The Operational and Financial Hedging Against the Weak Dollar - Case Study Example

Operational and Financial Hedging with the Weak Dollar Introduction Hedging is a common feature in international financial management. Industry has gone global with the liberalization of global trade and commerce. The world economy has a global market and companies and industries are reaping the fruits of globalization. With this advent of globalization, comes a need for International Financial Management with Hedging being a common feature of Finance. Hedging is the tool which neutralizes the difference between the financial transactions of two countries having separate currencies. The currency difference at the time of financial transaction differs from the original monetary contract resulting in profit / loss over the agreed figure of a particular job. This report will discuss Operational and Financial Hedging against a weak dollar and what would be the effects of it. A. Tracking of the currency/US dollar exchange rate over the last 5 years Year Euro Dollar Exchange Rate 2012 1 0.74 2011 1 0.75 2010 1 0.70 2009 1 0.72 2008 1 0.68 The last 5 years has seen the dollar exchange rate fluctuate between 1.3 euro and 1.5 on an average. In the past 5 years, the euro has gone up to 1.6 on a high and 1.2 on the lower side against the dollar. Previous Year Euro: Dollar Exchange Rate Month, Year Euro Dollar Exchange Rate March 2011 1 0.725 May 2011 1 0.675 July 2011 1 0.69 Sep 2011 1 0.70 Nov 2011 1 0.73 Jan 2012 1 0.77 The last year has seen fluctuations of the dollar ranging from 0.725 against a euro to the strength of 0.69 in the middle of the year to the weakening of the dollar to 0.77 in Jan 2012. The dollar had started weak, strengthened briefly between May and July again to weaken in the next half of the year. B. Identifying the key issues that have affected the currency over the last year. Determining the key issues which affect the currency, analysts have to analyze a lot of factors which determine the economic condition of a country and the currency exchange rate over other currencies. The various factors which can be regarded as key issues are: 1. Interest Rate Factor 2. Relative Growth 3. Trade Account/Current Account 4. Inflation 5. Equity Flow Interest rate factors are the primary reason which determines the day to day foreign exchange rate diversifications followed closely by the relative growth factor of the dollar as compared to other currencies. Relative growth factor accounts for the relational growth as a result of trade and commerce between two countries where currency swings can take place. The trade / current account deficit can be offset with higher exports than imports. “If our imports are greater than our exports, we will have a deficit in our current account. With a strong economy, a country can attract foreign capital to offset the trade deficit.” (Investopedia, 2009). A higher export will always yield inflow of foreign currency to the country which will result in boosting the currency as well as economy. Inflation is another important factor as price rise in food and fuel have served the currency adversely in the past year thereby further weakening of the dollar. Equity Flows are also an important factor which determines the currency change. Equity flows in and out of a country thereby affecting the country’s stock exchange and the currency. Inward flow increases the stock exchange returns and vice versa. (Lozada,2012). C. Appropriate hedging techniques The appropriate hedging techniques for a firm to adopt for the dollar to reduce exchange risk can be segregated into operational hedging and financial hedging. The report will discuss each hedging technique separately which would support the key factors affecting currency movement. Operational hedging is the natural hedging arising out of situations where a firm is producing and selling in the same country. Even when the firms are having manufacturing units in multiple countries and if they are selling in the same country, a natural hedge follows as there is no major currency swing affecting them. A second example of operational hedging comes when firms have global plants and machinery from which they hedge by using the currency difference wisely. (Allon,2010). The operational hedging techniques can be referred as the natural hedges where firms have operational advantages of being present locally in different countries having different economies and then work to their advantage. The first example had a natural hedge where the firms were selling only in those places where they were manufacturing. In the second example given by Allon, it is imperative for the firms to sell in the country where the currency is strong. If US have a strong dollar, then selling to the US becomes a profitable venture. With a two way exchange of trade happening between branches of the same company, natural hedging occurs which the firms can use to their advantage. For example: the same firm can have plants in USA & France and both can use the import and export of machinery to their advantage. Thus operational hedging works naturally for these firms thereby covering risks in currency conversions and exchanges. This kind of hedging has a direct impact on the key factors affecting currency rates like there is a good amount of equity flow, trade /current account balances and relative growth. Financial Hedging on the other hand requires a great deal of financial analysis and skill to determine future contracts for firms who need to be protected from the market currency differences. These future contracts allow firms to settle for a lock in currency exchange on a preset future date where the currency rate for transaction on that day will not vary as per market but will function as of the agreed lock in exchange currency. The firms buy the foreign currency from financial institutions on a future date. “Forward contracts and future contracts allow an MNC to lock in a specific exchange rate at which it can purchase a specific currency and, therefore, allow it to hedge payables denominated in a foreign currency.” (Madura,2009). By performing such a hedge, the companies ensure security against a volatile market and reduce their market risks. The lock in exchange currency needs to be wisely analyzed by financial analyst of the firms so that they can gain maximum advantage from the transaction and at the same time covering the risks. The Second Financial Hedging method is the Money Market Hedge. This hedge requires firms to have a money market position by putting in excess cash which will cover a future payable transaction. Since most of the MNCs are not in favour of putting in cash, they create the money market position by borrowing funds in the home currency and having short term investment in a foreign currency. (Madura, 2009). Interest Rate factors and Inflation also are under control by exercising such financial hedging techniques. Operational and Financial Hedging and the weak dollar have a lot of significance for the smaller companies. The smaller companies get a lot of growth potential against the weak dollar as they get a higher return on their foreign transactions. The smaller firms have a price advantage as they get a higher return on the dollar as compared to the stronger dollar. This acts as a huge boost for the smaller companies as they tend to gain m ore in this period. When the dollar is weak, then operational hedging becomes advantageous for the US branches and firms where they can export more products in return of a larger sum of dollars. Similarly, financial hedging also has its advantages as the future contract will hold the risk coverage higher due to the weaker dollar. D. General advantages and disadvantages of each hedging method Operational Hedging Advantages & Disadvantages: A. Manufacturing and Selling in the same country Advantages: i) This is the best option for a natural operational hedge as the firms are manufacturing and selling in the same country where foreign exchange currency difference is not coming into the picture. This is applicable for MNCs having various branches across the globe but their operational policy of selling in the country of manufacture makes way for a natural hedge which is sensible thing to do. ii) Automatic risk coverage for volatile markets. Disadvantages: i) The company risk is reduced but it loses out on the calculated risks taken by firms in order to gain more from foreign exchange fluctuations specifically in the event of the weak dollar which could have fetched higher revenues. ii) This leads to a loss of opportunity for growth in a weak dollar market for the smaller firms. B. Buying and selling by various branches of the same company located in multiple countries. Advantages: i) It is advantageous for companies to sell their machinery and goods manufactured in European countries to US branches when the dollar is strong and doing the opposite when the dollar is weak. The companies use this currency fluctuation wisely with operational hedging to gain the maximum out of it. ii) This is a natural hedge which comes from the operational factor that both organizations belong to the same company and hence are in an advantageous situation. Disadvantages: i) If it is a single directional flow of goods, then it might not be advantageous at all times. Financial Hedging Advantages and Disadvantages: A. Future or Forward Contract Advantages: i) Future or Forward Contracts are always advantageous as it reduces the risk to the companies coming from foreign transactions where the currency value change takes place every second. ii) Since the process involves the buying of currency on a future date and the lock in exchange transaction, companies are secured against the volatility and the unpredictability of the market. Disadvantages: i) Businesses operating with calculated risk are denying themselves the opportunity of earning more revenue due to the currency lock in. B. Money Market Hedging Advantages i) The principal advantage of Money Market hedging is that it uses cash or short term investment in foreign currency or borrowing of funds in home currency to create a money market to hedge for a future date. This creates necessary cash flow to cover themselves against future payable transactions. Disadvantages i) Since it utilizes cash reserves, it is difficult for companies to arrange cash. For companies like Terex who are manufacturing in US and Europe as well, it is advisable for them to go for operational hedging. This is due to the fact that given their operations nature they are in a better position to use operational hedging to their advantage. Smaller companies benefit immensely from the weak dollar as they get a good amount of growth going with more dollars coming in terms of revenue. Operational hedging ensures that they have a natural hedge where they can manufacture and sell in the same country or utilize their multiple facilities in different countries to do operational hedging wisely. E. Conclusion In this report we have discussed the operational and financial hedging against the weak dollar. The weak dollar is advantageous for smaller firms who can grow with the situational factor as they can export goods and machineries and earn more dollars for the same transaction as compared to the strong dollar. Operational hedging becomes the wiser choice if the operational segment of the company permits. For the next two years the dollar will have difficulty in being stronger. This is due to numerous factors which includes inflation, interest rate fluctuations, economy getting out of recession and the fact that jobs have marginally increased and is nowhere near to the expected employment rate. Moreover, the dwindling of the euro in late 2011 has also not done well for the world economy thereby further daunting the chances of the dollar appreciation. Exporting of goods from the US will be a better option as it will help the smaller companies to grow with the weaker dollar. “CBO expects that economic growth will remain moderate this year and next. As measured by the change from the fourth quarter of the previous year, real GDP is projected to increase by 3.1 percent this year and by 2.8 percent next year.” (CBO, 2011). The Congressional Budget Office in its economic outlook has forecasted the economic growth to move at a slow pace. Due to the huge economic recession in the US, it has become very hard for the economy to overcome the ripple effects of the recession and move into main stream strengthening of the dollar. Therefore it is expected that in 2 years the dollar will not appreciate much and with all relative factors like trade / current account, interest rate fluctuation, inflation, relative growth and equity flows being responsible in a combined manner. It can be concluded that with a weak dollar, operational hedging has better options for the companies to gain from if used wisely than financial hedging. The companies get the risk coverage by financial hedging which is expensive but operational hedging becomes a natural process which benefits the firm. References: 1. Narayan,V (2012), book name, Publisher. / available from website (Accessed from date). 2. Congressional Budget Office (2011), Budget And Economic Outlook: Fiscal Years 2011 to 2021, available from http://www.cbo.gov/publication/21999 (Accessed on March 2 2012). 3. Gishen, S (2009), Investopedia: 3 Factors That Drive The US Dollar, available from http://www.investopedia.com/articles/forex/09/factors-drive-american-dollar.asp#axzz1nYPO3bZg (Accessed on February 29th, 2012). 4. Madura,J (2009), International Financial Management, Joe Sabatino 5. Lozada,C (2012), the National Bureau of Economic Research: What Drives Cross-Border Equity Flows? available from http://www.nber.org/digest/mar03/w9000.html (Accessed on March 1, 2012). 6. Allon,G (2010), Operational and Financial Hedging with the Weak Dollar, available from http://operationsroom.wordpress.com/2010/10/21/operational-and-financial-hedging-with-the-weak-dollar/ (Accessed on February 28th, 2012) Read More