Ordinarily, the selection of a funds adjustment strategy cannot proceed by evaluating each possible technique separately without risking suboptimization; for example, whether a firm chooses to borrow locally is not independent of its decision to use or not use those funds to import additional hard currency inventory. However, when the level of forward contracts that the financial manager can enter into is unrestricted, the following two-stage methodology allows the optimal level of forward transactions to be determined apart from the selection of what funds adjustment techniques to use.8 Moreover, this methodology is valid regardless of the manager’s (or firm’s) attitude toward risk.
Stage 1: Compute the profit associated with each funds adjustment technique on a covered after-tax basis. Transactions that are profitable on a covered basis ought to be undertaken regardless of whether they increase or decrease the firm’s accounting exposure. However, such activities should not be termed hedging; rather, they involve the use of arbitrage to exploit market distortions.
Stage 2: Any unwanted exposure resulting from the first stage can be corrected in the forward market. Stage 2 is the selection of an optimal level of forward transactions based on the firm’s initial exposure, adjusted for the impact on exposure of decisions made in Stage 1. When the forward market is nonexistent, or when access to it is limited, the firm must determine both the techniques to use and their appropriate levels. In the latter case, a comparison of the net cost of a funds adjustment technique with the anticipated currency depreciation will indicate whether the hedging transaction is profitable on an expected-value basis.
8 This methodology is presented in William R. Folks, Jr., “Decision Analysis for Exchange Risk Management,” Financial Management, Winter 1972, pp. 101-112.
10.6 Managing Transaction Exposure
As we saw in Section 10.1, transaction exposure arises whenever a company is committed to a foreign-currency-denominated transaction. Since the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change in the dollar (HC) amount of the cash inflow or outflow. Protective measures to guard against transaction exposure involve entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure.
These protective measures include using forward contracts, price adjustment clauses, currency options, and borrowing or lending in the foreign currency. For example, General Electric explained its hedging activities in its 2007 Annual Report (p. 52) as follows:
Financial results of our global activities reported in U.S. dollars are affected by currency exchange. We use a number of techniques to manage the effects of currency exchange, including selective borrowings in local currencies and selective hedging of significant cross-currency transactions. Such principal currencies are the pound sterling, the euro, the Japanese yen and the Canadian dollar.
Alternatively, the company could try to invoice all transactions in dollars and to avoid transaction exposure entirely. However, eliminating transaction exposure does not eliminate all foreign exchange risk. The firm still is subject to exchange risk on its future revenues and costs—its operating cash flows. In its 2007 Annual Report (p. 49), IBM explained that its hedging program may not completely eliminate all the risks:
The company earned approximately 47 percent of its pre-tax income from continuing operations in currencies other than the U.S. dollar. The company also maintains hedging programs to limit the volatility of currency impacts on the company’s financial results. These hedging programs limit the impact of currency changes on the company’s financial results but do not eliminate them. In addition to the translation of earnings and the company’s hedging programs, the impact of currency changes also will affect the company’s pricing and sourcing actions. For example, the company may procure components and supplies in multiple functional currencies and sell products and services in other currencies. Therefore, it is impractical to quantify the impact of currency on these transactions and on consolidated Net income.
We will now look at the various techniques for managing transaction exposure by examining the case of General Electric’s euro exposure. Suppose that on January 1, GE is awarded a contract to supply turbine blades to Lufthansa, the German airline. On December 31, GE will receive payment of €10 million for these blades. The most direct way for GE to hedge this receivable is to sell a €10 million forward contract for delivery in one year. Alternatively, it can use a money market hedge, which would involve borrowing €10 million for one year, converting it into dollars, and investing the proceeds in a security that matures on December 31. As we will see, if interest rate parity holds, the two methods will yield the same results. GE can also manage its transaction exposure through risk shifting, risk sharing, exposure netting, and currency options.