounting, because accounting standards generally require a specific hedged item. IFRS 9 allows a group of items with offsetting risks to be designated as a net position in some circumstances, particularly for foreign currency risk, while US GAAP generally requires a gross amount to be designated. Groups therefore often designate a portion of gross forecast sales or purchases equal to the net hedge. Exposure netting is commonly paired with multilateral netting of intercompany payments and with hedging programmes run by an in-house bank or treasury centre, as used by many a multinational corporation.