Transaction risk – while still significant inefficiencies exist for almost all international corporations, best practices is to protect the transactional exposure, if for nothing else but not to be surprised for missing earnings.
Best practices today show that over 90% protect their transaction risk – defined as the potential gains and losses on a given transaction susceptible to foreign exchange rate movement’s risk. Corporations do so by purchasing various derivatives, mostly forward contracts. Further research shows that common practice is to determine the net exposure (defined as summing up all currencies that are re-measured) and then purchase the derivative contract. Not much if any time is spent on the decision making process. The reasons include lack of performance measurement and policies reflecting them.
Not much has lately been written about this, but the world of corporate foreign exchange has not stood still. Purchasing derivatives as soon as the company exposure is defined is still common but no longer best practices. What do you do? What tools are out there to assist and improve the analytics and decision making?
Corporations look for better data and analytics to create what is referred to as the FX in-house banking function. The idea is to have a centralized communication where any currency transaction including conversions is communicated or input to a central platform and its effect highlight prior to actually executing. The effect is better understanding of the exposures and more effective and cost efficient foreign exchange risk management. What have you seen to make the process more effective and efficient?
Translation risk - Best practices is undetermined for translation risk. Translation risk defined as accounting-based risk stemming from the translation of financial statements from one currency to another is currently addressed by roughly 35% of corporations and is not as scientific as one would estimate. So why is there such a difference between hedging transaction and translation risk? The answer has three components;
1) Accounting – unlike with transaction risk where one considers not applying FAS133 and let everything flow through earnings, translation risk is longer term and as such FAS 133 becomes useful/effective in reducing otherwise incurred volatility on the derivative products versus the underlying.
2) Data - Transactional risk is “easier” to define
3) Economics – translation risk applies to longer term events that do not immediately effect earnings or the cash-flow. As such many make the argument against hedging translation risk as the revaluation of certain assets is not necessary as they are long term in nature and the acquisition reflects future value. This may well be the case as projecting the cash flows that a parent company will receive from a subsidiary, and forward selling is impractical for a long term strategy. The argument for hedging translation risk – obviously exercised by the minority today - that translation exposure hedges also reduce exposure. A possible explanation for the latter is that translation exposure approximates the exposed value of future cash flows from operations in foreign subsidiaries (i.e. economic exposure). If so, by hedging translation exposure, economic exposure is reduced and the company’s value more predictable, adding to the economic value of the company.
Are you hedging translation risk? What is your reasoning for doing so?
Economic exposure – defined as a competitive risk solely based on foreign exchange. Corporations rarely protect this risk as
1) most market participants’ Board of Directors and senior management don’t even understand what it is. Thus lack of understanding could be defining today’s best practices.
2) hedge accounting is difficult if not impossible and as such with most derivative products creates the ever unwanted volatility and as such decrease in the value of the corporation.
If you are one of the few that hedge economic risk, please share your results.
