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New Currents in Currency

It's relatively simple to hedge foreign-currency risk — if you can figure out your exposure.
Randy Myers, CFO Magazine
December 1, 2006

In the second quarter of this year, Weatherford International Ltd., a $4.3 billion provider of oil and gas drilling equipment and services, sustained nearly $9.9 million in foreign-currency losses. In the very next quarter, its foreign-currency losses shrank by almost 90 percent, to just $1.5 million. That's good news for a company that is keen to, as senior vice president of finance and CFO Andrew Becnel says, "remove the noise of foreign-exchange fluctuations from the income statement."

For many companies, that noise can be grating in the extreme. Four Seasons Hotels and Resorts would have seen its net income rise 24 percent over the previous fiscal year if it weren't for currency fluctuations; instead, it posted a 42 percent decline. Given that the S&P 500 derived more than 40 percent of its income from overseas sales in 2005, plenty of companies face similar risks.

Exposure Time
While currency options and currency forwards are useful tools for hedging (see "Opting for Options" at the end of this article), the true challenge lies not so much in deciding how to hedge as in deciding how much. Determining exposure can be a time-consuming and frustrating exercise because companies often funnel data from various departments, such as treasury, tax, forecasting, and the controller's office to a foreign-exchange (FX) specialist, who then tries to aggregate those pieces into an accurate whole. "To make sure you're hedging the right number," says Beau Damon, managing director of capital markets for Microsoft Corp., "you have to get input from the accounting group, the business units, and the folks who are forecasting and planning revenues." Because most companies rely on manual processes, that level of collaboration is difficult to achieve.

Manual processes also diminish visibility: if one subsidiary has revenue in pounds sterling, for example, and another has expenses in the same currency, those two positions can effectively create a natural hedge. But often companies fail to spot such situations and end up hedging the wrong amount.

Better technology may help. For the past year and a half, for example, Weatherford has been working with a large multinational bank to develop a software module designed to help Weatherford manage its FX exposure. The software, which has been up and running in test mode for several months and is scheduled to go live in early 2007, taps into the company's various enterprise systems, pulls out the data that Weatherford has found most critical to calculating its foreign-currency exposure (such as balance-sheet entries for cash and cash equivalents, and accounts receivable/payable in more than 100 countries), and presents that data in an easily digestible format on a nearly real-time basis. From there, Weatherford can figure out the best ways to hedge its foreign-currency exposure. "The key to it all," says Becnel, "is measurement, measurement, measurement."

Holistic Fix
FireApps, a subsidiary of Rim-Tec Inc., a financial risk-management firm, has developed Web-hosted software that helps companies better collect, aggregate, and analyze their foreign-currency risk by querying their information systems for relevant data and performing the analytics needed to devise hedging strategies. The software doesn't simply mirror what's in the general ledger, explains Rim-Tec CEO Wolfgang Koester, but instead presents data in a format that allows users to easily spot exceptions or mistakes and either account for or correct them — particularly in the area of intercompany transactions. The goal, says the firm, is to approach currency management as a holistic process that addresses strategy, exposure management and analytics, and transaction execution (using the firm's software and consulting services).

If companies suddenly find themselves able to shop among competing software companies for helpful products, more of them may hedge their FX exposure. Today, estimates Jeffrey Wallace, managing partner of consulting firm Greenwich Treasury Advisors LLC, only 75 percent of large companies that have FX risk do anything to hedge it. Smaller firms are even less likely to do so, for a variety of reasons: because the amount at risk isn't material, because the CFO or treasurer doesn't have the time or staff to focus on it, or because the management team simply doesn't believe hedging adds value.

The latter argument is flawed, according to New York University finance professor Ian Giddy, who says that "foreign-exchange risk does not even out in a given time period. Some companies are concerned about the cost of hedging, but done correctly, the cost is minimal and the effort is worthwhile."

Brent Callinicos, who helped launch Microsoft's FX hedging program in 1994 and now serves as corporate vice president and CFO of the company's platforms and services division, says the matter is anything but academic. "Shareholders and analysts don't give you a pass for saying, 'We would have made our earnings but for foreign exchange.' Many studies indicate that shareholders punish that."

Rim-Tec CEO Koester says software can highlight potential currency problems before they occur and help companies make better decisions. "And you can do it much more frequently," he says. "Corporations today have a hard time accumulating this data and really understanding it because by the time they assemble it in a spreadsheet, the underlying figures have already changed." FireApps software is sold on an annual subscription basis, from $90,000 to well into the six figures, depending on scope and complexity.

Randy Myers is a contributing editor of CFO.

Opting for Options

CFOs and treasurers who want to hedge their company's exposure to foreign-currency risk have two principal weapons in their arsenals: currency forwards and currency options. While CFOs sometimes regard currency options as too pricey and forwards as virtually free, neither approach is as extreme as that. Forwards are costless only in the sense that companies pay nothing for them up front: they simply enter into an agreement to buy or sell a specified quantity of a currency at a specified price on a specified future date. (Options, by contrast, require the payment of a premium in exchange for the right to buy or sell a currency at a specified price on or before a specified date.)

But Jeffrey Wallace, managing partner of consulting firm Greenwich Treasury Advisors LLC, argues that forwards can become expensive when the market moves against you. Say that, in a bid to hedge against a declining dollar, you lock in a forward contract to convert €100 million to dollars at a rate of $1.25 per euro. That would guarantee you $125 million in the exchange. Now assume the dollar actually rises to $1.15 per euro; you've forfeited $15 million. With an option, the most you can lose is the premium you paid for the contract — perhaps 1 percent or so on a one-year, near-the-money option, or just over 2 percent on a one-year, at-the-money option.

Like other sophisticated hedgers, Microsoft uses a mixture of options with differing maturity dates going out as far as three years, though its portfolio is usually more heavily weighted toward cheaper, shorter-term instruments. Beau Damon, managing director for capital markets, concedes that a company might legitimately eschew options as a hedging tool if it wants to devote its cash flow for other, more pressing needs, but adds that "in the long run there is no free lunch. Options are priced as they are for a reason, and they probably have about the same expected returns as forwards do over the long term." — R.M.