DESIGNING A HEDGING STRATEGY
We now come to the problem of managing exposure by means of hedging. As mentioned earlier, hedging a particular currency exposure means establishing an offsetting currency position so as to lock in a dollar (home currency) value for the currency exposure and thereby eliminate the risk posed by currency fluctuations. A variety of hedging techniques are available for managing exposure, but before a firm uses them it must decide on which exposures to manage and how to manage them. Addressing these issues successfully requires an operational set of goals for those involved in exchange risk management. Failure to set out objectives can lead to possibly conflicting and costly actions on the part of employees. Although many firms do have objectives, their goals are often so vague and simplistic (e.g., “eliminate all exposure” or “minimize reported foreign exchange losses”) that they provide little realistic guidance to managers.1 For example, should an employee told to eliminate all exposure do so by using forward contracts and currency options or by borrowing in the local currency? And if hedging is not possible in a particular currency, should sales in that currency be forgone even if it means losing potential profits? The latter policy is likely to present a manager with the dilemma of choosing between the goals of increased profits and reduced exchange losses. Moreover, reducing translation exposure could increase transaction exposure and vice versa. What trade-offs, if any, should a manager be willing to make between these two types of exposure?
These and similar questions demonstrate the need for a coherent and effective strategy. The following elements are suggested for an effective exposure management strategy:2
1. Determine the types of exposure to be monitored.
2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives.
3. Ensure that these corporate objectives are consistent with maximizing shareholder value and can be implemented.
4. Clearly specify who is responsible for which exposures, and detail the criteria by which each manager is to be judged.
5. Make explicit any constraints on the use of exposure-management techniques, such as limitations on entering into forward contracts.
6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm’s exchange risk posture.
7. Develop a system for monitoring and evaluating exchange risk management activities.
Objectives
The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy, and quality refers to the ability to provide better decisions. To be acceptable, a hedging strategy must be consistent with top management’s values and overall corporate objectives. In turn, these values and objectives are strongly motivated by management’s beliefs about financial markets and how its performance will be evaluated. The quality, or value to the shareholders, of a particular hedging strategy is, therefore, related to the congruence between those perceptions and the realities of the business environment.
The most frequently occurring objectives, explicit and implicit, in management behavior include the following:3
1. Minimize translation exposure. This common goal necessitates a complete focus on protecting foreign-currency-denominated assets and liabilities from changes in value resulting from exchange rate fluctuations. Given that translation and transaction exposures are not synonymous, reducing the former could cause an increase in the latter (and vice versa).
2. Minimize quarter-to-quarter (or year-to-year) earnings fluctuations owing to exchange rate changes. This goal requires a firm to consider both its translation exposure and its transaction exposure.
3. Minimize transaction exposure. This objective involves managing a subset of the firm’s true cash-flow exposure.
4. Minimize economic exposure. To achieve this goal, a firm must ignore accounting earnings and concentrate on reducing cash-flow fluctuations stemming from currency fluctuations.
5. Minimize foreign exchange risk management costs. This goal requires a firm to balance off the benefits of hedging with its costs. It also assumes risk neutrality.
6. Avoid surprises. This objective involves preventing large foreign exchange losses.
The most appropriate way to rank these objectives is on their consistency with the overarching goal of maximizing shareholder value. To establish what hedging can do to further this goal, we return to our discussion of total risk in Chapter 1. In that discussion, we saw that total risk tends to adversely affect a firm’s value by leading to lower sales and higher costs. Consequently, actions taken by a firm that decrease its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows.
Reducing total risk can also ensure that a firm will not run out of cash to fund its planned investment program. Otherwise, potentially profitable investment opportunities may be passed up because of corporate reluctance to tap the financial markets when internally generated cash is insufficient.4
This and other explanations for hedging all relate to the idea that there is likely to be an inverse relation between total risk and shareholder value.5 Given these considerations, the view taken here is that the basic purpose of hedging is to reduce exchange risk, where exchange risk is defined as that element of cash-flow variability attributable to currency fluctuations. This is Objective 4.
To the extent that earnings fluctuations or large losses can adversely affect the company’s perceptions in the minds of potential investors, customers, employees, and so on, there may be reason to also pay attention to Objectives 2 and 6.6 However, despite these potential benefits, there are likely to be few, if any, advantages to devoting substantial resources to managing earnings fluctuations or accounting exposure more generally (Objectives 1 and 3). To begin, trying to manage accounting exposure is inconsistent with a large body of empirical evidence that investors have the uncanny ability to peer beyond the ephemeral and concentrate on the firm’s true cash-flow-generating ability. In addition, whereas balance sheet gains and losses can be dampened by hedging, operating earnings will also fluctuate in line with the combined and offsetting effects of currency changes and inflation. Moreover, hedging costs themselves will vary unpredictably from one period to the next, leading to unpredictable earnings changes. Thus, it is impossible for firms to protect themselves from earnings fluctuations resulting from exchange rate changes except in the very short run.
Given the questionable benefits of managing accounting exposure, the emphasis in this text is on managing economic exposure. However, this chapter describes the techniques used to manage transaction and translation exposure because many of these techniques are equally applicable to hedging cash flows.
In operational terms, hedging to reduce the variance of cash flows translates into the following exposure management goal: to arrange a firm’s financial affairs in such a way that however the exchange rate may move in the future, the effects on dollar returns are minimized. This objective is not universally subscribed to, however. Instead, many firms follow a selective hedging policy designed to protect against anticipated currency movements. A selective hedging policy is especially prevalent among those firms that organize their treasury departments as profit centers. In such firms, the desire to reduce the expected costs of hedging (Objective 5)—and thereby increase profits—often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise.
If financial markets are efficient, however, firms cannot hedge against expected exchange rate changes. Interest rates, forward rates, and sales-contract prices should already reflect currency changes that are anticipated, thereby offsetting the loss-reducing benefits of hedging with higher costs. In the case of Mexico, for instance, the one-year forward discount in the futures market was close to 100% just before the peso was floated in 1982. The unavoidable conclusion is that a firm can protect itself only against unexpected currency changes.
Moreover, there is always the possibility of bad timing. For example, big Japanese exporters such as Toyota and Honda have incurred billions of dollars in foreign exchange losses. One reason for these losses is that Japanese companies often try to predict where the dollar is going and hedge (or not hedge) accordingly. At the beginning of 1994, many thought that the dollar would continue to strengthen, and thus they failed to hedge their exposure. When the dollar plummeted instead, they lost billions. The lesson is that firms that try simultaneously to use hedging both to reduce risk and to beat the market may end up with more risk, not less.