Strong euro alters thinking on foreign currency hedging: with a strengthened euro--combined with implementing FAS 133--how's a company to hedge foreign currencies? Here are some alternatives. (Risk Management).

When currencies trend in one direction, hedging the risk is easy. For almost three years, the European Union's (EU) new currency, the euro, weakened against the U.S. dollar. This provided corporate hedgers of their euro receipts and assets "gains" on their forward contracts when protecting a 90-day or quarterly cash flow.

As most CFOs and treasurers know, the "gains" on these contracts really are offsets to the underlying losses in value of the euro receipts and assets.

Since hedging under most corporate policies is used to smooth currency volatility on the company's financial statements, there is no real gain or loss, but hedging's major benefits is that it can reduce the potential of a catastrophic loss (or gain).

However, the test of a good hedging policy is not when the hedging instruments' (forwards or options) are "in the money" and providing cash settlement gains, but rather when a reversal in the trend occurs and the hedges at settlement or mark to market are "under water" or lose money.

While the underlying asset appreciated during this trend reversal, corporations must be diligent to show both sides of the ledger--the underlying risk and the hedge value at every reporting period. The hard part is to maintain the same strategy when the hedges purchased as risk avoidance actions can be second-guessed.

Pressure to abandon the hedging program can come from a number of sources:

* A board of directors uncomfortable or unfamiliar with the impact of hedging.

* A new CEO or CFO who either has an historic dislike of hedging or is inexperienced with hedging.

* The complexity of implementing FAS 133 accounting by the controller's department.

* The treasurer having to explain "losses" on contracts instead of "gains."

In light of the pressures, companies need to make sure the euro's recent strength does not weaken their resolve to hedge their currency risk.

By focusing on the euro since its inception, the value of hedging the risk for most multinationals are illustrated in Exhibits 2 and 3. The example assumes the company has a EUR-denominated asset worth 100 million EUR.

What should a company do in the face of these pressures to stop hedging its assets? The answer is to review its risk tolerance levels, measurement and reporting and its strategies and tools. These categories are detailed below.

Identifying Risk Tolerance Levels

First, look at possible risk tolerance levels. In the example in Exhibit 3, the 100 million without any hedging has shown a range of 14 percent loss to a 11 percent gain at year-end 1999 and the end of the third quarter 2002, respectively. Can the company absorb a 14 percent maximum swing yearly or a 9.22 percent absolute average move yearly?

A more detailed analysis quarter-by-quarter over the last three-and-a-half years shows the euro weakened in 11 of 15 quarters (see Exhibit 2). There were four quarters when the euro strengthened against the dollar, but none of those quarters were consecutive.

The quarterly movement ranged from 1 percent to 8 percent negative--and 3 percent to 14 percent positive. Can a company absorb a 14 percent maximum move or a 5.16 percent absolute average move quarterly?

The risk tolerance of choosing not to hedge can lead to a 1 million to 14 million impact on quarterly results on a 100 million asset. If a company chooses not to hedge, it must live with the explanation to its shareholders why simple hedging techniques were not employed to smooth volatility. If the results are only 1 percent or 2 percent, this may not be an issue. But if the movement is 7 percent to 14 percent in either direction, the explanation may be difficult.

Since no one knows how much or in which direction a currency will actually move, hedging all or some of the risk can help avoid catastrophic impact to the company's financials. With today's pressure on reporting and delivering accurate financial statements, currency risk is not a tolerable risk for most corporations.

Measurement and Reporting

A company must determine how to measure and report its currency risk, and there are a number of techniques to evaluate its foreign exchange exposure. The notional measurement of a 100 million asset is not enough. A company must look at the sensitivity analysis, range and averages, stress tests (a major loss or gain such as 15 percent or more), and potentially the value at risk and cash flow at risk of the notional exposures.

By using these and other measurement techniques, a company will get a complete look at its exposure and the possible impact to company financial statements.

In addition to measuring and discussing the results between treasury and the CFO, a well thought-out reporting format must be designed for the audit committee and board of directors. This must be accurate and clear for board members who do not deal with currency volatility on a regular basis. It is especially critical for companies that don't hedge to show that increased euro volatility could lead to significant surprises on financials.

Financial managers should not attempt to minimize the impact of these risks in reports to senior management just to avoid hedging because they are either uncomfortable or historically have not used hedging instruments. The euro is one of the simplest and deepest currency markets in the world, and not finding the appropriate forward, option or funding choice is not acceptable.

Developing the Strategy

The next step is to develop the strategy and select the appropriate tools. It was implied above that hedging everything 100 percent of the time is the safest path. However, this may not always be possible. Some reasons include:

* Credit restrictions on the company.

* Pricing on certain currencies and markets may be prohibitive.

* Liquidity in certain markets may not be present.

* Forecasting of company exposures may be unavailable or inaccurate.

Due to these and other restrictions, a company may hedge only a small percentage of its exposure. Typical strategies include hedging 100 percent of first-quarter exposures, 70 percent to 80 percent of second-quarter exposures and 50 percent to 75 percent of third- and fourth-quarter exposures. Others try to guess the timing of hedging by placing some or all hedges before a critical political or economic event, following advice from bankers and brokers, or by using technical models for long- and short-position timing.

Developing a strategy and sticking with it is critical. Measuring and reporting fully the results of the hedging performance beyond the treasurer's office is where the strategy will be truly tested.

Selecting the Tools

Operational Techniques: Hedging tools can vary. Using non-financial hedges, such as pricing strategies (a built-in pricing buffer to cover expected small gains or losses), sourcing from vendors in local currencies, which offset sales in these local currencies, shifting production to countries with plants in euro or other related currencies, and other natural offsets (using a risk-sharing agreement where the buyer and seller each share the currency risk, up to a 10 percent movement in either direction) can also be employed.

Debt: Many companies will employ local currency debt to offset the exposure (euro debt is cheap and readily available). But matching the asset with the liability in amount and duration must be carefully monitored to achieve accounting and economic objectives.

Derivatives: Finally, derivatives such as simple forwards, options and slightly more complex collars are very flexible tools to protect specific risks. For some reason, many companies still have not used derivatives to hedge risks. Companies that limit the management of currency risk to one manager are missing an opportunity to really understand this risk management tool and provide an education to their employees and a safeguard for shareholders.

In conclusion, the strengthening euro, as well as the volatility in other currencies, should not cause companies to stop hedging foreign assets. Following the steps described above, CFOs should evaluate risk tolerance, measure both assets and liabilities more rigorously and report performance results to all levels of management. The strong euro may cause corporations to develop different hedging strategies and employ some tools not previously used. With these actions, companies can avoid surprises and protect their financial statements.

[GRAPH OMITTED]

Exhibit 2

Quarterly Analysis

                   USD Value of Asset  Quarterly Change in
  Date               (in millions)          USD Value

12/31/98                  $117
03/31/99                  $107                 -8%
06/30/99                  $103                 -4%
09/30/99                  $107                  3%
12/31/99                  $100                 -6%
03/31/00                   $96                 -4%
06/30/00                   $95                 -1%
09/30/00                   $88                 -8%
12/31/00                   $94                  7%
03/31/01                   $88                 -7%
06/30/01                   $85                 -3%
09/30/01                   $91                  7%
12/31/01                   $89                 -3%
03/31/02                   $87                 -2%
06/30/02                   $99                 14%
09/30/02                   $98                 -1%
Absolute Average
 Quarterly Change                             5.16%
Exhibit 3

Yearly Analysis

                     USD Value of      Yearly Change in
Date              Asset (in millions)     USD Value

12/31/98                 $117
12/31/99                 $100                -14%
12/31/00                  $94                 -6%
12/31/01                  $89                 -6%
09/30/02                  $98                 11%
Absolute Average
 Yearly Change                              9.22%

Source for all charts Ernst & Young LLP

Daniel M. Perkins is a partner in the Global Treasury Advisory Group of Ernst & Young LLP, and the lead partner for this group's central region. He can be reached at [e-mail] or 312.879.5951.