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.
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&G. For example, countries like Argentina, Egypt, and the U.K. have experienced major exchange rate fluctuations and have driven P&G’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.