Financial Performance

What CFOs Should Know About Foreign Exchange Risks

Understanding foreign exchange risk in the context of enterprise risk management enables finance chiefs to avoid overhedging their forex risks.
Kristina NarvaezMay 21, 2015

In January 2015, Alan Lafley, the chief executive officer of Procter & Gamble,  stated that the strong dollar would shrink the company’s fiscal 2015 sales by 5% and its net earnings by 12% or about $1.4 billion after taxes. Like other U.S.-based multinationals, P&G uses long-term hedging to reduce the volatility  spawned by fluctuations in foreign exchange rates. But there are risks involved in forex hedging itself.

One long-term hedging technique includes two currency swaps: one swap at the inception of the loan contract and the other swap at the specified future date. Although analysts tend to prefer long-term hedging over short-term hedging,  the long-term variety can lead a MNC to be over-hedged. Understanding forex risk in the context of enterprise risk management enables finance chiefs to not fall into the trap of over-hedging their forex risks.

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Kristina Narvaez

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Some international transactions, for example, involve an uncertain amount of goods to be ordered, and therefore involve an uncertain transaction payment in a foreign currency. Companies like P&G, exposed to the risk of overestimating their future foreign sales, may negotiate currency hedges that end up being far greater than the actual transaction payments. That can lead to excessive risk-financing costs.

Opinion_Bug7One way to avoid over-hedging is to hedge only the minimum known payment involved in the future transaction. By hedging a portion of the transactions,  a company can reduce the sensitivity of its cash flows to exchange rate movements without creating serious  mismatches between the hedge and the risk. In this way, ERM — which consists of managers taking a holistic view of their company’s various risks,  prioritizing the material ones, and devising ways to curb them — can help CFOs identify the most volatile foreign exchange rates and reduce some of the guesswork involved in deciding how much of their foreign exchange risk to hedge.

Deploying a more comprehensive risk management mindset can help finance executives to more effectively analyze which currency hedges to use. Corporations typically protect themselves from foreign exchange rate volatility with forwards, which are contracts that lock in the exchange rate for the purchasing or sale of a currency at a future date. The upside of this hedging strategy is that it has no up-front premium. But there’s no backing out if the locked-in-rate proves adverse to the organization. That could be especially damaging if, for instance, the organization had anticipated last year a weaker U.S. dollar but discovered when the time came that it actually appreciated. Taking the positive and negative aspects of forwards can help CFOs decide whether and how much their companies should be using them.

Protecting Profit Margins

In general, measuring and managing exchange rate risk exposure is important for reducing a firm’s vulnerability to major exchange rate movements, which could adversely affect profit margins and the value of the organization’s assets. While reduction of volatility through hedging is an important technique to master, it’s more fundamentally important for CFOs to understand the underlying risks of foreign exchange rates and how to measure them before selecting a hedging strategy for their organization.

In Exchange Rate Risk Measurement and Management Issues and Approaches for Firms, a paper done for the International Monetary Fund in 2006, however, Michael Papaioannou writes that “selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposures and deciding on the appropriate degree of risk exposure that ought to be covered.”

Papaioannou’s paper provides excellent insights into how to measure and manage a company’s foreign exchange rate risks. To measure the impact of the exchange rate movements on a firm engaged in foreign currency transactions, the company must be able to identify three main types of exchange-rate risks:

  • Transaction risk. The cash-flow risk, including the effect of exchange rate moves on transactional account exposure related to receivables (export contracts) and payables (import contracts), and repatriation of dividends. In transaction risks,  an exchange rate change will spur a direct-transaction, exchange rate risk to the company.
  • Translation risk. The balance sheet exchange rate risk, which relates exchange rate moves to the valuation and consolidation of a foreign subsidiary to the parent company’s balance sheet.
  • Economic risk. The risk to the firm’s present value of future operating cash flows from exchange rate movements.

Once a firm has defined how the three types of exchange rate risk work within its own structure, it must measure its currency risk. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions aren’t hedged.

Measuring currency risk may prove to be a hard task when dealing with translation and economic risks. For example, exposed assets and liabilities are translated at the current exchange rate while non-exposed assets and liabilities are translated at the historical exchange rate. Devaluation of foreign currencies can lead to increased competition in both overseas and domestic markets. Economic risk is the most crucial to hedge, and yet it is rarely addressed.

One widely used method to measure these types of risks is the value-at-risk (VaR) model. VaR is used by companies to estimate the riskiness of their foreign exchange positions resulting from its business activities. These positions include the foreign exchange position taken by its treasury over a certain time period and under normal conditions. The VaR calculation depends on three factors:

  • The holding period or length of time over which the foreign exchange position is planned to be held.
  • The confidence level at which the estimate is planned to be made. The usual confidence levels are 99% to 95%.
  • The unit of currency to be used for the denomination of the VaR.

To calculate the VaR there are three widely used methods: “historical simulation,” which assumes that currency returns on a firm’s forex position will have the same distribution as they had in the past;  the “variance-covariance model,” which assumes that currency returns on a firm’s total foreign exchange position always happen within a normal distribution or that the changes in the value of the foreign exchange position is linearly dependent on all currency returns; and “Monte Carlo simulation,” which assumes that future currency returns will be randomly distributed.

After identifying the types of exchange rate risks and measuring the associated risk exposure, corporate finance executives and financial risk managers need to decide whether to hedge or not to hedge these risks. Some sophisticated corporate treasurers are developing “efficient frontier” models to measure their hedging strategies. These models represent a more integrated approach to hedging currency risk than buying a traditional forward contract to cover certain foreign exchange exposures. An efficient frontier model determines the most efficient hedging strategy that is the cheapest for the most risk hedged.

Part of an organization’s hedging strategy should follow the basic principles of an ERM program. They are: 1) identify the types of exchange rate risks; 2) assess the financial impact of those exchange rate exposures; 3) analyze the correlations of those exchange risks to other types of operational risks and aggregate their effect in a statement of the company’s risk appetite; 4) decide on what risk controls to use and which key risk indicators to follow; 5) have a process in place to monitor the movement of the exchange rate and have a process to report to the C-suite any changes due to exchange rate fluctuations that affect the company;  and 6) evaluate regularly how the hedging strategy is affecting the company’s profit margins.

Above all, it’s important to set up a risk oversight committee at the board level to approve limits on positions taken, examine the appropriateness of hedging instruments and associated VaR positions, and review the risk management procedures associated with the hedging strategy. Indeed, managing exchange rate risk exposure must involve the efforts of both the C-suite and the board.

Kristina Narvaez is president of ERM Strategies.