Currency Risk: To Hedge or Hedge Not?

Between 1994 and 2004, the value of products imported into North America more than doubled, rising from $928 billion to about $2 trillion. During the same period, product exports also grew dramatically, jumping from $739 billion to $1.324 trillion, according to the World Trade Organization. As the volume of cross-border transactions has skyrocketed, however, many North American companies have failed to adopt policies for hedging their exposure to fluctuating foreign exchange (fx) rates.

Historically, North American organizations could grow sufficiently by focusing on domestic markets. Executives had little reason to learn the ins and outs of foreign currencies. So today, when these companies do conduct cross-border transactions, many of their managers ignore tools such as forward contracts and options that could protect their firm's bottom line against changing currency values. Of the 100 U.S. and Canadian finance professionals responding to a 2004 survey by Travelex Commercial Foreign Exchange, a New York City-based company, 70 percent said that their business did not use hedging tools to protect against foreign currency risks, and about two-thirds said that their organization lacked an fx policy.

Some finance executives believe they can mitigate their company's fx risks by setting all prices in U.S. dollars. That thinking doesn't hold up, says Bob Murray, senior vice president and managing director of foreign exchange with Sovereign Bank in Boston. "Even if you bill or pay in dollars, you're not mitigating the currency risk," he explains. After all, someone has to convert the invoice or payment into the local currency. Doing business only in your company's home currency allows the counterparty to determine the exchange rate. And it's not uncommon for that entity to build into the price a premium for its own exposure to currency fluctuations, Murray says. In addition, a company loses a competitive edge when it deals only in one currency, says Kevin Kilkelly, director of treasury operations with Symbol Technologies Inc., an enterprise mobility company based in Holtsville, N.Y. "You could risk market share if your competitor is offering to bill in euros and your customer prefers that." Symbol Technologies generated about 42 percent of its $1.8 billion in revenue outside the United States in 2005.

Some treasurers eschew hedging instruments out of concern about the cost or effort hedging entails. "A lot of companies avoid using options," says Jiro Okochi, CEO and co-founder of Reval.com Inc., a New York City-based provider of derivative risk management solutions. "It may be because of the more complex hedge-accounting issues or the negative connotations of paying a premium" to purchase an option. Quite a few finance executives assume that hedging is more expensive than it's worth. Sometimes that's true; hedging is often proportionally more expensive for smaller and midsize businesses than it is for larger organizations, says Wolfgang Koester, CEO of Scottsdale, Ariz.-based Rim-Tec Inc., which provides foreign currency management services for midmarket companies. For instance, a bank may charge a company more if it purchases hedging instruments infrequently rather than on a regular basis, Koester says.