Managing foreign currency exchange risk.

When a company begins a transaction in a foreign currency, it accepts an economic risk due to fluctuating exchange rates. Scott R. Flicker, staff accountant at Arthur Andersen & Co., San Antonio, Texas, and Dennis M. Bline, PhD, assistant professor of accounting at the University of Texas--San Antonio, discuss several widely practiced hedging policies and strategies to manage this risk.

The globalization of the world economy and the devaluation of the U.S. dollar have allowed more American companies to enter the export/import markets. Additionally, many managers who previously avoided these markets are finding that international transactions can make their companies more competitive in marketing products and procuring parts and/materials. As new companies are exposed to foreign exchange risk, managers will necessarily be concerned with the development of an effective hedging program. While the task of managing financial risks generally falls to the CFO or treasurer, it is often others in the accounting department who are asked to evaluate the bottom line impact of these risks. This article introduces several of the most widely practiced hedging policies and strategies.

STRATEGIES FOR

CONTROLLING FOREIGN

EXCHANGE RISK

Participation in international markets may result in a foreign exchange risk known as transaction exposure. This risk occurs when a company has a payable (or receivable) denominated in a foreign currency (FC). The risk lies in the fluctuation of the FC exchange rate. For example, if the FC appreciates before the liability is settled, the company has to pay more dollars to purchase the FC needed to settle this liability. As a result, the company will experience a foreign exchange loss. Conversely, a company with a liability position in a weakening FC will experience a foreign exchange gain between the date the liability is incurred and its settlement. Opposite relationships hold for net asset positions, which are denominated in an FC.

As a result of the cash flow impact of transaction exposures and the requirements of Financial Accounting Standards Board Statement no. 52, Foreign Currency Translation, to include foreign exchange transaction gains and losses in the determination of net income, most companies are hedging these exposures. In fact, a 1986 FASB research report, Foreign Exchange Risk Management under Statement 52, revealed that 84% of 162 company treasurers engaged in foreign trade regularly or selectively hedge foreign transaction exposures. A variety of hedging strategies are available to assist managers in controlloing such foreign transaction risks. These include pricing, settlement, forward contracts, leading and lagging, netting and reinvoicing.

Pricing. The most fundamental of the strategies to control risk is pricing, or controlling the billing currency. Exchange risk is eliminated if the company bills customers in the company's reporting currency. For example, a company can negotiate a price for a receivable in its own reporting currency and thereby shift the exchange risk to the other party in the transaction.

Furthermore, risk is substantially reduced if customers are billed in the same currency the company uses to pay suppliers. For example, if a company already has an exposed liability position (an FC payable), it can hedge that exposure by making a sale (an FC receivable) denominated in the same, or a closely related, FC.

Settlement. When a company cannot bill in the reporting currency, it can use the settlement strategy to help mitigage foreign exchange risk. This strategy requires that management consistently negotiate or offer discounts for the early settlement of payables or receivables denominated in an FC. Overall, this strategy forces a company to relinquish the benefits of the time value of money in order to avoid the risks of foreign exchange fluctuations.

Forward contracts. When the company does not wish to settle early and it cannot control the billing or payment currency, it must use other techniques to control future cash flows. Probably the most well-known hedging technique is buying and selling forward contracts in FC. These are contracts to buy or sell FC at a future date at a fixed exchange rate. The benefit is that the company's exposure associated with an FC asset or liability position can be offset, fully or partially, by taking an opposite position in the forward market. The costs of this hedging technique are the transaction cost of buying a forward contract and the cost of currency conversion.

For the forward contract strategy to be effective, management must assess the volatility of the applicable exchange rate and the expected trends in its movement. Management must then decide whether to hedge its exposure in the forward market, a decision usually based on management's aversion to risk and the magnitude of the exposure.

Some countries, especially those with hyperinflationary economies, do not allow forward contracts in their national currency. In such cases, management has the option of taking a forward position in another currency that tracks closely the exchange rate of the FC. In an entrepreneurial climate or a decentralized corporate structure, speculation on exchange rate movements by local managers may be a very effective policy.

Leading and logging. Larger, more centralized corporations have additional options that may be employed to help control the foreign exchange risk of intercompany transactions. One effective and potentially profitable approach involves leading (prepaying) payments when the payer's currency is devaluing against the payment currency and lagging those payments if the payer's currency is appreciating. From a companywide standpoint, the treasurer can direct leading and laging policy in order to take advantage of the favorable effects of exchange rate fluctuations. Additionally, leading and lagging policies may be used to shift funds from cash-rich to cash-poor affiliates, thereby improving short-term liquidity.

Netting. Netting intercompany transfers is another common international cash management strategy that requires a high degree of centralization. The basis of netting is that, within a closed group of related companies, total payables will always equal total receivables. The advantages of netting are

* A reduction in foreign exchange conversion fees and funds transfer fees.

* A quicker settlement of obligations reducing the group's overall exposure.

The exposure that remains--net payments to payees--can be hedged in the forward market if desired. Suppose for a given month three affiliates have the intercompany obligations displayed in exhibit 1 on page 130.

Total intercompany obligations equal $1,200,000 ($100,00 + $200,000 + $150,000 + $350,000 + $400,000), while total foreign exchange funds are $1 million (all the previous obligations except the $200,000 between the U.S. parent and subsidiary).

The first step in netting is to determine the net payable or receivable for each entity. As shown in exhibit 2 on page 130, the U.S. parent and the Canadian subsidiary are net payers of $150,000 and $100,000, respectively, while the U.S. subsidiary is a net payee of $250,000.

The second step--settlement of the obligations--can occur in one of two ways: the net payers can remit directly to net payees or the net payers can send funds to a clearing center that remits funds to net payees. In either case, netting requirs someone who knows the positions of all units to coordinae the payments.

In the above example, the U.S. subsidiary receives

* $150,000 from the U.S. parent (not affecting foreign exchange).

* $100,000 from the Canadian subsidiary (a foreign exchange transfer).

Consequently, netting effectively resulted in a 79% reduction in funds transfer fees ($250,000 transferred versus $1,200,000) and a 90% reduction in foreign exchange conversion fees ($100,000 converted versus $1 million).

Reinvoicing. Reinvoicing goes one step beyond the centralized approach of multilateral netting by way of a clearing center. A reinvoicing center buys goods from the manufacturing subsidiary or parent, without taking possession, and reinvoices other company affiliates or third parties when it sells the goods. By conducting all transactions in the affiliate's functional currency, the reinvoicing center bears all currency risks. This prevents the FC exposures from distorting the subsidiary's operating profit (loss). In addition, the reinvoicing center allows for centralized cash flow management, increase international business expertise and oppotunities for arbitrage. The center also improves and centralizes banking relationships and acts as a central purchasing agent for subsidiaries.

Most important, the reinvoicing center can assess its net position on all intercompany transactions and hedge in the forward market accordingly. Problems with reinvoicing centers are

* Some countries prohibit reinvoicing centers, as well as any third-party billing (for example, France, Spain, Japan).

* They are very expensive to set up because sophisticated information systems and legal and tax expertise are required.

OTHER FACTORS

To manage foreign exchange risk, large and small companies alike must effectively gather and digest a large volume of information, including spot and forward exchange rates, currency conversion and funds transfer fees and government regulations regarding allowable transactions and currency controls. Management must also be aware of the subsidiary's balance sheet exposures, as well as cash flows and expected cash transactions.

In addition, tax considerations for international and intercompany transactions are some of the most complicated and confounding issues facing these businesses. Such issues include classification of foreign exchange gains and losses and their accounting treatments, interest rates and payments made on borrowings by the foreign subsidiaries, tax deferrals on foreign income and even selecting the location of reinvoicing centers. These issues must be raised with qualified accountants and international financial consultants.

COMBINATION OF METHODS

One of the greatest challenges for today's management is the efficient and effective operation of an internationally oriented business. One of the difficulties in effective management of an international business is due to fluctuating exchange rates. This management can be improved through a variety of hedging strategies discussed here. Often, a combination of methods will be most efficient for a given situation.

No matter what hedging strategy is adopted by a company, it must be clearly communicated by management. In addition, when evaluating subsidiary peformance, management must recognize the effects of exchange gains and losses on income and profit margins. The success of any of these strategies depends on management's sensitivity to the foreign exchange markets and the needs of its subsidiaries.