How do Global Companies Manage Exchange Rate Risk?

International transactions are growing as a result of globalisation and interdependence of countries however at the same time the market itself have become increasingly more volatile due to major international imbalances. The Asian crisis in 1997 is looking to be repeated and Russia is in financial crisis due to the events in Ukraine with the trouble causing their currency to fall to a historic low against the dollar on the 03/03/2014.

The increase in global trade is only part if the reason that foreign exchange transactions have increased considerably with one of the main contributors is the need for investors and multinational firms seeking to tap these new markets to get the best returns and access funds or decrease the costs of borrowings.

This is evidence that companies that wish to conduct international trade must accept exposure to the risks associated with changes in currency. There are different exposures that companies wishing to do so are open too:

-          Transaction exposure

-          Translation exposure

-          Economic exposure

Translation exposure is created when the company has either the commitment or intention of receiving foreign currency or paying monies in a foreign currency. The risk with this exposure is that the cash income in the domestic currency will be lower than expected or the cash payments will be higher. This could potentially cause losses that have a significant impact on net profit for a company.

Translation exposure occurs because of the requirement for companies to produce consolidated accounts and translate the financial position of foreign subsidiaries back to the currency of the parent company. This exposure doesn’t reflect a cash loss as translation exposure does but does have an effect on the reported profits and balance sheet values.

Economic exposure risks occur when the trading position of the business is at risk to adverse changes in the short or long term movements of exchange rates.  This can undermine the firm’s competitive position both directly and indirectly. Direct impact is when company’s expected future receipts and payments are in the foreign currency and have not yet been made or when firm’s home currency strengthens and so its products are more expensive when compared to competitors, affecting the sales of it. Indirect impact is when a business is exposed to long term risks because of adverse developments in the country it is based in, resulting in exchange rate movements that benefit foreign competitors.

Companies and try and manage the exposures and risks with international transactions by hedging. There are several forms of hedging that they may adopt and can be both internal and external.

-          Invoicing the customers in their home currency

-          Netting – subsidiaries of multinational organisations can trade with each other to   reduce the amount of currency that is at transaction exposure risk

-          Matching both the inflows and outflows in the different currencies caused by trade

-          Leading or lagging – speed up or delay payments

-          Increase productivity and reducing costs

-          Forward market hedge  (includes wide range of currencies) or futures (includes limited range of currencies) hedge - where a contract is agreed to exchange currencies at a fixed time in the future at a predetermined rate, so the risk of foreign exchange variation is removed

-          Money market hedge – borrowing money in the money markets

-          Currency options – a contract that grants the holder the right to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker

-          Currency futures - to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date

-          Currency swaps - exchange of principal and interest in one currency for the same in another currency

-          Do nothing and take the risk, hoping that the foreign exchange rate movements work favourably or that the profits and losses balance out.

Finally, what are the reasons and benefits of hedging? It ensures availability of funds for investment opportunities, lessens the cost of financial distress, reduces incentives to under invest, lowers manager’s risk and reduces the costs to adjust capital structure.

However, to begin to hedge may incur costs and if hedging activities are not managed well, it can bring losses. Therefore if a company is big, secure and strong enough to handle the volatility of markets, there may not be a need to hedge and so choose the option of doing nothing and taking the risks as failed hedges can be even more costly. For example, in 2012 JPMorgan Chase, the largest bank in the US, has lost $US2 billion ($1.99 billion) in a failed hedging strategy, a disclosure that hit financial stocks and the reputation of the bank and its prominent CEO, Jamie Dimon. The bank's shares fell 5 per cent after the closing bell, and other financial shares also fell sharply. Citigroup was down 2.4 per cent and Bank of America was down 1.7 per cent. They recognised that the portfolio proved to be riskier, more volatile and less effective as an economic hedge than they thought.

Raising Finance: Debt or Equity?

Many companies would not be the size they are without the need to raise finance, this can be done through equity or debt capital or through a mix of debt and equity in order to finance its activities.  However it is not as simple as just ‘raising finance’ and it is important that a company recognises the cost of the finance and the affect it may have on the business and the way the business is seen. Raising finance can be costly for both the firm and investors so a minimum rate of return is required in order to balance this out. Therefore the weighted average cost of capital (WACC) is indicative of the required rate of return that will give value to the company (The value pentagon as mentioned in Blog 1) and to earn these returns for the investors. The idea is generally to drive down the WACC to increase the market capital.

Raising capital through equity finance involves the company issuing ordinary shares. This could potentially raise a large amount of finance, the capital doesn’t have to be repaid and there is no legal obligation that the company has to pay its shareholders dividends, but volatile dividend payments often mean return is less than WACC.  However this does come at a high cost as it has a direct cost of issuing the shares and the cost of the return required to satisfy the shareholders. There is also a loss of control as the issue of shares dilutes the shares already in control by the company and the new shareholders have the right to exercise control over the company, vote at shareholder meetings and are entitled to a share in the rising prosperity of a company. In addition any dividends paid can’t be used to reduce the taxable profit as they are paid out after tax earnings which take a direct amount from the company’s baseline profit.

Equity can also be sourced globally and can be done so with added benefits for some companies as for their domestic stock markets can be highly illiquid, small and segmented so in doing so the liquidity of their shares are improved, provides a new and bigger market for new issues of shares and increase share price as visibility of the firm is increased. 

Capital can also be raised through debt finance for example a variety of bonds and bank loans. There is also the option for larger and more credit worthy companies to operate and tap into the Euromarkets. These companies that are large enough to use the Euro securities markets can out themselves at a competitive advantage compared to smaller firms as the finance can be available at a lower cost, there are fewer rules on these markets and national markets are often not able to provide the large amount of finance that may be required. Debt differs to that of equity as the lenders have no official control over the company which is an important factor for some companies for example Sir Richard Branson bought back £375m of Virgin’s shares as soon as the company’s profits increase. However debt does require regular cash outlays in the form of interest and the repayment of the initial capital sum, there is also less risk for the lenders as interest is paid before the dividends but is higher risk for the company but one that could generate more of a return than equity (risk/return trade off).

For many companies it is a choice that the managers of that company have to make when deciding on how to raise finance and often different countries favour different methods of financing for example both UK and US favouring equity compared to Germany and Japan favouring debt as their way of financing their activities.

One of the most recent companies in the news to raise finance was Facebook as it bought Whatsapp on the 19/02/2014 for approximately $16 billion, consisting of $4 billion in cash plus 184 million shares or approximately $12 billion worth of WhatsApp’s stock. Facebook chose to use equity finance as a way of raising this capital and had done so previously as in 2012 it filed for an initial public offering to be listed on the stock exchange. Facebook did so to raise $5billion to make it one of the largest IPO’s in internet history and to increase its membership and income as both were decelerating.

However the founder, Zuckerberg, managed to avoid the usual disadvantage of loss of control of the company that comes with share issue as in 2009 they instituted a dual-class stock structure to ensure that the early investors would retain control of the company and Zuckerberg was to own 57% if the voting shares and a 22% ownership in Facebook.

So is there a best way to raise finance…….

Shareholder Value Creation in Companies

Value creation is key in creating and maintaining a successful company. However, some companies don’t acknowledge this and remain implementing an outdated and narrow approach to value creation in which they focus on optimising short term financial performance and ignore the broader influences that would determine their success long term.

Blackberry is a company that only focused on the short term financing activities and has been chasing the market ever since the decline in the usage of their phones. This has led to product delays and products that have failed to take off, in particular their Playbook tablet that was launched without email or a calendar. These activities have all led to Blackberry’s share price dropping by 77% in the last year. Furthermore, most recently the CEO of Blackberry, Thorsten Heins was removed from his position as he failed in his primary objective to the save the company yet still received a $22 million severance payment. This again shows Blackberry is not acting in the shareholders best interests and not even on the other side of the argument, the stakeholders interests.  

Competition is driving more companies to adopt a shareholder value maximisation approach in their business.  It is believed that managers should strive to maximise this value and in doing so social welfare is maximised. A normative consensus is now widespread that corporate managers should act exclusively in the economic interests of the shareholders yet no country, even the most shareholder-friendly USA or UK, have a legal requirement that managers should act solely in shareholders’ interest.

One of the methods identified to ensure this value is created and that can be used to ensure a long term view is accounted for is the value pentagon. This consists of five actions:

1.       Increase the return on capital

2.       Raise investment in positive spread units

3.       Divest assets from negative spread units to release capital for more productive use

4.       Extend the planning horizon

5.       Lower the required rate of return 

If managers are to follow the actions from the value pentagon they should not only increase value for shareholders but also increase the success and longevity of their company.

However numbers aren’t everything, suppose managers are unaware that they have increased the company’s share price to a level where the stocks intrinsic value is higher than the market value, this would defeat the long term view of a company. They would find it difficult in securing more finance for investment activities (so wouldn’t be able to meet point 3 of value pentagon) as shareholders are unlikely to buy shares if they are viewed as overpriced and existing shareholders may also be inclined to sell.

With this in mind it is important that shareholder wealth should be at the forefront of managers actions as in a semi-strong form market any news that is made public can affect the share price, as in the case of Blackberry.