Natural Performers

Companies are increasingly relying on natural hedges to juggle currency risks.

Expense and earnings volatility are Gillette’s prime considerations here. “The cost of hedging earnings [with financial instruments] on an ongoing basis is worth taking on only if you feel that the volatility that you will have in your earnings will somehow preclude you from making investments that are necessary,” says Sullivan. She notes that the company isn’t in that position.

The challenge of hedging translation risk to earnings with financial derivatives is compounded by the fact that the dollar tends to move in broad cycles against other major currencies, typically lasting five to seven years, notes Jeff Wallace, the managing partner of Greenwich Treasury Advisers, in Greenwich, Connecticut. “If one consistently hedges [revenues and expenses] in a major currency with forwards, one could have five years of losses on those forwards,” says Wallace. “And that is difficult for any corporate to keep doing.” That’s particularly true as a result of FAS 133, which makes it harder to use hedge accounting for such instruments and thus avoid having to subtract such losses from reported earnings.

At some companies, to be sure, the use of financial hedges began to decline in anticipation of FAS 133. The amount of currency forward contracts held by Procter & Gamble Co., for instance, fell by almost half during the year that ended June 30, 1999, to $1.9 billion in notional value from $3.4 billion in fiscal 1998. And their value declined by another $110 million or so in fiscal 2000. While the company chalked up much of the reduction in 1999 to the disappearance of local currencies by countries embracing the euro, P&G also cited in its 10-K for that year “increased efficiencies in our hedge program.” The company attributed the decline in 2000 exclusively to better hedging as a result of centralization. (It should be noted that P&G suffered a huge hit in the early 1990s from a bad derivatives bet, which helped prompt FASB to produce FAS 133 in the first place.)

Still, experts say other companies have become better hedgers as a result of FAS 133. “There is less [financial] hedging, but better hedging,” asserts Wallace.

Consider, for instance, Movado Group, Inc., which is based in the United States but designs, manufactures, and distributes watches in Switzerland. With many of its costs incurred in Swiss francs, the company hedges that exposure through a combination of forward contracts, purchased currency options, and spot purchases. But according to its treasurer, Frank Kimick, Movado also uses natural hedges whenever possible. And while he notes that some companies are still quick to eliminate natural hedges if they believe a currency is going to move in their favor, “I always prefer to take advantage of them,” he says.

Losing Balance

Neither centralization nor natural hedges, however, can insulate corporate balance sheets from currency exposure. Consider Gillette’s experience before the U.S. dollar began falling in value last year. The currency-driven decline in the value of its investments in foreign subsidiaries took a significant toll on its shareholder equity from 1997 through 2001, when the dollar was gaining value against many foreign currencies. During that period, Gillette’s shareholder equity fell 54 percent, from $4.8 billion to $2.1 billion. And 20 percent of that was the result of losses from foreign-currency translation.

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