Judging from the earnings statements coming out of corporate America during the last half of the year, more than a few companies were hit by unfavorable foreign currency fluctuations. Amazon.com, Inc.; Lennox International, Inc.; and Pfizer, Inc., among many others, all reported a negative impact to earnings from foreign exchange rates. "Companies that thought their foreign exchange exposures weren't material got hit with large losses," says John Herrick, principal with Treasury Strategies, Inc., New York City.
Several factors converged to bruise companies' top and bottom lines. For starters, the volatility, or the pace of change in the exchange rate between currency pairs, shot up. During the past 12 months, volatility between the U.S. dollar and the Canadian dollar was 15.3 percent, compared to a 3-year volatility rate of 12.17 percent, according to RatesFX.com. Similarly, the volatility between the U.S. dollar and the euro hit 13.20 percent over the past year, vs. 10.25 percent over the past 3 years.
Moreover, volatility ramped up just as sales were falling off at many companies. Strong revenue increases can obscure the negative impact from currency fluctuations, says Joseph Neu, president of The NeuGroup, Katonah, N.Y. "If you're generating huge growth when you're not managing foreign exchange optimally, the results won't show up," he says. When growth slows, however, unprotected exposures come to light.
At the same time, the increasingly global economy means that many firms are doing more business internationally. The average daily volume in the foreign exchange markets hit U.S. $3.2 trillion in April 2007, estimates the Bank for International Settlements in its Triennial Central Bank Survey. That's a jump of 60 percent from 2004.
More companies also are working in smaller and emerging markets. "Volatility is largest in the non--G-10 currencies," notes Wolfgang Koester, chief executive officer with FiREApps, a Scottsdale, Ariz.-based provider of solutions to manage foreign exchange risk. The three most volatile currencies against the U.S. dollar over the past year were the Hungarian forint, the Polish zloty, and the South African rand, again according to RatesFX.com.
In another shift, a growing number of businesses outside the U.S. are requesting payment in their local currencies, says Chuck Bernstein, chief financial officer with Ladas & Parry, an international law firm focused on intellectual property.
A New Approach
Combined, the uptick in FX volatility, the economy grinding to a halt, and increased globalization have prompted many corporate financial executives to take a more comprehensive and strategic approach to managing their firms' exposure to foreign exchange. "We're at an inflection point in foreign exchange management where the traditional ways of doing things will change dramatically," Neu says.
One of the first steps that companies are taking is to develop systems that will allow them to better identify and quantify their exposures. Most treasurers spend too much time hunting down data from operating units. The data that they do get often is dated and incomplete, making them leery of basing hedging decisions on it, Koester says.
"Typically, forecasts aren't granular," says Randahl Finnessy, vice president and corporate treasurer with FLIR Systems, Inc., a U.S. $1.1 billion manufacturer of thermal-imaging infrared cameras based in Wilsonville, Ore. That is, they rarely identify payables and receivables for each division and region by currency. Instead, a treasurer may receive a sales forecast in euros, even if the division sells in euros, U.S. dollars, and sterling.
To compensate for the incomplete data, many treasurers review historical patterns. If 80 percent of past sales have been done in euros, 15 percent in sterling, and 5 percent in greenbacks, the treasurer may assume that this will continue. This works only if the company operates in a stable economic environment and has a commanding market share and predictable sales, Finnessy adds. Over the past year, of course, these were luxuries that few companies enjoyed. Moreover, it's not clear that stability and predictability will return anytime soon.
This makes accurately identifying a company's foreign currency exposures all the more critical. FLIR, for instance, has major manufacturing operations in the U.S. and Sweden, as well as sales offices in the U.S., Europe, and Asia. Since joining FLIR in late 2008, Finnessy has been working to pinpoint the currency exposures that exist within the company. Using an application from FiREApps, he has been able to identify FLIR's currency pairs, as well as its exposure at the corporate level.
While FLIR operates in three relatively autonomous divisions, looking at exposures on a divisional level can obscure any natural hedges between divisions, where income in one currency in one division is offset by expenses in that currency in another division. Identifying these is key, since a natural hedge is the most cost-effective way to hedge, Finnessy notes.
Leveraging natural hedges is likely to be increasingly important, as the guidelines for accounting for derivatives transactions used to hedge continue to tighten, says Neu. "Hedge accounting increasingly requires a one-to-one linkage between the hedge, or derivative instrument, with the item being hedged." Most companies, on the other hand, would rather hedge just their net exposure.
At the same time, the cost of hedging has risen. When the relationship between two currencies becomes more volatile, the premiums on the options a company might use to hedge its exposure also increase. The prices on some options have jumped three to five times over the past year or so, estimates Lucio Sarno, author of The Economics of Exchange Rates and a professor of finance at City University London. "It's when you most need the instruments that the prices go up." Given limited dollars, treasurers need to identify the exposures that will get the most benefit from hedging. (In the currency markets, options provide the right, but not the obligation, to buy or sell a specific amount of a currency at a specified price during a set period of time.)
The FiREApps system identified about three dozen currency pairs, one-third of which are material, Finnessy says. He also can determine FLIR's exposures on a daily basis, to within 15 minutes. Armed with this information, FLIR is better equipped to go to the markets and offset its net currency exposures. "You need to go through this exercise," Finnessy says. "Understanding our exposures and their magnitude gives us an idea of where to attack volatility." FLIR's next step is to begin a program of entering into spot and forward contracts to mitigate exposure, he adds.
Keeping It Simple
Even as treasurers and CFOs strive to cut their firms' foreign exchange risk to immaterial levels, few are interested in engaging in complicated options strategies that they can't explain to their board. "We've seen a move away from leverage and complexity," says Derek Sammann, managing director of financial products and services with CME Group, a derivatives marketplace in Chicago. "It's driven by concerns over counterparty risk. Also, firms realize that they shouldn't leverage their balance sheet."
Instead, most corporate financial executives are focused on reducing surprises -- whether positive or negative -- to their financial statements, Sammann adds. "At the end of the day, the corporate hedger's job is to reduce volatility in the earnings statement."
When Ladas & Parry helps its clients to obtain U.S. patents or trademarks, it also helps them to protect their intellectual property abroad. To do that, the firm usually works with law firms in other parts of the world. More than half of the firm's annual revenue, which is in the high eight figures, can be attributed to IP matters outside the U.S., Bernstein notes.
When Ladas & Perry partners with firms in other parts of the world, it obviously has to pay them for their services, as well as any fees they incur from foreign patent and trademark offices. Ladas & Parry must also bill and collect these disbursements from its clients. The time gap between the transactions can be as long as several months, giving exposure to currency fluctuations. "The longer it takes clients to pay, the more risk you have," says Bernstein.
The firm uses several tactics to reduce the chances that it will have to pay one amount for services and disbursements abroad while collecting another amount from its clients. For larger amounts -- generally, any transaction that's in the tens of thousands -- it usually purchases an agreement to lock in a conversion rate that's good for 180 to 210 days and that covers an individual invoice, Bernstein says. These agreements, which it purchases through Travelex, let Ladas & Parry set the exchange rate on an invoice and schedule a payment in the future.
Many law firms that deal with intellectual property must settle invoices in different currencies, says Alfred Nader, vice president of sales for Travelex's legal division. While each transaction may be relatively small, the volume can quickly add up. With this type of agreement in place, they can cost-effectively lock in the exchange rates.
In some cases, Bernstein will purchase forward contracts that can be used across several invoices. Or, if the amounts are small -- say, less than $5,000 -- then it generally is most cost-effective to go with the spot exchange rate, Bernstein says.
While the goal of corporate hedging programs should be to reduce volatility and fluctuations in the financial statements, not every one (often, including board members) understands this. Herrick notes that hedging decisions are some of the most difficult ones that treasurers face, because they're so often a heads-you-win, tails-I-lose proposition. That is, when currency pairs are moving in the company's favor, the hedges will dampen any potential positive impact on the financial statements. When the rates are going against the company, the treasurer may be questioned for not have hedged more.
"There will always be times when the program looks brilliant and times when it looks like a detriment to the company," Finnessy says. "Over time, however, the program should be beneficial by muting currency's impact on net income."
Impact on Operations
Some strategies for reducing FX exposure involve the company's operations rather than the financial markets. As a starting point, treasurers need to keep tabs on the currency fluctuations in those countries where their firm does business. In today's environment, it's not unusual for suppliers to say that they're raising prices in order to compensate for a currency's ups and downs, says Patrick Furey, senior category manager with Ariba, Inc., a provider of spend management solutions in Sunnyvale, Cal.
"If they're not tracking this, they have to take the supplier at its word," he adds. What's more, few companies will volunteer a price reduction when exchange rates move in their partner's favor. By staying abreast of the FX markets, treasurers can negotiate more effectively.
If a company is going to allow a business partner to vary its price when exchange rates fluctuate, it needs to spell out the terms in the contract, Furey says. In contracts with suppliers, for instance, the provisions might indicate that if the supplier's currency moves by more than, say, 10 percent against the dollar, the price will adjust by some portion of the movement. Rarely will the total price of the goods or services change on a one-for-one basis with a currency fluctuation.
GlowTouch Technologies, a $7 million Louisville, Ky.-based IT outsourcing provider, has used this approach with its larger customers, says President Vidya Ravichandran. GlowTouch has operations and employees in the U.S. and Mangalore, India. Over the past year, the U.S. dollar had declined about 11 percent against the Indian rupee. Even so, GlowTouch still has to pay its Indian employees their regular salaries. So, the company began including clauses in its contracts that allow the company to adjust its pricing when the dollar moves. If the dollar falls by more than a certain percent, the customers' fees move up; if the dollar strengthens, the customers enjoy a discount.
To be sure, not all customers welcomed the switch. Some argued that they weren't responsible for fluctuations in the currency markets. However, Ravichandran pointed out that GlowTouch is able to take advantage of varying rates of labor by having some of its work done in a lower-cost region of the world. At the same time, working internationally means that the firm is subject to the ups and downs of the currency markets. Most recognize this and also want the company to remain healthy and viable, Ravichandran notes.
On a longer-term basis, a company can try to diversify its supplier base across different currencies. If a company has several suppliers approved and ready to go in, for instance, Thailand, Mexico, and the Czech Republic, it may be able to vary the amount of work allocated to each as exchange rates move. This tactic can be tough to actually implement, however. Suppliers' overall pricing and quality levels, along with delivery times, often weigh more heavily than its currency's volatility when deciding which ones to use, Furey notes.
In some cases, fluctuating exchange rates force changes to operations. "We're particularly concerned about our operations in Brazil, Indonesia, and Senegal, because of how the dollar has lost purchasing power," says Jim Tuite, chief financial officer with ChildFund International, a nonprofit organization that helps children in 30-some countries. Currently, about two-thirds of ChildFund's income is derived in U.S. dollars, while it pays most of its expenses in the local currencies.
To compensate for currency movements, Tuite monitors expenses and adjusts budgets on a regional approach. In Africa, for instance, the U.S. dollar strengthened against the Sierra Leone leone by about 15 percent between July and early November. During the same period, the dollar weakened by about 5 percent against Senegal's Communauté Financière Africaine franc. Because the dollar is going further in Sierra Leone, the regional vice president in Africa will provide fewer dollars to that country, while boosting the allocation to Senegal. "We try to adjust our budgets accordingly," Tuite says.
Tuite and his colleagues also have been trying to increase the amount of funding that the organization receives from currencies other than the dollar; a few years ago, just 15 percent of contributions were in currencies other than dollars. One step was to come together with about a dozen other organizations to establish the ChildFund Alliance, which also includes groups in Europe and Asia. The Alliance has helped to increase funding from outside the U.S. "It's a nice, natural hedge to operations," Tuite says.
Long-Term Shifts
At this point, it's becoming clearer that the FX landscape is shifting in ways that are likely to be long-term. "The emerging countries are growing quickly and the BRIC (Brazil, Russia, India, and China) countries are gaining strength," says Kina Lamarche, North American president of Travelex global business payments. The continued status of the U.S. dollar as the world's reserve currency is in question.
Treasurers are responding. "We've seen a fundamental change in the DNA of finance and accounting," Lamarche says. They're more intent on gaining visibility to cash flows, understanding their exposures, and then taking steps to manage them. "In the past, the message has been there, but it's been like telling people to stop smoking. They don't do it until there's a crisis," she adds.
Move to Exchange-Traded Hedges?
One issue that has dominated discussion of foreign exchange management is whether transactions done to hedge corporate FX exposures should be moved to centralized exchanges. Currently, about 98 percent of foreign exchange hedging transactions are over-the-counter transactions, says Tim Weithers, a lecturer in mathematics at the University of Chicago and author of Foreign Exchange: A Practical Guide to the FX Markets.
Exchange-traded derivatives offer several advantages over their OTC counterparts, says Derek Sammann, managing director of financial products and services with CME Group, the parent of the Chicago Mercantile Exchange. Transparency is greater, so firms can easily check that they're getting fair prices on their hedge transactions.
In addition, because the exchange is a party to all transactions, it can step in if one party fails to make good on its promises. "The big lesson from the financial crisis was that you really can't trust anyone as a financial counterparty," says Joseph Neu, president of The NeuGroup, Katonah, N.Y. This message seems to have gotten across, as the average daily business on exchange-traded derivatives jumped from about $10 billion in 2001 to $100 billion currently, Sammann says.
There's a cost to this, however. Firms that purchase contracts on exchange generally have to post collateral, says John Herrick, principal with Treasury Strategies, Inc. This often isn't the case with over-the-counter hedges. In addition, by their nature, exchange-traded derivatives are standardized. Many companies customize their OTC transactions.
As it stands now, the legislation approved by the House Financial Services Committee would exempt most companies that employ derivatives to hedge operational risk, Herrick adds. As a result, the impact on corporate hedging programs could be minimal.