You already know two hedge designations. A fair-value hedge protects the carrying value of a recognised asset or liability, and both the hedged item and the instrument are marked through profit. A cash-flow hedge protects a future cash stream, and the effective portion sits in other comprehensive income until the hedged cash flow arrives.
There's a third, and it exists for one problem. A parent owns net assets in a foreign currency and doesn't want the translation reserve swinging with the rate.
A net investment hedge designates an instrument, most often foreign-currency borrowing but sometimes a forward or a cross-currency swap, against the parent's net investment in a foreign operation. The effective portion of the gain or loss on that instrument goes to other comprehensive income, into the same reserve as the translation adjustment, where the two offset. The ineffective portion goes to profit. On disposal of the operation both amounts recycle together.
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Worked example: a dollar loan hedging a US subsidiary
Bharat Precision borrows $30 million in Mumbai to fund the Ohio business, and designates it as a hedge of its net investment in BPI Americas. Watch what happens over the year the rupee falls from ₹82.00 to ₹87.00.
The loan was worth ₹246.00 crore when drawn and ₹261.00 crore at the year end, so the parent has a loss of ₹15.00 crore. Without a designation that loss is a foreign-exchange item in profit, and it sits alongside a translation gain of ₹21.20 crore that isn't in profit. The group reports a loss on a currency movement that made it richer. That's an awkward thing to explain to a shareholder.
With the designation, the ₹15.00 crore goes to other comprehensive income instead, into the translation reserve, where it nets against the ₹21.20 crore. Profit is ₹15.00 crore better. The reserve, which would have closed at ₹46.70 crore, closes at ₹31.70 crore. Its movement for the year shrinks from ₹21.20 crore to ₹6.20 crore.
The hedge is $30 million against opening net assets of $39.5 million, so 75.9494% of the opening net investment and 66.6667% of the closing. Both fractions are below one, which is the condition for full effectiveness.
Over-designate and the mechanism bites. Designate $50 million against a $39.5 million net investment and the total loss is 50.0 × (87.00 − 82.00) = ₹25.00 crore. Only 39.5 × (87.00 − 82.00) = ₹19.75 crore of it can be effective. The remaining ₹5.25 crore goes to profit, in a year when management believed it had hedged.
What should an analyst take from a net investment hedge?
Carry these points about the designation past the exam.
It is one of the few places where a company can move a real loss out of profit and into equity by writing a designation memo. The memo has to be contemporaneous, the effectiveness has to be documented, and the amount is capped at the net investment, but within those limits the choice is management's and its effect on reported profit is large.
The hedge does nothing for the group's economics. It converts a currency exposure on net assets into a currency exposure on debt, and the two offset. What it changes is where the movement is reported, which matters because debt covenants, screening filters and management incentives are all written on reported profit.
And the reserve is now a mixture. A translation reserve that carries hedge results as well as translation adjustments won't reconcile to the translation of the subsidiary's net assets, and if you try to rebuild it you'll chase a difference that is really a hedge. The note discloses the split. Read it before you build the reconciliation.