A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm's consolidated balance sheet. In theory, if this is achieved for each foreign currency the corporation holds a translation exposure will be zero. A change in exchange rates will change the value of exposed liabilities in an equal amount in the opposite direction to the change in value of the exposed assets.
There are costs to a hedge and justification must be weighed. The following are common justifications:
- The foreign subsidiary is about to be liquidated.
- The company has debt covenants and/or banking agreements that state the firm's debt/equity ratios will be maintained within specific limits.
- Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains.
- The foreign subsidiary is operating in a volatile environment
“The larger companies with the stronger balance sheets are in the position to lay out solid capital and generate consistent returns.” ~ Bill WarlickMore considerations are necessary including the change in foreign currency transaction exposure with translation exposure mitigated.