Continuing

Education

FX Management

Risk analys is

n FX Risk

ramework

Five considerations for judging your

com pan y s X Risk.

Whil

e most multin ational co mpanies

face fo   eign exchange risks, few under

sta nd all the cons iderations that need

to

be we

igh

ed

in order to manage them

ef fectively. Th ese cons

id

er

at

io n s

includ

e: 1)

the mate

ri

ality of the risks

to the company's P&L; 2) the econom

ic nature of th e exposures; 3) opera

tional

co nsideration

s; (4)

compet

itor

considerations; and (5) the company's

primary business ob ject ives.

Materiality Th e materiality of th e

risks is clearly somethin g that mu st be

v iewed aga in st the forei gn currency

flows and in proportion to each indi

vidu al co

mp

a

ny

's P&L. For exa mple,

what is

th

e probability

of an exposure

caus ing financial distress?

Generall y speaki ng, t he greater the

size and

numb

er of material risks, the

Economic Nature

more atte n

tion should be paid , and

resour

ces

devoted, to managing them.

Converse l

y,

no time shou ld be wasted

on de minimis ri sks.

Economic

nature

Equall y

funda

mental, but less compa ny specific, is

the eco nomi c nature of a co mpany's

busine

ss

activ iti

es.

Periodi call y, trea

sury needs to take a step back and

view

their

FX management act iv it ies

in

this co nt ext. Some sa mp l e cate

gor ies are shown in the chart below.

A company 's economic nature rela

tive

to these categories may not be

static. Thus treas urers should reexam

ine their company's economi c nature

w henev er

it und ergoes sig ca n

transformat ions-e.g. major fo re ign

acqui sit ions or

asset

sa l

es.

Expansion may also cause compa

ni es

to

mov

e from hav ing

primarily

lo

ca

l operations to becoming comp lex

multinationa ls.

As compan ies beco me

more complex, the FX risk in the oper

ating margins their t reas

ur i es must

mi

t igate

becomes progressively

greater, requiring greater attention to

FX risk

management , polici es, and

co ntrols.

Operational considerations Whil

e

FX r isk ca n be ef f ic iently mitigated

w ith f in anc ial instruments, it is often

better to ex haust internal hedg

in g

mechanisms f irst. Th

ese

includ

e:

• netting of exposures within group

legal entities;

• cr

ea

tin g offsetting FX exposures in

different lega l entiti es via leading and

lagging, fore ign currency

funding

, and

cas h po sit ion to reduce ou tstanding

net exposures;

•

in t

egrat in g FX risk w ith business

co nsiderations for cur rency of billing

and currency of

payment decisions .

Competitor considerations It

is

not

alw ays the first reason to manage X

pos it ions, but cu rren

cy

manageme

nt

can be a so urce of competiti ve advan

tage. Better foreign excha n

ge

manag

me  t similar to a low -cost producer

strategy- gives co

mp

ani es a greater

ab ilit

y to m a in ta in th e ir m ark

et

in g

st r

ateg

i es in t he face of adve rs e

exc hange rate moves.

The cur r

ency advantages/d isadvan

tages

are not always as they appear at

f irst g lance. Th e c lass ic examp le is

that of a sing le-co untry US exporter,

co

mp eting aga in st a Japanese single

co untry

exporter. At first glance, the

I

CU rrency o _ l p o s i t i  

J

4

Category

\Loca l-in-local

oper·ations

Revenues Expenses

Loca l cu rrency Local currency

Single-country Mu lticurrency US dollars

globa l exporters

mpl e

multinationals

Complex

multinationals

US do llars M ult icurrency

Multicurrency M ult icurrency

Explanation

Se lf-conta ined loca l un its w ith

li tt le cross-border act iv ity

jExamples

//

M c

Don

ald's

Campbe

ll Soup

Doll ar costs represe nt efforts to M erck

develop and manufacture prod- Caterp il lar

ucts so ld wor ldw ide on a

non-

dollar bas is

Multicurrency costs

to extract

product worl

dw

ide so ld wo rld

w ide on a dollar-price basis, even

if denominated in local currency

Products sou rced and so ld on a

multicurrency bas is

Exxon

Alcoa

Johnso n & johnson

General Motors

;

_ _ _ . . _ _ J

Sour  Gr  nwich Treasury Advisors

Inte

rn

ational Treas urer/M arch 6, 1995

 

US exporter , op e rat in g

out of a

weaker do ll ar currency e

nvironm

ent

wo uld appear to have the currency

advantage.

Yet, it it is the japa nese exporter that

often had the adva

nt

age: With the

g1eater pu1·chas ing power

of

the Yen,

it

was able to purchase dollar-based

indust

rial commod iti

es

more cheaply

relative to i

ts US

comp

et

itor. Its lo

ca

l

costs relatively hi gher, the j apanese

co

mpa ny also was forced to become

a more effic ient

producer.

The

US

company on the other ha

nd

may have

been lulled into in ert ia, perhaps in

part by

it

s

see

ming

cu

rrency advan

tage._

Obv iousl y , t

hi

s is a simplif ied

exa

mpl e and analyz ing the competi

tive

imp

acts of currency positions is

mu ch more campi cated. Usu all y,

such analysis invo lves looking at the

sourcing and siting and other FX cost

structure specif ics fo r compone

nt

s or

products in a given industry and then

determining the component/product

mix of competitors .

Management s business objectives:

This is an important co nsiderat ion in

determining how a company wishes

to hedge. Most

publicly held

compa

nies in the US , for example, have the

primary

objective

of ma x imizing

reported ea rnings according to their

GAAP P&L. One r

es

ult

is

a tendency

to determine hedging strategies and

in strum ents on t he bas is of their

account ing

treatment.

Accounting tre tment aod obje.c- _

tive co nsiderations can also

come

into play w ith competitor co nsidera

tions. Compan ies w ith similar eco

nomic exposures

m y

have different

business ob j ec tiv es;

fo

r exa mpl e,

1

on e may be managing for long-term ,

growth w hil e another's goal may be

improv ing short-term ea

rnin gs per

share. •

This framework

ha

s been adapted from

one used by Greenwich reasury

Advisors to evaluate its clients   FX risks.

In ternationa l Treasurer/Ma rch 6, 1995

Option contracts

Putting our Eggs

in One Basket

Basket options are a popular concept

but

some

corporates prefer

having

more than one option when managing

a portfolio of different risks.

Th e co nceptua l

appea

l

of basket

options is that they h

arness

the diversi

fication effects of a portfolio of expo

sures and reduce the cost of opt io n

coverage by using a single optioQ_con

tract: a basket

option

. Thu s, using a

basket option becomes a low-cost way

for central ized

ri sk management pr

o-

grams to hedge the domest ic va lue of a

basket of currency or other exposures.

Grouping negatives

The reduct ion in cost- compared to a

basket of opt

ions hedging each expo

su re independentl y- is achi eved by

constru ct ing a portfo li o of exposur

es

that are imperfect ly or negative ly co r

related see table

belowL

and hedging

this portfolio with a single option that

is tailored to each of th e portfolio

co

mp

nents (e.g. FX exposures) .

It

is

erivative

Instruments

this negative corre lation between the

exposure compone

nt

s that r

ed

u

ces

the

ove rall vo lati li ty of the portfol io and

thus the price the

opt

ion hedge.

As Stephen Godfrey fro m Bank of

America' FX advisory group notes in

the latest issue of its

Curr

ency Review,

these cost

sav

in

gs

come at the cost of

upside potential. Because the va lue of

the option, and upside

pa

rti cipation, is

linked to the

va

lue of the underlying

portfolio

or

basket as a whole, some of

the upside potential of any component

of the

portfolio

is given up.

Thus, basket options

are not the best

vehicle for

profiting on currency views

through active management-i.e. a

basket option is designed

to appeal to

the cost-center rather than the profit

center mentality.

One stop shopping

As Demetri Papacostas, w ith Chase

Manhattan's options group notes, bas

ket options make a lo t of

se nse for

clients who say

I

spe

nd X amount of

dollars every year on option premiums

and I would like that X amount to be

l

ess

.  As he describes t hem, basket

options a l lo w a corporate to take

advantage of thei r existing underlying

exposures - e.g. to un corre

l ated

con tinued on back page

Correlat ion Positions Diversification Bas ke t option price generaiiY:l

Hi

gh pos itive

· (va lUes nea r

+1 )

High posit ive

v

a lues near

+1 )

Low positi ve,

Low n

egat

ive

lu between

.5

and

-.5)

A

 

lo ng 01

a   short

Some

l

ong

and

some

short

A

 

long or

a

 

short

Low

Hi gh

Hi gh

High negative A  long or Hi gh

va lues around -1

)

a

 

short

Hi gh

ne

gat ive

Some

long a nd Low

va lues around -1 ) so me short

Source: Bank of America Currency Review, M arch 7995

Cl

ose

to a ask

et

of

opt

ions

Tn ot

mud1 cost savings)

Cheaper

tha n a basket of

I ptions substa ntia l cost sav in gs)

Cheaper than a basket

of

options substanti a l cost savi ngs)

I

I

I

heaper than a basket of

options

substantia l

cost

sav i

ngs)

1

c lose

to

a basket of opt ions

(not muc h

cost

sav in gs)

5