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Why one company began hedging the currency

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Why MNCs Hedge Foreign Currencies

 

Multi-National
Corporations are basically forced to hedge foreign currencies in this
competitive market.  Foreign exchange rate risk is one of the most common
forms of market risk.    Foreign exchange risk is also known as
currency risk and this is the risk of an investment’s value changing due to
changes in the currency exchange rates. Foreign exchange risk is most common
with companies that import/export their goods/services. It also affects
investors who are looking to invest internationally because any change in the exchange
rate will cause the investment to gain or lose value once converted back to
original currency.   

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Multi-national
corporations hedge foreign currency to stay afloat if one of the currencies
completely tanks. A MNC evaluates its exposure on a centralized basis to take
advantage of natural exposure correlation and netting. A MNC is essentially
betting against themselves in case something goes south in the economy and the
currency heavily appreciates/depreciates.  For example, a MNC will purchase
500 foreign exchange future contracts against the exchange rate (USD and EUR)
in anticipation of the dollar appreciating. If the dollar “strengthens” the MNC
will lose money on the imported goods but will be backed by the hedging of
these future contracts. Once one company began hedging the currency exchange,
others realized it can be very helpful to combat appreciation/depreciation of
the dollar.   

 

MNC’s
cash flows and valuation are also heavily impacted by currency risk and
economic exposure. International cash flows that MNC receive from foreign
country sales all depend on the current health of the that country’s economy.
If economic conditions have been improving, and the unemployment is trending
down, spending goes up in correlation. Consequently, this results in the MNC
sales to increase. This shows how a MNC’s cash flows can increase due to its
exposure to international economic conditions. On the contrary, it is always
possible that the country a MNC is exposed to can have a withering economy or a political
debacle that causes the opposite effect. The MNC cash flows begin to take a
negative hit because of the exposure to international economic conditions.
 

 

Translation
exposure is another form of exchange rate risk. This exposure stems from the
financial statements every company has for reporting purposes. When a MNC is
dealing with their financial statements, they are often dealing with statements
in multiple forms of currency.  Hence the translation exposure of getting
the foreign currency back to USD. These translations can be risky because of
the very unpredictable foreign currency. This may not impact a firm’s cash
flow, but it can change the reported earnings of the firm. Resulting in a
declining stock price because people are speculating a loss.   

 

Hedging Strategies

 

When
companies have an objective to neutralize exchange rate risk as much as
possible, often times they choose futures to hedge risk. For example, a MNC may
generate an extra $10,000 dollars in revenue from a foreign country when that
country’s currency appreciates 1%, and the opposite occurs when the foreign
currency depreciates 1%. To eliminate this unpredictability in foreign exchange
movements, the company would hedge with a short futures contract. To short
means to bet against, and a long position means to bet on. The short position
would then lose the MNC $10,000 when the foreign currency appreciated and gain
$10,000 when it depreciated. This would then eliminate the foreign exchange
rate risk. (Hull, p. 49-50).

 

As
mentioned above, some multi-national corporations hedge their exposure so their
value is not strongly influenced by exchange rates rather than speculatively
hedging. This means MNCs hedge most of their exposure and do not necessarily
expect a profit or loss for it. In multiple cases, companies even use hedging
strategies that will likely result in losses that would negatively impact
profit compared to using no hedges at all. Rolls Royce is a good example of
this and will be discussed later. Although hedging transaction exposure can
lead to losses, it also allows companies to more accurately predict future cash
flows, allowing the opportunity to make more fine-tuned financial decisions (Madura,
p. 355).

 

The
different types of hedging multi-national corporations use are the following:

 

Money
Market Hedge

Forward
Contracts

Currency
Options

Futures
Contracts

 

Some
MNCs use selective hedging when deciding which strategy to use. Selective
hedging is where MNCs consider each type of transaction separately.
Multinational corporations that are well diversified across many countries may
forgo hedging their exposure except in rare circumstances. The corporations
that do participate in selective hedging however, focus on hedging exposure to
payables and receivables. A MNC may decide to hedge part or all of its known
payables transactions as a way of insulating itself from possible appreciation
of the currency. To choose the most optimal strategy, MNCs normally compare
cash flows that would be expected when using each technique (Madura, p. 355-356).

 

MNCs
choose to hedge part or all of its receivables transactions retained in foreign
currencies so that it is protected from the possible depreciation of those
currencies. Corporations can apply the same techniques available for hedging
payables to hedge receivables (Madura, p. 363).

 

Forward
contracts and futures contracts offer the ability to lock in a specific
exchange rate and purchase a specific currency at an agreed upon price. This
creates the opportunity to hedge payables or receivables denominated in that
currency. A forward contract is negotiated between one party and a financial
institution. This allows contracts to specifically meet the one party’s needs.
The futures rate is normally close to the forward rate, so the main difference
is that futures contracts are standardized and can be purchased on an exchange
(Madura, p. 357). These same strategies can also be used for hedging
receivables. The set future prices allow companies to budget and predict income
easier and they can help avoid large changes in appreciation or depreciation.

 

A
money market hedge on payables involves taking a money market position to cover
a future payables position. If a firm has excess cash, then it can create a
simplified money market hedge. However, many MNCs prefer to hedge payables
without using their cash balances. A money market hedge can still be used in
this situation, but it requires two money market positions: borrowed funds in
the home currency, and a short-term investment in the foreign currency (Madura,
p. 357). A money market hedge for receivables works the opposite way. The firm
would borrow funds from in foreign currency it wanted to hedge and then take
those funds and invest them in the firm’s domestic market.

 

A
currency call option gives a party the right to buy a specified amount of a currency
at an agreed upon price during a certain period of time. Yet unlike a futures or
forward contract, the currency call option does not force the party to buy the
currency at that price. The party has the opportunity to let the option expire
and simply acquire the currency at the existing spot rate when the contract
expires. There are difficulties that come along with options, however. a firm
must assess whether the advantages of a currency option hedge are worth the
price premium paid for it. The cost of hedging with call options is not known
with certainty at the time that the options are purchased. It is determined
once the payables are due and the spot rate at that time is known. The cost of
hedging call options includes the price paid for the currency as well as the
premium paid for the call option. A MNC can develop a contingency graph that
determines the cost of hedging with call options for each of several possible
spot rates when payables are due. This procedure is especially useful when a
MNC would like to assess the cost of hedging for a wide range of possible spot
rate outcomes (Madura, p.358).

 

Because
payables are hedged with call options, receivables are hedged with put options.
A put option allows a MNC to sell a specific amount of currency at a specified
exercise price by a specified expiration date. A MNC can purchase a put option
on the currency denominating its receivables and thus lock in the minimum
amount that it would receive when converting the receivables into its home
currency. Although opposite of calls, the costs and unpredictability of puts
are the same. An estimate of the cash to be received from a put option hedge is
the estimated cash received from selling the currency minus the premium paid
for the put option (Madura, p. 364-365).

 

Arguments Against Hedging

 

Multinational
corporations that are well diversified across many countries may forgo hedging
their exposure except in rare circumstances. They might believe that a
diversified set of exposures will limit the actual impact that exchange rates
will have on their cash flows during any period (Madura, p. 355).

 

A
possible downfall to hedging is basis risk.

 

Basis = Spot price of
asset to be hedged – Futures price of contract used

 

If
an asset is being hedged and asset underlying the futures contract are the
same, basis should be zero when the contract expires. Basis may be positive or
negative. As time goes on, the moving spot price and the agreed upon futures
price begin moving away from each other. As a result, basis risk is created. John
C. Hull, author of Options, Futures, and
Other Derivatives states, “An increase in the basis is referred to as a
strengthening of the basis; a decrease in the basis is referred to as a
weakening of the basis.” The image below demonstrates how the basis might
change over time (Hull, p. 55, Chapter 3).

 

 

There
are also limitations to hedging. Some international transactions involve an
uncertain amount of goods needed to be ordered and consequently involve
uncertain transaction payment risk. In some cases, MNCs create hedges that end
up being larger than the number of units actually needed. This results in the
opposite form of risk and exposure. There is also limitation to the repetition
of short-term hedging. The repeated hedging of near-term transactions has
limited effectiveness in the long run. Hedging techniques that are applied over
long-term periods can more effectively insulate the firm from exchange rate
risk in the long run. This strategy is limited, too, however. The amount of a
foreign currency to be hedged further into the future is more uncertain because
many factors such as economic and political risks. An example of this would be
the losses Rolls Royce experienced in 2016, which will be covered later (Madura,
p.371-372).

 

Arguments Supporting Hedging

 

There
are a variety of reason why a company should hedge. Companies that are not
involved with financials who focus on different business industries, such as manufacturing,
retailing, or wholesaling, do not specialize in calculating what will happen
with exchange rates. So inherently it makes sense for these firms to try and
minimize their risk of this unpredictable financial factor, and they can
accomplish that with hedging. This allows these companies to focus on their
skills and industry trends without being too concerned with economic activity. Hedging
help to avoid overpowering shocks like foreign exchange rates.

 

There
is an argument that shareholders themselves can hedge the risks of a company
through their own individual investments. A shareholder can diversify their own
portfolio in the act of hedging their original investment. For example, in
addition to being a shareholder in a company that heavily relies on wheat, a
well-diversified shareholder would invest in a wheat producer, limiting the
amount of overall exposure to the price of wheat (Hull, p.152).  

 

Procter and Gamble

 

As
a large MNC, Procter and Gamble becomes victim to both translation and
transaction exposure with the fluctuations of exchange rates.  These
exposures are quite different but both impact the corporation’s bottom line at
the end of every year.  First, translation exposure relates to foreign
exchange rate fluctuations impacting income statements with foreign
subsidiaries that do not use the U.S dollar. Additionally, they deal with
transaction exposure, which is regarding input costs that are not in a local
currency and the reevaluation of transaction related working capital costs that
are not in local currency.  The past four years, the U.S dollar has
strengthened versus other foreign currencies resulting in lower earnings and
sales for P.  For example, countries like Argentina, Egypt, and the
U.K. have experienced major exchange rate fluctuations and have driven
P’s net sales down 2% in the last year, as shown in the image below.

 

 

 

P&G
being a MNC with diverse product offerings exposes them to multiple market
risks.  Interest rate risk, currency exchange rate risk, and commodity
pricing are the most common risks they face as a company.  Evaluation of
these exposures on a centralized basis is necessary to see where they can take
advantage of natural exposure.  To try and manage these risks P&G
enters in various financial transactions to attempt to hedge the market risks.
 

 

To
manage interest rate risk, P&G uses a mix of fixed-rate and variable-rate
debt.  To insure the most efficiency, P&G enters into interest rate
swaps with an opposing party.  This These exchanges happen at specific
intervals and are looking to find the difference between fixed and variable
interest amounts.  These swaps meet specific accounting criteria and are
either recorded as fair value hedge or a cash flow hedge.    

 

P&G
manufactures and sells products in many countries across the world they are
constantly exposed to the impact of movements in the currency exchange on their
revenue and expenses.  To combat exchange rate risk with financing their
business activities, P&G mainly uses the purchases of 18 month forward
contracts.  Additionally, P&G hedges exposure to exchange rate
movements on intercompany financing transactions with some specific currency
swaps with maturities up to 5 years.  

Rolls Royce

 

Operating
as a large MNC, Rolls Royce has developed a well-structured approach for
managing financial risk.  Internally, they have a group called the FRC
(financial risk committee) which is headed by the company’s CFO.  This
group meets as a whole at least once a quarter to review and assess future or
previous market risks.  Like many MNCs, Rolls Royce is susceptible to
currency, interest rate, commodity, and credit risks.  The FRC stresses
the use of financial instruments to manage and hedge daily operational risks.
 In house hedging policies have been set by the FRC to reduce the risk of
transactional foreign exchange rates.  These policies have a minimum and a
maximum cover ratio to insure they are taking advantage of the natural
exposures.  This allows Rolls Royce to capitalize on favorable exchange
rates while still remaining within the cover ratio.  

 

Hedge
accounting is an area that Rolls Royce is very familiar with.  Hedge accounting is a
method of accounting where entries for the ownership of a security and the
opposing hedge are treated as one. This is an attempt by an MNC to reduce risk
caused by constant adjustment of a financial instrument’s value.  Rolls
Royce uses hedge accounting to manage the fair value and cash flow exposures of
their borrowings.   

 

 

Although
Rolls Royce’s FRC often times eliminates risk and helps obtain stability, its
hedging strategies do not always reduce all forms of risk. In 2016, Rolls Royce
announced one of the biggest losses in British corporate history.  A loss
of approximately 4.6 billion pounds, roughly 7 billion U.S. dollars. This
caught the attention of many investors, causing the stock to plummet. A
well-known, MNC announcing a $7 billion annual loss is quite a red flag.
Initially, investors saw this as a sign of poor performance of the company, but
in reality, this was caused mainly by Brexit and the collapse of the pound. This technically makes
it not a loss to investors, and they received the same amount of sterling
pounds as they should have.  Because of this, Rolls Royce demonstrated little concern. The company released
statements expressing the importance of recognizing the reported loss as a
non-cash impact. On the books, this becomes an accounting charge. Rolls Royce
generates nearly all of its revenue from the U.S. and nearly all of its
expenses in the U.K. This is why Rolls Royce stands behind its decision that
led to losses. If they had not hedged at all however, Rolls Royce would have
saved roughly 2 billion pounds.

 

By
hedging long the pound, the company can predict fairly accurately its
anticipated expenses because if the pound appreciates, expense costs would rise
but the gains from having a long position would help offset the increased expenses.
By hedging short the dollar, Rolls Royce would make up losses when the USD
depreciated. This is important because of the negative correlation between the
dollar and pound. If one depreciates, the other is likely to appreciate against
it. Being a British-based company, Rolls Royce would be experimenting with much
more risk by not hedging against the pound because if the pound appreciates,
not only will its expenses rise but a most likely depreciating dollar will
marginalize revenue streams.

 

How Bitcoin entering the CME may affect domestic and MNCs

 

The
Chicago Mercantile Exchange will begin offering Bitcoin futures contracts on
December 18, 2017. Bitcoin is a fast-growing cryptocurrency that has become
very popular over the past couple years and especially the past couple months.
The use and faith in the currency has

driven
its value up dramatically, as shown below (CME Group News Release).

 

 

Many
investors are hopping on this rollercoaster of momentum in hopes of large
returns. Individual investors and investment firms are not the only ones hoping
on the bandwagon, though. MNCs such as Microsoft, Overstock.com, and Intuit
accept Bitcoin. These giant companies are able to take on the extra risk
because they have large cash reserves that can be turned into bitcoin in order
to execute transactions between customers. Most other MNCs and smaller
businesses have not started accepting this cryptocurrency yet because of its
price uncertainty and complexity of mining each Bitcoin. Even though many analysts
will argue this is a currency, it does not yet trade like a currency. With a
value that continues to change drastically each day, accepting Bitcoin for
receivables or payables involves a great deal of risk, but the CME group might
be helping eliminate that risk.

 

As
Bitcoin futures contracts enter the market, there could be a lot more
companies, especially MNCs, accepting the cryptocurrency as a form of debt or
asset. With the ability to minimize exchange risk and increase confidence in
cash flow streams, other large corporations now have a logical and rational
reason for adapting to this growing trend.

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