Painful Conversions

As currency risk intensifies, companies of all sizes are taking steps to protect cash flows.

Just two years ago, EXL, a business process outsourcing company, didn’t have a treasury department. The finance staff and senior management watched currency fluctuations carefully, but they lacked an explicit policy to address the risk to their cash flows.

That risk hit with a vengeance in 2008, when the $180 million company confronted a $9 million foreign-exchange loss, largely as a result of losses on forward contracts and the revaluation of assets and liabilities due to the rapidly depreciating rupee in India, where many of the company’s employees are based. “The currency moved very rapidly and very suddenly,” says Rohit Kapoor, EXL’s chief executive officer and former finance chief.

Such moves concern many companies these days; even small businesses now routinely operate in global markets, and the relationship between the dollar and many major currencies has reached new levels of volatility.

EXL decided to invest in what Kapoor terms “a structured program to eliminate the risk.” Today the company has a treasury staff of four and a carefully designed protocol for guarding against currency risk in its contracts, which can run as long as five years. “Currency risk is one of the most important issues that we deal with,” says Kapoor. “Unfortunately, we learned that the hard way.”

Other companies may soon share his view. In the past two years, one of the most watched international rates — the euro versus the U.S. dollar — has swung wildly, from as high as $1.60 to the euro to as low as $1.25 (see the chart below). As recently as 2002, the euro was worth 85 cents. “It is stunning how what you think is going to happen changes 180 degrees in a few months,” says Larry Harding, president of High Street Partners, an international business-services firm that advises companies on their overseas expansion plans. “Two or three months ago, the big worry was the declining dollar. Now, that has completely turned around.”

The growing sense that the dollar was losing its place as the world’s reserve currency, and speculation that it could be replaced by the euro or a basket of other currencies, have all but disappeared as the euro has tumbled into crisis. With Greece’s economy teetering and other nations in the European Union possibly following it into the abyss, the euro looks nothing like the hearty competitor it was prior to the recession.

The euro-U.S. dollar exchange rate has swung wildly over the past 12 months.

And despite burgeoning deficits and an economy that could grow slowly for the next few years, the United States has, somewhat surprisingly, reclaimed its long-standing role as the world’s safest currency. “It’s really a race between the Europeans and us to see who can screw up their fiscal policy more,” says Richard Marston, a professor of finance and economics and director of the Weiss Center for International Financial Research at The Wharton School of the University of Pennsylvania.

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.

Today, EXL hedges about 60% of its currency risk through one of these two approaches. For clients that don’t like either method, EXL will agree only to a shorter-term contract, and will address any resulting foreign-exchange risk through financial hedges.

While EXL faced some reluctance from clients when it introduced these policies, Kapoor says most customers are understanding, in part because they realize that they still save money by outsourcing to EXL even after accounting for potential currency-related adjustments.

Who Should Hedge?

The aerospace and defense giant Lockheed Martin also considers its currency risk from the very beginning of every contract. But instead of attempting to directly share the risk on a specific program with its potential customers as EXL does, Lockheed develops a financial hedging strategy for the life of the program — which could be as long as 20 years — and factors in the expense of executing the necessary hedging contracts with the bank before quoting a price, says CFO Bruce Tanner.

Lockheed has honed its currency-risk-management strategy as its international business has expanded rapidly; at $2 billion, its foreign-currency hedge portfolio is more than double what it was just two years ago. With long-running fixed-price contracts, offsetting the impact of currency fluctuations — a certainty over such a time frame — is critical, says Tanner.

“The company’s treasury department leads training seminars across the company to make sure employees are equipped with the information and tools they need to identify foreign-currency exposure, assess the related risk, and properly price the risk in their proposals,” says Tanner. The company also provides training for finance and accounting staff to make sure that everyone understands the accounting and reporting requirements for hedging activities.

Such an approach, however, may be best left to large, well-staffed companies such as Lockheed. When iRobot CFO Leahy was finance chief at Keane, an IT consulting and business process outsourcing firm with approximately $1 billion in annual revenue, the firm spent significant amounts of time investigating a currency-hedging strategy, only to decide it lacked the expertise internally to even vet possible service providers properly. “With outside help, we did a lot of work to try to educate ourselves and to find better ways to protect ourselves, but for a company our size, it was pretty tricky,” he says. “Hedging needs to be approached thoughtfully and carefully with the right advisers. It is not for neophytes.”

Still, given the volatility of the past two years, even small companies are starting to explore the possibility of hedging through derivatives, according to Sanela Hodzic, director of strategy and business development at Calypso, a developer of trading and currency-management software platforms for banks and corporate treasury departments. “Over the last 18 months, we have had CFOs and treasurers of smaller corporations from all different sectors calling us and saying they’d like to put currency-hedging programs into place,” she says. “Having gone through the financial crisis without these programs, a lot of them have been caught with losses that they’d like not to face again.”

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.”

Kate O’Sullivan is senior editor for strategy at CFO.

Beyond the Eurozone

The next currency-risk hot spot: China

While it is the dollar’s relationship to the euro that has garnered the most attention of late, another major foreign-exchange risk — one that would affect a vast number of U.S. firms — looms: the appreciation of the Chinese yuan. The Chinese government, which has long pegged the yuan to the U.S. dollar in an effort to make its exports competitive, began to let the yuan appreciate for several years before the global financial crisis. As the markets spun out of control, it returned to the dollar peg, but experts say it is only a matter of time before China allows the currency to float — and appreciate — again.

“China’s currency is going to start appreciating sooner rather than later,” says Richard Marston, a professor of finance and economics and director of the Weiss Center for International Financial Research at The Wharton School at the University of Pennsylvania. “Over the next 5 to 10 years, the Chinese currency and other Asian currencies will appreciate substantially against the U.S. dollar, and that’s a movement CFOs have to be aware of.”

IRobot, a robotics company with approximately $300 million in annual revenue, is one of many U.S. companies that would face rising costs if the yuan were to strengthen. “It will hurt companies like us and anybody who manufactures in China,” says CFO John Leahy. “We’re monitoring it, but we’re not actively out looking at [hedging] instruments.”

China let the yuan float in 2006 and the exchange rate shifted noticeably. Will it happen again?

Even for those who do want to hedge against the risk of a rising yuan, Marston says options are few, as China strictly controls its financial markets and won’t allow the creation of forward contracts, a common hedging tool.

For now, firms that manufacture or source materials in China can only watch and wait. The timing of a move “is a political decision in China,” says Marston. “I’m really surprised they haven’t done it already.” — K.O’S.

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