As more businesses enter the global marketplace, the currency exchange rate is becoming a bigger player in their decision making. Companies want to know where the currency is heading. Many companies rely on their bank for this information, but as former Fed chairman Alan Greenspan once said, “To my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin.”
The currency markets are affected by economic growth expectations and interest rate differentials, and there is no way to predict how exchange rates will react to either of those events, says Don Lloyd, senior vice president, Capital Markets, Associated Bank.
“Today’s big drivers include the rising price of oil caused by unrest in North Africa and the Middle East,” says Lloyd. “Rising oil prices create fear that the U.S. economy will slow, which, in turn, drives the Federal Reserve to be accommodative. But U.S. interest rates are only part of the equation; the other side is the interest rates affecting the other countries you’re dealing with. Specifically, the interest rate differential and expected changes create changes in investment decisions.”
Smart Business spoke with Lloyd about hedging strategies to maximize opportunities and minimize risks.
What kinds of companies should consider a hedging strategy?
Any time there is a cross-border flow of funds, companies need to understand how foreign exchange hedging works and how it can reduce their risks. There are five types of businesses that should consider hedging.
First, any company buying or selling goods overseas is a good candidate, as an organization that makes or receives payments in more than one currency may benefit. Second are overseas subsidiaries of companies based in the U.S., which face two kinds of foreign exchange risk. There’s transactional risk, which applies to accounts payable and receivable. When money trades hands and two or more currencies are involved, a risk exists that could be mitigated with a hedging strategy. The other is translational risk, which applies to your balance sheet. For example, say an Illinois company pays for an overseas plant in foreign currency. At the end of each year, it has to value the plant in U.S. dollars for its balance sheet and may lose equity because of changes in the exchange rate. However, proper hedging can help eliminate this risk.
Third, local subsidiaries of foreign-owned companies can benefit, depending on whether the foreign exchange risk is handled by the parent company or the subsidiary. Fourth are firms that send payroll overseas, and, finally, anyone who invests overseas should consider hedging options.
What volatile markets do businesses need to be aware of?
China, a major trading partner for U.S. businesses, has a volatile currency. China is quickly developing its banking system and monetary policy but still has a ways to go. And changes in its interest rates tend to be extreme because the economy is growing so quickly. Over the next 10 years, volatility should decrease, but, for now, it remains a significant threat to China’s trading partners.
In Europe, the debt crisis facing countries such as Italy, Greece and Ireland affects all countries that use the euro, with uncertainty resulting in volatility. We will continue to see volatility in foreign exchange rates in 2011 and 2012 as the complicated global recovery takes its course.
How can companies reduce volatility?
Organizations doing business overseas can reduce volatility in their income statements and more accurately forecast cash flows by using tools to hedge their foreign exchange risks. Some people mistakenly associate hedging with speculation and think they’ll be taking on more risk, but hedging limits risks.
How can companies determine which hedging strategy fits their situation?
There are three categories of hedges. The first is forward outright purchase or sale, in which a company locks in a rate today to be used in the future. Money doesn’t change hands until settlement day, and you lock in your profit margin on goods you’re selling. The value of this hedge is the certainty that it provides, i.e., a company will know today what exchange rate will be used in the future.
However, some companies use this hedge and then, if currency rates move in their favor before the transaction settles, they are not happy because they would have come out ahead if they had done nothing. Unfortunately, the company is only looking at one side of the equation, and tends to focus on the change in the exchange rate being a good versus bad decision, rather than the real value of taking an unknown (where the exchange rate will be in the future) and making it known (by locking in a rate today.) In that case, the company has the right idea but has chosen the wrong product. What they want is an option.
With options, you lock in the right, but not the obligation, to sell at a specified price. You pay an up front premium, with the amount dependent on the strike price you choose. You get 100 percent protection from adverse exchange rate movements but dollar-for-dollar gain if the currency moves in your favor.
Yet, some companies do not want to pay a premium up front, so should consider a structured option, where you put two or more options together to reduce or eliminate the premium. You start by buying a regular option, but to reduce that premium, you also sell an option to your FX provider. You earn premium for the option you sell, which reduces or eliminates your cost of the structured option. Then you will be fully protected if the currency moves against you, but you benefit if the currency moves in your favor.
Companies should educate themselves on how to maximize their business opportunities and minimize their risk in foreign exchange markets by identifying exposures and implementing appropriate hedging strategies. <<
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Don Lloyd is senior vice president, Capital Markets, Associated Bank. Reach him at (312) 861-1501 or Donald.Lloyd@AssociatedBank.com.