A Global Manager's Guide to Currency Risk Management

Topics: Exchange rate, Foreign exchange market, Inflation Pages: 42 (15859 words) Published: January 16, 2011

A Global Manager’s Guide to Currency Risk Management
Since the advent of the floating exchange rates, any time that a transaction—whether that transaction is in goods, services, people, capital, or technology—has crossed borders, it has been subject to the influence of changes in exchange rates. The basic problem posed by exchange rates on the cross-border firm is that money across borders has no fixed value. Consequently, neither does a transaction undertaken across borders. In this Note, our purpose is to understand, categorize, and define the specific types of exchange rate risks that firms face across borders, and to address how managers can plan for, manage, and hedge these risks. Specifically, this Note provides an overview of the risks posed by exchange rates to the cross-border firm and the major strategies and solutions managers can employ to deal with them.

Why Should Companies Hedge?
Peter Drucker once noted that, “Not to hedge is to speculate. Exchange rates are a cost of production that financial executives must manage.”1 But what constitutes hedging and what constitutes speculation? What is the purpose of hedging? How, if at all, does hedging create value for shareholders? An exchange rate hedge is an asset or position whose value changes (∆H) in the opposite direction to that of an exposure (∆X) as a result of a change in the exchange rate. A perfect hedge would be one whose value changes in an equal and opposite direction, resulting in a net change of zero in the value of the combined position:2 ∆V = ∆X + ∆H Hedging therefore protects the owner of the existing asset from loss. It is, however, important to note that while a hedge protects the firm against an exchange rate loss (relative to being unhedged), it can also eliminate any gains from an exchange rate change that is favorable. But this does not really answer the question as to what is to be gained from hedging. The value of a firm is simply the net present value of all expected future cash flows discounted at an appropriate riskadjusted discount rate. Hedging reduces the variance in expected cash flows, but does not necessarily affect the expected cash flows themselves. Reducing the variance—or what is referred to as “total risk” in the theory of finance—is not necessarily the same as reducing “risk,” and therefore not necessarily the same as reducing the discount rate from the standpoint of the investor. From the investors’ standpoint, 1

Keynote Address, Peter Drucker, Business International’s Chief Financial Officers Conference, San Francisco, 1990. 2 Of course, as we will see, perfect hedges are nearly impossible to come by. To quote a professional colleague, Gunter Dufey (Professor Emeritus at the University of Michigan Business School), “A perfect hedge is only found in a Japanese garden.” Copyright © 2003 Thunderbird, The American Graduate School of International Management. All rights reserved. This case was prepared by Professors Michael H. Moffett and Anant K. Sundaram for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

the risk that matters is that portion of the total risk that cannot be diversified away, often called the “systematic risk.” If currency risk is defined as “unsystematic risk” or “noise” in expected future cash flows arising from exchange rate changes, it has no impact on firm value. According to this argument, all that a manager does is waste the shareholder’s money by such hedging. That said, proponents cite a number of reasons for why hedging can be valuable to the firm. The argument most often made is that reduction of variance in future cash flows improves the planning capability of the firm. If the firm can more accurately predict future cash flows, it may have a greater incentive to undertake specific investments or activities which it might otherwise not consider. In a related (and somewhat more subtle) vein, hedging can...
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