Transactional currency risk can be hedged tactically or strategically by the corporate Treasury to preserve cash flow and earnings, depending on their currency view.
Translational currency risk is usually hedged opportunistically rather than systematically, notably to try to avoid emerging market-related shocks to net assets, usually focusing on either long-term foreign investment or debt structure.
Hedging economic risk is complex, requiring the corporation to forecast its revenue and cost streams over a given period and then to analyse the potential impact on these of an exchange rate deviation from the rate used in calculating revenue and cost. For the debt structure, the currency of denomination must be chosen, the amount of debt estimated in that currency and the average interest period determined. The effect on cash flow should be netted out over product lines and across markets. What’s left from this process is the economic risk that has to be managed. For large multinationals, the net economic risk may in fact be quite small because of offsetting effects. However, economic risk can be substantial for corporations that have invested in only one or two foreign markets.
The first two steps of this process appear to have been accomplished. Firstly, we have defined very specifically the types of currency risk that a corporation is exposed to. Secondly, we have looked at broad strategy, the brushstrokes of managing that currency risk. Yet, while this currency risk may be defined, it must also be quantified. Quantifying an amount of currency may be easy for transaction risk, but for translation or economic risk it is no easy task. Just as with other types of risk management, the most popular way of doing this is to use a “VaR” model.
July 6th, 2009
The translation of foreign subsidiaries concerns the consolidated group balance sheet. However, this does not affect the real “economic” value or exposure of the subsidiary. Economic risk focuses on how exchange rate moves change the real economic value of the corporation, focusing on the present value of future operating cash flows and how this changes in line with exchange rate changes. More specifically, the economic risk of a corporation reflects the effect of exchange rate changes on items such as export and domestic sales, and the cost of domestic and imported inputs. As with translation risk, calculating economic risk is complex, but clearly necessary to be able to assess how exchange rate changes can affect the present value of foreign subsidiaries. Economic risk is usually applied to the present value of future operating cash flows of a corporation’s foreign subsidiaries. However, it can also be applied to the parent company’s operations and how the present value of those change in line with exchange rate changes. Summarizing this part, transaction risk deals with the effect of exchange rate moves on transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value of future operating cash flows, focusing on the “currency of determination” of revenues and operating expenses. Here it is important to differentiate between the currency in which cash flows are denominated and the currency that may determine the nature and size of those cash flows. The two are not necessarily the same. To complicate the issue further, there is the small matter of the parent company’s currency, which is used to consolidate the financial statements. If a parent company has foreign currency-denominated debt, this is recorded in the parent company’s currency, but the value of its legal obligation remains in the currency denomination of the debt. In sum, transaction risk is just the tip of the iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an attempt by the academic and economic communities to apply the traditional exchange rate models to the corporate world for the purpose of demonstrating how exchange rates impact a corporation. More specifically, the models typically used for this purpose have been those of PPP, the international Fisher effect and the unbiased forward rate theory, which we looked at in earlier posts. To recap:
PPP (or the law of one price) suggests that price differentials of the same good in different countries require an exchange rate adjustment to offset them.
The international Fisher effect suggests that the expected change in the exchange rate is equal to the interest rate differential.
The unbiased forward rate theory suggests that the forward exchange rate is equal to the expected exchange rate.
Generally, these theories are grounded in the efficient market hypothesis and therefore flawed at best. Over the long term, these traditional “rules” of exchange rate theory suggest that competition and arbitrage should neutralize the effect of exchange rate changes on returns and on the valuation of the corporation. Equally, locking into the forward rate should, according to the unbiased forward rate theory, offer the same return as remaining exposed to currency risk, as this theory suggests that the distribution of probability should be equal on either side of the forward rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not and cannot deal with the practical realities of managing currency risk. What academics regard as “temporary deviations” from where the model suggests the exchange rate should be can be sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L and the balance sheet.
To conclude this part, a corporation should define and seek to quantify the types of currency risk to which it is exposed in order then to be able to go about creating a strategy for managing that currency risk.
July 5th, 2009