Currency Hedging at Firm Levels - Essay Example

Currency Hedging at Firm Levels Adds Shareholder Values Introduction Foreign currency risk is an ongoing problem associated with modern economic transactions. The risk involves the subsequent loss of unexpected ‘currency’ rate changes in the global financial markets. It largely affects persons engaged in international trade since they need to indulge in foreign exchange transactions at any time during the course of their business deal. In order to prevent these unforeseen contingencies some tools like ‘currency hedging’ are formulated which will help business firms to protect themselves from the risk of loss. The following part of this part will discuss the various aspects of currency hedging at the firm level and its impacts on shareholders. Currency hedging Machiraju (2007) states, “Hedging means securing oneself against loss from various risks that arises in international financial markets” (Machiraju 2007, p.94). Currency hedging is an activity associated with hedging and is carried out for the purpose of elimination of risks associated with foreign currency transactions. For instance, consider a US based manufacturing company enters into a contract with a German business partner at $1 million. The contract amount is expressed in euros and 1 euro equals 1 dollar on the date of the contract. Two years later, the value of the euro increases with respect to the dollar and hence it reached a level of 1 euro equals 2 dollars. It leads the manufacturing firm to suffer a foreign currency loss of $500,000. This loss can be avoided by the firm if it uses some currency hedging tactics. Capital hedging can save investors or firms from unfavorable shifts in the global money market; and it will also help them to achieve a reasonable amount of return on investment even if the value of the currency falls during the period of business contract. An idea connected with currency hedging is that converting or exchanging currency while the exchange rates are favorable, and then invest the money in the home currency of the respective nation where we want to make our investment (Sharpio, 2006, p.343). Currency hedging instruments/strategies at firm level There are numerous capital hedging methods have been formulated in order to protect a firm’s future cash flows from exchange rate fluctuations. The firm can adopt most appropriate technique after considering a number of factors such as firm’s strategies regarding hedge, present market situations and possibility of future exchange rate fluctuations. According to Collier and Ampomah (2007), currency hedging methods can be classified into two such as internal and external hedging techniques. 1. Internal hedging techniques Under this method, the firm uses the sources or techniques available within the company in order to solve risks associated with exchange rate. Since these techniques are not operated through the ‘foreign exchange markets’ the ‘associated costs’ can be avoided. Some of the internal hedging techniques are described below. Invoicing the home currency; in this case, the firm would try to transfer the exchange rate risk to customers by invoicing in its own currency. Bilateral and multilateral netting; in case of bilateral netting ‘pairs of companies in the same group net off their own positions regarding payables and receivables’; even without the help of a ‘central treasury department’ Collier and Ampomah (2007). On the other hand, a central treasury department is necessary to perform multilateral netting where ‘several subsidiaries are involved and interact with head office’ (Collier & Ampomah. P.364). Restructuring; the firm can manage exchange rate risk also by restructuring its operations such as increasing or reducing sales in foreign markets; dependency on foreign suppliers; level of debt denominated in foreign currencies. 2. External hedging techniques Under external hedging techniques, foreign-currency variations are hedged by using the financial markets. Since external hedging techniques depend on financial markets, it cannot be relieved from direct costs. It includes forward markets, futures, options and swaps on currencies. Forward markets; a firm can make use of forward markets if it has entered into forward exchange contract. By forward exchange contract, a person agrees to deliver a fixed amount of a particular currency to another at a specified exchange rate on a predetermined future date. Futures; according to Collier and Ampomah (2007), financial futures are ‘contracts to buy or sell an amount of foreign currency at a future date’ which are ‘traded on futures exchanges such as the Chicago Mercantile Exchange’. Options; it provides the client ‘right-but not obligation-to buy (‘call’) or sell (‘put’) a specific amount of currency at a specific price on a specific date’ (Collier & Ampomah. P.372). Swaps- it is the regular exchange of interest or cash flows’ in one currency with respect to another currency. Currency swaps is more suitable for the purpose of medium-term and long-term hedging; since forward markets, futures and options can be used for hedging only up to one year. But it is important to be noted that these instruments are not 100 percent effective all time due change in market strategies and financial market policies. Impact of currency hedging on shareholders Shareholders are real owners of a firm since they have invested their money into the business and thereby they are interested to its assets and cash flows. “Equity investors look for one or a combination of two things: income, a money return by way of dividend, or capital gain, a money return by way of selling shares at more than their purchase price” (Alexander, D. Britton, A & Jorissen 2007, p.5). We can undoubtedly say that shareholders are also risk holders since they get returns only if anything is left over after all vendors and employees have been paid. Therefore if there arise any currency loss to the firm as a result of global financial market fluctuations, it may cause shareholders to loose their investment and thereby their interest in the firm. Hence, currency hedging techniques can be adopted against currency loss in order to safeguard the well being of shareholders. Even though currency hedging may reduce profitability in case of rise in the exchange rate, it is a very helpful tool to defend unexpected, huge losses if the adverse price changes are severe. As mentioned above, there are various hedging strategies or instruments such as futures, options, or swaps from which most appropriate one can be adopted after a thorough scrutiny of current market and forecast of possible market changes. Similarly the firm must give priority to shareholders’ likes and dislikes when they make decisions of hedging strategies to be adopted with regard to corporate risk management. As Varma points out finance theory regards shareholder value maximization as the principal objective of the company and therefore currency hedging becomes significant (Varma, 2008). Although hedging is an efficient tool to achieve certainty about cash flows, it can also be used for several purposes like planning and controlling, or performance. It makes much easier for plan and control future cash requirements of the firm as there is an absolute certainty regarding cash flows. The organizations involved in export and import processes are very much affected by profitability swings simply because of currency losses. Thus, currency hedging is a better instrument to defend profit variations and thereby a firm can use it for evaluating its actual performance. Moreover the greater certainty of cash flows allows the company to concentrate more on its business without worrying about exchange rate fluctuations. It facilitates the company or shareholders to acquire maximum earnings from business which adds value to the shareholders and their reputation (Varma 2008). US Dollars (USD) to 1 Euro (EUR) (Source: Exchange.Org). The given table illustrates historical exchange rates for US Dollar (USD) per 1 Euro (EUR). The rates are taken from the closing date of each month for a period of six months from May 2010 to Oct 2010. The minimum exchange rate is 1.22330 on Jun-10 and the maximum exchange rate is 1.39675 on Oct-10. That means a difference of 0.17345 between the minimum rate and the maximum rate within the period of six months. It will result in a large variance for huge amounts and create contingencies for traders. The average exchange rate during this period is 1.29779. From the chart, we can understand the importance of currency hedging in order to protect the shareholders and thereby organization from the risk of currency loss. (URL attached below at no.5) Case study Kolb and Overdahl (2007) illustrate a case of 1992, a suit that was filed against the directors of an Indiana grain elevator cooperative by its share holders for the $400,000 in grain sale losses. The shareholders argued that the directors had failed to inform themselves about the hedging opportunities which could have prevented the huge loss incurred. The shareholders pointed that director’s irresponsibility caused ‘a breach of the fiduciary duty owed by the directors to the cooperative’s shareholders’ Kolb & Overdahl 2007, p.145). The Indiana court concurred with the shareholders and held that the cooperative’s directors were personally liable for the loss incurred to the investors due to failure of the management to hedge. The Indiana cooperative raised 90 percent of its revenue from grain sales; thus according to the court, directors’ failure to hedge had proved that they were not adequately informed about ‘the hedging opportunities provided by commodity future markets’(Kolb & Overdahl, 2007, p.145). Under Indiana law, the directors of a corporation has a legal obligation to hedge in order to minimize risk associated with changes in commodity prices; if these changes are an important part of corporation’s business. Even though it is a particular case related to Indiana law, it illustrates the need of directors’ attention to the hedging opportunities. Therefore, in order to preserve the interest of shareholders of the firm, it is necessary for the management to adopt suitable hedging strategies according to global market fluctuations; otherwise the directors will be held liable in a legal suit. A shareholder will always be interested on maximum return on his investment; hence currency loss incurred by the firm will certainly hurt its shareholders’ interests as it reduces the firm’s earned capital. In shortly currency hedging at firm level always adds its shareholder’s values. References Alexander, D. Britton, A & Jorissen, A 2007, International Financial Reporting and Analysis, Edition3, Thomson Learning. Collier, PM & Agyei-Ampomah, S 2007, Management Accounting-Risk and Control Strategy. Edition-4, Butterworth-Heinemann. Kolb, RW & Overdahl, JA 2007, Future, options, and swaps, Edition 5, Wiley-Blackwell. Machiraju, HR 2007, International Financial Markets And India, Edition 2, New Age International, Delhi. Sharpio, A 2006, Multinational Financial Management, Edition 8, Wiley. Delhi. US Dollar to 1 Euro. Exchange-Rates.Org. Accessed 7 Nov 2010 http://www.exchange-rates.org/history/USD/EUR/T Varma, JR 2008, Derivatives and Risk Management, Tata McGraw-Hill, New Delhi. Read More