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Saturday, 27th April 2024 |
| To hedge or not to hedge |
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| Kilian Maxwell on the hedging option in the context of the euro. |
A s one of the oldest money markets in existence, the foreign exchange market has undergone significant change in both competition and size in recent years. Changing market conditions have required FX users to modify trading procedures and alter operational procedures to better manage the risks inherent in the business. Multinationals, eager not to see their profits dissipated by FX fluctuations, tend to choose hedging as the most appropriate tool to safeguard their revenue from overseas subsidiaries. An MNC’s FX transactions exposure arises when the company invoices its overseas distributors/suppliers etc. in foreign currency. The MNC is therefore permanently in a situation whereby it is expecting to receive foreign receipts at an unknown future exchange rate. The typical CEO comment to the issue of transactions exposure is something like the following:
‘We’re not interested in making money on FX. But we want to make sure that we get what we calculated we would.’
However, recent years have seen an explosion of hedging instruments, which have often created more headaches than they have solved for financial management. Many myths have emerged with these new products to the extent that the perception these products portray is that they are the ‘Jim’ll Fix It’ of the international finance sphere.
It is appropriate therefore to unravel much of the wrapping paper which envelopes the hedging market and return to basics. It is only through this that management can tailor their needs to the array of products currently available.
Among the more popular hedging strategies open to corporate management are the following:
l Manufacture close to the local market
l Invoice in domestic currency
l Swaps
l Forwards
l Futures
l Options.
Manufacturing close to US market
There are two possibilities here - either to manufacture in the local market itself, or in a neighbouring low cost economy. It has become increasingly popular in many
industries - automobile, sportswear, glass etc. However, management must account for the image of the change on overall strategy. In many cases, it is doubtful as to whether they would as readily purchase a Mexican or Chinese manufactured good. The most obvious way to avoid transaction exposure is to invoice distributors etc. in home-based currency. However, companies frequently assert that they have a strategic interest in maintaining the financial health of their distributors and such a policy would only shift the transaction exposure further along the distribution chain. Although it may work for some US, German or Swiss MNCs, Irish multinationals cannot typically expect all their dealings to be conducted through punts.
Swaps
If interest parity holds, then exporters who are due to receive foreign currencies are indifferent between selling them forward and using a swap. From an Irish MNC perspective the latter would involve taking the following steps. Firstly, they would borrow the total amount of foreign currency (eg USD) which they expect to receive in a given period. Then they would sell the borrowed dollars for Irish punts at the spot rate. They then employ these punts in Ireland (to pay wages, invest in new machinery, invest the money in a local bank, etc). Finally, they repay the borrowing with the proceeds from their US sales. However, where there is a significant spread between the US lending rate and the return on deposits offered by Irish institutions, more punts would be received from selling the dollars forward than by using a swap.
Forwards
Financial managers at MNCs are well-educated on the forwards market, since it has been the most popular tool for companies and often their sole hedging tool.
Futures
Futures-market hedging achieves essentially the same result as forward hedging. The company should be aware that with futures the foreign exchange is sold at the spot rate at maturity, and the balance of receipts of selling the foreign currency is reflected in the margin account. Unlike forwards, futures are a standardised ‘product’, with standardised settlement date, amount etc. They are generally used where there is a potential credit risk problem with one party to the contract.
Options
FX options are increasingly popular with international firms. Currency options have the power to provide a company with upside potential while limiting the downside risk. They are typically portrayed as a form of financial insurance. However, the truth is that the range of truly non-speculative uses for currency options, arising from the normal operations of a company, is quite small. Options can be useful in certain well-defined situations, but these are situations that few companies seem to grasp. Options could be considered to be relatively expensive. (They must be paid for whether they are exercised or not.) Prices can jump about, depending on the currencies involved and how volatile the market is. Many believe it to be the answer to exposure problems, without truly understanding when and why these instruments can add to shareholder value. The glossy rationale can mask reality. Too many organisations use FX options to disguise the true cost of speculative positioning. For example, it is often believed that options can be the best hedge for accounting and transactions exposure. Instead of incurring opportunity costs with forward contracts, options offer the chance to hedge exposure by buying put/call options.
This argument certainly has appeal. Many like the options hedging idea for purely cosmetic reasons and the confidence it instils in shareholders. But if management chooses this tool, it must accept that the cost of ‘cosmetics’ is equivalent to the extent to which a open, unmanaged option’s position can add to the variability of real cash flows.
Evaluating hedging strategy
Financial managers need to educate themselves on the implications of their treasury decisions. Certain categories of the tools above work well for different situations. Management should start with the question as to what they expect to receive from their treasury department (and hedging division). Are they adding value to the overall company? How can our strategy be improved? There are many variables and factors which must be examined and re-evaluated. Some of these factors include maturity dates of existing contracts and implications on the cash management functions of the company, political and economic stability of your overseas investments, credit risk of your dealers/clients etc. and future exchange rate uncertainty. For example, a company such as Jaguar, who operates uniquely on 12 month forward contracts based on estimated sales receipts for the coming year can print with certainty a price list in America for the coming year, which is consistent with its UK costs of production. It may provide an incentive for corporate management to work at getting costs down but it places pressure on the cash management division as it leads to a more stilted cash flow than would be the case with 3 or 6 month forwards as revenue is only repatriated annually. The premium is also higher for a 12 month forward, than a 3 or 6 month contract because there is a smaller market for the 12 month hedge. This can also impose an opportunity cost if there are interest rate differentials between the countries.
Implications of the euro
The principal issue facing current hedging strategy concerns the introduction of the euro. There may be senior management concerns to switching to a hedging market, based on the euro rate. We can reasonably expect the essence of the hedging market to remain the same, in that international organisations dealing outside the EU will still hedge, but covering against transactions exposure should be simpler to deal with.
Nevertheless, the following scenario may develop in the FX market: If, as expected, the euro will be a strong stable currency, organisations will tend to adopt a strategy of hedging against the appreciation of the euro relative to the US dollar. However, this policy is contingent on how the euro is perceived by the international money markets. Many corporate treasurers and FX dealers are predicting an increase in demand for extended maturities on hedges with the euro’s introduction. There is also a view held by certain economists, such as John Power of the UK Treasury, that the currency option is perfectly suited to MNCs in this scenario as the probability of their foreign currency receipts depends on an exchange rate, which is as yet unknown.
As Power puts it, ‘both the natural exposure and the hedging instrument have returns that are exchange rate dependent and a currency option is exactly the right kind of hedge’.
The overall philosophy of MNC senior management on hedging will not change. The focus of organisations is to sell their products, not speculate in sophisticated derivative instruments. Speculating on the FX market is too difficult to profit from for many organisations on the long run, and most will merely use the hedging market to make sure profits are not decimated by unfavourable exchange rates. Contracts are not won or lost solely because of an exchange rate change. However, this does not mean that improvements cannot be made. Although forwards will remain the most pervasive of all hedging tools in the future, new products are coming on-line with the introduction of the euro. These more sophisticated forms of derivative are becoming better tailored to specific needs. Innovative products spur organisations to adopt more innovative hedging strategies. The challenge for management is to ensure that their present strategies are not creating imperfect hedges for the organisation.
As a wise man once said, ‘a good hedge always keeps the dog in the yard!’ |
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| Article appeared in the March 1999 issue.
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