There is a mistaken belief that only companies with business in currency other than its reporting currency are exposed to foreign exchange (FX) risk. The reality is that even domestic companies may be affected by volatility in the currency market. The decision facing corporates is whether to hedge or not.
Most companies now understand that hedging is not speculating and, should they decide to hedge, they need to look at their net consolidated exposure. The techniques used vary according to the level of sophistication of the treasury organisation, which is normally charged with hedging responsibilities. The more advanced treasury group employs value-at-risk (VaR) and cash flow-at-risk (CFaR); some even use Monte Carlo simulation to quantify their risk. When they hedge, the vast majority of the companies simply buy and sell FX contracts to lock in the rates.
What is less clear is how companies decide whether to hedge or not. Compared to hedging in financial institutions, where value is created from profiting from mispriced securities, it is not a straightforward exercise to determine where value is created from corporate hedging. It is rare to hear that a company’s hedging objective is to make money, as it is generally accepted that corporates should focus on making money from their core business.
Of the companies that do hedge, their reasons vary. Some argue that they hedge to ensure earnings predictability because Wall Street ‘hates’ surprises. Even if their hedge lost money, it can still be considered a good thing as long as their earnings are on track. Others argue that hedging potentially reduces their cost of capital. Another justification for hedging is that it could lead to better performance evaluation, as the manager’s performance would no longer be subject to currency risk.
Many companies, on the other hand, do not believe in hedging. For example, most of the major oil companies do not hedge. The reasons for not hedging vary from credit reasons, where highly-rated oil companies do not want to deal with counterparties that are lower rated, to the belief that exchange rates exhibit mean-reverting tendency and the gain/loss evens out in the long run. It could also be that companies that do not hedge face a different strategic situation to those that do.
To Hedge or Not to Hedge
If the strategy is to hedge, corporates should be guided by the key objective of corporate currency risk management, which is to enable the company to make better investment and operating decisions so that it can operate and produce/sell its products more efficiently. In fact, the centrepiece of a currency risk management programme should be to understand how and why hedging could lead to a company’s more profitable business investments and efficient operations. In short, corporate FX management is about producing value, not a zero-sum game.
Another perspective on how corporates should approach currency risk management is to focus on the strategic elements of hedging and less on the tactics and execution. In effect, companies should not get lost in the mechanics of hedging. Also, corporate hedgers should avoid superficial issues and go straight to the core issues.
At one global company, currency risk in and of itself was not its focus because it believed shareholders could absorb this risk as part of their global portfolio. However, the company decided to manage its currency risk when they observed that fluctuations in the dollar value of their earnings had been adversely affecting business decisions. For example, lower earnings due to a stronger dollar had resulted in lower research and development (R&D) spending, which affected the company’s growth value.
The above examples could support the argument that there are no direct benefits to hedging, only indirect benefits. The company’s annual operating and long-term plans are not affected by a hedging decision. The hedge accommodates the operating decisions, not the other way around. Therefore, hedging does not directly increase the value of the company’s investments and operations.
To strengthen the argument, we could invoke the Modigliani-Miller theorem of capital structure as it addresses hedging. What the theorem implies is that there is no direct value to hedging: it is a zero net present value (NPV) transaction, in which the company gets a lower return from a lower risk transaction. Also, if you assume that the capital market is efficient and prices are fair, then how can corporates make money by hedging? In other words, if you are in the market and trading risk at a fair price, then there is no opportunity for profit. Why would the value of a safe asset to a company be different from the cost of acquiring it from the marketplace?
Whether one subscribes to the theorem or not, corporate hedgers need to find ‘wedges’, which, if they exist, should strongly support hedging. This means finding extra values and not just, for example, smoothing or predictability of earnings.
As currency risk is unquestionably a very important element of decision facing many companies, it is important to understand that currency risk management involves assessing trade-offs. This encompasses defining and quantifying currency exposure, determining the cost of currency risk to the business, understanding how the market values and prices currency risk, and using this knowledge to manage risk for the benefit of the business.
In designing a currency risk management programme, corporates need to answer the following questions:
- What is the company’s competitive advantage and how does it make money? Is this important in the hedging decision?
- What are the costs of hedging? It may be that with hedging the company lowers the variability of earnings, but it could also give up return.
- Would the company’s operations be disrupted if it does not hedge its currency risk?
- If the company decides to hedge, should it adopt a dynamic or static strategy? In a dynamic model, one would look at risk through time.
- How would the company quantify the benefits of hedging? Where is the value coming from?
- Does hedging affect the value of the firm? How much does the value of the company change? Are there any penalties for not hedging?
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