The how of Dow: managing currency risk.

Equipped with technology that rivals any bank's, Dow's risk management centers protect the company from the slings and arrows of market fortune. And just as the military makes sure rising stars get combat experience, Dow sees that its best and brightest financial executives get their tickets punched on a trading desk. But finding out how risk affects the bottom line wasn't easy. It took the company years to trace the effects of currency risk on its global petrochemicals business.

The collapse of Asian currencies, the crisis in Russia, stock market volatility and rambling rumors of global depression - American corporations are taking punch after punch, and there's no let-up in sight. Economists at the Federal Reserve Bank of New York compare the current situation to the early 1980s, when the dollar soared above other currencies. One result: the term Rust Bowl entered the American vocabulary as whole industries - steel and machine tools, most notably - all but vanished as Japanese and other competitors rode to glory on their cheap currencies.

The currency crisis of the early '80s spurred researchers at several universities to analyze precisely how currency fluctuations affect companies, and some firms implemented the results immediately; the stakes were too high not to. But ascertaining how risk affects the bottom line wasn't easy.

There are many kinds of risk, and many ways to deal with each. Dow Chemical, based in Midland, Mich., has one of the most sophisticated financial risk management systems in the world, tighter controls than the average nuclear submarine and a strong record of success in difficult times.

With manufacturing plants in 33 countries, sales in 169 and over 50 percent of its revenues coming from outside the U.S., Dow faces a complex skein of exposures to currency, interest rates, credit, political and other international business risks. Yet Dow hasn't joined the headline-making roster of companies shell-shocked by the current global economic crisis. "We've not incurred any losses due to turmoil in emerging markets, despite the recent currency slide," CFO Pedro Reinhard says.

Accepting Risks

From an office nestled among central Michigan's rolling hills, Reinhard directs a financial organization prepared for crisis. "I think companies doing business outside the U.S., like it or not, are exposed to currency fluctuations. Some choose to deny that. We chose to accept it and try to manage the risk," he says. To say Dow hasn't suffered currency or credit losses is not to say the company has escaped unscathed by the dollar's recent strength; price cuts caused by the strong dollar cost Dow $400 million in revenue in the first quarter of 1998, and $500 million in the second.

But, says Reinhard, "We have had no surprises." A tall, taciturn Brazilian, he made his bones at Dow dealing with problems like hyperinflation and blocked funds in the wake of Latin America's debt crisis during the early 1980s. In 1987, he began the first detailed and comprehensive study of Dow's economic exposures. The study considered the effects of currency shifts on prices, costs and competitive position, and found the effects to be both dramatic and subtle.

Dramatic because - depending on the product and the price elasticity of demand - currency shifts could make the difference between gaining or losing in the market. Subtle because the competitive structure of the chemical market is anything but transparent. When the dollar strengthens against European currencies, competitive pressure from local suppliers may impact how much Dow can raise local currency prices. Therefore, the dollar revenue from European sales may be reduced.

What's more, the chemical business is incestuous. Chemical companies not only compete with each other, they also sell to each other. A competitor on one product line is therefore a customer on another. So while a strong dollar may hurt Dow's sales in Germany, it may also lower the dollar cost of raw materials Dow buys from Germany.

Working with operating units, Reinhard put together a task force to delve into every aspect of the company's business. It included treasury staff from regional operations in the U.S., Europe, Canada, Latin America and the Pacific, plus marketing and purchasing staff from 30 groups representing over 80 percent of Dow's products. It took over a year just to measure the effect of currency rates on each product in the market.

Depending on the competitive environment, operating managers might be able to raise or cut prices, or change suppliers to cope with currency effects. But there's only so much that operating measures can do to protect the company. That's why Dow relies on a financial risk management program to protect cash flows that operating measures alone can't defend.

The Importance of Cash Flow

"Cash flow" is the key. The accounting profession has struggled to cope with the proliferation of new financial products that have come to market since the development of derivatives in the mid-1980s. Many corporate financial officers have been discouraged from hedging by their auditors' insistence that some kinds of hedges be "marked to market." If a long-term option hedging anticipating future revenue did not qualify for narrowly-defined "hedge accounting," any gain or loss in market value would have to be recognized in quarterly earnings statements. Using the option to hedge might be the best thing from a long-term, cash-flow perspective, but in the short term, it may mean accepting (and having to explain) volatile earnings.

Faced with a choice between protecting accounting image and cashflow reality, Dow has consistently opted for cash flow. "When we talk about economic currency risk, it's the effect of changes in currency on the cash flows derived from netting foreign prices and foreign costs," Reinhard explains. Dow doesn't measure its own performance by accounting earnings, but rather by what Reinhard calls "economic profit," the added value above the cost of capital. "When you try to minimize financial expense on an after-tax basis, you are indirectly minimizing the cost of capital," he says.

That's the objective of the company's financial risk management program, and it's so important that a stint in one of Dow's three risk management centers (in Midland, Zurich or Singapore) is a key part of career development for anyone hoping to move up the ladder in Dow's finance unit. "Currency is a major part of doing business, and the more they understand the dynamics, the better equipped they are to handle volatility," Reinhard explains. "This program has created a management culture that knows how to handle situations like we find ourselves in today in the Pacific or in Russia."

Dow Vice President and Treasurer Geoffrey Merszei explains the risk management decision as the final phase of a three-step process. The first step is to recognize there is an exposure, the second is to measure the exposure and the third is to decide whether and how to manage it. "We take a view on everything we manage," he says. "We may hedge 10 percent, we may hedge 50 percent, we may hedge 100 percent or we may open it up again."

Some corporations, as a matter of policy, forgo hedging altogether, often with the explanation that the kind of selective hedging Dow uses is only a hair-breadth removed from speculation. Merszei bristles at the suggestion. He says, "If a company has an exposure and decides not to manage it, that to me is speculation. When you assume an exposure because of a conscious decision, then it's not speculating, it's taking a financial position based on some fundamental analysis."

Dow's young finance department professionals don't just hedge, though. They also trade for profit, placing bets on the direction of currencies and interest rates. Whenever a trader enters a transaction, he or she designates it as either a hedge, which covers an existing exposure, or a trade, which could create an additional exposure to generate a profit. Their active involvement in the market gives Dow an important source of financial intelligence, Reinhard says. "They better understand the dynamics of the marketplace [because] they have to analyze, make decisions, react. It makes them better finance personnel."

Typically, a new hire at Dow starts in the credit or financial planning area, moving into a financial risk management center three to five years later. "The reason they come in is not to become a good trader but to better understand the market, because these markets have a big impact on our business environment and there's no better way to understand them than to get into risk management," Merszei explains.

Trading Posts 

Dow measures its global currency, interest rate and commodity exposures using a value at risk (VAR) model put in place by assistant treasurer Fernando Ruiz in 1990. This is a statistical measurement that looks at historical market behavior to calculate the potential loss or gain of any position, given normal market behavior. Assuming normal market behavior, the VAR model shows the potential maximum loss that can happen on any given day with any position or portfolio of positions with a 95-percent confidence level.

New professionals in risk management typically spend a year or two working with VAR and similar analytical tools. Says Merszei, "Before actually getting into buying and selling currencies, they spend some time in the trading environment, not actually trading but looking at models, stress testing and working with mathematical analytical tools. The next key thing is to understand the derivative instruments, some of which are pretty complex. By the time anybody gets on the trading desk, they understand the ABC's of all the products available in the marketplace."

Dow was one of the first major American corporations to use derivatives, and has a reputation among bankers as a savvy, sometimes intimidating customer. Dow's traders have been known to play an arbitrage game with bankers, calling several for a two-way price on some derivative, then buying from the low bidder and selling to the high. The company's analytical skills discourage bankers from even presenting some of the so-called "toxic waste" derivatives that dragged certain major corporations and even government entities into the news several years ago.

But the real key to success is discipline. Merszei thinks the common denominator in all the big derivative trading losses by corporations and banks has been the lack of discipline. "We have a rigorous procedure, tightly implemented," he says. For example, trades are usually made by phone, but bankers then confirm them in writing. At Dow, the trades are made in the treasury department, but confirmations go to the controller's department. This guarantees a double-check on the activities of treasury staff, and makes it impossible for traders to conceal their activities. It sounds like common sense, but the absence of this basic control has caused hundreds of millions of dollars of losses for corporations and bankers in recent years, and was even behind the 1995 collapse of Britain's Barings Bank.

Merszei also underscores the importance of sophisticated technology. "If we don't have the best system, we're not involved in the activity," he says. "We have the most up-to-date treasury systems, some developed in-house, some bought outside. Our approach is that if you do foreign exchange trading, you make sure you have the very best, most current system for it. We have the kind of systems you'd expect to find in the bank trading world."

Yet while the company uses systems, it's also aware of technology's limits. Through its long and carefully measured exposure to difficult markets, Dow has learned the role of gut judgment in the risk management game. For example, skepticism about the much-ballyhooed market reforms in Russia kept Dow out of that problem-plagued financial system. "The rules and regulations seemed arbitrary, so we have never gone into that market, as we have in Latin America," Reinhard says. An appreciation of what numbers cannot reveal also helped the company to minimize its credit exposures in that market. "Most multinationals have retrenched to a global center in the U.S.," he notes. "But the type of information you have on the ground in Moscow is different from the type you have just by looking at the account balances, invoices and payments center data." Sometimes, there's just no substitute for experience, and Dow relies heavily on the hands-on local managers to make the calls about credit risk.

There's no arguing with success. Dow's ship has withstood some rough weather indeed, and looks set to sail cleanly through the storms ahead.

Reversal of Fortunes

There is a precedent to the dollar's cent strong performance - its stunning rise during the early 1980s, when the currency's strength alone brought the producer price index up by an average of 35 percent. High American prices gave Japanese and European companies a competitive windfall, allowing them to seize market share worldwide. The dollar's fall after 1985 tilted the competitive field back in favor of U.S. manufacturers, but didn't reverse the damage. While U.S. exports grew at triple the rate of German and Japanese exports during the late 1980s and early '90s, many foreign competitors consolidated their market share gains by building plants in the U.S.

So, with the dollar strengthening again, corporations face a complicated array of challenges and opportunities.

In a recent report from the Federal Reserve Bank of New York, economists Thomas Klitgaard and James Orr say the dollar's strength poses a serious threat to American corporations. "To keep up with foreign firms, U.S. exporters will have to pursue cost-cutting measures and perhaps accept lower profit margins," they explain. Because it takes more yen, marks, pounds or pesos to buy dollars, products manufactured in the United States are now more expensive in foreign currency terms, even if their price in dollars remains constant.

More Sales, Fewer Dollars

A strong dollar also means foreign currency revenues are worth less in U.S. dollar terms. This can cause a disconnect between business performance and reported financial results. For example, in the first quarter of 1998, Ford sold more cars in Europe than in the first quarter of 1997, but those sales were worth fewer dollars. Coke sold more cola, but its stock lost fizz when the company announced disappointing financial results blamed on the strong dollar. And Johnson & Johnson announced the dollar had cost it 9 percent of international revenues.

"At this point in the development of the financial markets, a well-run firm is going to understand its exposures and have a thoughtful policy for managing them," says Clifford Smith, a professor at the University of Rochester's Simon School of Business. Some corporations cope with volatile financial risks by trimming their fundamental business sales, adjusting manufacturing and other decisions accordingly. Others adopt a sod of "hair of the dog" approach - since financial markets have caused their problem, they reason, financial markets can provide a solution.

For example, Caterpillar was blindsided by the dollar's surge during the early 1980s. Caterpillar equipment had traditionally sold for about a 15-percent premium to Japan's Komatsu machines. The currency shift of the early '80s widened the gap to 40 percent, and Komatsu ate market share. Douglas R. Oberhelman, vice president and CFO of Caterpillar, says, "We recognized that our company was exposed to currency movements and embarked on a long-term strategy to be less currency sensitive." Key to the strategy was a global manufacturing presence that allows Caterpillar to protect margins by matching the currency in which it incurs costs with the currency in which it earns revenues.

At Merck, CFO Judy Lewent adopted a very different approach. A study in the late 1980s convinced her and others in Merck's senior management ranks that volatile currency markets threatened the company's long-term plans. So Lewent devised a strategy to guard against currency shocks by hedging with long-term options.

Honeywell CFO Larry Stranghoener last year became the first major corporate CFO to treat currency risk like fire, liability or worker's compensation risk by including it in a long-term, comprehensive insurance policy. At least three major insurance companies - AIG, Swiss Re and Cigna - now offer such comprehensive risk management policies.

Small wonder, then, that the Simon School's Smith notes with exasperation, "There are some firms for whom what is going on in the FX markets provides more of an excuse than a reason for poor performance." With the wide variety of solutions now available, that's a much less credible alibi than it used to be.

Gregory J. Millman is author of The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central Banks.