Managing Currency Risk in a Volatile Global Market
The growth of trade internationally, combined with volatility in global markets, has increased the need for foreign exchange risk management. There is a school of thought that believes hedging is about generating additional profit. The real purpose of a hedging program however, is to lessen volatility in earnings and cash flow. In fact, hedging enables risk managers to focus on maximizing the operating value of their company while minimizing the financial disruptions caused by moves in the currency market.
Many U.S. companies are under the belief that pricing a forecasted transaction with an overseas customer or vendor in U.S. dollars does not incur foreign exchange risk. This is not always the case. In reality, the risk has simply been moved to the supplier or customer. Since 2012, the market has seen the U.S. dollar rally versus most of its trading partners. For example, over the last five years the Euro has lost as much as 25 percent of its value, the Mexican peso, 45 percent, and the Canadian dollar as much as 33 percent. Over the past year, the dollar is up more than six percent against a basket of six major currencies and up around 25 percent versus that same basket since 2014. Although this can be a boon for U.S. importers that deal in foreign currency, it can provide quite a challenge for U.S. exporters selling only in dollars that compete with in-country providers and multi-nationals that are able to sell in local currency. The lesson is that companies that limit the terms of payment often lose out on opportunities.
Case: U.S. Manufacturer (Exporter)
Consider a basic example of a U.S. manufacturer that is bidding on a project with a Canadian customer in U.S. dollars vs. an in-country competitor. All things being equal, the Canadian client is better able to quantify the value of its purchase with a supplier that can price in local currency terms versus the U.S. based manufacturer who appears unwilling to quote in Canadian dollars. A better solution may be for the U.S. manufacturer to price the project in Canadian dollars, and hedge the U.S. dollar value of the receivable when the bid is won.
Case: Insurance Carrier
In the case of a global insurance carrier anticipating monthly premium payments from Canadian-based policyholders, a hedging program is able eliminate the exchange rate component upon conversion of funds. Canadian policyholders are able to remit premiums in their local currency, simplifying the payment process. Meanwhile, the U.S. based provider hedges, via forward contracts, the anticipated receivable to mirror its internal cash flow needs. In addition to a fixed date hedge, forward contracts can be customized to hedge a series of dates via a “Window Forward” to match timing uncertainty.
Case: U.S. Importer
Another example involves an overseas supplier that accepts payment in dollars. That supplier will have to sell the dollars received in payment and purchase its local currency to cover its cost. If foreign exchange (FX) rates move, the supplier may go back to its U.S. customer to get a price adjustment for the shortage. Over time, the supplier may seek to raise its prices or is unable to supply the product to the U.S. buyer. A better solution may be to pay the supplier in the local currency and manage the foreign exchange risk. This would leave the U.S. importer in control of the exposure rather than with the vendor and its ability to deliver as promised.
The term “Foreign Exchange Exposure” refers to risks originating from overseas dealings in currency that is not the company’s functional currency. What can companies do – from a best practices perspective – to manage risk?
The Essential Framework
The typical framework for a successful foreign exchange risk management strategy is based on the creation of a board approved internal policy. Five key elements should be incorporated into this policy:
1. Define the hedging objective
2. Establish the risk management procedures
3. Define the terms and percentages of the exposures to be hedged
4. Determine what hedge instruments are to be utilized
5. Define under whose authority hedging and execution decisions are permitted
Elements of Exposure
Most organizations recognize foreign exchange exposure as it relates to actual overseas payment activities, referred to as transactional exposure. Because changes to the value of transactional exposures due to foreign currency moves are reported in current earnings, cash flow hedge accounting is not typically desired. Typically, a short dated forward contract is an effective means to hedge in these situations. There is, however, an often overlooked currency risk known as translation exposure.
Translation exposure is the currency risk associated with a company’s financial statements. Overseas holdings such as short term assets, foreign real estate holdings, plant and equipment, cash, and foreign denominated receivables and payables are considered translation exposures. Translation risk arises when these assets and liabilities are measured in the company’s functional currency for accounting consolidation purposes. Currency, movement from reporting period to reporting period can cause wide swings in the value of these exposures.
Case: Translation Exposure Management
As an example, assume a U.S. company owns a manufacturing facility in Japan that is valued at JPY 500MM. You decide to hedge the asset value for translation risk to the balance sheet and lock in the value of the U.S. dollars by executing a one year forward contract to sell Japanese yen for dollars. As the underlying asset changes in value, the value of the forward contract will move in the opposite direction, thereby providing an offset. Net investment exposure involves the holding company’s investment in the foreign entity as recorded in the holding company’s books. The holding company’s investment in the foreign subsidiary is denominated in the functional currency of the subsidiary and is equivalent to the U.S. dollar value of the subsidiary’s assets less liabilities.
Managing Unreal Expectations
Oftentimes, especially with those new to hedging programs, there’s a misconception in a hedging program that “the only good hedge is one that results in a realized gain”. It is certainly not unusual for a treasury team to be challenged by upper management after a particular hedging instrument appears to be underwater. Such behavior can often lead to the cancellation of an entire hedging program. A more objective approach is to evaluate the overall effectiveness of a hedge versus the gain or loss on the underlying exposure.
Best Execution Strategies
With an ever expanding global marketplace and the uncertainties that can arise under a new U.S. administration, the need for a well-managed FX risk management policy is heightened. Such a policy can serve as a “best execution strategy” to protect both a company’s bottom line and support the continued strength of the balance sheet that supports it. A well-documented foreign exchange policy allows management the opportunity to increase a company’s global presence and enables it to adjust with potential changes in the global economy.
About the Author
Director of Global Banking Business Development Jon Macapinlac
Jon serves as Director of Global Banking Business Development for First National Bank of Omaha. Since 2011, he is charged with the enhancement and growth of the bank’s international portfolio. Jon has 20 years of experience advising a wide array of clients on strategies to mitigate international risk. He is a 1993 graduate of the University of Iowa with a BSBA in Finance.
The articles in this blog are for informational purposes only and not intended to provide specific advice or recommendations. When making decisions about your financial situation, consult a financial professional for advice. Articles are not regularly updated, and information may become outdated.