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Continuing Education: FX Management

Risk analysis
An FX Risk
Five considerations for judging your
company's FX Risk.
Whil e most multinational companies
face for eign exchange risks, few under-
stand all the considerations that need
to be weighed in order to manage them
ef fectively. Th ese cons id er at i o ns
include: (1) the materi ality of the risks
to the company' s P&L; (2) the econom-
ic nature of the exposures; (3) opera-
tional considerations; (4) competitor
considerations; and (5) the company's
primary business obj ectives.
Materiality: The materiality of the
risks is clearl y something that must be
viewed against the forei gn currency
flows and in proportion to each indi-
vidual company's P&L. For exampl e,
what is the probability of an exposure
causing financial distress?
Generall y speaki ng, t he greater the
size and number of material ri sks, the
Economic Nature
more attention should be paid, and
resources devoted, to managing t hem.
Conversely, no time should be wasted
on de minimis ri sks.
Economic nature: Equ all y funda-
mental, but less company specific, is
the economi c nature of a company's
business act iviti es. Periodi call y, trea-
sury needs to take a step back and
view their FX management activi ti es
in this context. Some sampl e cate-
gories are shown in the chart below.
A company's economi c nature rela-
tive to t hese categories may not be
static. Thus, treasurers should reexam-
ine their company's economi c nature
w henev er it undergoes si gnifi ca nt
transformat ions-e.g., major foreign
acqui sit ions or asset sales.
Expansion may al so cause compa-
ni es to move from hav ing primarily
local operations to becoming complex
multinationals. As compan ies become
more compl ex, the FX risk in the oper-
ating margins their t reas uri es must
mi t i gate becomes progressively
greater, requiring greater attention to
FX risk management , polici es, and
Operational considerations: Whil e
FX risk can be effi c i ently mitigated
w ith f inancial instruments, it i s often
better to ex haust internal hedg ing
mechanisms f irst. These include:
netting of exposures within group
legal entiti es;
creating offsetting FX exposures in
different legal entiti es via leading and
lagging, foreign currency funding, and
cash posit i on to reduce outstanding
net exposures;
integrat ing FX risk w ith business
considerations for currency of billing
and currency of payment decisions.
Competitor considerations: It is not
always the first reason to manage FX
pos it ions, but cu rrency management
can be a source of competiti ve advan-
tage. Better foreign exchange manage-
ment-simil ar to a low-cost producer
strategy- gives compani es a greater
ab ility to maintain th eir market ing
st r ateg i es in t he face of advers e
exchange rate moves.
The currency advantages/di sadvan-
tages are not always as they appear at
f irst gl ance. Th e cl ass i c examp l e is
t hat of a single-country US exporter,
competing against a Japanese single
country exporter . At first glance, t he
\Local-in-l ocal
Revenues Expenses
Local cu rrency Local currency
Single-country Multicurrency US dollars
global exporters
Si mpl e
US doll ars Mul t icurrency
Multi currency Mul t icurrency
Self-conta ined local units with
li tt le cross-border activity
Campbell Soup
Doll ar costs represent efforts to Merck
develop and manufacture prod- Caterpill ar
ucts sold worldwide on a non-
doll ar basis
Multi currency costs to extract
product worldwide sold worl d-
wide on a doll ar-price basis, even
if denominated in local currency
Products sourced and sold on a
multi currency basis
!Johnson & j ohnson
General Motors
_....._ _____ _... ____ ---- ____ __,..__ ______ _J
Source: Greenwich Treasury Advisors
Intern ational Treasurer/ March 6, 1995
US exporter , oper at in g out of a
weaker doll ar currency environment
would appear to have the currency
Yet, it it is the j apanese exporter that
often had the advantage: With the
g1eater pu1chas ing power of the Yen,
it was abl e to purchase dollar-based
industri al commoditi es more cheaply
relative to its US competitor. Its local
costs rel ati vel y hi gher, the j apanese
company also was forced to become
a more effi ci ent producer. The US
company on the other hand may have
been lull ed into inert ia, perhaps in
part by its seeming currency advan-
Obv i ousl y, t hi s i s a simplified
exampl e and analyzing the competi-
tive impacts of currency positions is
much more campi i cated. U su all y,
such analysi s involves looking at the
sourcing and siting and other FX cost
structure specif ics for components or
products in a given industry and then
determining the component/product
mi x of competitors.
Management's business objectives:
Thi s is an important considerat ion in
determining how a company wishes
to hedge. Most publicly-held compa-
ni es in the US, for exampl e, have the
primary objective of maximizing
reported earnings according to their
GAAP P&L. One result is a tendency
to determine hedging strategies and
inst ruments on t he bas i s of their
accounting treatment.
Accounting treatment aod obje.c- _
tive considerations can also come
into play with competitor considera-
tions. Compan ies with simil ar eco-
nomi c exposures may have different
business obj ect ives; fo r exampl e, 1
one may be managing for long-term ,
growth whil e another's goal may be
improv ing short -t erm earnings per
This framework has been adapted from
one used by Greenwich Treasury
Advisors to evaluate its clients' FX risks.
International Treasurer/ March 6, 1995
Option contracts
Putting Your Eggs
in One Basket
Basket options are a popular concept,
but some corporates prefer having
more than one option when managing
a portfolio of different risks.
Th e conceptua l appea l of basket
options is that they harness the diversi-
fication effects of a portfolio of expo-
sures and red uce the cost of opt ion
coverage by using a si ngle optioQ_con-
tract: a basket option. Thus, using a
basket option becomes a low-cost way
for central ized ri sk management pro-
grams to hedge the domestic value of a
basket of currency or other exposures.
Grouping negatives
The reduct ion in cost- compared to a
basket of options hedging each expo-
su re independentl y- is achi eved by
construct ing a portfo li o of exposures
that are imperfectly or negatively cor-
related (see table belowL and hedging
this portfolio with a single option that
i s tailored to eac h of th e portfolio
components (e.g. FX exposures) . It is
Derivative Instruments
this negative correl ation between the
exposure components that reduces the
overall vol ati lity of the portfol io and
thus the price of the option hedge.
As Stephen Godfrey from Bank of
America' s FX advisory group notes in
the latest issue of its Currency Review,
these cost savings come at the cost of
upside potential. Because the value of
the option, and upside parti cipation, is
linked to the va lue of the underlying
portfolio or basket as a whol e, some of
the upside potential of any component
of the portfolio is given up.
Thus, basket options are not the best
vehicle for profiting on currency views
through active management-i.e., a
basket option is designed to appeal to
the cost-center rather than the profit-
center mentality.
One-stop shopping
As Demetri Papacostas, w it h Chase
Manhattan's options group notes, bas-
ket options make a lot of sense for
clients who say " I spend X amount of
doll ars every year on option premiums
and I would like that X amount to be
l ess ." As he describes t hem, basket
options allow a corporate to take
advantage of thei r existi ng underl ying
exposures- e.g. to un correl ated
continued on back page
Correlation Positions Diversification Basket option pri ce generaiiY:l
Hi gh pos itive
(valUes near +1 )
Hi gh posit ive
(va lues near +1 )
Low positi ve,
Low negat ive
(va lues between
.5 and -.5)
All long 01
a ll short
Some long and
some short
All long or
a ll short
Hi gh
Hi gh
Hi gh negative All long or Hi gh
(values around -1 ) a ll short
Hi gh negat ive Some long and Low
(values around -1 ) some short
Source: Bank of America Currency Review, March 7995
Close to a basket of options
Tnot mud1 cost savi ngs)
Cheaper tha n a basket of
I options (substantia l cost savings)
Cheaper than a basket of
options (substanti al cost savi ngs)
Cheaper than a basket of
options (substant ia l cost savings)
c lose to a basket of opt ions
(not muc h cost savings)