KEY ISSUES IN FOREIGN-EXCHANGE RISK MANAGEMENT
KEY ISSUES IN FOREIGN-EXCHANGE RISK MANAGEMENT
To protect assets adequately against risks from exchange-rate fluctuations, it is important for management to (1) define and measure exposure, (2) organize and implement a reporting system that monitors exposure and exchange-rate movements, (3) adopt a policy on assigning responsibility for hedging exposure, and (4) formulate a strategy for hedging exposure.
Measurement
Most MNEs will be subject to all three types of exposure described above. In order to develop a viable hedging strategy, the firm must be able to forecast
the degree of exposure in each major currency in which it operates. Because the three types of exposure are very different from each other, the actual exposure by currency must be kept separate. The translation exposure in Brazilian cruzeiros, for example, should be kept separate from the transaction exposure. The reason is that the transaction exposure will result in an actual cash flow, whereas the translation exposure may not. Thus the firm may adopt different hedging strategies for the different types of exposure.
Forecasting Exchange Rates
Another key aspect of measurement involves forecasting exchange rates that are applicable to the identified exposure. Estimating future exchange rates is similar to using a crystal ball: Approaches range from gut feeling to sophisticated economic models and with varying degrees of success. Whatever a firm decides to do, its management should estimate ranges within which it expects a currency to vary over the relevant decision period.
Some firms develop in-house capabilities to monitor exchange rates, using economists who also try to obtain a consensus of exchange-rate movements from the banks with whom they deal. Their concern is to forecast the direction, magnitude, and timing of an exchange-rate change. Other firms contract out this work.
Reporting System
Once the firm has decided to define and measure exposure and estimate future exchange rates, it must design, organize, and implement a reporting system that will assist in protection against risk. Because of the nature of the problem, substantial participation from foreign operations must be combined with effective central control. Foreign input is important in order to ensure the quality of information being used in forecasting techniques. Since exchange rates move frequently, firms must obtain input from someone who is attuned to the pulse of the country. In addition, the maximum effectiveness f hedging techniques will depend on the cooperation of personnel in the
foreign operations.
A central control of exposure is needed to protect resources more efficiently. Each organizational unit in the firm may be able to define its exposure, but the corporation itself also has an overall exposure. To set hedging policies on a separate-entity basis might not take into account the fact that exposures of several entities (i.e., branches, affiliates, subsidiaries, and so on) could offset one another.
Management should devise a uniform reporting system to be used by all units reporting to the MNE. The report should identify the exposed accounts the firm wants to monitor, the exposed position by currency of each account, and the different time periods to be covered. Exposure should be separated into translation and transaction components, with the transaction exposure identified by cash inflows and outflows over time.
The time periods to be covered depend upon the firm. One possibility is to look at long- as well as short-run flows. For example, staggered periods (thirty, sixty, and ninety days; six months, nine months, and twelve months; and two, three and four years) could be considered. The reason for the longer time frame is that operating commitments, such as plant construction and production runs, are fairly long-run decisions.28
Once each basic reporting unit has identified its exposure, this should be sent to the next organizational level for a preliminary consolidation. That level may be a regional headquarters (such as Latin America or Europe) or a product division. The organizational structure of the firm will determine what that level is. The preliminary consolidation allows the region or division to determine exposure by account and by currency for each time period. These reports should be routine, periodic, and standardized to ensure comparability and timeliness in formulating strategies. Final reporting should be at the corporate level. There, corporate exposure can be determined and strategies identified to reflect the best interests of the corporation as a whole.
Exposure Management Policy
It is important for management to decide at what level hedging strategies will be determined and implemented. To achieve maximum effectiveness in hedging, policies should be established at the corporate level. With a larger overview of corporate exposure and the cost and feasibility of different strategies at different levels in the firm, the corporate treasury should be able to design and implement a cost-effective program for exposure management. As a firm increases in size and complexity, it may have to decentralize some decisions in order to increase flexibility and speed of reaction to a more rapidly changing international monetary environment. However, such decentralization should stay within a well-defined policy established at the corporate level. This is the strategy that GM uses.
Some companies, such as Eastman Kodak and Nestle" Foods, tend to run their hedging operations as profit centers and nurture in-house trading desks, whereas most MNEs are very traditional and conservative in their approach, preferring to cover exposure rather than extract huge profits. Mattel, Inc., the U.S. toymaker, straddles the line between the two approaches. Mattel combines in-house expertise with the use of an outside manager. Treasury felt that it did not have the expertise to manage exposure to take advantage of significant opportunities, so it decided to turn some of its exposure over to an outside professional foreign-exchange manager with the goal of generating profit.29
Another part of the management strategy has to deal with deciding which exposure will be hedged and at what level. Even though the different
exposures were identified above, not all firms feel the same way about them. For example, Kodak has a cash-flow definition of exposure that largely ignores translation exposure.30 Coca-Cola's treasurer, however, disagrees that approach. He says that "From a treasury point of view, all exposures current exposures."31 The assistant treasurer of Black & Decker feels the way. His point is that translation exposure can reduce equity and raise leverage, thus potentially affecting borrowing costs. His approach is to hedge translation exposure 100 percent.32
Effective management of exchange risk involves deciding which of thr risks is important and then establishing a management structure that manage the risk.
Hedging Strategies
Once a firm has identified its level of exposure and determined which exposure is critical, it can hedge, or protect, its position from exchange-r changes. A firm can adopt numerous strategies, each with cost/benefit impfi-cations as well as operational implications. The safest position for a firm to be in is a balanced position, in which exposed assets equal exposed liabilities.; This involves operational strategies to hedge exposure. The principal opera- tional methods that MNEs use to protect against exposure are balance-sheet management and leads and lags in the transfer of funds. In addition, firms
can enter into a number of contractual obligations to hedge exposure, such as forward-exchange contracts and currency options.
operational strategies Operational Strategies To reduce exposure through operational strategies ,nvolvc management must determine the working capital needs of the subsidiary.
Although it might be wise to collect receivables as fast as possible in an infla-
tionary country where the local currency is expected to depreciate, the nm must consider the competitive implications of not extending credit.
In reality, working capital management under exchange risk assumes that currency values move in one direction. A weak-currency country gen-! erally (although not always) suffers from inflation. The approach to protecting assets in the face of currency depreciation also applies to protection against inflation. Inflation erodes the purchasing power of local currency, whereas depreciation erodes the foreign currency equivalent.
In the weak-currency situation, subsidiaries' cash should be remitted to the parent as fast as possible or invested locally in something that appreciates in value, such as fixed assets. Accounts receivable should be collected as quickly as possible when they are denominated in the local currency and stretched out when denominated in a stronger currency. Liabilities should be treated in the opposite manner.
A policy for inventory is difficult to determine. If inventory is considered to be exposed, it should be kept at as low a working level as possible. However, since its value usually increases through price rises, it can be a successful hedge against inflation and exchange-rate moves. If the inventory is imported, it should be stocked before a depreciation since it will cost more local currency after the change to purchase the same amount in foreign currency. Where price controls are in effect or where there is strong competition, the subsidiary may not be able to increase the price of inventory. In this situation, inventory can be treated in the same way as cash and receivables. These principles can be reversed when an appreciation is predicted—that is, keep cash and receivables high, and liquidate debt as rapidly as possible. The safest approach is to keep the net exposed position as low as possible.
The use of debt to balance exposure is an interesting phenomenon. Many firms have adopted a "borrow locally" strategy, especially in weak-currency countries. One problem is that interest rates in weak-currency countries tend to be quite high, so there must be a trade-off between the cost of borrowing and the potential loss from exchange-rate variations. Coca-Cola, for example, has a strategy that at least half of its net exposed asset position in foreign countries is offset by foreign currency borrowings.33 Black & Decker also uses local borrowings to hedge a net exposed asset position, but each exposure is considered on a case-by-case basis rather than automatically covering with local borrowing.34
Protecting against loss from transaction exposure becomes very complex. In dealing with foreign customers it is always safest for the firm to denominate the transaction in its own currency. Alternatively, it could denominate purchases in a weaker currency and sales in a stronger currency. If forced to make purchases in a strong currency and sales in a weak currency, the firm could resort to contractual measures or try to balance its inflows and outflows through more astute sales and purchasing strategies.
Leads and Lags Another operational strategy, known as "leads and lags," is often used to protect cash flows among related entities, such as a parent and its subsidiaries. The lead strategy involves collecting foreign currency receivables before they are due when the foreign currency is expected to weaken and paying foreign currency payables before they are due when the foreign currency is expected to strengthen. A lag strategy means that a firm will delay receiving foreign currency receivables if that currency is expected to strengthen and delay payables when the currency is expected to weaken. Another way to state this is to say that a company usually leads into and lags out of a hard currency and leads out of and lags into a weak currency. For example, General Electric used a lag strategy in 1984 when the Japanese yen was relatively weak against the U.S. dollar. Because GE predicted a strengthening of the yen, it delayed remitting a yen dividend to the parent company until the yen began to strengthen.
Leads and lags are much easier to use among related entities in which a central corporate financial officer can spot the potential gains and implement a policy. There are two problems with the lead/lag strategy. First, it may not involve the movement of large blocks of funds. If there are infrequent decisions involving small amounts of money, it is easy to manage the system, but as the number and frequency of transactions increase, it becomes difficult to manage. Second, as mentioned earlier in the chapter, leads and lags are often subject to governmental control since movements impact the balance of payments of a country.
Forward Exchange Contracts In addition to the operational strategies just mentioned, a firm may resort to contractual arrangements. The most prevalent approach is the forward contract, a contract between a firm and a bank to deliver foreign currency at a specific exchange rate at a set date in the future.
For example, assume that a U.S. manufacturer sells goods to a British manufacturer for £1,000,000, with payment due in 90 days. The spot exchange rate is $1.9000 and the forward rate is $1.8500. In 90 days, the actual exchange rate is $1.8700. At the time of the sale, the sale is recorded on the books of the exporter at $1,900,000, and a corresponding receivable is set up for the same amount. However, the exporter is concerned about the exchange risk. The exporter can enter into a forward contract, which will guarantee that the proceeds of the receivable can be converted into dollars at a rate of $1.8500, no matter what the actual future exchange rate is. That would yield $1,850,000, or a cost of protection of $50,000. Or the firm could wait until the receivable is collected in 90 days and gamble on a better rate. Assuming an actual rate of $1.8700, the exporter would receive $1,870,000, which is not as good as the initial receivable of $1,900,000, but it is better than the forward yield of $1,850,000. However, if the dollar were to strengthen to $1.8000, the exporter would have been much better off with the forward contract.
Currency Options The foreign currency option is a relatively recent foreign-exchange instrument. It is more flexible than the forward contract because it gives the purchaser of the option the right, but not the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.
For example, assume that a U.S. exporter decided to sell merchandise to a British importer for £1,000,000 when the exchange rate was $1.9000. At the same time, the exporter went to the Philadelphia Stock Exchange and entered into an option to deliver pounds for dollars at an exchange rate of $1.9000 at an option cost of $25,000. That means that whether or not the exporter exercises the option, the right to have the option costs $25,000. When the exporter receives the £1,000,000 from the importer, a decision must be made on whether or not to exercise the option. If the exchange rate is above $1.9000, the exporter will not exercise the option, because he/she can get a better yield by converting pounds at the market rate. The only thing lost is the $25,000 cost of the option, which is like insurance. On the other hand, if the current exchange rate is below $1.9000, say $1.8000, the ex-
porter will exercise the option and trade pounds at $1.9000. The proceeds will be $1,900,000 less the option cost of $25,000.
Historically, firms have preferred to use forward contracts when the amount and timing of the future cash flow are certain. The flexibility of options makes them useful for firms when there is high uncertainty in the amount and timing of the cash flows. Although the option can appear to be more expensive than the forward contract, especially when exchange markets are highly volatile, its flexibility can make it very useful in some cases. The option is also being used more often by corporate treasurers because of its flexibility, a move that has accelerated since the mid-1980s.
There are many other instruments that firms can use to hedge exposure, but the forward contract and the option illustrate the role contractual procedures can play.
To protect assets adequately against risks from exchange-rate fluctuations, it is important for management to (1) define and measure exposure, (2) organize and implement a reporting system that monitors exposure and exchange-rate movements, (3) adopt a policy on assigning responsibility for hedging exposure, and (4) formulate a strategy for hedging exposure.
Measurement
Most MNEs will be subject to all three types of exposure described above. In order to develop a viable hedging strategy, the firm must be able to forecast
the degree of exposure in each major currency in which it operates. Because the three types of exposure are very different from each other, the actual exposure by currency must be kept separate. The translation exposure in Brazilian cruzeiros, for example, should be kept separate from the transaction exposure. The reason is that the transaction exposure will result in an actual cash flow, whereas the translation exposure may not. Thus the firm may adopt different hedging strategies for the different types of exposure.
Forecasting Exchange Rates
Another key aspect of measurement involves forecasting exchange rates that are applicable to the identified exposure. Estimating future exchange rates is similar to using a crystal ball: Approaches range from gut feeling to sophisticated economic models and with varying degrees of success. Whatever a firm decides to do, its management should estimate ranges within which it expects a currency to vary over the relevant decision period.
Some firms develop in-house capabilities to monitor exchange rates, using economists who also try to obtain a consensus of exchange-rate movements from the banks with whom they deal. Their concern is to forecast the direction, magnitude, and timing of an exchange-rate change. Other firms contract out this work.
Reporting System
Once the firm has decided to define and measure exposure and estimate future exchange rates, it must design, organize, and implement a reporting system that will assist in protection against risk. Because of the nature of the problem, substantial participation from foreign operations must be combined with effective central control. Foreign input is important in order to ensure the quality of information being used in forecasting techniques. Since exchange rates move frequently, firms must obtain input from someone who is attuned to the pulse of the country. In addition, the maximum effectiveness f hedging techniques will depend on the cooperation of personnel in the
foreign operations.
A central control of exposure is needed to protect resources more efficiently. Each organizational unit in the firm may be able to define its exposure, but the corporation itself also has an overall exposure. To set hedging policies on a separate-entity basis might not take into account the fact that exposures of several entities (i.e., branches, affiliates, subsidiaries, and so on) could offset one another.
Management should devise a uniform reporting system to be used by all units reporting to the MNE. The report should identify the exposed accounts the firm wants to monitor, the exposed position by currency of each account, and the different time periods to be covered. Exposure should be separated into translation and transaction components, with the transaction exposure identified by cash inflows and outflows over time.
The time periods to be covered depend upon the firm. One possibility is to look at long- as well as short-run flows. For example, staggered periods (thirty, sixty, and ninety days; six months, nine months, and twelve months; and two, three and four years) could be considered. The reason for the longer time frame is that operating commitments, such as plant construction and production runs, are fairly long-run decisions.28
Once each basic reporting unit has identified its exposure, this should be sent to the next organizational level for a preliminary consolidation. That level may be a regional headquarters (such as Latin America or Europe) or a product division. The organizational structure of the firm will determine what that level is. The preliminary consolidation allows the region or division to determine exposure by account and by currency for each time period. These reports should be routine, periodic, and standardized to ensure comparability and timeliness in formulating strategies. Final reporting should be at the corporate level. There, corporate exposure can be determined and strategies identified to reflect the best interests of the corporation as a whole.
Exposure Management Policy
It is important for management to decide at what level hedging strategies will be determined and implemented. To achieve maximum effectiveness in hedging, policies should be established at the corporate level. With a larger overview of corporate exposure and the cost and feasibility of different strategies at different levels in the firm, the corporate treasury should be able to design and implement a cost-effective program for exposure management. As a firm increases in size and complexity, it may have to decentralize some decisions in order to increase flexibility and speed of reaction to a more rapidly changing international monetary environment. However, such decentralization should stay within a well-defined policy established at the corporate level. This is the strategy that GM uses.
Some companies, such as Eastman Kodak and Nestle" Foods, tend to run their hedging operations as profit centers and nurture in-house trading desks, whereas most MNEs are very traditional and conservative in their approach, preferring to cover exposure rather than extract huge profits. Mattel, Inc., the U.S. toymaker, straddles the line between the two approaches. Mattel combines in-house expertise with the use of an outside manager. Treasury felt that it did not have the expertise to manage exposure to take advantage of significant opportunities, so it decided to turn some of its exposure over to an outside professional foreign-exchange manager with the goal of generating profit.29
Another part of the management strategy has to deal with deciding which exposure will be hedged and at what level. Even though the different
exposures were identified above, not all firms feel the same way about them. For example, Kodak has a cash-flow definition of exposure that largely ignores translation exposure.30 Coca-Cola's treasurer, however, disagrees that approach. He says that "From a treasury point of view, all exposures current exposures."31 The assistant treasurer of Black & Decker feels the way. His point is that translation exposure can reduce equity and raise leverage, thus potentially affecting borrowing costs. His approach is to hedge translation exposure 100 percent.32
Effective management of exchange risk involves deciding which of thr risks is important and then establishing a management structure that manage the risk.
Hedging Strategies
Once a firm has identified its level of exposure and determined which exposure is critical, it can hedge, or protect, its position from exchange-r changes. A firm can adopt numerous strategies, each with cost/benefit impfi-cations as well as operational implications. The safest position for a firm to be in is a balanced position, in which exposed assets equal exposed liabilities.; This involves operational strategies to hedge exposure. The principal opera- tional methods that MNEs use to protect against exposure are balance-sheet management and leads and lags in the transfer of funds. In addition, firms
can enter into a number of contractual obligations to hedge exposure, such as forward-exchange contracts and currency options.
operational strategies Operational Strategies To reduce exposure through operational strategies ,nvolvc management must determine the working capital needs of the subsidiary.
Although it might be wise to collect receivables as fast as possible in an infla-
tionary country where the local currency is expected to depreciate, the nm must consider the competitive implications of not extending credit.
In reality, working capital management under exchange risk assumes that currency values move in one direction. A weak-currency country gen-! erally (although not always) suffers from inflation. The approach to protecting assets in the face of currency depreciation also applies to protection against inflation. Inflation erodes the purchasing power of local currency, whereas depreciation erodes the foreign currency equivalent.
In the weak-currency situation, subsidiaries' cash should be remitted to the parent as fast as possible or invested locally in something that appreciates in value, such as fixed assets. Accounts receivable should be collected as quickly as possible when they are denominated in the local currency and stretched out when denominated in a stronger currency. Liabilities should be treated in the opposite manner.
A policy for inventory is difficult to determine. If inventory is considered to be exposed, it should be kept at as low a working level as possible. However, since its value usually increases through price rises, it can be a successful hedge against inflation and exchange-rate moves. If the inventory is imported, it should be stocked before a depreciation since it will cost more local currency after the change to purchase the same amount in foreign currency. Where price controls are in effect or where there is strong competition, the subsidiary may not be able to increase the price of inventory. In this situation, inventory can be treated in the same way as cash and receivables. These principles can be reversed when an appreciation is predicted—that is, keep cash and receivables high, and liquidate debt as rapidly as possible. The safest approach is to keep the net exposed position as low as possible.
The use of debt to balance exposure is an interesting phenomenon. Many firms have adopted a "borrow locally" strategy, especially in weak-currency countries. One problem is that interest rates in weak-currency countries tend to be quite high, so there must be a trade-off between the cost of borrowing and the potential loss from exchange-rate variations. Coca-Cola, for example, has a strategy that at least half of its net exposed asset position in foreign countries is offset by foreign currency borrowings.33 Black & Decker also uses local borrowings to hedge a net exposed asset position, but each exposure is considered on a case-by-case basis rather than automatically covering with local borrowing.34
Protecting against loss from transaction exposure becomes very complex. In dealing with foreign customers it is always safest for the firm to denominate the transaction in its own currency. Alternatively, it could denominate purchases in a weaker currency and sales in a stronger currency. If forced to make purchases in a strong currency and sales in a weak currency, the firm could resort to contractual measures or try to balance its inflows and outflows through more astute sales and purchasing strategies.
Leads and Lags Another operational strategy, known as "leads and lags," is often used to protect cash flows among related entities, such as a parent and its subsidiaries. The lead strategy involves collecting foreign currency receivables before they are due when the foreign currency is expected to weaken and paying foreign currency payables before they are due when the foreign currency is expected to strengthen. A lag strategy means that a firm will delay receiving foreign currency receivables if that currency is expected to strengthen and delay payables when the currency is expected to weaken. Another way to state this is to say that a company usually leads into and lags out of a hard currency and leads out of and lags into a weak currency. For example, General Electric used a lag strategy in 1984 when the Japanese yen was relatively weak against the U.S. dollar. Because GE predicted a strengthening of the yen, it delayed remitting a yen dividend to the parent company until the yen began to strengthen.
Leads and lags are much easier to use among related entities in which a central corporate financial officer can spot the potential gains and implement a policy. There are two problems with the lead/lag strategy. First, it may not involve the movement of large blocks of funds. If there are infrequent decisions involving small amounts of money, it is easy to manage the system, but as the number and frequency of transactions increase, it becomes difficult to manage. Second, as mentioned earlier in the chapter, leads and lags are often subject to governmental control since movements impact the balance of payments of a country.
Forward Exchange Contracts In addition to the operational strategies just mentioned, a firm may resort to contractual arrangements. The most prevalent approach is the forward contract, a contract between a firm and a bank to deliver foreign currency at a specific exchange rate at a set date in the future.
For example, assume that a U.S. manufacturer sells goods to a British manufacturer for £1,000,000, with payment due in 90 days. The spot exchange rate is $1.9000 and the forward rate is $1.8500. In 90 days, the actual exchange rate is $1.8700. At the time of the sale, the sale is recorded on the books of the exporter at $1,900,000, and a corresponding receivable is set up for the same amount. However, the exporter is concerned about the exchange risk. The exporter can enter into a forward contract, which will guarantee that the proceeds of the receivable can be converted into dollars at a rate of $1.8500, no matter what the actual future exchange rate is. That would yield $1,850,000, or a cost of protection of $50,000. Or the firm could wait until the receivable is collected in 90 days and gamble on a better rate. Assuming an actual rate of $1.8700, the exporter would receive $1,870,000, which is not as good as the initial receivable of $1,900,000, but it is better than the forward yield of $1,850,000. However, if the dollar were to strengthen to $1.8000, the exporter would have been much better off with the forward contract.
Currency Options The foreign currency option is a relatively recent foreign-exchange instrument. It is more flexible than the forward contract because it gives the purchaser of the option the right, but not the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.
For example, assume that a U.S. exporter decided to sell merchandise to a British importer for £1,000,000 when the exchange rate was $1.9000. At the same time, the exporter went to the Philadelphia Stock Exchange and entered into an option to deliver pounds for dollars at an exchange rate of $1.9000 at an option cost of $25,000. That means that whether or not the exporter exercises the option, the right to have the option costs $25,000. When the exporter receives the £1,000,000 from the importer, a decision must be made on whether or not to exercise the option. If the exchange rate is above $1.9000, the exporter will not exercise the option, because he/she can get a better yield by converting pounds at the market rate. The only thing lost is the $25,000 cost of the option, which is like insurance. On the other hand, if the current exchange rate is below $1.9000, say $1.8000, the ex-
porter will exercise the option and trade pounds at $1.9000. The proceeds will be $1,900,000 less the option cost of $25,000.
Historically, firms have preferred to use forward contracts when the amount and timing of the future cash flow are certain. The flexibility of options makes them useful for firms when there is high uncertainty in the amount and timing of the cash flows. Although the option can appear to be more expensive than the forward contract, especially when exchange markets are highly volatile, its flexibility can make it very useful in some cases. The option is also being used more often by corporate treasurers because of its flexibility, a move that has accelerated since the mid-1980s.
There are many other instruments that firms can use to hedge exposure, but the forward contract and the option illustrate the role contractual procedures can play.
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