HEDGING — MANAGEMENT RELUCTANCE AND INTERNAL METHODS

admin — Thu, 02 Jul 2009 08:34:45 +0000

Having looked in detail at the issue of managing currency risk, we should now be looking at the specifics of how to hedge that risk. Before we do that, we first have to examine the issue of management reluctance to hedge a risk many see as merely an operational hazard of international investment. Some may dismiss this section, either because it is irrelevant to them or because they view any such approach as inappropriate. While I too share the view that currency risk should be managed, such management reluctance should not be ignored, but instead should be understood and thereafter combated. Three key reasons for this reluctance which come up time and again are the following:
Management does not understand active currency management methods
Management thinks currency risk cannot be measured accurately
Management sees active currency management as outside of core business
Some of these points are reasonable. Currency forwards and options may well be outside the field of expertise of a corporation’s management, and will certainly be outside the core business operations. Many managements consider such financial instruments as speculative. However, it is the job of Treasury to explain that not managing currency risk actively leaves the corporation vulnerable to major exchange rate movements, which can cause substantial swings in the company’s value. Using forwards or options may indeed be speculative, depending on what they are used for. However, not hedging currency risk may be even more speculative. Active currency management is a necessary byproduct of a corporation’s overseas investments and operations. Again, it is the job of the Treasury to educate the management and ultimately the board on the need for active currency management, not least to maintain and ensure the corporation’s equity market value. A corporation may not be able to boost shareholder value significantly through active currency risk management, but it can certainly damage it by not managing currency risk.
When management says it is difficult to measure currency risk it is correct, but that does not mean such risk cannot be quantified. Imprecision is not an excuse for indecision in the corporation’s underlying business. Neither should it be tolerated with regard to currency risk management.
Even if a management is willing to consider currency hedging, there are ways of “natural” or internal hedging that it may consider first, such as:
Netting (debt, receivables and payables are netted out between group companies)
Matching (intragroup foreign currency inflows and outflows)
Leading and lagging (adjustment of credit terms before and after due date)
Price adjustment (raising/lowering selling prices to counter exchange rate moves)
Invoicing in foreign currency (this cuts out transactional exposure)
Asset/liability management (for balance sheet, income or cash flow exposure)
Netting involves the settling of intragroup debt, receivables and payables for the net amount. The simplest form of this is bilateral netting between two affiliates.
Matching is similar but can be applied both to intragroup and third-party flows. Here, a corporation “matches” its foreign currency inflows and outflows with respect to amount and timing.
Leading and lagging refer to adjusting credit terms between group companies, where “leading” means paying an obligation in advance of the due date and “lagging” means after the due date. This is a tactic aimed at capturing expected currency appreciation or depreciation. Price adjustment involves increasing selling prices to counter exchange rate moves. Invoicing in foreign currency reduces transaction risk relating specifically to exports and imports.
Asset and liability management can be used to manage the balance sheet, income statement or cash flow exposure. Corporations can adopt either an active or a passive approach to asset and liability management, depending on their currency and interest rate risk management policy.
Finally one can hedge internally by increasing corporate gearing. Leverage shields corporations from taxes because interest is tax-deductible whereas dividends are not. However, the extent to which one can increase gearing or leverage is limited by costs. That said, if currency hedging reduces taxes, shareholders benefit.
For practical purposes, three questions capture the extent of a corporation’s currency risk:
1. How quickly can a corporation adjust prices to offset exchange rate impact on profit margins?
2. How quickly can a corporation adjust sources for inputs and markets for outputs?
3. To what extent do exchange rate moves have an impact on the value of assets?
Within a corporation, it is usually the case that those who can come up with the best answers to these questions are directly involved in such tasks as purchasing and production. Thus, finance executives who focus exclusively on the credit and currency markets can in fact miss the real essence of a corporation’s currency risk. Furthermore, the exact answers to these questions need to be known not only by the oversight or risk committee, but preferably by the CEO as well. If they don’t, they effectively don’t know both the value and the exposure of the corporation.

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HEDGING — MANAGEMENT RELUCTANCE AND INTERNAL METHODS