Taming the currency tiger: some companies have controlled most of their currency risks through a mix of operating decisions and financial hedges. Active risk management sets them apart from those that passively accept whatever punches the currency markets throws.

Caterpillar Inc. announced a hefty second-quarter earnings increase in July, with machinery sales volume up $1.35 billion. But something was missing. Although many American companies were reporting sharp performance improvements, thanks largely to the dollar's weakness in 2003-2004, Caterpillar managed to gain only $116 million on the currency shift. Even more surprising, Cat's archrival, Japan's Komatsu Ltd., claims to have suffered little from the dollar's plunge.

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It's no exaggeration to say that the dollar-yen rate used to be the single most important factor in the competitive duel between these two companies. In the early 1980s, when inflation-busting Federal Reserve Board Chairman Paul Volcker jacked up U.S. interest rates, he incidentally handed Komatsu a massive competitive advantage.

Caterpillar manufactured in the U.S. and priced its product in dollars, so the dollar's strength against other currencies meant that Cat's local currency prices surged in markets all over the world. The pain didn't begin to ease until 1985, when the G-7 countries met at New York's Plaza Hotel and announced a coordinated plan to send the dollar tumbling. Caterpillar gained, and Komatsu lost accordingly.

The markets give, the markets take away. But Caterpillar and Komatsu seem to have decided that it makes little sense to bet their businesses on the uncontrollable, perhaps unfathomable decisions of central bankers and currency traders. For the past two decades, they have been working steadily to minimize, if not eliminate, the impact of currency on their competitive duel. Recent performance demonstrates that they've succeeded.

Observes Caterpillar CFO Lynn McPheeters, "We were dollar-based and they were yen-based, and when currencies got out of whack, it created a significant competitive advantage for them. But now our position is to be the low-cost manufacturer in each currency zone. I've heard our chairman say more than once that if we take care of that, we take care of the currency competitiveness issues." Similarly, a spokesperson for Komatsu explains that his company locates its plants close to each equipment market and notes: "The global operation of Komatsu absorbs FX [foreign exchange] fluctuations of each currency in the world."

Caterpillar and Komatsu mirror each other in their manufacturing philosophy and in their hedging strategy. Both hedge short-term cash flow exposures and rely on natural hedges to mitigate the impact of currency on their long-term competitive position. Says McPheeters, "We still face regional competition that is euro-based, and when the euro was significantly undervalued, it made it difficult [to perform] against regional competition. If we can be competitive in local currencies against that competition, our ability to compete against the global competition is enhanced. That's what we've tried to focus on."

Obviously, currency isn't the only factor in determining where these heavy equipment companies manufacture. Earthmovers and backhoes are so expensive to ship that globally dispersed production might make sense even in a single-currency world. But Cat's apparent failure to capitalize on the recent dollar weakness was anything but a flaw.

It demonstrated that the company has actively managed to neutralize a risk that at one time posed a potentially fatal threat. In contrast, companies that crowed about a rise in earnings due mainly to fact that a strong euro boosted the sales of U.S.-made goods in Europe were really betraying vulnerability.

Floating currency rates have been with us every since President Nixon closed the gold window in 1971. And although most developed currencies aren't as volatile now as in the 1980s, they certainly aren't stable. Dow Chemical Co. CFO Pedro Reinhard says, "Globalization has not minimized the issues relating to currencies. It's one of the conditions of doing business, and the better you integrate it into strategy and operations, the better off the company will be. I don't think companies can ignore the risk. Ignoring the risk is the biggest risk."

Yet some companies keep ignoring it--usually at their peril.

Hot Money and Hot Cars

Consider the auto industry. In 2003, currency markets hit Ford Motor Co.'s luxury car division hard, when Ford CFO Don Leclair said the division "would do well to break even." Analysts were quick to note Jaguar's contribution to the problem. With all of its manufacturing facilities in the United Kingdom but 48 percent of its sales in North America, Jaguar got caught in the classic currency bind.

The weakening dollar posed a tough choice. Even keeping prices constant in dollar terms would have meant cutting U.K. margins. But keeping dollar prices constant wasn't a viable competitive option, either, because Jaguar's luxury car competitors Daimler-Benz AG and BMW were turning up the heat with a price war in the U.S. market.

That's because the dollar's weakness hurt them a lot less than it hurt Jaguar. There was a BMW plant in South Carolina and a Mercedes plant in Alabama. Daimler-Benz's stake in Chrysler also gave it a substantial natural hedge against dollar weakness. Asked to explain Jaguar's competitive difficulties with the currency shift, a Ford spokesperson said, "Exchange is cyclical, and you can't really change a manufacturing footprint overnight on the basis of a single quarter or even a single year."

But Porsche AG proved that it is possible to address the competitive impact of currency without global manufacturing. The company boasts that, "First and foremost, Porsche stands for 'Made in Germany.'" Yet Porsche posted what it called "the best results in the company's history" in 2003, despite the euro's sudden strength. Why didn't Porsche suffer Jaguar's fate?

In fact, it had once been caught in the same trap as Jaguar. Having focused on the U.S. market during the strong-dollar years of the early 1980s, Porsche suffered after the G-7 meeting in 1985. The company slashed prices to hold market share as the dollar fell, but a flood of red ink eventually forced the chairman's resignation.

Lesson learned. Now Porsche pursues a hedging program that could be characterized as both the most aggressive and the most conservative in its industry. Aggressive, because Porsche relies heavily on options to hedge 100 percent of its currency exposures over a five-year time horizon; conservative, because the option hedges eliminate the risk of currency market shifts marring Porsche's competitive game plan. For a company whose brand depends on its German identity, changing the manufacturing footprint would be risky even if additional plants could produce at scale economies (which is probably doubtful). So natural hedging isn't really feasible.

But Porsche's synthetic hedges protected it from currency moves very effectively. Porsche doesn't reveal what it spends on options. When currencies are volatile, they are probably as costly as fire insurance in a hot, dry summer--and as prudent an investment.

But Porsche's strategy isn't for everybody. Companies that hedge pay a price. Sometimes, the price is to forgo a potential windfall gain from currency in order to lock in an acceptable level of performance. "If your competitor is getting those windfall profits, he can use them against you," observes Prof. Thomas O'Brien of the University of Connecticut. Similarly, consultant and fund manager Ira Kawaller, president of Kawaller & Co. LLC, says, "When a company is thinking about risk management, an important consideration is whether they're going to be consistent or divergent with the general practice of their peer group. If you do something different and the markets do not cooperate, you put yourself at a disadvantage. So there's a game-theoretic aspect to the practice."

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Perhaps that thinking helps explain the curious case of Peugeot-Citroen, whose CFO, Yann Delabriere, insisted that there would be no currency hedging on his watch, even as a strengthening euro was cutting margins in Peugeot's automotive division by 41.3 percent. Delabriere called currency hedging "a kind of gamble." Says O'Brien, "This CFO has been burned in an earlier cycle when he had hedged and forgone windfall profits."

The Nature of Risk

Whatever his reasons, Delabriere apparently speaks for many. According to Professor Mihir A. Desai of the Harvard Business School, "It's fair to say that many firms have worried about what active risk management policies have gotten them, and have been skeptical. General Motors and others have switched to something more passive. That passivity is cheaper, and it may be more in line with what shareholders expect."

There are three different kinds of currency risk, and almost every firm faces at least one of them. Transaction risk is the possibility that currencies may shift between the time an order is placed and the invoice is paid. It affects payables and receivables, is short-term, easy to calculate and easy to hedge. In a case study of GM's practice, Desai noted that GM's policy was to hedge 50 percent of these exposures with forwards in months one through six and options in months six through 12.

Translation risk, on the other hand, is the risk that a change in currency rates may alter the value of foreign assets or liabilities as reported to shareholders. It is essentially an accounting risk with no cash flow impact, but it can lead to earnings volatility. Competitive or strategic risk is the prospect of currency volatility disrupting a firm's market position over the long term.

Those are the textbook definitions of risk--but sometimes they interact in subtle and unexpected ways. In a classic study during the 1990s, for example, Merck & Co. discovered that currency fluctuations were affecting its long-term R & D plans and its resulting competitive position. When the dollar strengthened against the euro, Merck's dollar earnings fell as a result of transaction and translation risk. When earnings fell, Merck cut expenses--including the R & D budget.

The connection between currency rates and R & D wasn't obvious, and Merck noticed it only after a team pored over years of financial history. Once it recognized the risk, though, Merck embarked on an innovative program to hedge its currency exposures using options.

Few firms have followed suit. Some blame accounting rules for putting a damper on even the most prudent hedging strategies. "FAS 133 requires derivatives to be marked to market on the balance sheet," notes Charles Smithson of risk management consultancy Rutter Associates. "That, in itself, is not a big problem, but the other side is not marked. If you mark the derivative to market and don't mark the thing you're hedging to market, it will make reported income more volatile."

Dow's Reinhard was one of the first CFOs to build an effective currency risk management program in the 1980s. Now, he says, lessons learned dealing with currencies is proving useful as Dow copes with commodity price risk. He gives short shrift to concerns about hedge accounting, saying simply, "You don't manage risk for accounting purposes. You manage it from an economic perspective."

Richard Marston, a professor of finance at the University of Pennsylvania's Wharton School, reports that many American companies still try to avoid currency risk by trying to do business only in dollars. "Companies often justify the practice of denominating business contracts in their domestic currency by claiming that it reduces risk to their shareholders," he says. "But international business does not escape currency risk simply because it's conducted in the home currency." Marston suggests that companies that invoice only in dollars may put themselves at a competitive disadvantage, and would be better off offering local currency prices and managing the risk with financial and operating hedges.

Economically, currency risk is here to stay. But there are numerous ways to manage it. While American firms may have little to fear from a strong dollar in the near term, history suggests that they may have a great deal to fear from complacency.

Gregory J. Millman ([e-mail]) is a New Jersey-based freelance business writer and a frequent contributor to Financial Executive.