BACKGROUND
"Why Derivatives Don't Reduce FX Risk" is the title of a case I analysed a few years ago. Unfortunately I do not have access to the full article but if you have a subscription to The McKinsey Quarterly you can access here. Even without reading article, however, you will still find aspects of the analysis very useful.
-----
The objective of the article, “Why Derivatives do not Reduce FX Risk” is to highlight that sophisticated risk management programmes usually employed to mitigate against FX risk are highly ineffective. In particular aspects of FX risk - transaction and translation exposure - are examined.
The article examines the impact of FX risk on the cash flow of companies and how the variability of these cash flows can impact on the value of business units. In order to reduce the variability of these cash flows brought on by FX risk, specific hedging options such as forward contracts are explored.
Copeland’s and Joshi’s basic premises are: (1) for hedging programmes to be effective they must increase the so called “time to ruin”. This means that they must delay significantly the process of the reduction in cash flows that results in disruption costs and ultimately paralyses a company; and (2) FX risk can be greatly reduced if there is a high correlation between operating cash flows and cash flows from the foreign exchange position.
In concluding, Copeland and Joshi maintain that of 200 companies investigated, there was overwhelming proof that hedging techniques for the most part fail. In other words they do not reduce significantly the variability of cash flows resulting from FX risk.
They advance that hedging programmes have a hard time creating value because of the many and complex nature of unpredictable variables that constantly change in relationship to each other. As a result of the findings, the article suggests that managers must not always look to derivatives as the answer to solving FX risk situations but that other options such as plant relocation and structural adjustments to pricing sometimes provide viable alternatives.
A critical assessment of the article summarised above requires a closer look at key terminology:
FX Risk
FX risk is the potential loss or gain that could result from a position denominated in a foreign currency as result of a movement in the exchange rates. The exposure to FX risk is regarded as FX exposure.
Derivative
A derivative is a financial instrument whose value is based on an underlying asset. Derivatives include forward contracts, options, currency futures, and swaps.
The definitions above are key to understanding Copeland’s and Joshi’s article on why derivatives are largely ineffective against FX risk. In addition, however, there are other key elements that are important ingredients in understanding the FX exposure of companies. These include:
Decomposition of FX risk
FX exposure is typically broken down in transaction, translation and economic elements. Another categorisation is to view FX exposure as broken down into accounting (translation)and cash flow (transaction and economic) exposure.
Transaction exposure refers to the possible gain or loss that may result from a transaction arrangement denominated in another currency which will come due for settlement in the future. Translation exposure on the other hand exists when the financial position of a company denominated in another currency must be converted to the currency of its parent. This translation process exposes the parent to possible gains or losses.
Economic exposure are of two categories - competitive and portfolio. The competitive component refers to the potential threat to a company from a competitor with advantage in a stronger currency while the portfolio component refers to the extent to which the company transacts its business in various currencies. Overall economic exposure impact on the after tax cash flow of a business and ultimately on its value.
Hedging Programmes
As is shown in the preceding section, various elements figure in management’s decision to hedge. In developed markets especially, many products are available to hedge against FX exposure. These include derivatives and other options such as currency invoicing.
The Forward Contract
This arrangement involves the delivery on a specific date, a pre-set amount of currency at an agreed rate. A variation of the forward contract is an option dated forward contract where settlement of the contract itself can be effected within an agreed period. This provides added flexibility especially where the timing of cash flows are uncertain or where unforeseen events can cause problems. Forward contracts are typically used to hedge against transaction (short- and long-term) and translation exposure.
The Currency Option
This affords one party the option of buying an agreed amount of foreign exchange on an agreed date. This is known as a call option. The put option is the reverse and affords the opportunity of selling a block of foreign currency at an agreed rate and point in time. Currency options are attractive for although they involve an up-front cost, they allow settlement only if the environment so warrants, hence preventing unnecessary cash outlays and possible losses. Currency options are used to hedge short-term transaction exposure.
The Futures Contract
The futures contract like the forward contract affords the a specific amount of foreign currency to be bought or sold at an agreed price and specific point in time. The difference between the two types of contracts is that the futures arrangement requires an up-front charge. Similar to currency options, futures can be used against short-term transaction exposure.
Swaps
Swaps are typically used to hedge long-term transaction exposure. In one form, a company anticipating future cash flows in one currency may feel that it can borrow at effectively lower cost in another currency. Therefore it proceeds to setting up loan through a bank with agreement to repay in the currency of the future cash flows while the bank agrees to provide currency in same denomination of loaned funds to offset the company’s obligations.
Other Hedge Products
Other forms of hedging techniques include currency invoicing, money market hedge, leading and lagging, cross-hedging and currency diversification.
Currency of Invoicing
This form of hedging is typically used against short-term transaction exposure. It involves invoicing in the currency that is anticipated to strengthen to gain potential benefits from converting the stronger currency to the weaker currency.
Money Market Hedge
If a company has cash flow in a particular currency in the future, it can enter into a money market hedge to protect itself from any adverse impact resulting from that flow. For example it may wish to borrow an amount in that currency and sell the loan proceeds for a currency it desires. When the future cash flow is realised, the amount can then be used to settle the amount due on the loan facility. Money market hedges are common in offsetting transaction exposures.
Leading and lagging, Cross-hedging and Currency Diversification
These techniques are more used in managing transaction exposure. They are more effective in reducing the form of exposure than totally eliminating it.
Leading and lagging is based on expectations about currency adjustments. The company speeds up payments in a particular currency if the home currency is expected to depreciate against the currency of payment (leading) or attempts to delay payments (lagging) if the reverse is expected. Cross-hedging involves offsetting an FX position denominated in one currency X with a hedge on another currency that has a high correlation to X. Currency diversification attempts to offset risk by diversifying into a number of currencies rather than just one or a few.
Business Configuration
FX risk faced by companies and the extent to which hedging techniques are feasible depend on the kind of business in question. In other words a pertinent question is whether the business’ cost and revenue elements are based in home currency or are they spread in other currencies and to what extent. Important businesses for consideration are domestic, import/export businesses, multi-domestic domestic business and global organisations.
The domestic business set-up essentially has its cost and revenue elements in its home currency. The main type of FX exposure faced by these companies are economic (more specifically competitive).
The import/export business has its revenues and cost elements denominated in both home and other currencies. The kind of exposure faced include both transaction and economic. The economic exposure faced in this instance includes the elements defined - competitive and portfolio. Portfolio being present as a result of the revenue and cost elements denominated in different currencies.
The multi-domestic business has predominantly independent establishments in different countries and does not necessarily share resources across borders. The global business on the other hand, while difficult to define, share significant resources across borders or are operated as a more integrated unit. Global companies face all three FX exposures described.
Forecasting
An important aspect of managing FX exposure is the ability of management to forecast future trends. With this forecast information and based on management’s understanding of its accounting or cashflow exposure, hedging programmes can be embarked upon with confidence.
Management’s Objectives
Management’s objectives are also an important consideration for hedging programmes. This brings into focus the often talked about principal/agent relationship. While management’s responsibility is to ensure the maximisation of shareholders wealth what they often do in practise may not reflect this goal.
Hedging programmes require significant resources in time and money. Management may have other objective’s in mind other than shareholder value maximisation and as such may chose not to hedge or chose techniques that are sub-optimal and cost less. Therefore, while management is seeking to maximise profits, it may in the process destroy shareholder value by not hedging its foreign exchange positions or going with programmes that are less effective.
Strategic Considerations
Corporate strategy sometimes hold important clues to hedging programmes. For example, experience may have taught some companies that in the long run losses or gains from FX exposure tend to even themselves out and as there is no need to spend considerable resources and elaborate schemes. Alternately, strategy may dictate that only particular kind of FX exposure components are worth hedging against. Thus a company may chose to hedge against transaction exposure while ignoring translation and economic exposure.
Timing Issues
Timing considerations may prevent some companies from properly hedging themselves against FX exposure. In particular in the case transaction exposure, cash flows may have a very long duration before they materialise. In such instances, the providers of hedge products may be unwilling to take attendant risks and as such may be reluctant to enter in any hedge arrangements. In developing counties such as Jamaica, hedge instruments such as forward contracts are often times limited to at most three months.
Other Considerations
Other important considerations is that some companies are unable to enter in to hedging arrangements because of poor banking record or where credit lines cannot be had. Hence while companies may want to hedge certain FX positions, they are constrained by these issues and may be able to hedge only apart of there total exposure or none at all.
Has Article Effectively Considered these Important Elements?.
The first criticism of the article is its inappropriate title. While the bulk of the article focuses on hedging programmes which are wide ranging (derivatives and others such as currency invoicing) it concludes that derivatives do not reduce FX risk. Derivatives, as was shown, are only some of the possible options available for hedging programmes and this qualification could have been made. It is important to note that hedging involves insulation against exposure to exchange rate fluctuations.
The aspects of FX exposure, business configurations, strategic decisions, etceteras are all important to hedging programmes and their effectiveness. Copeland and Joshi claim that derivatives are ineffective means of managing FX exposure but should important qualifications be made. This will be dealt with in the context of the considerations outlined above which are all important ingredients for any effective hedging programme.
As previously mentioned hedging programmes and their effectiveness in handling FX exposure requires a good grasp of the different components of FX risk (translation economic and transaction). The first criticism of the article is that Copeland and Joshi focus on transaction and translation risk but did not put the third dimension of FX risk (economic exposure) in perspective. In any event, it would have been important to point out the difficulties in hedging against transaction and translation exposure.
Both forms of exposure pose serious problems to the amount of hedge required. In particular, with translation exposure it is highly unlikely that a company could hedge itself against an entire portfolio of foreign currency assets or liabilities. So while partial hedges may be in place, the company still assumes risk in having FX rates impact upon unhedged positions. Some firms counter the problem of hedging the size of translation exposure by matching foreign currency assets with liabilities. This option, of course, comes with its own set of problems (for example gearing issues).
Additionally, translation exposure may be difficult to hedge because of problems with accurately forecasting earnings. This being only natural with the ever changing environment and unplanned for eventualities. Other problems with translation exposure include increased transaction exposure and accounting distortions resulting from the difference in calculating forward rate gains or losses as opposed to calculating translation gain or loss.
Problems in Hedging Against Economic Exposure
It is true that while hedging instruments sometimes, at best, can be effective against transaction and translation exposure, they do not hedge against economic exposure. So while the article’s claim may be true, putting economic exposure in context would have demonstrated better why even when transaction and translation exposure are dealt with, economic exposure still remains and requires a different solution outside of hedge products.
Economic exposure requires treatment that are more far reaching than derivatives. In fact, in order to deal with economic exposure, the longer-run is more realistic alternative. AS Copeland and Joshi suggests, structural adjustment may be the solution to dealing with economic exposure. This means considerable effort and time are allocated in relocating operations in foreign countries. However, the end result in being able to compete effectively, as cost or revenue elements are similar to that of competitors are well worth it. Copeland and Joshi also suggests that another effective way of dealing with FX exposure is by changing the pricing structure is also a consideration in dealing overall FX exposure.
The article could have included other pertinent considerations. These include decisions whether to step up or reduce sales efforts in foreign markets, whether to borrow more extensively in foreign currencies or to reduce its exposure and whether to concentrate efforts on finding more local suppliers or to move to foreign based ones who are for example more reliable.
The second criticism of the article is that it did not put the companies studied in proper perspective. As discussed, business configurations are important in hedging programmes. It would seem that Copeland and Joshi did not make this useful distinction. While they conclude that from the studies carried out on over 200 companies that hedging programmes were largely ineffective, some kind of separation of these companies into configurations described could have added perspective to the article. It would provide a better handle on how the cost and revenue elements of these companies were denominated hence providing more information on the kinds of exposure faced by each category of companies.
Another criticism of the article is that it did not provide any insight into possible reasons as to why many companies refused to hedge. For example, while Copeland and Joshi insist that a substantial number of companies did not engage in these programmes it would have been useful to add that management’s objectives which sometimes are different from that of shareholder expectations may see deliberate strategy not to enter into these programmes.
In addition, as was shown, the decision not to hedge may be entirely strategic or based on past experience. As was shown hedging programmes require considerable resources resulting sometimes in deliberate decisions not to hedge. Other reasons not to hedge could be as a result of the unavailability of hedge products, prohibitive costs or the because of the long-term nature of cashflows.
Lastly, the article can be criticised for some examples used were misleading or did not justifiably look at other scenarios. For example in demonstrating the use of forward of forward contracts Copeland and Joshi could have suggested that instead of the straight forward contract another option could have been an option dated contract or a currency option. In such a situation it could have been pointed out that the use of these more flexible contracts provides the opportunity to minimise losses should such thing as an economic recession prove unfavourable.
Copeland and Joshi could have also focused on the role of forecasts. Again, the large number of companies abstaining from hedge products may suggest an stable period where forecasts for the most part hold good and hence no need to enter into expensive hedging arrangements.
Conclusion
Copeland and Joshi claim that hedging programmes although very elegant, seldom work in practise. While some would agree with this statement, it was shown that the article could have been put in an improved perspective which would more justify the claim. Firstly, it was shown that hedging programmes are wide ranging with derivatives only making up one category of options available. It was also shown that while companies can sometimes put in place hedge programmes to effectively control transaction and transaction exposure, a third element economic exposure which is not offset by normal hedge products tend to override the effectiveness of hedging programmes.
Additionally, as was shown, the article could have expanded explanations as to the many problems involved in hedging against FX exposure in essence bringing to the fore that is not that hedging programmes do not reduce FX risk but in fact that even when companies hedge they are only able to partially hedge and as such other aspects of FX exposure will remain. Additionally some companies take the option of hedging only specific exposures or exposures over a certain amount out of policy decisions or from lack of inability to enter in these kinds of arrangements with banks or other financial intermediaries. All these being very important in possibly explaining why Copeland’s and ?Joshi’s findings of the high percentage of companies abstaining from hedge programmes.
Finally, it is clear from the foregoing that the article’s assertion that derivatives have a difficult time reducing FX risk. However, derivatives are but one category of options used to hedge FX exposure. Hedge programmes that are more wide ranging can be structured to deal with all aspects of FX exposure ( especially economic exposure which require more radical treatment).