Duke’s Harvey agrees: “I do think many companies are reexamining their hedging programs. The tricky thing is that it’s not obvious which way things are going to go.” He urges finance chiefs and corporate-risk committees to model the impact of such extreme scenarios as the breakup of the euro and to try to determine how much risk the company is willing to take.
The decision to engage in financial hedging depends not only on a company’s own risk profile but also on its competitors’ positions. “If everybody’s got hedging programs except you,” Harvey says, “you need to think seriously about putting a program in place, because it’s really going to impact your competitive situation in a volatile currency environment.”
Of course, the decision to commit to a financial hedging program is just the start. Finance executives then have to determine how much risk to hedge, for how long, and through what type of vehicle.
Wharton’s Marston outlines three common tactics. First, the CFO could put a floor on any potential losses through an option hedge, protecting the company if the euro were to sink below $1.25, for example. There is a price for such security, however — anywhere from 2% to 3% of cash flows, depending on the length of the contract. A second option is to put a so-called collar on the company’s cash flows by entering into a contract with a bank that would protect the company’s downside if the euro dropped below $1.25. In turn, the company would agree to sell the currency to the bank at a predetermined ceiling price; the bank could then turn around and sell the currency at a higher price to another buyer. In this scenario, there would be no upfront cost, but the company would give up potential future upside should the euro strengthen significantly. Finally, a CFO could lock in the company’s foreign-exchange rate by putting a forward contract on its cash flows at a certain rate; if the rate later goes up, the firm does not gain.
CFOs seem well aware of the pitfalls of hedging and are not requesting elaborate programs, says Hodzic. “The types of derivatives they want to use are quite simple,” she says. “The complex derivative products of a few years ago are gone. It’s much more about control and risk management. It’s about limiting the downside.”
For EXL’s Kapoor, that’s the entire goal. “We are agnostic about which way the dollar moves. We hedge on the basis of what contracts we have, and how much revenue and how much cost we have in a particular currency.”
Regardless of whether a CFO feels he or she can dive into the complex world of financially hedging a company’s foreign-exchange exposure, it is clear that the time is right to review currency liabilities and develop contingency plans, because the uncertainty in the dollar and its relationship with other currencies is not going away any time soon. Indeed, even Marston, who spends much of his time researching and writing about currency movements, will not hazard a guess as to the dollar’s future. “I think there’s a greater than 50% chance that the euro will weaken further, but that’s about all I can say,” he says. “It’s very difficult to predict.”