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Home > Financial Risk Management Best Practice > To Hedge or Not to Hedge

Financial Risk Management Best Practice

To Hedge or Not to Hedge

by Steve Robinson

Executive Summary

  • How currency risks are created and managed and the types of risk inherent in international trading.

  • The techniques for managing currency risks.

  • A framework for selecting appropriate techniques in specific business situations.

  • An outline and illustration of the use, of the main financial derivatives.

Introduction

Business has become increasingly international, and companies cannot ignore the impact of currency changes on cash flows, profitability, and their asset and liability position. No company is wholly immune—the cash received from exporting is affected by the relationship between the currency used by the customer to pay and the currency in which the cost of providing the product or service is denominated.

Many commodity prices have been volatile, rising and falling dramatically in recent years—driven by exploding or plummeting demand from fast-developing countries. Copper, tin, wheat, platinum, and of course oil, have risen dramatically, and this has had a significant impact on costs for many industries. Declines can be equally sudden, although falling costs often take more time to work through to market prices.

A spectacular result was the sudden collapse of several airline businesses in late 2007 and early 2008. Among them was EOS, a business-class only carrier operating mainly between London and New York, which started only in 2005. Also, Oasis Hong Kong Airlines, an innovative long-haul discount operator between Hong Kong, London, and Vancouver, MAXjet Airways, and some smaller low-cost US carriers, have all ceased trading very suddenly. Although other factors, such as reduced business travel and turbulent financial markets, have had an impact, the price of aviation fuel is the main cost driver, closely followed by the impact of currency changes—airlines pay all their costs in US dollars.

The risks extend beyond the trading sphere. Many banks have had to write down the value of their assets—largely complex “trading” securities. Finance is a global industry, and companies borrow and invest in many currencies. It is not sufficient that only financial people know how currency risks are created and managed.

What Are the Risks?

Currency risk is the net potential effect of exchange rate movements on the cash flow, profit, and balance sheet of a business. There are three types of currency risk:

Economic, Strategic, or Competitive Risk

Economic exposure covers the indirect risk to the profitability and cash flow of a company that arises from changes in exchange rates. It is likely that ultimately a resultant transaction exposure will arise.

An illustration, relating to the US dollar, the euro, and sterling, could be holidays. For British holidaymakers, holidays in the euro zone and the US dollar zone become more expensive if sterling weakens. The UK holiday industry could benefit from the euro exchange rate if more British stayed in the United Kingdom for their holidays.

Translation Risk

Translation risk arises when amounts denominated in foreign currency are converted to domestic equivalents for financial reporting purposes. There is no immediate cash impact. Translation can affect both the profit and loss account and the balance sheet. Increasingly, converging accounting standards under International Financial Reporting Standards (IFRS, which do not apply to unquoted companies) are removing some previous distortions. The most common accounting policy is to convert trading profit and loss numbers at an average exchange rate during the accounting period, and to convert assets and liabilities at the year-end rate.

Profit and Loss Statement Translation

The profit and loss translation is only a paper figure initially, but it may become a real transaction exposure if cash interest or dividends need to be paid. A company with a large proportion of its income, or of its cash, in other currencies, will have a translation issue, but this can be helped by effective communication to investors, persuading them that short-term currency fluctuations will not necessarily lead to reduced long-term stockholder value creation.

Balance Sheet Translation

The foreign currency assets of the company are not exposed to currency fluctuations unless they are to be sold and the cash converted to another currency. Liabilities denominated in foreign currencies will represent a real exposure when they are due for repayment.

The impact of translation on the gearing level has to be evaluated to ensure that no covenants are breached, even if only technically. A very simple way around this is to match investment in foreign currency assets with loans dominated in equivalent currencies.

The practical difficulty is how far the company can go to protect reported earnings, while incurring a cost that will impact on the bottom line. It is also possible that a real transaction exposure could be created by a currency borrowing. Also to be considered is the impact of a fair value adjustment, on both the profit and loss bottom line and on reserves in the balance sheet.

Transaction Risk

This risk is that exchange rate movements affect the value of foreign currency cash flows. It is the only risk that has a direct and immediate impact on cash, and arises when a transaction is entered into to actually convert from one currency to another.

The most common trading situation creating this exposure is the sale or purchase of goods or services on extended payment terms in foreign currencies. Another common situation arises when dividend or interest payments are paid or received.

This type of risk is usually predictable and quantified, making the protection or hedging process straightforward. Really successful management of currency exposures needs to cope with transactions that have not yet been identified but are likely to occur.

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Further reading

Books:

  • Arnold, Glen. Corporate Financial Management. 4th ed. Harlow, UK: FT Prentice Hall, 2008.
  • Boakes, Kevin. Reading and Understanding the Financial Times. Harlow, UK: FT Prentice Hall, 2008.
  • Matza, Peter (ed). The International Treasurer’s Handbook 2009. 19th ed. London: Association of Corporate Treasurers, 2008.
  • Shomah, Shani Beverley. A Foreign Exchange Primer. 2nd ed. Chichester, UK: Wiley, 2009.
  • Slatyer, Will. The Debt Delusion: Evolution and Management of Financial Risk. Boca Raton, FL: Universal Publishers, 2008.

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