Corporate Foreign Exchange Risk Management

Lars Oxelheim, Alf Alviniussen, Hakan Jankensgard

• Verlag: Wiley
• Jahr: 2020
• ISBN:
  9781119598909
• Auflage: 1
• Thema: Business
• Thema: Corporate Governance

A practical and accessible guide that demystifies ForEx risk for managers in all areas of business

Virtually any organisation active in the global economy is impacted by fluctuations in foreign exchange (FX or ForEx) markets. Managers need to understand this increasingly complex issue and measure their firm's exposure to risk. Corporate Foreign Exchange Risk Management is an in-depth yet accessible guide on effective ForEx exposure management. Designed for professionals responsible for managing a profit & loss or balance sheet influenced by ForEx fluctuations, it enables risk managers to navigate the interconnected worlds of financial management and economics.

This innovative guide integrates academic discussion of the economics of risk management decisions and pragmatic advice for various situations in which performance measures affected by accounting standards are paid considerable attention. Readers are provided with the tools and knowledge required to handle a broad range of issues related to ForEx risk management. Clear, non-technical chapters demystify concepts that often appear complicated and confusing to managers. Written by globally-recognised experts in corporate finance, risk management and international business, this book:

• Employs a reader-friendly narrative style to explain complex concepts
• Provides a clear, actionable risk management strategy which can be used in a variety of businesses
• Places all concepts in relatable, real-world contexts
• Explains important academic research to practitioners in plain English
• Includes effective pedagogical tools and explanations, straightforward examples and end-of-chapter summaries which highlight key points

Corporate Foreign Exchange Risk Management is a must-read for any manager who deals with corporate exposure to ForEx risk, as well as analysts wishing to better understand the relation between corporate performance and ForEx fluctuations and students of corporate risk management.

Chapter 1
Why Manage Foreign Exchange Risk?

One of the more puzzling questions facing corporate management is the risk management decision. This is about deciding whether to use a company's resources to actively try to reduce risk, here understood as variability in corporate performance. Our focus in this chapter is therefore to understand when it makes sense for a firm to reduce variability in its performance through managing its FX exposures. Why would a firm be better off managing risk than just accepting its exposures as part of doing business?

To fix our ideas, we can take hedging as a proxy for corporate risk management. Hedging is the use of financial derivatives to alter a firm's exposure to a specific market risk. Many other forms of risk management are possible, like buying insurance, operational risk mitigation, relying on equity rather than debt financing, and keeping a buffer of cash to deal with adverse outcomes. We will in fact emphasize that hedging, while highly flexible, is for the most part only able to address relatively near‐term exposures (more on this in Chapter 9). By changing the currency exposure at an operational level (i.e. actively trying to net out cash inflows and cash outflows), or by borrowing long term in foreign currency, the firm is likely to achieve more durable reductions in FX risk.

Focusing on hedging for now, however, allows us to keep the terminology brief and tap into a rich literature that has developed on why firms should hedge their exposures. Most of the arguments developed in this chapter transfer over to other forms of risk management.

The business case for hedging is far from obvious. In some companies, questions like ‘Why should we hedge?’ and ‘Should we hedge cash flows or earnings?’ never seem to get fully settled. The issues are raised, meetings are held, memos are written, and policy documents established. Only for the question to get raised again a couple of years later, prompting new discussions and memos in what seems an endless cycle. A clear and robust answer to these questions continues to elude many companies.

Why is it so difficult to pin down why and when firms should use hedging? We are convinced that part of the difficulty lies in the fact that there is an almost infinite number of performance measures that potentially could be hedged. For most of these, a plausible‐sounding argument to reduce variability can be developed quite easily, because managers are naturally averse to risk and need little convincing that variability in performance, however measured, is ‘bad’. For example, it is not uncommon for business units and investment projects to be evaluated based on their operating margin. For the people involved in these projects, ‘protecting’ these margins through hedging may seem perfectly logical and desirable. Seeing currency fluctuations eat away at the margins, perhaps even causing them to turn negative, can be a terrifying prospect. The desire to protect margins is behind a large number of hedging proposals that are sent further up the corporate system for management, and sometimes even the board of directors, to decide on. So, what should they say to such proposals? Based on what principles?

In what follows we review the arguments in favour of corporate hedging. The goal is to develop a hedging policy that guides management's decision‐making, where a plausible case can be made that the advantages of hedging outweigh the disadvantages. The alternative to a unified hedging policy, we argue, is an ad‐hoc approach at least partly captured by different local agendas, pushing for the hedging of specific business projects, which only serves to make hedging incoherent and unpredictable.

From Individual Risk Management to Corporate Risk Management

In trying to come up with some suggestions for what can constitute a basis for a hedging policy in firms, one might consult the academic thinking on the topic. Academic finance has for several decades been analysing the circumstances in which hedging creates value for a firm.

In the literature, the hedging decision of the firm is sometimes contrasted with that of the individual trader or investor. When we are dealing with an individual it comes down to one thing: risk preferences. Why? Because the situation concerns an individual who makes decisions affecting his or her own expected wealth and risk. Therefore, it comes down to what you are comfortable with as an individual. Some people do not like risk and prefer a safer alternative. They are the ‘risk‐averse’ individuals who may prefer to hedge as much as they can. Other people are more tolerant of risk. They may consider it fine to retain certain exposures to risk so long as they also get a reward in the form of a commensurate upside potential. Still others may be positively ‘risk‐loving’. They are the kind of people willing to take significant risks for the pleasure of the thrill.

The broader point here is that for individuals, the hedging decision follows risk preferences. Once the odds and the range of potential outcomes are known, it all depends on this parameter.

Unfortunately, the model for decision‐making based on personal risk preferences does not carry over to firms. This is true despite the fact that businesses are run by people. One might think that risk‐averse managers will hedge more and risk‐seeking ones less, and that is it. But this does not provide a robust business case for hedging. Managers are in fact hired by the owners of a firm to run its operations on a daily basis. In more formal language, they are agents hired by a principal. According to corporation law, the managers and directors of the firm are obliged to use their decision‐making powers in the ‘best interest of the firm’. This pretty much rules out using managers' own feelings and sentiments about risk as a justification for risk management decisions.

Instead we need to think about how hedging can promote the best interest of the firm. Phrased a bit differently, this is the question of how hedging can increase shareholder value. It changes the question from ‘How do we feel about this risk?’ to ‘How can we demonstrate that shareholders are expected to be better off with this hedge than without it?’ This is a much trickier question to answer.

The Case for FXRM: Cash Flow Hedging

The basic thing achieved by a hedge, if correctly executed, is to reduce variability in corporate performance. Let us for now take performance to mean cash flow. This is the metric favoured by academics due to its close relation to firm value, which is given by the discounted value of future free cash flow. Reducing variability in cash flow by itself falls short, however, of presenting a convincing business case for hedging. Why? The answer lies in the symmetric impact of hedging on cash flow variability. Say that we enter an FX hedge, which lowers our maximum loss by US$20 mn. The symmetry of a forward contract implies that we also lower our maximum gain by US$20 mn. A firm that protects itself against unfavourable scenarios has to accept that it misses out on the windfall it would have received in more favourable scenarios. The expected value of such a hedge is zero (or even negative, if there are transaction costs). So, while reducing variability might be ‘nice’ to some of the managers involved, this is not enough to build a case for hedging.

We can conclude, then, that simply achieving a narrower range of potential outcomes for cash flow does not justify corporate risk management. Instead, theorists have sought to build the case by looking for asymmetries in the way corporate performance is affected by hedging. Hedging can be valuable when there is a negative consequence from cash flow falling below a certain threshold and there is no corresponding positive side‐effect at high levels of cash flow. Hedging, by reducing the probability of cash flow dropping below the threshold level, reduces the expected cost of these negative consequences. This, in a nutshell, is the idea behind corporate hedging in academic models.

What are the negative consequences that could happen in low‐cash‐flow scenarios? It is straightforward. Firms need money to meet important cash commitments, like investing in new projects and paying interest and instalments on loans. There are many other commitments to various stakeholders that also require liquidity, like dividends and pension obligations. When a firm does not generate enough cash flow internally, it may not be able to service these cash commitments. Falling below this threshold usually implies some sort of negative consequence. If the firm cannot invest optimally, it will end up being less competitive. If it defaults on its interest payments, it will be sent into bankruptcy. If it sells assets in a fire sale, it may have to accept a price below the assets' fair value. If it cuts back the dividend, shareholders will grumble and reassess the firm's future prospects.

We have now identified the asymmetry we needed. The firm suffers various negative consequences when it fails to reach a certain threshold level of cash flow, but there are no positive consequences, beyond the pure monetary gain, when cash flow is higher than expected. In the good scenarios the surplus cash flows will simply accumulate as more cash.

Someone might reply that it does not matter if cash flow falls below the threshold level because the firm can always borrow to cover up the difference. There might be a credit line it can draw on, or it might have unused borrowing capacity to mitigate the consequences of cash flow shortfalls. Such untapped resources will obviously have to be considered. But all they really do is move the threshold level of performance. With spare debt capacity and cash buffers the firm can tolerate larger cash flow shortfalls. But at some point, the opportunities to get external funding at a reasonable cost will be used up. Creditors will worry about the risks involved, and may suspect that managers will engage in excessive risk‐taking. These things push up the cost of debt, and financially weak firms may find themselves shut out of the credit markets altogether. Equity financing provides no easy escape, as the issuing costs are substantial and investors demand a large risk premium. In these circumstances, the availability of operating cash flow plays a crucial role in terms of being able to execute the business plan and meet various cash commitments.

To summarize, the academic literature recommends looking for different threshold levels of cash flow performance where different negative consequences would be triggered. This is a test to which all hedging proposals should be subjected. The question to be asked is: ‘Would implementing this hedge, in a meaningful way, reduce the probability that cash flow ends up below the threshold level given by our cash commitments?’ This question raises the bar significantly compared to hedging to protect operating margins, or simply locking in a ‘good’ FX rate.

The Case for FXRM: Protecting Financial Ratios

In academic finance, cash flow has the highest pedigree because of its close relationship with firm value. However, corporate performance is more multifaceted in real life. Realistically, more things will matter than cash flow. Once we acknowledge this, things get more subtle and subjective, but the arguments are worth taking seriously.

One way to motivate FXRM is to say that a particular financial ratio needs to be stabilized, or ‘protected’. Some firms have a stated objective that, for example, the debt‐to‐equity ratio should not go above 0.7. Since both debt and equity are exposed to FX translation gains and losses, it may decide to manage its composition of assets and liabilities in such a way that the probability of exceeding this target is minimized. This is an argument for FXRM that is not uncommon in practice. Granted, maintaining a set of target ratios over time gives a sense of direction and an impression that management is on top of things. But what is there to say that defending a particular ratio actually translates into higher shareholder value? Being a corporate objective by itself does not justify using resources to protect it. An objective is a fairly arbitrary thing, and may not always be connected to shareholder value in an obvious way.

Defining threshold levels of performance in terms of financial ratios can be more easily motivated if breaching them is clearly connected to a negative consequence. Again, we are looking for some asymmetry in the outcome distribution. One way this could happen is if the firm has agreed to a covenant as part of its loan agreement. A covenant is a way for a bank to monitor the firm and decrease the risk of default. If breached, the covenant gives the bank increased legal powers to demand specific actions, or even take control of the firm...

Inhaltsverzeichnis

• Cover
• Table of Contents
• Acknowledgements
• About the Authors
• Preface
• Key Terms and Abbreviations
• Introduction
• Chapter 1: Why Manage Foreign Exchange Risk?
• Chapter 2: Commercial Exposure to FX
• Chapter 3: Net Income Exposure to FX
• Chapter 4: Balance Sheet Exposure to FX
• Chapter 5: FX Derivatives Explained
• Chapter 6: Hedge Accounting Explained
• Chapter 7: Centralizing Exposure Management
• Chapter 8: Integrated Risk Management
• Chapter 9: Managing FX Risk Exposures
• Chapter 10: Communicating FXRM
• Index
• End User License Agreement