Murray Ronnie

Currency Risk Management & Corporate Strategy
Exchange Rate Risk Management Strategies Before and After the Economic Downturn

Ron Murray
Nick Roth
FIN 627 – FALL 2009

Abstract
Foreign exchange rate risk is an inherent aspect of international commerce. Fortunately, for companies that operate in this global arena – particularly for those that transact with counterparties having major currencies – there are a variety of derivatives instruments that can be used to mitigate this risk, including forward contracts, futures contracts, and options. (Kawaller, 2008)
The purpose of this paper is to identify any changes in corporate strategy relating to foreign exchange risk management in light of the current economic downturn. We want to know if companies hedge their foreign exchange rate risks differently now that we are have just been through one of the greatest recessions this world has ever seen. While currency risk management is no new concept, exchange rate risk management has seen a strategic evolution in the past few years. In order to fully understand any new techniques implemented by firms, we first must grasp the basic fundamentals of exchange rate risk management and the best practices popularized by companies before the recent economic downturn.
Introduction
According to an article written by Alpha Dhanani at Financial Management, a United Kingdom periodical, the most common risk that a company ensues in international business are risks related to currencies. These risks, called currency risks or exchange rate risks, manifest themselves in three basic ways. Because these three common types of uncertainties can affect profit levels and even lead to significant losses to otherwise profitable operations, a better understanding of how and why they affect firms is essential.
The first type of currency risk is translation exchange rate risk. The name is just as it sound; this is the risk a company ensues through ‘translating’ or re-stating the financial statements of foreign subsidiaries into the currency terms of the parent company. After all, a parent company must consolidate their financial statements into one currency for reporting purposes. As a result, a United States firm with foreign subsidiaries denominating debts and revenues in British pounds must consolidate their financials into greenbacks on their balance sheets (Dhanani, 2000).
Secondly, global companies will frequently encounter transaction exchange rate risk. Transaction exchange rate risk hinges on trading agreements. Firms often times will open a trading agreement in a foreign currency on a credit basis; however, by the time the contract delivery date arrives the exchange rates may be drastically different than at the inception of the agreement. These fluctuations can have significant effects on cash flows between firms (Dhanani, 2000).
The third main type of currency risk is economic exchange rate risk. While this form of risk is much harder to predict and identify, it is a very significant threat nonetheless. Economic exchange rate risks are long-term movements and have significant repercussions with respect to expected cash flows. Dhanani illustrates this risk by using an exporting company as an example. If the dollar appreciates in value against the Euro, Ford Motor Company will experience diminished cash flows compared to those of BMW when competing in Germany (Dhanani, 2000).
Another form of currency risk comes in the form of operational exchange rate risk. Operational risk presents itself in a variety of different ways. Parent companies face operational exchange rate risk when making subsidiary location decisions, decisions concerning sourcing of inputs, markets and market segments, and debt currency denomination (Bradley & Moles, 2002).
Now that the different types of exchange rate risk have been identified, the traditional techniques used to address these risks can be explored. In turn, new trends in currency risk management can be identified and contrasted.
Currency Risk Management Strategies –Pre Economic Downturn
Now that the different types of currency risk have been identified, the subsequent strategies to combat these risks can be further explored. While currency risk management is believed by some companies the following tools and techniques reveal that a proactive approach to currency risk management is not only feasible, but also essential.
In a survey conducted in 2002, Bradley and Mores gathered data about exchange rate risk management from the United Kingdom’s largest firms. They found that only two hedging techniques were used by more than half of the respondents: foreign currency-denominated debt and sourcing inputs in the same currencies as sales. Foreign currency-denominated debt is just as it sounds; simply denominating the obligations of the company in the currencies of the foreign countries in which they operate. Sourcing inputs in the same currency as sales refers to coordinating upstream and downstream currencies.
The respondents also reported that 61% of them never locate production facilities in the same country as sales are made, 63% do not diversify their sales in many different currencies, and 85% have never changed production location as a result of foreign exchange rate risk. Long-term currency exchange rate risks can only be corrected through effective forecasting. Nearly a third of respondents to the survey do not forecast at all while 46% forecast only 12 months or less into the future. According to this survey, 90% of companies believed that their costs and revenues were insensitive to exchange rate movements while nearly 20% indicated that their companies made no considerations for their foreign exchange rate risk (Bradley & Mores 2002). It’s the 80% we turn to next to see how companies have accounted for the various types of currency risks.

Forwards & Futures Contracts
One of the primary ways that companies combat foreign exchange rate risk is through the use of forward contracts. Forward contracts are used to hedge transaction risk, particularly for short term exposures. Forward contracts have been traditionally used to lock in exchange rates for a product at a future delivery date. The use of forward contracts allows companies to avoid risk and use concrete numbers for future planning. Furthermore, forwards, along with futures and options, are used as the result of forecasted exchange rate movements in the future. They are agreements between private parties and have varying terms and conditions and settle at the end of the contract (Dhanani, 2000).
Additionally, companies often use futures contracts to hedge their exposure to foreign exchange rate risks. Futures are similar to forwards in that they can effectively hedge foreign exchange rate risk; however, futures do have significant differences. Unlike forwards, futures contracts are exchange-traded, standardized contracts. These contracts are marked to the market daily, often speculative in nature, and are rarely delivered (Dhanani, 2000).

Exchange Rate Risk Management Software
Wolfgang Koester, the CEO of RimTec, a software development company that operates Fireapps, a platform that enables companies to optimize their foreign exchange rate processes. Companies have used software like Fireapps to provide “enhanced visibility into corporate foreign exchange exposures and analysis based on real-time currency and internal banking data.” This software enables companies to collect data throughout various business divisions of an organization in an interpreted and usable fashion. Koester estimates that 80% of companies of companies don’t even know what their real foreign exchange risks are and that software like Fireapps can provide tremendous benefits toward hedging efforts (Platt 2007).

Operational Hedging
As stated earlier, operational risk exposure comes from a mismatch between sensitivities of exchange rate risk between inputs and outputs. According to Bradley and Mores, some firms have carefully chosen location of production facilities, how they source their inputs, the nature and scope of their products, which markets and market segments to engage, and the denomination of their debt. The goal of all these operational hedging actions is to reduce corporate exposure by matching the sensitivities of their inputs and outputs. An article from Managerial Finance uncovered that less than 25% of responding firms made operation decisions without considering currency exposure; however, only four percent of the sample switch suppliers to capitalize on currency effects. The article also revealed that companies are aware of their competitive position and denominate their debt and locate their facilities in similar locations as competitors (Bradley and Mores, 2002).

Selling & Purchasing Strategies
Global companies have also been shown to show strategy in selling and purchasing with regards to foreign exchange rate management. The tools that companies use for selling hinge upon expected values of currencies verse the spot and forward buying rates. The following three examples exhibit the relationship between currency and these rates and how optimally handle them:
When foreign currency is expected to rise (value of domestic currency falls) above the bank spot buying rate, cash sale and sale with a forward exchange contract suffer a loss. Such conditions are best addressed by a credit sale.

When foreign currency is expected to fall (value of domestic currency rises) below the bank forward buying rate, cash sale and sale with a forward exchange contract will reap a gain. These conditions are best addressed by a cash sale.

When foreign currency is expected to rise (value of domestic currency falls) above the bank forward buying rate but below the bank spot buying rate, cash sale will score a gain while sale with a forward exchange contract will suffer a loss. These conditions will yield a wash for a credit sale. (Yang & Midgette, 1998)

Purchasing strategies follow the same concepts. The following examples exhibit the relationship between currency and the spot/forward buying rates and how to strategically deal with them in purchasing:
When foreign currency is expected to rise (value of domestic currency falls) above the bank forward selling rate, cash purchase and purchase with a forward exchange contract will reap a. The cash purchase becomes optimal in these circumstances.

When foreign currency is expected to fall (value of domestic currency rise) below the bank spot selling rate, cash purchase and purchase with a forward exchange contract will suffer a loss. These circumstances are best addressed with a credit purchase.

When foreign currency is expected to increase (value of domestic currency fall) above the bank spot selling rate but below the bank forward selling rate, cash purchase score a gain, forward exchange contract will suffer a loss, while a credit purchase is neutral. Cash purchase would be the optimal choice. (Yang & Midgette, 1998)
Currency Risk Management Strategies – Current/Post Economic Downturn
There have been several significant changes in the international economic and political landscape that have led to uncertainty regarding the direction of foreign exchange rates. Most notable of these is the global melt-down and recession. This uncertainty leads to volatility and the need for an effective vehicle to hedge foreign exchange rate risk and/or interest rate changes while, at the same time, effectively ensuring a future financial position.
The current economic downturn started in 2007, and has affected most nations of the world. It has had dire affects on numerous companies throughout the world. During these challenging economic times companies struggle to cut costs (operations and capital spending), access capital and accurately forecast performance. Earnings have always been the benchmark with which companies have been judged. In the current economic environment earnings are looked at even closer; by private owners, shareholders, and lenders. Corporations are holding more cash in an attempt to stay liquid.
All this has increased the importance of properly hedging foreign exchange risk many companies face. Basically, with leaner earnings, it has become even more important than ever for companies to have the proper strategies in place to mitigate the foreign exchange risk. (Hollein, 2002)
In the following sections of the paper we will look at strategies being incorporated currently in companies’ foreign exchange management strategies and see if they differ from strategies that were popular before the current economic downturn. In other words, has the economic downturn and increased global volatility changed the way companies hedge their foreign exchange risk?

Forwards & Futures Contracts
As stated earlier, one of the primary ways that companies combat foreign exchange rate risk is through the use of forward contracts. This has not changed in the time after the economic downturn. What has changed is the duration of the hedges. With so much uncertainty in the economy, companies have shortened the duration of their hedges. Companies are hedging more frequently for shorter periods and then rolling over the hedges to cover known exposures. (Gamble, 2009)
Companies are choosing to go shorter term with their forward contracts because long term maturity forward contracts result in a higher rate of credit utilization, and as mentioned above, in these uncertain times companies are trying to maintain higher cash balances and hence be more liquid.
Companies also don’t want to over-hedge their positions, as they may not qualify for friendly hedge accounting rules under Financial Accounting Standards Board (FAS) 133. (Gamble, 2009) Forward contracts not qualifying under FAS 133 could potentially be a costly event. Under FAS 133, hedges are valued at fair value only if the hedged position and the underlying hedged item have a correlation ratio between 80% and 125%.

Options
As noted above, credit has tightened up during the economic downturn and the global economy has become very volatile. Because of these issues several companies are now turning to simple options to hedge foreign exchange rate risk.
Options require less cash investment as a company is only buying the option, and is not obligated to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. With credit tight and less cash needed, and with volatility high, options are an increasing trend to hedge foreign exchange rate risk. (Gamble, 2009)
Another reason options have become increasingly popular is because they are a good hedging technique to use when future cash flows are unpredictable. As stated above, it is increasing difficult for companies to forecast with any certainty because of all the unknowns within the global economy. The general rule is to hedge certain foreign currency cash flows with forwards and hedge uncertain foreign currency cash flows with options. (wikipedia.com, 2009)

Conclusion
While we did find some research that stated that forwards and options are becoming increasing popular to hedge foreign exchange rate risk, they always have been very popular. (Carter, Pantzalis, Simkins, 2001) What can be taken from our research is that because of the economic downturn and increased volatility globally, forwards are being used in even shorter terms than normal and options are gaining more momentum because of the lack of cash needed to trade them.

References

Bradley, Katrina, Moles, Peter. Managing strategic exchange rate exposures: Evidence from UK firms. Managerial Finance. Patrington:2002. Vol. 28, Iss. 11, p. 28-42 (15 pp.)

Dhanani, Alpha. Risky business. Financial Management. London:Nov 2000. p. 30-31 (2 pp.)
Platt, Gordon. Increased Volatility In Exchange Rates Spurs Adoption Of Best Practices In Currency-Risk Management. Global Finance. New York:May 2007. Vol. 21, Iss. 5, p. 72,74-76 (4 pp.)
Yang, James, Midgette, Jerry. Managing the exchange risks of international transactions. The Mid - Atlantic Journal of Business. South Orange:Jun 1998. Vol. 34, Iss. 2, p. 141-162 (22 pp.)

Hollein, Marie. Pricing in foreign currency vs. U.S. dollars – how is your company managing currency risk? AFP Exchange. Bethesda:Nov/Dec 2002. Vol. 22, Iss. 6, p. 11-116 (3pp.)

Gamble, Richard. All Eyes on FX Risk. Treasury & Risk: The Future of Finance Today. Sept 2009 pgs. 10-11

Kawaller, Ira. Hedging Currency Exposures by Multinationals: Things to Consider. Journal of Applied Finance. Tampa:Fall 2007. Vol. 17, Iss. 2, p. 62-71 (10pp.)

www.wikipedia.com. http://en.wikipedia.org/wiki/Foreign_exchange_option. viewed October 6, 2009

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