Net investment hedge
AccountingDesignating a foreign currency liability or derivative as a hedge of the net assets of a foreign operation, so the two offset within equity.
Also written: hedge of a net investment
A group holding a subsidiary abroad carries translation exposure on that subsidiary's net assets. When the subsidiary's currency weakens, the presentation currency carrying value of those net assets falls, and the loss accumulates in the currency translation reserve within equity.
A net investment hedge places an offsetting item against that exposure. The commonest form is borrowing in the subsidiary's own currency, so that a weakening currency reduces the carrying value of the debt at the same time as it reduces the carrying value of the net assets. A derivative can serve the same purpose. Where hedge accounting is applied, the effective portion of the gain or loss on the hedging instrument goes to other comprehensive income alongside the item it hedges.
The purpose is to stabilise reported equity and the leverage ratios calculated from it, not to protect operating margin. Protecting margin is the job of a rolling forward programme against transaction exposure, and confusing the two is a common error, because it leads people to conclude that a company with a net investment hedge has hedged its trading exposure.
The hedge is effective only up to the amount of the net investment. Hedging beyond it leaves an ineffective portion that goes straight to profit or loss, which is a frequent reason a treasury policy fails to deliver what was expected of it.
Worked example
A euro reporting group owns a UK subsidiary with net assets of 500 sterling and borrows 500 sterling at the parent, designating the loan as a hedge of that net investment.
Sterling weakens. The euro carrying value of the net assets falls, and the euro carrying value of the sterling loan falls by a matching amount, so the two meet in other comprehensive income and reported equity is broadly unaffected.
Nothing about this protects the margin on goods the group sells into the United Kingdom. That is a separate exposure needing a separate hedge.