Manufacturers and other businesses importing from or selling to countries in Europe and elsewhere all face the risk of fluctuating currency rates. Most agree that the best mitigation for this risk is to lock in contracts and work with foreign-exchange experts rather than try to become one.
John Brittain, managing director at Accordion Partners, a corporate financial-services firm, agrees with this strategy. He advises companies to “understand [their] risks first, spend [their] time focusing on where the true transactional cash-based exposures are, and utilize the foreign exchange (FX) markets, particularly the forward and options markets for hedging those risks.”
It sounds straightforward, but companies can sometimes take their eye off the ball, mistakenly adopt an improvised approach to hedging, or just convince themselves that their exposure is inconsequential.
Even if a company sells products in the U.S. domestic market only, it should be hedged. For example, retail companies that source goods internationally — from fashion retail to consumer electronics — have currency exposure relative to sourcing goods, points out Brittain. “Often you try to negotiate the currency risk on to your counterparty, but if you have to incur the FX exposure, you generally should hedge it in order to lock in the cost of your imported product for domestic sale to your customers,” he says.
Juniper Networks, a technology company that provides high-performance network infrastructure, sells its products and services primarily in U.S. dollars. But Catherine Portman, vice president of treasury, says that with a presence in 46 countries, her company is exposed to fluctuations in currency exchange rates to the extent that “we have non-U.S. operational costs, and a weakened U.S. dollar increases the cost of local operating expenses.”
The company hedges this exposure to mitigate the impact of changes in exchange rates on operating costs. She notes that the hedging instrument currently deployed by the company is forward contracts, but it has used currency options in the past.
Despite the sophisticated tools available, some companies become complacent about hedging. During the past three years (essentially the start of the euro crisis), payments firm AFEX has seen a 25%-plus uptick in forward contract volume. But when the dollar strengthened in the United States last summer, AFEX saw “a general reluctance to hedge too far out,” says Guido Schulz, executive vice president of strategic management. “There was definitely a wait-and-see attitude, and most of the CFOs were taking a somewhat relaxed view.”
Although there were more “knee-jerk reactions initially when [the] Greece [crisis] started to heat up,” says Schulz, that relaxed view has also become “the new normal” with respect to U.S. companies’ exposure in Greece and other parts of the euro zone.
AFEX’s clients, mostly importers, are getting short-term gains from buying goods at discounted prices in some areas of the euro zone. However, “it’s definitely looming in people’s minds what the impact will be if the euro zone partially collapses or if there is an orderly exit by Greece,” Schulz says. “We have definitely seen some companies looking for alternative sourcing from more stable markets.”
The companies just standing by, in the euro zone or elsewhere, are taking on a big risk. “If you know what FX conversion rate you will be paying ahead of time, then you can budget with that and strategize accordingly,” says Schulz. However, by waiting to see what the market is doing, “you open yourself up to big holes in your budget or surpluses in your budget that are not forecastable and are an element of surprise in your internal budgeting process,” he says.
Juniper Networks’s Portman says accurate forecasts are key to effective hedging, which means working closely with internal business partners. “Forecasting is key, and that’s an area where risk managers need to rely on internal teams that are responsible for forecasting and planning to fully understand the company’s FX exposures,” she says.
Understanding FX exposure is not so easy for some companies though, and that in itself can lead to large FX risks. Firms that incur FX exposure and that are not under firm contracts with either their international suppliers or customers “have no effective way to hedge that exposure based on the variable nature and timing of the underlying cash payments,” Brittain says, adding it can be difficult for companies to mitigate this risk unless they have specific contracts with clients that are not subject to termination.
“If a company has a long-term contract with an international customer or supplier, they can lock in that revenue or cost, and they can do that efficiently through the FX markets,” says Brittain. “Their business is not to take currency risk, but to buy or sell product at a profit.”
Currency-risk hedges can be built into a business model, however. Roger Moody, CFO of Nanosphere, a molecular-diagnostics company that does genetic testing, favors mitigating currency risk in Nanosphere’s global international business by employing distributors. While there are larger considerations for how Nanosphere’s products are marketed internationally, he says, “it just so happens that these considerations result in a distribution partner model and this model also happens to allow us to achieve the currency-risk benefit.”
Nanosphere sells its products to distributors in U.S. dollars, “so [FX risk] has not been nearly as large an issue for us as many other companies that operate with foreign subsidiaries,” Moody says.
The company recently entered into a distribution deal with ThermoFisher and also works with Grifols in other parts of Europe. Moody says that large, multinational distributors sell many different products from other companies as well, putting them in a good position to aggregate their various currency exposures. “This makes it easier for them to hedge or take whatever other actions they feel are necessary to mitigate their risk,” he says.
There is a downside to this approach, however. Nanosphere surrenders direct control of marketing its product in those international markets, explains Moody. “We also give up margin for the costs associated with their sales and marketing expense. So we don’t collect as much and the margins are not as high for the products we sell internationally as they are in the U.S.”
Whatever the approach to hedging, the one thing CFOs should not do is try to “game” the market, says Schulz. A lot of CFOs “think they can beat the market and generate additional revenue for the company if they do it right,” he says. “But from experience, we know that it’s very hard to beat the markets in the long term. We tell CFOs to abandon that casino mentality.”