On Hedging FX Risk: Old And New Versions

In the late 80′s I was in touch with a few dozen US multinationals. The issue was foreign exchange risk, and what to do about it. What triggered my role were the big losses the companies kept taking.

Think of a big company in Ohio, one that had a nice business making “stuff” in Japan. They have a factory worth yen 150b ($100m equivalent). The Treasurer worries about this balance sheet risk. He hedges it with a $100m forward short sale of yen. At the end of the Q the yen is up 10% against the $ and the Treasurer and the CFO meet:

CFO – How’d we do in FX?

Treasurer – Great! No gain or loss from the accounting exposure. We had a paper gain of $10m and a cash loss of $10m from the hedges.

CFO – What! You lost $10m of my precious cash to protect a paper gain? You’re an idiot, and you’re fired!

Then you had the company who on Jan 1 budgets a profit of STG 100m from the UK operation for the coming year ($200m notional value). That profit will be remitted back to the USA at the end of the year. Twelve months later:

CFO – Great news! I just heard from London, they made their number for the year, they booked a profit of STG 106M; ahead of plan!

Treasurer – Well, actually, from our perspective, we didn’t do so good. The UK operation ended up way under what we expected. Sterling fell against the dollar, so the STG106m is only worth $170m today – the net is, we look like we’re $30m short.

CFO – What! You didn’t hedge a cash transaction that you knew was coming? You’re an idiot, and you’re fired!

I knew a bunch of the guys (it was all guys back then) who were getting yelled at and fired. So one day I got on a plane (say, Cincinnati) and had a few drinks, after work, with one of them.

Treasurer – I’m getting my ass kicked either way. What can I do?

BK – If I was you, I’d pass the buck to the ‘big boys’ upstairs. Take the heat off of you.

Treasurer – I’m loving that! How do we do it?

BK – Write up a policy on what gets hedged, when and how. Get a sign-off on the policy from the CFO, the CEO and even the Board. I’ll help you write it up - you steer me some Biz.

Treasurer – Sweet! That puts FX management on auto policy! I just have to follow the rules. If things go wrong, the bosses will take the blame. The policy is my ‘cover’.

Ohio is a pretty small place, and not so long after I got a call from Cleveland; another plane, more cocktails:

Treasurer – Heard you cooked up something with a pal of mine down in Cinci. I want one too. If I had a letter from you on bank stationary, about a few things on our FX policy, it would help me get it sold to the bosses.

BK – I’d by happy to do that. I’ll have something on your desk by the end of the week. Now, about that bond deal you’re doing….

In 2013 nearly all of the major companies in the world have a written policy on FX. A very high proportion of those policies have the things that I thought were important (for real and cosmetic reasons). The thinking behind the policies that were adopted:

A) We report quarterly, we manage FX quarterly.

B) We only hedge actually cash transactions that are upcoming and identifiable.

C) We can’t sweat the small stuff. 5% changes in FX rates are okay. Above 5% we have automatic stabilizers that kick in. See D.

D) We will manage FX risk by changing both the pricing and sourcing of our products. We will do this on a quarterly and semi annual basis.

E) Hedging, using FX forward and futures contracts should only be considered after every opportunity under D has been exhausted.

My point (finally), is that there is a 3-6 month lag time in the multinational’s reactions to changing exchange rates. If the FX needle moves by more than 5%, ‘things’ start to happen. Multinationals do not hedge cross border risk beyond six months, so when key FX rates move big, in a short period of time, the multinationals are forced to react in order to catch up with the market changes. Multinationals are always behind the curve, they are never in front of it.

Hello! In the past 6 months the euro has climbed a very big 9.5% versus the dollar, a huge 26% versus the yen, and a very important 6% versus the CNY. As I write, those “adjustments” are happening.

German Car Company
Bean counter – According the the optimization model, at today’s FX rate we should be changing production. Increasing US, down in Germany.

COO – How big a change?

Bean counter – 2%.

COO – The dollar looks weak, make it 3%; we have to stay competitive. Maybe the Unions won’t notice…..

French Solar Manufacturer
COO – We make a global product. Our biggest competitor is China. We lost 6% in production costs against them in just six months! The Americans, and now the damn Japanese, are going to kill us. Every panel we make, must now be sold at a loss. That, or we shut down.

CEO – Don’t worry so much. Our friends in Paris will write us a check to cover the losses. After all, we have 2,000 people working in the plant…..

If the global economy were a four-legged stool, the legs would be the EU, USA, China, and Japan. As of January, 2013, the EU is by far the weakest leg of the stool. The EU also has the strongest currency, insuring a deflationary slowdown. Whatever your thinking was about Europe a few months ago, take down your expectations today. At EURUSD 1.3250 (and all the dollar based crosses) and EURYEN 119, the EU is going to take a big hit, soon.

The FX moves that are killing the EU are, in part, self inflicted. The strong Euro is an ECB/Draghi creation. The Euro price is also a function of the US/Japanese government policies to undermine the dollar/Yen. China, with its link to the dollar, is getting a free ride, a big boost, and, no doubt, a bit of a laugh.

If you try to sit on a four-legged stool that has one busted leg, you fall on your ass, look surprised or stupid, and maybe get hurt. I’m amazed that the “deciders” are engineering precisely that outcome.