How to Hedge for Exchange Rate Risks in Corporations

¶ … Exposure Transaction exposure risk may be defined as "cash flow risk" and is associated with the impact of FX rate moves on exposure due to transactional accounts, regarding exports, import or dividend repatriation: and FX "rate change in the currency of denomination of any such contract will result in a direct transaction exchange rate risk" (Papaioannou, 2006, p. 4), thus impacting the multinational corporation in terms of affecting the inflow and outflow of cash over a given period.

Translation risk may be defined as the FX rate risk associated with the balance sheet of a company's holdings. The notion is that exchange rates affect the value of a subsidiary in a foreign country and in instances where the subsidiary is consolidated to the parent balance sheet, the risk becomes translational. The way to measure this risk for a company is by assessing the net asset exposure and measuring it against potential FX moves.

How translation exposure might impact the operations of a multinational corporation is in the consolidation of financial statements: various regulations will doubtlessly impact the parent company, depending on the nation in which it is situated; therefore, different method of translation will occur -- whether taking average FX rate for a given period or the rate at the close of the period.

This makes a difference because as statements of income typically translate at an average FX rate, a balance sheet translation exposure could be in terms of the rate that prevailed at consolidation (Papaioannou, 2006, p. 4). Economic exposure may be defined as FX rate moves that impact the corporation's valuation of predicted operating cash flow. This risk would impact a multinational corporation in terms of revenue and how revenue is affected by FX rate alterations. Operating expense is also an issue that is impacted.

Thus, both sales and costs are considered in economic exposure/risk. A corporation's strategy for managing this exposure would depend upon the current valuation of future cash flow (both of parent and subsidiary companies) and sort of currency risk associated with these markets and their operations.

Overview of the Hedging Strategies That a Company Can Apply to Manage its Exposure As Dominguez and Tesar (2001) illustrate in their analysis of the impact of exchange rate moves on corporate value, a number of factors are important in assessing how a firm can best manage its exposure. First, choosing the rate of exchange is pivotal and incorporation of a "trade-weighted exchange rate" is more likely than not to cause the exposure to be understated. Second, exposure estimates change in relation to conditioning, whether value- vs.

equally-weighted-based or international index based. Third, risk limitations are not identifiable by high variance random variables but risk does, however, increase in proportion to the return horizon. Hedging strategies that a company can thus apply to manage its exposure to each of the three types of exchange rate risk will necessarily incorporate some consideration for the various factors relating to its FX exposure.

Transaction exposure can be hedged in order to maintain cash flow/earnings, which a corporation will want to preserve based on its own assessment of future exchange rate moves. Selective or strategic hedges can be performed depending on this assessment. A tactical hedge would include reducing transaction exposure due to short-term receivables/payables. A strategic hedge would include reducing exposure due to long-term accounts. An alternative to both is a passive hedge that is defined as a single hedge for a regular duration of time without regard for FX alterations.

In other words, a passive hedge strategy involves no consideration of currencies involved. While any of these hedges may be beneficial to a multinational corporation depending on its own particular situation, assessing the factors that affect a firm's value with respect to exchange rate movements is the best way to protect a corporation against losses incurred by FX moves. Instruments that can be utilized in these hedges include forward contracts, futures contracts, synthetic forward contracts, and options (Bodnar, 2015).

One way to determine which instruments to employ is to evaluate the cost/cash flow adjustments for each, and as each method of hedging involves unique cash flow types over unique time periods, the valuation or trend of the market is also a factor that should be considered. An efficient market will determine the level of risk and option premiums will be viewed as the expected discounted value payoff. Translation exposure can be hedged to avoid potential or sudden currency movements that might weigh substantially on net asset valuation.

This exposure is especially important to consider with longer period FX risks, including subsidiary values, debt structures and investments abroad. The main way to hedge for translation risk is to hedge the net assets of the subsidiary company that is likely to be impacted by FX moves against the interests of the company. In so doing, a model of optimization may be employed that considers currency exposure. Again, a tactical hedge may also be utilized.

However, if FX rates do not move as expected, the volatility impact on earnings/cash flow could be unfavorable. In this case, it is important to determine whether the costs of a translation hedge outweigh the costs on no hedge strategy whatsoever. In some cases, where costs are indeterminate, a passive hedge may be the only viable method of protecting against loss.

The most common instruments for hedging FX currency are options and futures instruments, using calls for options strategies, where upside strike is bought in a rate without exercise obligations: it is a simple and effective, low cost strategy with a minimum limited risk, which is the premium or price of the option paid. A call spread would reduce the premium but it would also alter the risk-reward ratio (Papaioannou, 2006). Hedging against economic exposure depends upon how one measures its risk.

The possible affect of rate moves utilized in the prediction of a company's profit-loss stream throughout a time duration is one way to assess this exposure. Netting over markets may offset some consequences of movement, but a company may prefer to hedge by borrowing to finance operational costs in the foreign currency of the most inflation among the subsidiaries.

Treasuries thus offer a complex solution utilizing an optimization model, and in fact such a model can be utilized in any exposure type hedge, so long as the company has a view of currency valuations for a given time length. Possible Implications for a Multinational Corporation Facing a Fixed Exchange Rate Regime When a country pegs its exchange rate to another more stable foreign currency, it appeals to foreign investors and corporations, especially if the peg is the currency of that particular corporation's parent company.

A fixed exchange rate also tends to have a positive implication for multinational corporations because it allows them to participate directly in foreign investments and not have to worry about movements of exchange rates. Fixed exchanges allow for currency conversion of foreign income to the parent company's national currency without concern that price may degenerate over a certain period. In fixed or pegged rate countries, the implications are more positive than in other regime systems, such as free-floating rates which fluctuate with market volatility (Maduro, Fox, 2007).

Pegging to a strong currency, such as the dollar, can limit exchange rate risk, but there may be an impact in terms of import-export valuation, and with the advent of currency wars in recent years, the situation is much more volatile than before, as no country's currency appears safe. As central banks take efforts to stabilize currencies and export deflation, the situation becomes tentative and requires careful monitoring of political and economic trends. Surging nationalism in various parts of the world may also impact these considerations substantially.

In short, a number of factors must be considered, from social to economic and political (Dohring, 2008). Quantum Industries With the spot price of EUR 1.37584 per GBP 1.00, Quantum Industries will want to purchase put option contracts. The March 16 put with a strike price of 138 (i.e. EUR1.38/£) would be the most sensible as this is closest to where the price is in October when the treasury department is making its suggestion. The March 16 put is also sensible as this is the month in which the transaction is occurring.

However, if the department is interested in not holding the options but selling before expiration, the onset of Theta decay in the last thirty days of the contract would rapidly decrease the value of the option, especially if there has been no movement whatsoever in the spot price. If the income is not expected until March, the options might expire worthless (out of the money) and the loss on the purchase (while limited would equal to 87,000 pounds. For example, 5,000,000 contracts at a price of 1.74 pence each (i.e.

£0.0174), the cost would be: 5,000,000 x 0.0174 = £87,000. If the spot price is €/£ 1.23826 in March 2016, the EUR has actually declines as anticipated and the puts will go up in price, therefore culminating in an effective hedge strategy. The option may be exercised in that month for a profit.

If, however, the EUR goes up to a spot price of €/£ 1.51342, the loss would significant, if put option contracts are bought at a March 16 strike price of 1.38 -- particularly as the time decay that will set in over the last thirty days will considerably diminish the value of the contracts An alternate strategy therefore would be to push the options out to APR 16 contracts and purchase the same strike price in anticipation of a volatility move higher, but this would still not effectively limit the risk to the upside.

A more appropriate options strategy might be to do a spread, depending on the outlook that the department chooses to hold, whether it is bullish or bearish or neutral. Indeed, a delta neutral strategy might be the safest play here, in which case a straddle could be the most effective spread.

A straddle would involve buying a put and a call contract at the same strike price in the same strike month (and to avoid theta decay over the last 30 days of the life of the option, April would be the best month to purchase, in case the department decides not to the hold the options to their exercise date but sees more value in selling them). The same number of call contracts would be bought as the put contracts.

This is a delta neutral strategy which, although it costs almost twice as much, the impact of volatility swings in the trade are offset by the positions on both sides of the trade (both bullish and bearish in nature). Thus, if the EUR drops, the put side is there to profit, and if the EUR rises, the call side is there to profit.

The risk graph would indicate that the EUR would have to move as many points as the cost of the two options added together subtracted or added to the strike price. So if in March, the spot price of the EUR is €/£ 1.23826, the puts be in the money, and if it is €/£ 1.51342 the calls will be in the money.

In fact, if the EUR moves significantly both ways over the months preceding the strike date, the department may choose to sell the in the money options for a profit and hold the out of the money options in case the EUR swings the other way later on -- which it very well could do. In this case, the EUR could move up, and the department would make money on the trade, and it could then plunge the other way, and the department could again make money on the trade.

A naked short position would not be recommended because of the unlimited nature of the risk involved, but a bear call spread or a bear put spread might be a viable alternative, though the risk-reward would change with the nature of the debit-cost relationship. Task 2 Hedging.