75
`
`Hedging Foreign Exchange Risk]
`How Does it Work in Practice<
`
`Nathan L. Joseph
`
`DURING THE LAST TWO DECADES, there has been rapid
`
`growth in the use of financial hedging instruments
`(derivatives) by firms.* The growth in the use of fin-
`ancial instruments has been attributed to the increase
`in the degree of global involvement of firms and the
`greater volatility of foreign exchange (FX) and interest
`rates, and commodity prices. Firms tend to use fin-
`ancial instruments to hedge their strategic exposure.10
`Strategic exposure can be taken to encompass all
`types of exposures.† It reflects the extent to which the
`firm’s value and therefore the present value of its
`future cash flow, is likely to be affected by changes in
`FX and interest rates, and commodity prices.24 Since
`managers may have different perceptions regarding
`the impact of financial price changes on the firm’s
`value, they are likely to hedge exposure for different
`reasons.
`The use of derivatives in corporate hedging
`decision has not always resulted in the expected
`(favourable) impact on the firm’s value. Yet, sub-
`
`* There has also been rapid growth in the types of financial
`instruments that are used for hedging. The volume of trade for
`individual instruments is also substantial. For example, in a nor-
`mal day, the volume of FX contracts associated with hedging
`‘‘genuine trade’’, e.g., exports and imports, in London is about
`2% of the U.K.’s gross domestic product (Sunday Times, 20th
`September, 1992).
`† The literature has traditionally identified three types of
`exposures. These are: (i) translation/accounting or balance sheet
`exposure; (ii) economic exposure; and, (iii) transaction exposure.
`Translation exposure arises because of the need to consolidate
`the accounts of the subsidiaries and other operations of the par-
`ent company at the year end for financial reporting purposes,
`while economic exposure arises because of the potential impact
`of FX rate changes on all future cash flows. Transaction exposure
`is part of economic exposure except that it arises in the immediate
`short-term. Strategic exposure encompasses long-term econ-
`omic exposure and focuses on all the operations of the firm.9,24
`
`\
`
`Pergamon
`
`PII: S0024–6301(99)00127–7
`
`This article presents a brief discussion of the
`motives for hedging strategic exposure and
`relates the theoretical work to a practical
`situation. The theory suggests that strategic
`exposure management can have a favourable
`impact on the firm’s value. In practice, firms
`may pursue a limited number of hedging
`motives and the organisational arrangements
`within firms can have important impacts on the
`extent to which specified hedging motives can be
`pursued. © 1999 Elsevier Science Ltd. All rights
`reserved
`
`stantial economic losses can be incurred if the poten-
`tial impact of FX risk is ignored.‡ There is generally a
`strong view among both finance managers and market
`analysts
`that FX exposure should be hedged.
`However, some executives have expressed concerns
`about the amount of time corporate treasury staff
`devote to hedging activities.7
`Indeed, risk man-
`agement is seen as one of the most important financial
`decisions facing executives.24 It has important impli-
`cations for the global competitiveness of firms.9
`The academic literature lacks both a practical
`
`‡ Laker Airways and Metallgesellschaft are two notable exam-
`ples of firms which pursued distinctly different corporate hedging
`strategies that resulted in substantial economic losses. Laker Air-
`ways was exposed to the volatility of the U.S. dollar but pursued
`a no hedge strategy. This resulted in significant economic losses
`and default on loans which in 1981 was over U.S.$400 million.25
`In contrast, Metallgesellschaft’s use of futures and swaps to
`hedge oil contracts resulted in losses of over U.S.$1 billion and
`the need for an emergency line of credit (Financial Times, 16th
`November, 1994).
`
`Long Range Planning, Vol. 32, No. 1, pp. 75 to 80, 1999
`© 1999 Elsevier Science Ltd. All rights reserved
`Printed in Great Britain
`0024–6301/99 $—see front matter
`
`GAIN CAPITAL - EXHIBIT 1022
`
`

`

`76
`
`implementing corporate hedging
`framework for
`decisions and clarity about the potential impact of
`hedging* on the firm’s value. This problem can be
`partly attributed to a general lack of understanding of
`exactly how exposure is measured within firms and
`the strategies firms pursue in practical hedging situ-
`ations. For example, a firm may restructure its balance
`sheet as well as utilise hedging instruments to manage
`its exposure. The decision variables considered by
`the firm for such hedging actions are not readily
`observed by external parties. Yet, when researchers
`attempt to measure the firm’s exposure, they usually
`proceed by testing the sensitivity of the firm’s stock
`returns to FX rate changes.13 It is not clear whether the
`results obtained by researches necessarily indicate
`exposure or lack of exposure, nor, successful or
`unsuccessful hedging strategies†. It may well be that
`stock prices do not capture the short-term impact of
`hedging. Despite the fact that most firms hedge, there
`is insufficient empirical evidence to suggest that FX
`risk is priced in the stock market.11
`This article reviews the theoretical work on cor-
`porate hedging motives and employs a case study to
`illustrate the extent to which the issues considered
`are applied in a specific firm. We use this approach
`for the following reasons. Firstly, we want to link the
`theoretical work with exposure management practice
`in order to identify areas of agreement. Also, by
`addressing the risk management problem from the
`perspective of both stakeholders and the firm, we
`hope to identify potential areas of conflict. In practice,
`we known very little about the hedging activities of
`shareholders.
`Secondly, we hope that our evaluation of current
`research will generate some debate among both aca-
`demics and practitioners so that a better framework
`for addressing the corporate hedging problem can be
`adopted. We believe that both accountants and fin-
`ance managers have important roles to play in this
`context because of their familiarity with the financial
`(exposure)
`reports used in corporate hedging
`decisions. Indeed, up to 74% of U.K. treasury man-
`agers have been shown to have had previous occu-
`pations either as finance managers or as professional
`accountants.12 We hope therefore that our review and
`
`* Froot et al. assert:8 ‘‘finance theory does a good job of instruct-
`ing firms on the implementation of hedges . . . Unfortunately, fin-
`ance theory has had much less clear cut guidance to offer on the
`logically prior questions of hedging strategy’’.
`† On failing to find a significant contemporaneous relationship
`between abnormal stock returns and FX rate changes, Bartov and
`Bodnar concluded that investors do not use all freely available
`information to predict the firm’s future value in terms of changes
`in FX rates.3 In contrast, Cassidy et al. used ‘‘event study’’ meth-
`odologies to show that investors respond positively to news
`about the expansion of the risk management departments of U.S.
`(insurance) firms,5 implying that investors value firm-specific risk
`management activities.
`
`Hedging Foreign Exchange Risk
`
`discussion will shed further light on the problems of
`hedging strategy. We do not suggest that the exposure
`management practices of the firm which we will con-
`sider are the same for all other firms.
`
`Theoretical Considerations
`The traditional arguments against corporate hedging
`largely reflect Modigliani and Miller’s (M&M’s) irrel-
`evance proposition22 and modern portfolio theory
`(MPT). While M&M’s proposition suggests that fin-
`ancial policy is irrelevant where there are no taxes
`and no transaction costs, etc., MPT suggests that if FX
`risk is unsystematic, it can be diversified by investors.
`The motives for hedging are briefly discussed below
`under broad sub-headings. To keep this article to a
`reasonable length, we have cited the main theoretical
`studies.
`
`Home-Made Hedging
`Following the implications of M&M’s work, share-
`holders can obtain home-made hedging, thereby mak-
`ing hedging by the firm irrelevant. This means that
`every investor would be able to hedge his/her own
`exposure in the firm at the same (or lower) cost as the
`firm. However, market-based hedging instruments are
`traded in minimum sizes which are too large to be
`used by ordinary investors. The initial margin
`requirements and daily settlement arrangements of
`the futures markets can also cause substantial cash
`flow and liquidity problems for investors. Further-
`more, investors may be unable to determine the firm’s
`exposure through the use of published financial
`reports, unless the firm’s exposure to FX risk is
`reflected in its share price.
`
`Risk Diversification
`The arguments based on MPT assert that unsystematic
`risks are diversifiable and only systematic risk
`matters. Investors would therefore only be concerned
`about the additional risk that an asset or liability con-
`tributes to their (already) efficiently diversified port-
`folios. The reason is that in efficient capital markets,
`corporate hedging is redundant since shareholders
`can diversify the FX risk at the same (or lower) cost
`as the firm. Whether or not FX risk is systematic or
`unsystematic the firm’s value should not be affected
`since
`the
`stock market would have
`already
`impounded the FX risk into its share price.16 The
`literature also suggests that investors can reduce the
`risk of their domestic portfolios by investing in fore-
`ign securities. However, there are problems in gaining
`access to foreign stock markets and in dealing with
`the risks associated with foreign investments.14
`
`

`

`77
`
`Risk Aversion
`Stulz argues that while external shareholders can
`diversify their risk, the firm’s managers can protect
`their own wealth more cheaply by hedging the firm’s
`value.29 Hedging also increases the firm’s value by
`reducing the amount of compensation required by
`managers, employees, suppliers and customers for
`bearing non-diversifiable risk. If hedging is costly,
`shareholders can devise managerial compensation
`plans which discourage corporate hedging.29 To be
`effective, shareholders would have to devise com-
`pensation plans which incorporate incentives to
`attain the desired effect.17
`
`Information Asymmetry
`If firms hedge to improve the information content
`of earnings as a signal about managerial ability and
`product quality, then hedging is the equilibrium pol-
`icy since managers have more information about the
`sources and magnitude of the firm’s risk.6 As man-
`agers have more accurate expectations about the
`firm’s exposure than shareholders,2 the maximisation
`of managers’ expectations would also maximise the
`firm’s value. Mello et al. also demonstrate19 that the
`firm’s value will be maximised if the firm’s pro-
`duction plans depend on the firm’s hedging strategy.
`
`Taxation
`The firm will also have an incentive to hedge the more
`convex the tax schedule and the more volatile the
`firm’s before tax earnings.26 Tax preference items can
`also cause the tax schedule to become (more) convex.
`Hedging is therefore likely to reduce the variability of
`the firm’s profits as well as the probability that the
`firm will encounter financial distress. Stakeholders
`would benefit economically since hedging is likely to
`reduce
`the probability
`that
`the firm incurs
`bankruptcy,26 reorganisation or social costs. Fol-
`lowing the capital asset pricing model (CAPM), a
`reduction in the variability of the firm’s returns while
`leaving their expected level unchanged, should have
`little or no effect on the firm’s value. Further, if for-
`ward contracts are priced according to the CAPM and
`FX risk is systematic, hedging would only move the
`firm along the security market line without any
`accompanying increase in its value.
`
`Agency Costs
`Corporate hedging can reduce the potential for the
`redistribution of wealth from shareholders to bond-
`holders if it makes the firm less risky.23 Here, hedging
`would appear to reduce the agency problem by reduc-
`ing the variability of the firm’s cash flows. Smith and
`Warner argue that the agency problem can also be
`reduced by issuing convertible debts rather than
`straight debts.27 Bessembinder shows that hedging
`reduces the incentive to under-invest by reducing the
`sensitivity of high priority claims on the benefits of
`
`incremental investments.4 Hedging is only irrelevant
`when financial markets are integrated and investors
`are homogeneous.21 The inclusion in the general
`model of differentials in taxation, inflation and inter-
`est rates results in value-maximising decisions where
`financing and investment decisions are independent
`and corporate hedging has value. Thus it is suggested
`that hedging is desirable since it lowers the external
`financing costs which are associated with capital mar-
`ket imperfections.8
`
`Other Considerations
`On the assumption that the firm hedges, the full ben-
`efit of hedging would only arise if exposure man-
`agement policy was implemented on a global basis.
`Most normative models argue for a centralised rather
`than
`a
`decentralised
`treasury management
`function.1,28 However, centralisation is likely to lead
`to a loss of initiative by subsidiary managers since it
`can affect performance evaluation criteria. Melumad
`and Reichelstein’s model suggests20 that the firm can
`exploit information for decision making if it elicits
`information from its subsidiaries or delegates infor-
`mation to them. However, given the high degree of
`uncertainty in global markets, there are still likely to
`be significant problems of operation control.
`
`Exposure Management Practice:
`A Case Study
`Background
`X incorporated is a U.S. multinational corporation
`with an annual turnover of about U.S.$6 billion. X
`manufactures computer and electronic office equip-
`ment in the U.S. and three European countries. Its
`products are sold in over 100 countries. European
`sales account for over 60% of the firm’s annual turn-
`over. The industry in which X operates is research
`intensive and very competitive. X has fully-owned
`subsidiaries in over 20 foreign countries. The prod-
`ucts for sale are imported from the manufacturing
`units. The sales units/subsidiaries have responsi-
`bility for marketing and distribution. Imports are gen-
`erally priced in U.S. dollars and sold in local
`currencies. The local costs of subsidiaries and other
`operating units, include administration, salaries and
`wages, distribution and marketing.
`
`Treasury Centralisation and Corporate
`Hedging Strategy
`During the early 1980’s, X established a centralised
`treasury function with responsibility for implement-
`ing its hedging policy. X’s corporate hedging policy
`was formalised.
`It specified that both economic
`(including transaction) and accounting/balance sheet
`exposure should be hedged. The motive for hedging
`was to reduce the impact of FX rate fluctuations on
`
`Long Range Planning Vol. 32
`
`January 1999
`
`

`

`78
`
`X’s market value, thereby ensuring that U.S. share-
`holders’ wealth would not be adversely affect by FX
`rate changes. Specific clientele effect* considerations
`in hedging policy were ignored as were con-
`siderations related to minority interest, and the wel-
`fare (and knowledge-based skills) of employers and
`employees. X’s managers were very certain that their
`main concern was the potential impact of FX fluc-
`tuations on the wealth of U.S. shareholders at large.
`This view was documented in the firm’s FX policy
`manual and was supported with illustrations of the
`potential value which could be added to share-
`holders’ wealth if the hedging policy which was put
`forward was followed. It was believed that the man-
`agement of all FX risk would provide added value to
`shareholders. Consequently, all FX exposures which
`were identified were hedged against the U.S. dollar.
`X’s accounting exposure was defined as the projected
`net financial asset, i.e., current assets less all liabil-
`ities, over the identified exposure horizon. Financial
`distress and agency costs were very minor con-
`siderations in hedging decisions since X had sub-
`stantial liquid cash. Also, little consideration was
`given to the possibility that customers were likely to
`demand more substantial guarantees for X’s products
`due to the potential impact of FX risk. Interestingly,
`the products supplied often included associated ser-
`vice contracts for periods in excess of three years. The
`FX policy of X was noted in the published accounts
`and gains/losses were reported in accordance with
`FASB No. 52.
`
`Reporting Procedures and Policy
`Implementation
`The identification of X’s main hedging motive also
`required establishing set procedures to ensure that the
`FX policy was followed. This meant that the corporate
`treasury function had to establish standard formats
`for reporting exposures and procedures for ident-
`ifying those items which should appear in the
`exposure reports. Where appropriate, a forecast
`income statement and balance sheet were submitted
`by each subsidiary/operating unit. These were sub-
`mitted on a monthly basis. Dividend and royalty pay-
`ments to the parent were also included in the income
`statement and inter-affiliate merchandise payments
`and receipts were reported separately within the
`groups’ inter-company netting system. All exposure
`reports were submitted to the centralised corporate
`treasury function in order
`to hedge X’s global
`exposure. Exposures which unexpectedly arose
`between reporting periods were also reported to the
`
`corporate treasury function for immediate action, if
`they were significant. In addition, the corporate tre-
`asury function regularly evaluated the exposure mea-
`sures and corporate hedging policies and strategy,
`in order to accommodate changes in X’s competitive
`position. This included the use of both regression and
`correlation analyses. The regression coefficients were
`used as indicators of the sensitivity of the exposures
`of subsidiaries or operating units to FX rate changes.
`The statistical results often provided support for
`hedging. Where the currencies were found to be
`highly correlated, the exposures for those operating
`units were hedged on a consolidated basis, in a selec-
`tive manner.
`X typically used 3-months FX forward contracts to
`hedge FX exposures. FX contracts of shorter maturit-
`ies were used only when the cash flow from the under-
`lying exposure or related exposure was certain.
`Conversely, FX forward contracts of longer maturities
`(6-months or more) were avoided because of the gre-
`ater uncertainty of the cash flows from the exposure
`and the potential for greater divergence between the
`forward rates of longer maturities and the realised
`spot rate†. Both aspects were likely to increase the
`variance of X’s cash flow and adversely affect liquid-
`ity. Thus there was a strong preference for rolling over
`shorter maturities since this reduced the degree of
`uncertainty in cash flow.
`
`Corporation Tax and Other Implications
`Finance theory emphasises a very important role for
`hedging when the firm’s tax schedule is not constant
`and income is volatile. Tax is therefore identified as
`a motive for hedging. In the case of X, the tax dif-
`ferentials of various countries and differences in the
`profitability of operating units would imply that tax-
`ation would be an important consideration in its
`hedging strategy. However, the tax issues which were
`considered by X seem to follow primarily from the
`consequences of hedging. Indeed, taxation did not
`initiate hedging but became important when the
`decision to hedge was made. X’s approach was to
`consider tax-related issues on a case-by-case basis.
`The U.S. tax code required the predetermination of
`ordinary and capital FX transactions at the inception
`of the FX contract. This created significant problems
`in tax planning and limited the ability of X to offset
`certain capital gains and losses. The rules which
`determine how losses can be carried forward or back-
`ward also impeded efficient tax planning. X often
`avoided hedging exposures where section 1256 rules
`applied. The U.S. inland revenue code 1256 applies
`to certain broad-based hedging instruments including
`
`* In a related case study, Lewent and Kearney15 also suggested
`that it was difficult to incorporate clientele effect considerations
`into hedging policy because of the diverse hedging requirements
`of shareholders.
`
`† The economic loss and liquidity problems of Metallgesell-
`schaft18 have been partly attributed to the mismatch between the
`futures maturity structure and the cash flow at delivery.
`
`Hedging Foreign Exchange Risk
`
`

`

`79
`
`FX contracts which are denominated in certain cur-
`rencies. When applying the rules, section 1256 con-
`tracts have to be marked-to-market at the end of each
`financial year and the gains or losses arising from
`those contracts have to be treated as 60% long-term
`and 40% short-term capital gains or losses. The exis-
`tence of section 1256 contracts, introduced further
`uncertainty into X’s tax planning. The difficulties of
`determining the tax consequences of hedging
`decisions meant that certain hedging strategies were
`not implemented consistently. As there were dif-
`ficulties in tax planning,
`local managers’ views
`regarding the impact of tax on hedging strategy were
`not always consistent with that of the corporate tre-
`asury function. In certain situations, the tax effect was
`unfavourable since it was included in managers local
`performance measures and incentive schemes. Inter-
`estingly, it turned out that the overall tax burden of X
`was often greater than those of its competitors.
`Although X hedged most of its exposures internally,
`the balance of the exposures which were hedged in
`the FX market was still substantial. For example, the
`total value of FX forward contracts for the first eight
`months of 1992 was U.S.$3.2 billion. X’s strategy was
`to hedge all exposures in excess of U.S.$2 million but
`there was some flexibility in the way this policy was
`applied. Since balance sheet exposures do not gen-
`erate underlying cash flows, X’s accumulated trans-
`lation adjustment (ATA) account exhibited FX loss of
`several million U.S. dollars during the late 1980’s and
`early 1990’s*. The problem was exacerbated by ad
`hoc tax-effecting strategies. The significant loss on
`the ATA account was of serious concern to corporate
`managers. There were occasions when corporate tre-
`asury raised the threshold at which balance sheet
`exposure was hedged in an attempt to avoid the
`impact of the premium/discount when settling FX
`forward contracts. As expected, the strategy of hedg-
`ing accounting exposure reduced the volatility on the
`reserves account at the expense of increased volatility
`on the firm’s overall cash flow.
`The form of exposure reporting also appeared to
`have had a significant impact on the corporate hedg-
`ing strategy. The local managers of subsidiaries had
`full responsibility for identifying and reporting local
`exposures. They were allowed to identify exposures
`over the time horizons they considered appropriate
`for their individual operations. For example, one
`manufacturing subsidiary identified exposure over a
`15-month period, but exposure horizons of 6- or 12-
`months were the norm, irrespective of the nature of
`the unit’s operations. Since local managers had full
`
`* It is worth noting that when accounting exposure is hedged,
`the gain or loss on the FX contract does not exactly offset the
`loss or gain on the exposure because of the premium or discount
`on the forward contract.
`
`responsibility for identifying exposure and FX gains
`or losses were incorporated in their performance mea-
`sures, the amount of exposure reported often reflected
`their views about developments in the FX market.
`Thus, local managers sometimes reported a lower
`(higher) level of exposure based on their expectation
`of changes in FX rates. Indeed, since the amount of
`exposure and its nature were determined locally, it is
`possible that X was not always fully hedged.
`
`Conclusion
`This article has focused on two important aspects; (i)
`the
`theoretical motives
`for hedging
`strategic
`exposure; and, (ii) the relevance of corporate hedging
`motives in practice. The theoretical section of the
`article focused on the reasons why firms may hedge.
`As many of the motives for hedging are interrelated,
`it is possible that a firm would focus on one or two
`motives. The main hedging motive of X was to reduce
`the impact of the FX rate fluctuations on its future
`cash flows and net financial asset. Since X was very
`liquid, financial distress was a minor consideration
`in its hedging decisions. This behaviour is consistent
`with recent empirical work.12 The cases study also
`shows that the motive for hedging was linked with the
`desire to maximise shareholders’ wealth. The implicit
`assumption was that all X’s shareholders had the
`same degree of risk in their portfolios and that the
`managers were better informed of the firm’s exposure
`than the shareholders. In this case, the managers’ per-
`ceptions regarding shareholders’ exposure to FX risk
`and the potential impacts of changes in FX rates, were
`used to formulate X’s hedging strategy. The case study
`also illustrates the problems which can arise when
`implementing a specific hedging strategy. When
`exposure information is generated locally, it is essen-
`tial to establish an exposure strategy which does not
`adversely affect measures used to evaluate managers’
`performance. Alternatively, action should be taken to
`reduce the adverse impacts on performance-related
`measures. Otherwise local managers may pursue dys-
`functional activities. Also, the corporate hedging pol-
`icy should be applied to all the organisational units
`of the firm. Hedging policy can only be effective if all
`the organisational units agree on the hedging strategy.
`Firm’s managers also have discretion over the
`means by which information regarding hedging poli-
`cies can be communicated to various interested
`parties. This discretion can be used to signal the man-
`agers’ private information about the firm’s financial
`performance. Indeed, the case study suggests that the
`managers believed that they had more accurate infor-
`mation about the firm’s exposure than the share-
`holders. Also, they used that information to seek to
`maximise the firm’s value.2
`
`Long Range Planning Vol. 32
`
`January 1999
`
`

`

`Dr N. L. Joseph is a
`lecturer in accounting
`and finance at the Man-
`chester School of Ac-
`counting and Finance,
`University
`of Man-
`chester, U.K.
`
`80
`
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`Hedging Foreign Exchange Risk
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