Managing FX Exposure: Hedging Strategies for Multinationals

Types of Foreign Exchange Exposure

Transaction exposure risk may be defined as "cash flow risk" and is associated with the impact of FX rate movements on exposure arising from transactional accounts regarding exports, imports, or dividend repatriation. An 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), thereby affecting the inflow and outflow of cash for a multinational corporation 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 into the parent balance sheet, the risk becomes translational. The way to measure this risk is by assessing the net asset exposure and measuring it against potential FX movements.

How translation exposure might impact the operations of a multinational corporation becomes apparent in the consolidation of financial statements. Various regulations will inevitably affect the parent company depending on the nation in which it is situated; therefore, different methods of translation will occur — whether taking the average FX rate for a given period or the rate at the close of the period. This distinction matters because income statements typically translate at an average FX rate, while a balance sheet translation exposure could reflect the rate that prevailed at the time of consolidation (Papaioannou, 2006, p. 4).

Economic exposure may be defined as FX rate movements that affect the corporation's valuation of predicted operating cash flow. This risk impacts a multinational corporation in terms of revenue and how that revenue is affected by FX rate changes. Operating expenses are also subject to this influence. Thus, both sales and costs are considered under economic exposure and risk. A corporation's strategy for managing this exposure depends upon the current valuation of future cash flows — for both parent and subsidiary companies — and the type of currency risk associated with these markets and their operations.

Hedging Strategies for Each Exposure Type

As Dominguez and Tesar (2001) illustrate in their analysis of the impact of exchange rate movements 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 exposure to be understated. Second, exposure estimates change in relation to conditioning, whether value-weighted, equally-weighted, or international-index-based. Third, risk limitations are not identifiable by high-variance random variables, but risk does increase in proportion to the return horizon.

Hedging strategies that a company can apply to manage its exposure to each of the three types of exchange rate risk will necessarily incorporate consideration for the various factors relating to its FX exposure.

Transaction exposure can be hedged in order to maintain cash flow and earnings, which a corporation will want to preserve based on its own assessment of future exchange rate movements. Selective or strategic hedges can be applied depending on this assessment. A tactical hedge would include reducing transaction exposure due to short-term receivables and payables. A strategic hedge would include reducing exposure due to long-term accounts. An alternative to both is a passive hedge, defined as a single hedge maintained for a regular duration of time without regard for FX changes — in other words, a passive hedge strategy involves no consideration of the currencies involved. While any of these hedges may benefit a multinational corporation depending on its 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 and cash flow adjustments for each. Because each method of hedging involves unique cash flow types over unique time periods, the valuation or trend of the market is also a factor to consider. 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 primary way to hedge translation risk is to hedge the net assets of the subsidiary company most likely to be impacted by FX movements against the interests of the parent company. In doing so, an optimization model may be employed that accounts for currency exposure. A tactical hedge may also be utilized; however, if FX rates do not move as expected, the volatility impact on earnings and cash flow could be unfavorable. In such cases, it is important to determine whether the costs of a translation hedge outweigh the costs of no hedge strategy whatsoever. 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, using calls for options strategies, where the upside strike is bought at a rate without exercise obligations. This is a simple, effective, and low-cost strategy with a minimum limited risk equivalent to the premium or price of the option paid. A call spread would reduce the premium but would also alter the risk-reward ratio (Papaioannou, 2006).

Hedging against economic exposure depends on how one measures risk. One approach is to assess the possible effect of rate movements on the prediction of a company's profit-loss stream over a given duration. Netting across markets may offset some consequences of currency movement, but a company may prefer to hedge by borrowing to finance operational costs in the foreign currency of the subsidiary experiencing the most inflation. Treasury departments thus offer a complex solution utilizing an optimization model; indeed, such a model can be applied to any exposure type hedge, provided the company maintains a view of currency valuations for a given time frame.

References

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Dohring, B. (2008). Hedging and invoicing strategies to reduce exchange rate exposure: A euro-area perspective. Economic Papers 299, European Commission.

Dominguez, K., & Tesar, L. (2001). Exchange rate exposure. National Bureau of Economic Research, Working Paper No. 8453.

Madura, J., & Fox, R. (2007). International financial management. Cengage.

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