When it comes to currency risk, companies are going natural. No, that doesn’t mean they’re exposing themselves completely to risk. They are forsaking derivatives for natural hedges — matching revenues and costs for the same currency or offsetting losses in one currency with gains in another.
There are two main reasons for this shift, and probably a third. One, most multinationals have centralized their treasury operations, at least on a regional basis. With access to data from intercompany and third-party transactions within the various countries in which a multinational operates, risk managers can better understand how transactions in one currency offset those in another, and thus erect natural hedges.
The second reason, closely allied with the first, is the cost of derivatives, which can become prohibitive if they are used to excess. “Some companies hedge themselves into oblivion,” observes Christos Pantzalis, an associate professor of finance at the University of South Florida. “You don’t want to run that risk,” agrees Gail Sullivan, treasurer of The Gillette Co., noting that hedging everything can lead to costs greater than those of unhedged exposures.
A third reason why companies are going natural may be the burdens associated with FAS 133, the Financial Accounting Standards Board’s three-year-old standard for accounting for derivatives. The rules require (1) that financial instruments be marked to market instead of reported at historical cost, and (2) that gains and losses on those instruments be included in earnings when they can’t be shown to effectively hedge an exposure. Moreover, FAS 133 makes it more difficult to use one derivative instrument to offset another. Merely conducting the tests required to determine a hedge’s effectiveness can eat up lots of time and money, as reflected in FASB’s implementation guidelines, which run several hundred pages.
It’s not clear whether companies are in fact cutting down on derivative use as a result of FAS 133, but recent studies by the Association for Financial Professionals suggests they may be doing so. What is clear is that companies can, and do, use natural hedges to greatly reduce transaction exposure — the impact of currency fluctuations on cash flows.
Natural hedges are less effective, however, at reducing translation risk — the impact of variations in exchange rates on a multinational’s reported earnings and shareholders’ equity. Such hedges aren’t available to limit the translation exposure of investments in foreign subsidiaries — but then, financial derivatives are often too costly on that front as well.
The Razor Company’s Edge
Gillette, which has some 60 percent of its sales coming from outside the United States, uses its in-house bank in Zurich to centralize and net transaction risk, according to treasurer Sullivan. The residual net transaction exposure is hedged primarily through forward contracts. As for translation risk, Gillette no longer makes much use of derivatives for managing this risk as far as earnings are concerned, says Sullivan. “Gillette’s basic policy on that is to use more of the natural types of hedging,” she says. Those hedges mainly involve pricing and sourcing policies.