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Back2Basics - What is hedge accounting?




Risk management is an important component of financial management for firms, particularly those engaged in international trade, due to their susceptibility to foreign currency price volatility. This comes after the foreign exchange market has experienced significant volatility, which has created anxiety. The inherent currency risks produce adverse exchange rate swings, which might result in organizational losses if foreign currencies are used. According to Barney (2001), forex risks are those connected with unexpected changes in currency rates and overall foreign exchange exposure. Companies are exposed to this risk if their project outcomes are contingent on future exchange rates, especially when future exchange rate variations are difficult to predict. currency risk management entails putting in place evaluation techniques meant to swiftly recognize and quantify currency hazards in order to counteract and eliminate them, hence preserving firms’ economic worth (Giddy, 2010).

Financial risk management has so emerged as one of the most important business strategies for firms. Firms that do not alter their financial risk management strategies are likely to have slower growth than those that do. There are several financial risk management measures that can be used to reduce financial hazards, such as portfolio diversification for diversifiable risks and hedging practices for non-diversifiable risks. (Sharpe, Alexander & Bailey, 2013)Businesses’ operating conditions have become very volatile as a result of increased globalization and internationalization. Furthermore, the Nigerian economic climate has experienced major swings in foreign exchange prices in recent years, with the Nigerian naira depreciating versus the widely used US dollar. Because most businesses source their inputs or sell their output on a global scale, currency rate changes have had an impact on them, necessitating the development of critical procedures to manage foreign exchange risk. As a result, businesses and investors must consider hedging operations to limit the damage caused by the risks. Firms utilize derivative financial instruments to mitigate certain risks. Businesses’ economic circumstances have grown more complex over time (Mbungu, 2013).Hedging has generally been defined as a risk-reduction method for preserving a market position, whereas speculation refers to taking a position on how markets will move. Hedging and speculating strategies, as well as derivatives, are now widely used tools or ways for corporations to control risk. Currency risk can be managed using a variety of hedging measures. These methods are classified into two types: internal techniques, which are intended to reduce or prevent an exposed position from occurring, and external techniques, which are typically contractual measures designed to minimize exchange losses that may result from an existing exposure (Giddy & Dufey, 2012). Hedging is a common risk-mitigation tactic employed by organizations. Hedging reduces the risk of future price swings, which can be detrimental to a company if not managed appropriately (Horne & Wachowicz, 2012). A firm or individual hedges against a price fluctuation that would otherwise reduce profits (Brigham & Ehrhardt, 2014). It provides relatively inexpensive and highly liquid positions equal to those obtained from diversified stock portfolios (Sharpe, Alexander, & Bailey, 2013). To achieve its hedging objectives, a company can use a range of financial instruments such as forward agreements, futures contracts, options, and swaps. According to Bartram, Brown, and Conrad (2011), a survey of organizations from 47 countries found that the use of these instruments reduced total risk and was more common in firms with higher exposures to interest rate, currency, and commodity price concerns. In the United States, 83% of hedging firms use forward agreements, futures contracts, options, or swaps to hedge foreign exchange risk, 76% for interest rate risk, and 56% for commodity price risk (Bodnar & Wong, 2000). As a result, forward agreements, futures contracts, options, and swaps are commonly used to mitigate interest rate, foreign exchange, and commodity price risks. The choice of exchange risk hedging measures can be influenced by a number of factors, including firm size, R&D expenditure, exposure to exchange rates through international sales and trade, company liquidity, and ownership structure. Large firms are thought to be heavily exposed to foreign exchange risk, which is vigorously controlled (Bodnar & Wong, 2000). Smith and Stulz (2005) observed that larger businesses that rely on export revenue are less vulnerable to exchange rate fluctuations. Financial performance is the extent to which a firmware’s financial objectives have been met. Financial performance is monitored using a variety of methods, including stock market and accounting measurements. The most common accounting metric is return on total assets (ROA). It demonstrates the management’s ability to convert assets into net earnings. The higher the ROA, the better the performance. Profit margin, return on equity, dividend per share, and earnings per share are some other financial performance metrics (Li, Visaltanachoti, & Luo 2014). Exchange rate fluctuations impact corporate value differently than share prices and shareholder rewards (Gutierrez, 2013). The movement of the general exchange rate has an impact on the reporting of financial statements for firms operating in several markets since financial statements are prepared by converting one currency transaction into another. Companies, on the other hand, use a range of measures to mitigate the impact of large fluctuations in foreign currency prices. These efforts aim to limit exposure, hence increasing overall financial returns on investment. Rutagi (2017) discovered that fluctuations in the cost of various currencies have a direct impact on the current pricing of goods on the local market, as well as the organization’s overall profitability. It also influences the volume of goods traded since it affects consumers’ purchasing power. Gachua (2011) found that foreign exchange rate exposure influences enterprises’ overall financial results. These risks exist whenever a company has cash obligations and assets to be collected in the future (Mweni, 2014).According to Mbire and Atingi (2017), most multinational corporations employ various hedging or arbitrage strategies to stabilize financial earnings or company value, especially when global currency movements are plainly inconsistent. Effective risk management improves corporate profitability. Firms typically use micro hedging to manage the interest rate risk exposure of a portfolio of financial assets and obligations. As a result, study into the effects of hedge accounting on the financial performance of publicly traded commercial banks is critical.


There is no such thing as self-reliance because every country has to import and sell some things. According to Vong and Hoi (2009), firms that conduct business across national borders are subject to risks resulting from general variations in the cost of different currencies, which have an influence on payables and receivables denominated in foreign currencies. SWAPs, forwards, options, and foreign currency-denominated rates are among the tools used by firms to hedge their risk. Commercial banks listed on the Nigeria Stock Exchange have faced a slew of FX concerns as a result of volatile exchange rates, which have caused the Kenyan currency to weaken against other currencies. Unstable forex created big losses for certain businesses when they imported some inputs and exported some output. To protect their exposure, businesses required to employ a number of FX risk management strategies. In late 2008, foreign exchange volatility increased dramatically and unexpectedly, having a huge impact on global markets. The global financial crisis pushed many organizations to either return to old risk management procedures or develop new ones. Companies were reevaluating their use of foreign currency derivatives in order to effectively manage the excessive increase in currency risk induced by the global financial crisis (Kirschner, 2009). Despite being recognized as one of Africa’s best, Nigeria’s security market remains rather mediocre in terms of encouraging new financial innovations (Mwangi, 2001). Nigeria’s economy is growing more open, with international trade steadily increasing, and as a result, Nigerian enterprises are becoming increasingly vulnerable to foreign exchange rate changes. Relative pricing changes alter the ‘firms’ competitive market position, resulting in changes in cash flows and, ultimately, firm performance (Noor & Abdalla, 2014). Several research on hedge accounting and corporate performance have yielded varied results. On an international scale, Ahmed, Azevedo, and Guney (2014) investigated how different hedging techniques affected the value of enterprises using non-financial firms from the United Kingdom. According to another study conducted by Ahmed, Azevedo, and Guney (2014), the use of hedge accounting helps financial firms manage their positions and hence enhance overall financial results. The investigation was done among commercial banks and yielded mixed results. Mbungu (2013) found that foreign exchange risk management provided improved overall financial results for exporting enterprises by allowing them to improve their financial performance. Furthermore, Gachua (2011) evaluated how a firm’s exposure to fluctuations in foreign currency values affects an organization’s overall financial results using a case study of publicly traded corporations. The findings revealed that fluctuations in foreign currency prices have a negative impact on enterprises. Makau (2008) investigated the response of Kenyan financial institutions’ securities to changes in lending and foreign currency costs over a ten-year period (2001–2010). Elahi and Dehashti (2011) investigated how currency price changes affect tea exports using the case of smallholder tea manufacturers in Nigeria, concluding that they caused uncertainty in overall earnings. According to the aforementioned assessment, the current research were either conducted in other economies, which limits their applicability in Nigeria. This study was conducted in the banking sector to fill a previously identified gap. This study aims to investigate the impact of hedge accounting on the financial performance of listed commercial banks in Nigeria.