With such volatility in a key exchange rate — not to mention significant weakening against the Japanese yen and the expectation that China will eventually allow its currency to float again, which would result in steady and significant appreciation (see “Beyond the Eurozone” at the end of this article) — how can finance executives protect their companies from the risk in the dollar? There are multiple options that any CFO with international exposure should consider, from structuring operations and contracts to offset risk to financial hedging.
Sharing the Risk
Perhaps the most straightforward way to eliminate or reduce currency risk is to structure the business so that revenues are earned and expenses are incurred in the same currency. Then, if a company sees declining revenue due to currency shifts, it can offset some of the impact with correspondingly lower costs. “A lot of hedging is not done with derivatives,” says Campbell Harvey, a professor of international finance at Duke University’s Fuqua School of Business. Choosing where to borrow or where to source raw materials, for example, are decisions that affect the currency-risk profile of the business.
High Street Partners’s Harding counsels clients to try to take advantage of such natural hedges. “If you have expenses in pounds or euros, try to have sales in pounds or euros,” he says. “It’s the safest, cheapest way to hedge.” Indeed, many multinationals do not hedge their cash flows through complex derivative contracts but instead rely on such operational hedges.
At iRobot, a $300 million, publicly traded robotics company, CFO John Leahy is pleased to have been able to keep the majority of his sales in dollars, despite dramatically increasing the company’s European business in the past year. “We have a network of distributors in Europe, and they buy the product from us on a U.S.-dollar basis, so we’re well protected,” says Leahy. “Down the road we may get pressure to make changes, because we’ve basically pushed the foreign-exchange risk to our distributors.” For now, though, “a company our size could not take the foreign-exchange exposure,” he says.
Addressing possible currency fluctuations through contract design is another relatively simple and efficient strategy. EXL did precisely that, and today, when renewing or entering into a new contract, the company offers two different options. First, the client could agree to a fixed price within a 3%-to-5% trading band. “Within that band we absorb the risk, and outside that band we share the risk with the customer either way,” says Kapoor. If the currency shifts so that EXL stands to gain, it discounts the price; likewise, if EXL faces an outsize loss, the customer agrees to a higher price.
In the second scenario, the client can agree to a minimum amount of committed business for the three-to-five-year period of the contract. EXL will then hedge that risk using financial instruments for the life of the agreement. If the client wants to terminate the contract early, it agrees to cover the cost of unwinding the hedge.