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Currency Risks: Disturbance in the Water

After two years of relative stability, the currency markets may be readying for a year of heightened volatility. Will companies be prepared?

Meanwhile, although U.S. companies may have a lower total-dollar exposure to emerging-market currencies, the extreme volatility of those currencies increases the risk to cash flows and, in some cases, balance sheets. “Finance departments may become more attuned to currency fluctuations the rest of 2013 and 2014 due to currency devaluations in Latin America and high volatility in emerging-market currencies like the Indian rupee and the Russian ruble,” says Amol Dhargalkar, managing director for corporate advisory at Chatham Financial.
A lot of companies just ride out the wave in emerging-market currencies, says Schulz, because they can be tougher to hedge due to the lack of a market for currency forwards. But emerging-market exposures can be managed. To deal with volatility in markets like Russia and Brazil, consumer-goods company Unilever, for example, hedges emerging-market currencies in three-month-to-six-month periods. The length of the hedges is the time it takes for Unilever to pass through higher product prices in the local currency, part of its strategy for covering forex losses.

The Cure or the Disease?
Many companies won’t hedge in 2014. Some see their forex exposure as not warranting the cost of hedging, as CFO’s survey found. There may be “negative” reasons also. “What keeps companies from hedging is one, they have a risk tolerance that is greater than they ought to have; two, they can’t get the credit they need to hedge; or three, they don’t have the knowledge or data necessary to place the hedge,” says Ryan Gibbons, managing partner of GPS Capital Markets.

The credit issue arises because “banks are becoming increasingly more stringent” about underwriting hedges, Gibbons says. A hedge exposes a bank to credit risk, market risk and settlement risk, he explains. If a bank underwrites a $150 million forex hedge over 15 months, for example, “there are real dollars at stake should the company it underwrites not be able to perform on it.”

13Dec_Outlook_p28cSomewhat ironically, the complexity of hedge accounting can prevent a less sophisticated finance department from hedging forex risk, says Dhargalkar. And hedge accounting is absolutely necessary if a company is hedging.

“If a business doesn’t apply hedge accounting, it actually can introduce more volatility into earnings,” says Dhargalkar. “The business might enter into the right set of hedges that reduce cash-flow risk but actually increase its earnings at risk, because of the volatility of the derivative showing up in earnings per share.” That could lead to the CFO having to provide a lengthy explanation on an earnings conference call.

Explaining hedge accounting itself can be just as difficult. In conjunction with its third-quarter earnings call, search giant Google posted a video tutorial on its investor relations website to explain why its hedging costs addressed by ASC 815 (the accounting standard for derivatives and hedging, formerly known as FAS 133) were so volatile quarter to quarter.

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