Currency risk management

Improved technologies coupled with the
liberalization of trade policies have led to
an explosion of global business opportunities. In order to fully maximize the benefits of
conducting business in this surging international market, it is imperative to implement
appropriate risk management tools.

“There are several tools available in the foreign exchange hedging portfolio toolbox to
manage exchange rate risks,” says Hilary
Love, vice president in the Foreign Exchange
Group of PNC Bank, National Association.

Smart Business spoke with Love about
currency risk management and how to shield
against exchange rate risks.

Why is currency risk management so critical
in today’s global economy?

We are so interrelated now; what happens
in one country affects what goes on in other
parts of the world. Financial flows are global
in nature. Investment decisions made in one
country can affect the currency of another
country and can lead to disruptions in a
domestic economy, based on the decisions
fund managers or central bankers make in
other parts of the globe.

For instance, because the United States is a
large importer, U.S. companies paying overseas entities in U.S. dollars is resulting in an
accumulation of large reserves of U.S. dollars
overseas. Ultimately, overseas investors must
decide if they want to keep the reserves in
U.S. dollars or diversify into other currencies.
By diversifying into other currencies, overseas investors sell U.S. dollars in exchange
for the desired foreign currency, putting
downward pressure on the U.S. dollar, a
trend that has been accelerating over the past
year or so. As global funds become more liquid, there is an increased volatility in the U.S.
dollar, which affects every entity doing business in the U.S. — through exchange rate
movements and also domestic interest rates.

What steps can be taken to manage
exchange rate risks?

For currencies that are freely traded on the
international exchanges — like the euro,
British pound, Japanese yen, Canadian dollar
— many companies use a hedging technique
called a forward contract to manage exchange rate risk. A forward contract is an
agreement that a company enters into with a
bank that obligates the company to buy or
sell a certain amount of foreign currency in
exchange for a certain amount of U.S. dollars
at a pre-agreed date, or range of dates, in the
future. Another technique to manage exchange rate risk is called a foreign currency
option, which gives the buyer the right, but
not the obligation, to buy or sell currency at a
pre-agreed rate.

For government-controlled, or restricted
currencies, which are usually in the emerging
parts of the world, a hedging technique called
a non-deliverable forward contract has been
developed. This is an agreement similar to a
forward contract, but where no currency
changes hands. This is increasingly being utilized in the Chinese market. The fear of U.S.
companies that import from China is that the
yuan could rise and cause their cost of goods
sold to escalate rapidly. To hedge against this
risk, companies enter into a non-deliverable
forward where they lock in a value of the
yuan for a certain period of time. A non-deliverable forward essentially provides a way of
settling up in U.S. dollars for fluctuations in
the currencies.

How can a company effectively balance risk
and return when investing in global markets?

While there are some higher investment rates of return available in non-U.S. markets,
right now it is important to take into consideration the potential negative impact of currency moves. To effectively manage this risk,
U.S. companies should consider having a
baseline hedged amount. Companies should
also consider implementing foreign exchange risk management polices in written
form that describe what risk the company
will tolerate in terms of the impact rate fluctuations may have on both business and
investment decisions.

How can foreign currency loans benefit companies with a subsidiary in another country?

In the past, many companies believed they
had to establish a borrowing relationship
with a local foreign bank if their non-U.S. subsidiary had funding needs. Increasingly, there
are alternatives that allow a parent company
to use its U.S. bank. The first option is to borrow directly in a foreign currency to fund the
subsidiary, with the assumption that the subsidiary will generate sufficient revenue in the
applicable currency to repay the debt.
Another alternative is a cross-currency interest rate swap, where the company, either in
the name of the parent company or the subsidiary, can borrow in U.S. dollars from its
U.S. bank and swap it into a foreign currency.
This method removes the risk of foreign currency movements and the interest rate risk.

This article was prepared for general
information purposes only. The information set forth herein does not constitute
legal, tax or accounting advice. You should
obtain such advice from your own counsel
or accountant. Under no circumstances
should any information contained herein be
used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Opinions
expressed herein are subject to change without notice. © 2007 The PNC Financial
Services Group, Inc. All rights reserved.

HILARY LOVE is vice president in the Foreign Exchange Group
at PNC Bank, National Association,
Member FDIC and a subsidiary of The PNC Financial Services Group, Inc. Reach her at
(888) 627-8703 or [email protected]. To learn more about
currency risk management, check out PNC’s Middle Market
Advisory Series at pnc.com/joinus.