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 firstname.lastname@example.org. To learn more about currency risk management, check out PNC's Middle Market Advisory Series at pnc.com/joinus.