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a firm’s translation exposure is the extent
to which its financial reporting is affected by
exchange rate movements. as all firms generally
must prepare consolidated financial statements
for reporting purposes, the consolidation
process for multinationals entails translating
foreign assets and liabilities or the financial
statements of foreign subsidiaries from foreign
to domestic currency. While translation expo-
sure may not affect a firm’s cash flows, it could
have a significant impact on a firm’s reported
earnings and therefore its stock price.
given the current situation in europe,
many financial teams are spending more time
monitoring their euro exposures. Corporations
are taking a sharper look at what their hedging
strategies need to be in 2012. my company,
multinational food importer atalanta Corpora-
tion, certainly is doing so.
Steps to Follow
The first step in preparing to hedge foreign
currency transactions needs to be measuring
how much of a particular foreign currency your
company bought or sold in the last 12 months
on a global basis.
The second step is calculating how much of
that currency you will buy or sell in the next 12
months, by month, for all divisions on a global
basis. many banks offer “treasury management
software systems” which facilitate the gather-
ing of information, the administration and
control of outstanding foreign exchange (fx)
contracts, etc. When there is significant hedge
activity, the cost of such systems can be a good
investment for larger companies.
The third step is to formulate both short-
term and long-term plans with management,
and the audit committee if the company has
one, and agree on the range of months forward
that you feel comfortable hedging. it could be
three, six, or 12 months, depending on recent
volatility. This analysis can also include whether
there are any “natural hedges” such as the situ-
ation where you are selling a product to a com-
pany in Canada in Canadian dollars (Cad) and
also buying a product from another company in
Canada in Cad. in this scenario there would
be an opportunity to open a bank account in
Canada and net the two transactions to better
manage Cad risk over time. other examples
of “natural hedges” would be building a plant
or opening a purchase/sales office in a foreign
country where sales and purchases are made.
The fourth step is to determine what propor-
tion of your exposure you feel comfortable hedg-
ing. Perhaps it could be 30, 40, or 50 percent
depending on recent volatility. if you are hedging
for a fixed supply contract it could be for 100
percent of the contract to ensure that your costs
and margins are fully protected.
The fifth step is to make a deci-
sion on what types of hedging tools
your company is comfortable using.
The most basic product is the
plain fixed forward. This is a con-
tract to exchange currency on a spe-
cific date at the difference between
today’s spot exchange rate and the
interest rate differential for the time
period (for example, lock into buy-
ing euros at 1.30 in six months and
selling usd on that date).
a variation is a forward window
contract, which gives a company
the ability to hedge a period of
time—30 days, for example—as
an alternative to the basic forward
contract (hedging to one date in
the future). a plain fixed forward is
a good tool for a 12-month supply
contract, but it does not give you an
opportunity to participate in any positive
movement of the currency in question.
Alternatives to Consider
as with most things in life, a variety of approach-
es may deliver the best result. other alternatives
include options such as
calls, collars,
and
puts
.
a call option, often simply labeled a “call,”
is a financial contract between two parties, the
buyer and the seller of this type of option. The
buyer of the call option has the right, but not
the obligation, to buy an agreed quantity of a
particular commodity or financial instrument
(the “underlying”) from the seller of the option
at a certain time (the “expiration date”) for
a certain price (the “strike price”). The seller
(or “writer”) is obligated to sell the commod-
ity or financial instrument should the buyer
so decide. The buyer pays a cash fee (called a
“premium”) for this right.
a “put” or “put option” is a contract between
two parties to exchange an asset, the underlying,
at a specified price, the strike, by a predetermined
expiry or maturity.The buyer of the put has the
right, but not an obligation, to sell the asset at the
strike price by the future date, while the seller has
the obligation to buy the asset at the strike price if
the buyer exercises the option.The buyer pays a
premium for this right.
This is a type of insurance but some compa-
nies do not want to spend cash for the product.
approximately 50 percent of
all corporations use options to
hedge fx exposures. forty-six
percent of those prefer to use
zero-cost structures, rather
than the cash premium put and
call examples above, to buy a
“range of values” without pay-
ing cash up front.
one option product with
zero cost is a “collar,” which
provides protection from ad-
verse exchange rate movements
and participation in beneficial
movements within a “specified
range.”Worst-case and best-case
scenarios are known up front.
for example, buy euro call
protection at 1.30 and sell euro
put upside at 1.20 for zero cost.
in this case your transactions
can be no better or worse than
the range of 1.20 to 1.30.
a second option product with zero cost is a
participating forward, which provides protection
at a given level and partial participation in favor-
able market moves. Worst case is known up front
(for example, buy euro call at 1.30 with 50 percent
downside participation below 1.30 for zero cost).
a third option product with zero cost is a
forward extra, which provides 100-percent
protection at a given level, with the ability to
participate on a one-to-one basis in favorable
market moves down to a barrier. should the
barrier be triggered, your company will be
locked into a penalty protection level. so you
get the good news up to a certain point, and
then the bank moves you back to a rate where
you have an unfavorable rate.
a sophisticated bank can offer 20-plus option
products, but the best advice is to stick to the
basics until you have a good track record.
Choose Your Partners
you are much better off working with a major
money center bank if you are buying or selling
“
AS WITH
MOST THINGS
IN LIFE, A
VARIETY OF
APPROACHES
MAY DELIVER
THE BEST
RESULT.
”
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