How and why companies hedge foreign currency risk depends on factors such as the industry, risk management acumen and management team perspective. But most public corporations do hedge their FX risk for one reason or another.
Here are ten common reasons why companies hedge foreign currency risk:
Reason #1: Market Place Punishes Surprises
Many hedge programs exist to save the CFO & CEO from explaining currency impacts during earnings calls. Stakeholders will penalize companies that haven’t hedged away foreign currency gains and losses. A lack of control of currency fluctuations on operations reflects poorly on the management team. Even when companies explain results with year over year comparisons, the analysts still expect management to meet their operating numbers. There is even less sympathy for companies that miss earnings per share (EPS) estimates associated with remeasurment losses, even when they are reported below the operating margin line.
Reason #2: Protect Margins
Companies need to protect margin percent and margin dollars when revenues and expenses are denominated in different currencies. Contract manufacturers, retailers and other tight margin businesses absolutely need margin protection in order to stay profitable. Foreign currencies can (and do) move more than their tight profit margins can afford. With little room for error, companies in these spaces are typically more in tune with currency risk exposures and manage/hedge appropriately to protect their margins.
Reason #3: Board Demands
Board members with experience at larger or more sophisticated companies will frequently introduce the benefits of hedging to their fellow Board members and management. Occasionally this precedes an FX surprise, but if not will generally follow quickly on the heels of one. While the Board may mandate the need for a currency hedge program, executing the appropriate hedge strategy falls to corporate Treasury. Treasury teams at “non-hedging” companies would benefit from a proactive approach to hedging in order to have more time to evaluate the Company’s currency risk profile and hedging strategies. Waiting until the Board addresses surprise gains (or unfortunate losses) can result in hasty decisions and rushed hedge program implementations in reaction to the Board’s demand for currency risk management.
Reason #4: Certainty of Results
Many bonus plans drive management to ensure a particular outcome relative to a budget or forecast. These companies hedge to add certainty around what USD value they will report foreign revenues and/or expenses.
For example, if revenues are in dollars but expenses are denominated in foreign currencies over the next 12 months, management may choose to lock down the USD value of that spend with a derivative to deliver the budgeted results.
Reason #5: Compete With Peer Groups
Senior management often look to industry peers for reinforcement of ideas and strategies that work. So, when it’s the norm to hedge in an industry, you see new industry participants following suit.
Some companies consider hedging a competitive advantage. This foresight allows the company to plan and deliver results when peers are reacting to the latest rate swing. Competitors will note (or analysts will point out) the benefits enjoyed by peers that hedge.
Companies should be very careful when implementing a hedge program to stay current with the competition and ensure a thorough understanding of their own risk profile before implementing a hedge program. There are many different currency hedge strategies and objectives even for similar exposure types. What might work for one company may be unsuited for another.
Reason #6: Provide Time to Pivot
Some companies hedge anticipated transactions to give them time to pivot. The farther out a company hedges, the longer the delay before they experience changes in currency rates. Hedging out 12 months each month means that the rate experienced in the market today will not impact earnings for 12 months.
For example, if operating expenses are hedged out 12 months and the Company sees currencies strengthening, they have 12 months to plan for changes to bring those expenses in line with USD revenue. If the Company has a relatively strong hedge rate for foreign revenues, then the Company has time before needing to raise foreign prices to meet margin targets and can plan for that eventuality.
Reason #7: Smarter than the market
A few companies execute hedge strategies to take advantage of perceived beneficial rates in the market. When companies find revenue currencies particularly strong (e,g, EUR at 1.45) or expense currencies particularly weak (e.g. CNY at 7.18) they may choose to lock in the rate. Unfortunately, it is difficult to predictably identify currency highs and lows. A better strategy is to stay the course and apply the hedge program systematically regardless of rate change expectations.
Reason #8: Smooth Rates
Companies will often hedge to “smooth” or “average in” currency rate impacts. Without these hedges, all activity in a month is recorded at the “current” rate. If 100 percent of a company’s revenue is booked in foreign currency between November and December, management may not be willing to wait and see where the accounting rates land. These companies will layer in hedges to achieve a desired amount of averaging so exchange rate impacts are muted. It also allows the business to budget more effectively given they know the average exchange rate for a large percentage of future revenue.
Reason #9: Improve Year-Over-Year Reporting
Companies may report to analysts on a year-over-year or constant currency basis. These companies can align their hedge strategy with their year-over-year reporting. This hedge program brings GAAP results closer to pro forma results and dampens the year over year impact they would otherwise experience from currency movements.
Reason #10: Protect From Downside Risk
Some Treasurers and CFOs choose to protect their downside risk, but aren’t willing to commit to the then current rate environment. They don’t want to dampen favorable currency trends but want insurance that margins won’t go upside down due to currency rates. These companies set a ceiling on foreign expenses or a floor on foreign revenue values.
While there are many other reasons why companies hedge foreign currency risk, these are some of the most common determinants for hedging. Many companies hedge for more than one reason and to achieve several desired results. Within each category, there are multiple hedge strategies, instruments, techniques, time horizons and other factors to consider when developing a hedge program.
Do any of these reasons for hedging strike a chord with your organization? Contact us today to develop and implement a customized hedge program that works for your unique needs and accomplishes your business goals.