Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in a way such that losses (gains) on the first exposed position will be offset by gains (losses) on the second currency exposure. This portfolio approach to hedging recognizes that the total variability or risk of a currency exposure portfolio will be less than the sum of the individual variabilities of each currency exposure considered in isolation. The assumption underlying exposure netting is that the net gain or loss on the entire currency exposure portfolio is what matters, rather than the gain or loss on any individual monetary unit.
Centralization versus Decentralization
In the area of foreign exchange risk management, there are good arguments both for and against centralization. Favoring centralization is the reasonable assumption that local treasurers want to optimize their own financial and exposure positions, regardless of the overall corporate situation. An example is a multibillion-dollar U.S. consumer-goods firm that gives its affiliates a free hand in deciding on their hedging policies. The firm’s local treasurers ignore the possibilities available to the corporation to trade off positive and negative currency exposure positions by consolidating exposure worldwide. If subsidiary A sells to subsidiary B in sterling, then from the corporate perspective, these sterling exposures net out on a consolidated translation basis (but only before tax). If A or B or both hedge their sterling positions, however, unnecessary hedging takes place, or a zero sterling exposure turns into a positive or negative position. Furthermore, in their dealings with external customers, some affiliates may wind up with a positive exposure and others with a negative exposure in the same currency. Through lack of knowledge or incentive, individual subsidiaries may undertake hedging actions that increase rather than decrease overall corporate exposure in a given currency.
A further benefit of centralized exposure management is the ability to take advantage, through exposure netting, of the portfolio effect discussed previously. Thus, centralization of exchange risk management should reduce the amount of hedging required to achieve a given level of safety.
After the company has decided on the maximum currency exposure it is willing to tolerate, it can then select the cheapest option(s) worldwide to hedge its remaining exposure. Tax effects can be crucial at this stage, in computing both the amounts to hedge and the costs involved, but only headquarters will have the required global perspective. Centralized management also is needed to take advantage of the before-tax hedging cost variations that are likely to exist among subsidiaries because of market imperfections.
All these arguments for centralization of currency risk management are powerful. Against the benefits must be weighed the loss of local knowledge and the lack of incentive for local managers to take advantage of particular situations that only they may be familiar with. Companies that decentralize the hedging decision may allow local units to manage their own exposures by engaging in forward contracts with a central unit at negotiated rates. The central unit, in turn, may or may not lay off these contracts in the marketplace.