A Garden Full Of HedgesChristopher Farrell
He's Topolino in Italy, Mai Kay Shiu Shu in China, and Micky Maus in Germany. While Mickey Mouse is a cartoon character to kids around the world, to Walt Disney Co., he's a money-making export.
He's also a problem. Mickey produces revenues and profits in numerous foreign currencies. Last year, 19% of Disney's sales came from overseas, almost double the 1987 figure. That exposes the company to increasingly volatile swings in foreign exchange rates. To reduce those risks, Disney, like many companies, employs a variety of complex hedging strategies.
Such hedging, of course, is not a new phenomenon. Yet several developments are causing chief financial officers and treasurers to take greater notice of their currency exposure. One is the rapid expansion in overseas business. Another is the prospect for a strengthening dollar in many parts of the world, which could reduce the value of earnings in local currencies. Europe may be on the edge of another debilitating currency crisis, with several countries under pressure to devalue their currencies. The pharmaceutical giant Merck & Co. expects that adverse currency moves will cut 1993 earnings by three percentage points. Little wonder "companies are putting a lot more time into managing currency risks," says C. William Schroth, managing director at First Boston Corp.
The strategies companies are using to deal with foreign exchange risks are widely divergent. Some companies try to integrate currency concerns into where they build plants, how they price products, and other basic business decisions. Among those companies that use explicit hedging strategies, some strive to get rid of most of their short-term foreign exchange exposure in the financial markets, while others hedge against only huge losses and accept smaller ups and downs in the currency markets. Some treasurers try to make money by taking selective bets on currency movements.
Who's right? Who's wrong? "This is one of the most difficult questions to answer in corporate finance," says Ariel E. Salama, managing director at Bankers Trust Co. and head of global risk consulting. The channels through which changes in currency rates affect a company are extremely complex, he says. Companies often buy and sell goods and services in dozens of countries, each with its own currency. And their suppliers may be scattered around the world. "Companies can't hedge their currency risks to zero because exchange rates affect their business in so many ways," says Richard Levich, economist at New York University.
'TEMPTATION.' Most experts agree, though, that speculation in foreign exchange is risky. A series of wrong bets, and a company can lose millions. "The temptation is always there for companies to try to enhance their operating profits through financial machinations," says Gunter Dufey, professor of international business and finance at the University of Michigan.
Perhaps the easiest and most common way to reduce exchange risks is expanding operations overseas. Of course, companies build plants abroad to take advantage of cheaper labor and transportation costs. But the idea of going abroad to manage currencies is increasingly entering profit calculations. For instance, German auto maker BMW will soon construct an assembly plant in South Carolina. Rival carmaker Mercedes-Benz recently said it, too, would build a plant in the U. S. Both moves will shield the companies against currency fluctuations.
Once operations are up and running in another country, a company can largely insulate its balance sheet from currency swings by matching sales and assets in the foreign country with purchases and liabilities in that country's currency. That's an approach taken by Hartford-based Loctite Corp., a $600 million specialty-chemicals company that does 60% of its sales abroad through subsidiaries in 33 countries, says Loctite Chief Executive Kenneth W. Butterworth.
POTENT BREW. French carmaker Renault believes that geographic diversification is enough. "We deal in the Deutschemark, the British pound, the Italian lira, the Spanish peseta, and other European currencies," says Thierry Moulonguet, deputy director of Renault's finance department. "We feel that so many currencies gives us a natural hedge, that the balance of countries is a hedge in itself. Clearly, there are times when currency movements are going to hurt you, but overall, we think our policy is sound." Last fall was one of those unfortunate times: Renault suffered a quarterly $108 million loss when Britain and Italy sharply devalued their currencies.
The Renault approach is too risky for most companies. So, many of them turn to the financial markets and use currency swaps and other financially engineered securities or float debt denominated in different currencies. The basic building blocks of currency hedging are forwards and options contracts, often combined in a potent brew. In essence, a forward contract is an agreement to buy or sell a currency at a fixed price on a specified date in the future, which allows a company to lock in an exchange rate. Currency options resemble their cousins, stock options, giving the owner the right to buy or sell a currency at a fixed price on or before a future date.
Merck, which does business in 40 currencies, uses currency options to hedge its foreign exchange risks. The main reason is to reduce the risk that Merck will not be able to maintain steady increases in research funding. Notes a 1990 Journal of Applied Corporate Finance article by Judy C. Lewent and A. John Kearney, Merck's chief financial officer and its assistant treasurer, respectively: "Cash flow and earnings uncertainty caused by exchange rate volatility leads to a reduction in research spending."
To be sure, like many companies, Merck doesn't try to hedge away all its currency risk, which could prove very expensive. As with a corporate fire-insurance policy, the company self-insures against currency losses up to a certain level and then buys protection against disaster. In 1993, says a Merck spokesperson, "the hedging program has had a mitigating impact, but the negative impact on sales from currency swings should still prove significant."
Eastman Kodak Co. runs one of the country's more sophisticated currency operations. Its foreign exchange specialists advise the company's business units on long-term currency strategies, including everything from sourcing alternatives to market pricing. "There is a tendency to think of managing currency risk as a forecasting problem, and that's O. K., short-term," says David Fiedler, director of foreign exchange planning at Eastman Kodak. "But when looking ahead five years, it's a currency exposure management problem, which impacts the company's future cash flow."
Some treasurers complain that conservative accounting rules needlessly complicate hedges. For instance, companies like to hedge overseas cash flows before they have booked a sale. But companies are required to mark-to-market hedges on anticipated cash flows without a firm commitment, which can make quarterly financial statements highly volatile. So companies turn to expensive hybrid securities with less impact on reported statements. "Unfortunately, the accounting profession hasn't seen the wisdom of multinational companies entering into these transactions," says Michael Durham, chief financial officer at American Airlines Inc. Adds Kenneth M. Baird, manager of worldwide cash and foreign exchange at Storage Technology Corp: "The rules make it a lot harder for businesses to reduce their risk."
SAFE EXPOSURE? The accountants are right to worry about speculation, though. Of course, some speculation is rather benign. Some multinationals are skilled at taking limited bets on short-term currency moves. At the moment, for instance, some companies are leaving their exposures to Japan unhedged as the dollar falls to record lows against the yen.
But then there's the case of Showa Shell Sekiyu, a Japanese oil refiner and distributor 50% owned by Royal Dutch/Shell Group. Beginning in 1989 and well into 1992, its finance department bet $6.44 billion worth in the futures market that the dollar would rise. It didn't. Showa Shell says it lost at least $1.07 billion and could lose as much as $1.37 billion. Foreign exchange traders say Showa Shell is not alone among Japanese companies with big--but undisclosed--speculative losses in currencies.
By avoiding rank speculation and sticking with hedging, companies can gain confidence in the reliability of future cash flows. And less cash-flow uncertainty means that companies can better fund research, development, and other long-term investments. In a world of volatile exchange rates, companies are finding that the riskiest and most expensive tactic is not to hedge.
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