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.