Foreign Exchange Hedging Strategy

Foreign exchange risk is a fact of life: managing that risk a responsibility.

The multinational and multicurrency nature of much contemporary business exposes firms to risks from exchange rate shifts. According to some theories, this source of risk should have produced greater impact on many firms, and in particular on their stock price, than has been observed. This is known as the "exposure puzzle" -- or the way in which firms minimized damage.

An Example

Giant Wire Maker Inc. (GWMI) is a vertically integrated company that mines copper at its operations in Chile, manufactures the wire at factories in Mexico, and sells it to customers in the United States.

Customers pay GWMI in U.S. dollars, but it pays most of its expenses in either the Chilean or the Mexican peso.

Three Ways to Manage

Financial hedging is one way of limiting this exposure.

The risk for GWMI is that it could be squeezed as the value or one or the other of the currencies in which it pays its expenses will suddenly increase relative to the value of the U.S. dollars of its revenue.

There are at least three ways to manage this risk, and they are not mutually exclusive. GWMI may seek to pass along any costs incurred as a result of exchange rate fluctuations in the prices it charges customers, to the extent its own competitive situation will allow that.

Or it might hedge against this situation in operational terms. It might change where it does business or what kind of business it does there.

Finally, there is financial hedging. GWMI might make investments that are "short" the dollar. That way, if the dollar does decline in value, the investments pay off and this helps cover the operational loss.

The Hedge

The financial hedging might be accomplished, for example, through options contracts. The company could buy "puts" in the dollar, i.e. buy the right (not the obligation) to sell U.S. dollars on a future date at a certain fixed amount in Chilean or Mexican pesos. Or, it could buy "calls" -- options to buy -- those other currencies in U.S. dollars. In either case the bet would pay off, the option would be worth exercising, if and only if the dollar falls in value before the expiration date.

Flexibility

FX options are not typically bought and sold through a standardized exchange, but over-the-counter, in ad hoc negotiated agreements. This fact gives the managers of the financial hedging operation within GWMI some flexibility in negotiating for the desired expiration dates and strike prices.

Why One Hedging Instrument Rather Than Another

The corporate treasury must select among possible hedging instruments.

Gregory Brown, Associate Professor of Finance, Kenan-Flagler Business School, at The University of North Carolina, has argued that there are a range of considerations that determine how a multinational will hedge such risks -- whether it will for example use options, futures, or forward contracts. These considerations include "accounting treatment, derivative market liquidity, foreign exchange volatility, exposure volatility, and recent hedging outcomes."

References

• SVB Financial Group: Avoiding Risky Business: Hedging Foreign Exchange
• "Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure"; Sohnke M. Bartram et al.; 2009.
• University of North Carolina, Kenan-Flagler BusinessSchool: Managing Foreign Exchange Risk With Derivatives.