Forex Risk Management

Risk analysis and its management is just as common in our everyday existence as the very concept of our ‘self-preservation’. It is very much a part of human psyche, yet so elusive. Enquire with the passengers in an airplane during turbulent flying conditions to ascertain if all of them have an equal degree of anxiety. We all know full well that flying in an airplane is far safer than driving a car; yet, some passengers will make anxious inquiries while some others snooze happily regardless of the weather. Event is the same but the effect is different from person to person. Is it because each person is ascribing his own value to risk?

Interestingly, organisations are no exception to these phenomena. Many in the organisations still view risk as an esoteric tool of science or engineering but not as a ‘grass-root’ metric. It is not hard to understand the reasons for such a mindset. Firstly, ‘risk’ raises many questions: Is all risk bad? Is risk a natural metric? Can risk be measured directly? In what units is risk measured? Can risk be added and subtracted? Thus, it raises more questions than answers about its nature. Secondly, to anyone trying to understand risk, there appears to be no frame of reference within which it could be understood. Thirdly, we cannot attach a probe to a device and measure risk. Fourthly, risk is an abstract parameter, requiring degree of intellect, to quantify it. Anyone of them could well be the reason why risk- and risk-management-related discussions even today sound theoretical, if not philosophical, and for the most part, irrelevant to many in the organisations.

While people are swaying in their own idiosyncrasies, forex market, on the other hand, moves to its own rhythms and operates by its own rules. It is also true that no one can influence exchange rate movements consistently over a long time. In the increasingly globalized economy where companies are moving across national boundaries, firms are more and more exposed to foreign exchange risk. Indeed, volatility in forex markets has become the order of the day since 1973 when Bretton Woods system of fixed exchange rates collapsed. The simultaneous publication of the Black Scholes option pricing formula and the emergence of derivatives market have sown the seeds for the growth of the risk management industry. Suddenly, risk management has become more complicated than it ever was. In short, risk management has become the universal management process demanding high quality of thought, process and action to keep businesses afloat.

Foreign Exchange Risk: To Hedge or Not To Hedge

A company involved in cross border transactions or in raising or placing funds in international markets is obviously exposed to exchange risk. Similarly, every business that has an asset or receivable in a foreign currency (exporters) loses if the currency depreciates, while a business having a liability or payable (importers) loses if it appreciates. At times, even companies engaged in domestic markets are exposed to exchange risk as the market is opened to overseas firms. No one business can afford to ignore the effects of exchange rate movements, since it can destabilize the cash flows and increase uncertainty from financial forecasts. In turn, the market valuation of companies would get a beating. This compels companies to hedge themselves against foreign exchange risks.

Currency hedging is a strategy that aims at minimizing the exposure to exchange rate fluctuations, thereby minimizing the uncertainty of future transactions denominated in a foreign currency and affording stability to earnings and cash flows. Hedging against foreign exchange risk means:

• Entering into a transaction whose sensitivity to movements in financial prices offsets the sensitivity of the core business to such changes; 
• To improve or maintain the competitiveness of the firm; 
• To improve bottom line while prudently positioning the firm so that it is not adversly affected by movements in exchange rates; 
• To reduce costs of funding or to lower their prices in markets that are deemed to be strategic and essential not to get priced out of sum important markets.

Hedging is of course contingent on the preferences of the shareholders. Some shareholders may not care what a firm is hedging against its risks or not, for they believe that they can hedge their portfolios at their individual level.

Incidentally, Merton Miller & Christopher Culp, economists from University of Chicago, observed, “most value-maximizing firms do not hedge”. Even according to the Modigliani and Miller Paradigm, risk management is irrelevant to the firm and they demonstrated that   firms make money only if they make good investments of those that increase their operating cash flows. According to them, it does not matter whether those investments are financed by debt, equity or by retained profit. The methods of financing, they said, will only determine how a firm’s value is divided among its investors but not the value itself. If this assertion is right, it has critical implications for hedging: if methods of financing and the financial risks thereof do not matter, there is no point in managing risk. In other words, hedging can not increase the firm’s value; on the other hand, it only adds to its cost, for derivatives do not come free.

Recent theories however suggest that hedging is a value increasing strategy for the firm. George Allayannis and James P. Weston, examined the use of foreign currency derivatives in a sample of 720 large non-financial firms between 1990 and 1995 and using Tobin’s Q as an approximation for firm market value, found significant evidence that the use of FCDs is positively associated with firm market value. They also averred that firms that begin a hedging policy experience an increase in value above those firms that choose to remain un-hedged and that firms that quit hedging experience a decrease in value relative to those firms that choose to remain hedged.

Rene Stelz argues that there are only a couple of good reasons why a firm should hedge: one, to cut tax bills, and two, being unable to get cash when it needs it, or facing a serious risk of running short. He therefore opines that a firm with little debt need not hedge, as the risk of it getting into financial trouble is remote.

Myron Scholes, an economist at Stanford University, however, does not agree with this thesis. He is of the opinion that firms with little debt could reduce their risk by hedging, and so be able to borrow more and rely less on equity. And equity is more risky to service than debt. However, he says, to be effective in risk reducing hedging, managers must have a very good understanding of the ‘risk’ and the risk to which their firm is exposed and of opportunities to hedge.

All this discussion leads to two conclusions: one, hedging of risks by nonfinancial companies is not that obvious; and two, with increased globalisation of economies, foreign exchange risk management is gaining greater importance. Even in India which is integrating with world economy more and more, hedging against forex risk is gaining importance. What is now happening mostly under the name of hedging is ‘transaction hedging’ and this has raised an allegation against finance managers: all hedging is nothing but financial managers’ hunches or a reflection of their fascination for fancy derivatives. Amidst these conflicting arguments there emerges a strong theoretical case for ‘strategic hedging’ from the perspective of the company’s overall cash flows. Strategic hedging goes beyond finance and derivatives. It expects businesses to understand all the main risks to which their future cash flows are exposed. It also takes cognizance of the trade-off between financial hedging and “natural” and operational alternatives. To accomplish these objectives firms must build more cooperation between general and financial managers and ensure that everyone has a sound knowledge of what the other does. Strategic hedging essentially rests on running the firm’s forecast budgeted through multiple simulations to reflect different currencies, their interest rates and growth scenarios. Such strategic risk analysis would be able to capture not only transaction risk but also economic risk and thus enables firms to take well informed decisions on whether and how much to hedge.

The other emerging strategy to hedge foreign exchange risk is the use of ‘natural’ hedges. For instance, if a company is setting up a factory in China, it makes great sense to finance it by borrowing in the currency of that country. An extension of this analogy is ‘operational hedging’ that calls for relocation of production facilities to better match the costs with the revenues. To hedge or not to hedge is thus not a simple question. To decide hedging strategy managers need to have right answers to three fundamental questions:

• How well does the manager understand the firm’s risk exposures? 
• If identified, would hedging these risks make shareholder better off? 
• If so, is it practical to hedge these risks adequately?  

There is of course no ‘set of rules’ that can provide right answers to these questions and guarantee that there would be no wild fluctuations in a company’s financial fortunes. The emerging need is ‘risk management’ which must be treated as a core skill by every firm. Hence, they should develop such internal control systems that allow managers to know instantly what risk they are exposed to and ensure that the risk containment strategy of the firm is implemented. It is in this context that Myron Scholes’ observations about the need for firms to hone their skills to better their understanding about ‘risk’ and its behavior at generic level, and relate its understanding to identify, assess, monitor and manage firm-specific foreign exchange risk effectively, becomes highly relevant.