Question

Due to omnipresent globalization throughout the world today, all multinational corporations are subjected to multi-faceted foreign exchange regulations, which impact their business operations and impact their financial success. At the business level, currency risk is called FX exposure. Identification of currency risks has become a crucial task for all multinational corporations and the ability to measure FX exposure is vital.

• Discuss how multinational corporations manage foreign exchange risk.
• Discuss how some multinational corporations hedge currency.

Answer 1

How multinational corporations manage foreign exchange risk -

Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it describes the possibility that an investment’s value may decrease due to changes in the relative value o­­f the involved currencies.

These are all excellent reasons to take a hands-on approach to FX risk management. And while setting up a solid FX risk management program isn’t trivial, it’s well within the reach of any company willing to make the effort. To create your own program, you’ll need to take the following steps:

1. Analyse your business’ operating cycle to identify where FX risk exists - This helps you determine the sensitivity of your profit margins to FX fluctuations and the stages of your operating cycle where you need protection.
2. Calculate your exposure to FX risk - This covers both unconfirmed risk (the risk that exists before a sales agreement is finalized) and confirmed risk (the risk that exists after a firm sale is completed but you haven’t yet been paid). Once you know your level of exposure, you can decide how much risk coverage (“hedging”) you need.
3. Hedge your FX risk - Hedging simply means that you use specially designed financial instruments to lock in the FX rate so that it remains the same over a specified period. There are numerous ways to hedge, but as an exporter you’re most likely to use an “FX facility,” which you’ll obtain from your bank. An FX facility resembles an operating line and can support various types of financial instruments (or “hedges”), all of which are designed to secure a specific exchange rate for an export contract, so you won’t get any surprises at payment time.
4. Create an FX policy and follow it - In this step you establish the FX risk criteria, procedures and mechanisms that will support your FX risk management program and implement this policy across the company.

Conversely, good FX risk management can bring your company the following benefits:

• Better protection for your cash flow and profit margins
• Improved financial forecasting
• More realistic budgeting
• Deeper understanding of how FX fluctuations affect your balance sheet
• Increased borrowing capacity, leading to faster growth and a stronger competitive edge

How some multinational corporations hedge currency -

Forex hedging is the act of strategically opening additional positions to protect against adverse movements in the foreign exchange market.

Hedging itself is the process of buying or selling financial instruments to offset or balance your current positions, and in doing so reduce the risk of your exposure. Most traders and investors will seek to find ways to limit the potential risk attached to the exposure, and hedging is just one strategy that they can use.

There are a vast range of risk management strategies that multinational companies can implement to take control of their potential loss, and hedging is among the most popular. Common strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives –

1. Simple forex hedging strategy - A simple forex hedging strategy involves opening the opposing position to a current trade. For example, if you already had a long position on a currency pair, you might choose to open a short position on the same currency pair – this is known as a direct hedge.

Though the net profit of a direct hedge is zero, you would keep your original position on the market ready for when the trend reverses. If you didn’t hedge the position, closing your trade would mean accepting any loss, but if you decided to hedge, it would enable you to make money with a second trade as the market moves against your first.

2. Multiple currencies hedging strategy - Another common FX hedging strategy involves selecting two currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs but in the opposite direction.

For example, say you’ve taken a short position on EUR/USD, but decide to hedge your USD exposure by opening a long position on GBP/USD. If the euro did fall against the dollar, your long position on GBP/USD would have taken a loss, but it would be mitigated by profit to your EUR/USD position. If the US dollar fell, your hedge would offset any loss to your short position.

It is important to remember that hedging more than one currency pair does come with its own risks. In the above example, although you would have hedged your exposure to the dollar, you would have also opened yourself up to a short exposure on the pound, and a long exposure to the euro.

If your hedging strategy works, then your risk is reduced, and you might even make a profit. With a direct hedge, you would have a net balance of zero, but with a multiple currency strategy there is the possibility that one position might generate more profit than the other position makes in loss.

But if it doesn’t work, you might face the possibility of losses from multiple positions.

3. Forex options hedging strategy - A currency option gives the holder the right, but not the obligation, to exchange a currency pair at a given price before a set time of expiry. Options are extremely popular hedging tools, as they give you the chance to reduce your exposure while only paying for the cost of the option.

Let’s say you’re long on AUD/USD, having opened your position at $0.76. However, you are expecting a sharp decline and decide to hedge your risk with a put option at $0.75 with a one-month expiry.

If - at the time of expiry - the price has fallen below $0.75, you would have made a loss on your long position, but your option would be in the money and balance your exposure. If AUD/USD had risen instead, you could let your option expire and would only pay the premium.

4. Forward Contracts - Forwards contracts or forwards are agreements between two parties to buy or a sell a specific amount of currency at a predefined exchange rate. If the foreign currency you'll be exchanging into domestic currency loses value, you will still receive the exchange rate specified in the contract, so you won't lose any money. However, if the foreign currency appreciates, you will still receive the same exchange rate, so there is no additional earning

The main difference between the hedge methods is who derives the benefit of a favourable movement in the exchange rate. With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour.