As more and more businesses enter the global marketplace, a question they all want answered is, “What’s the outlook for foreign exchange rates?” Businesses want to know the direction that the currencies of their trading partners are headed in relation to the U.S. dollar, but no one knows. Former Federal Reserve Chairman Alan Greenspan once said, “To my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin.”
“Currency markets are volatile, and they are affected by economic growth expectations and interest rate differentials,” says Don Lloyd, senior vice president, Capital Markets at Associated Bank. “Today’s big drivers include the fear of a Euro Zone debt crisis evolving into a Euro Zone banking crisis, which, in turn, could easily cause a world recession. Sluggish U.S. growth and Euro Zone concerns continue to drive an accommodative stance in U.S. interest by the Federal Reserve. But U.S. interest rates are only one side of the equation. The other side is the interest rates affecting the other countries that you’re dealing in.”
Smart Business spoke with Lloyd about how to take advantage of hedging strategies to protect your money overseas.
Where are businesses facing the most volatility with regard to currency markets?
Given the recent issues of the European debt crisis occupying the media, one immediately is drawn to the 17 member countries within the Euro Zone. The stronger Euro Zone partners, Germany and France, face leading the charge of recapitalizing the banking system of weaker member countries. However, with inflation in Germany hovering just above target levels, interest rates remain firm compared to those of the U.S. Likewise, concerns over the sustainable, consistent growth of China add uncertainly to an already fragile global economy. These two core economic drivers have created uncertainty and nervousness within the foreign exchange markets. U.S. growth seems to be dependent on the future of both Europe and China.
How can companies doing business overseas reduce volatility in their income statements?
Organizations can reduce volatility 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 your risk.
There are three categories of hedges. First, the forward outright purchase or sale allows you to lock in a rate today to be used at some time in the future. Money doesn’t change hands until settlement day, and you lock in your profit margin on goods you are selling.
The value of this hedge is the certainty it provides. Some companies use this hedge, and then, if currency rates have moved in their favor before the transaction settles, are not happy because they would have come out ahead had they done nothing. Right idea, wrong product. What those businesses want is another type of hedge, an option.
Options use a strategy similar to options on interest-rate swaps. They allow you to protect against the downside and, in some cases, benefit from the upside. You lock in the right, but not the obligation, to sell at a specified price. You pay an up-front premium for an option, 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.
However, some companies don’t want to pay a premium up front because of cash flow issues. In that case, you may want to consider a structured option, which allows you to put two or more options together to reduce or eliminate the premium. Start by buying a regular option, which costs some premium, but to reduce this cost, you also sell an option to your FX provider. You earn premium for the option you sell, which reduces or eliminates your overall cost of the structured option. You will be fully protected if the currency moves against you, but you limit the benefit if it moves in your favor. By limiting your dollar-for-dollar benefit, your premium is reduced.
What kinds of companies should consider a hedging strategy?
Five types should consider hedging. First is any company that buys and/or sells goods overseas; any company that makes or receives payments in more than one currency could potentially benefit from hedging.
Overseas subsidiaries of companies based in the U.S. also should consider hedging, as they face two kinds of foreign exchange risks. First is transactional risk, which applies to accounts payable and receivable. Any time money trades hands and two currencies are involved, there’s a risk that could be mitigated with a hedging strategy. The second is translational risk, which applies to your balance sheet. For example, say a company buys or builds a plant overseas and pays for it in foreign currency. At the end of each year, it has to put a value on the plant in U.S. dollars for the balance sheet. It might lose equity because of changes in the exchange rate but could hedge this risk. Some companies may decide not to hedge because they plan to operate in the foreign country forever, in which case the exchange rate may not matter. But sometimes, years later, the company closes the foreign plant and takes a large loss because the exchange rate has changed and it did not hedge the exposure.
Another type of organization that should consider hedging is local subsidiaries of foreign-owned companies. Sometimes the foreign exchange risk is handled by the parent company, but others prefer to have each subsidiary handle its own. Firms that send payroll overseas may also benefit from hedging. If a company has to meet payroll in a foreign currency, there’s an exchange rate risk that can be hedged. Finally, anyone who invests overseas, such as fund managers, foundations and pension funds may want to consider hedging, as this is by far the largest segment of the foreign exchange market.
Associated Bank, N.A. is a Member FDIC and Associated Banc-Corp. Equal Opportunity Lender.
Donald Lloyd is senior vice president, Capital Markets at Associated Bank. Reach him at Donald.Lloyd@associatedbank.com.