Currency Risk Management
by Richard Eliot
Order from Chaos
The impact of currency values on commercial operations is a familiar topic for the international executive. It is a source of fascination for the armchair economist, and a favorite explanation for this quarter's variance. Small and large players alike enjoy the glimmer of excitement when the latest rates are quoted, signaling the lead in a global sweepstakes.
Much of the attraction of currency markets stems from its synthesis of all aspects of the world economy distilled into a single, digestible value. The significance of relative currency values rests primarily on their relationship to world markets and their interaction with international trade, investment, and monetary practices.
A given exchange rate, when viewed in isolation, may at first appear to be little more than an abstraction. Yet, it exercises a significant influence on commercial relations as a pricing mechanism affecting every international transaction. The impact of exchange rate fluctuations on domestic aggregates can also affect the course of economic activity to the point that a sense of urgency is reached when dealing with volatile markets.
As long as currencies remain the medium of exchange for commercial transactions, market fluctuations of relative currency values will continue to attract the attention of the exporter, the manufacturer, the investor, the banker, the speculator, and the policy maker alike.
Exposure Defined
A currency is exposed to exchange rate fluctuations to the extent that it is used to conduct transactions with external markets. The greater the proportion of intercurrency exchange to total monetary transactions for a given market, the greater the exposure to changes in exchange rates.
Commercial operations conducting international trade are exposed to exchange rate fluctuations in proportion to their total volume of transactions. As the magnitude of intercurrency transactions increases relative to aggregate transactions, a business unit realizes greater exposure to exchange rate fluctuations.
The transactions approach to exchange exposure has gained prominence in recent years. A lingering preoccupation with currency translation for the measurement of operating performance, however, has tended to divert attention away from productive commercial activity towards disingenuous, while flashy, hedging techniques. The clever money manager can still generate significant cash gains from currency hedging without increasing the productive output of a business unit.
By defining currency exposure as the proportion of intercurrency transactions to total transactions, greater management attention can be aimed at operating units with a high degree of exposed risk to exchange rate changes.
Operating Performance
Evaluating operations performance on a global scale demands a shift in perspective towards techniques based on multilateral transactions analysis. An enterprise operating in a single market with single currency transactions can easily be evaluated in the operations currency, while one which is engaged in many markets and multiple currencies requires more extensive analysis.
Common financial accounting practices require financial positions to be translated at current exchange rates from the operations currency into the reference currency. Despite the need to consolidate financial results on a consistent basis, direct translation at current exchange rates continues to obscure actual operating results when the relative currency values fluctuate from period to period. As a result of these exchange rate fluctuations, and the extent of their volatility, comparisons over a number of periods become completely invalid from the perspective of the reference currency.
A recurring theme throughout the deliberation of multicurrency financial accounting is that a commercial operation should be evaluated from the perspective of the economy in which the unit is located, as measured by the operations currency; this is the fundamental argument for establishing current rate translation accounting over historical rate translation methods. Resolving this dichotomy can be an extensive process so long as the need remains to translate operating results for consolidation into a single currency of reference.
The task of evaluating performance in multiple currencies extends beyond contemporary financial accounting practices. One approach is to separate the evaluation of operating results from their consolidation. A multi-tier evaluation process then evolves as operations in an external market develop through a cycle from capital investment to normal commercial operations. Ongoing business operations are evaluated in the operations currency, consolidated enterprises from the reference currency, while the return on capital investment is measured in the investment currency.
Yet all of these measures fail to consider the actual impact of exchange rate fluctuations on business activity conducted between markets having different currencies.
When an enterprise imports raw materials and components from external markets, it is subject to currency transactions exposure between the time the goods are ordered and when payment is disbursed. Exports to third markets are affected by transactions exposure when their prices are denominated in third currencies; even when denominated in the operations currency, the demand for exports is directly related to the price of the goods as measured by the customer's reference currency.
Transactions exposure for both imports and exports directly affect the overall level of business activity through its impact on sales volumes, revenues, and production costs. It then becomes a practical matter to determine the most appropriate means for interpreting transactions exposure between the business unit and external markets with which it conducts trade.
In a global setting, where multiple international operations transact business between many different markets, the transactions exposure of one operation may differ substantially from the exposure of other operations within the enterprise. Aggregate transactions exposure of world-wide operations is determined by the consolidation of intercurrency transactions across the entire enterprise. Consolidation on the basis of currency, instead of by location or legal entity, yields a more complete picture of the total currency transactions exposure.
Investment Risk
Decisions to expand into a specific marketplace are primarily influenced by the projected course of economic developments within the market under consideration. Economic relationships between the external market and third markets are also taken into consideration. Whereas prior exports to this external market were likely to have been denominated in the base reference currency, a physical business presence in the external market entails an indefinite term commitment measured by a new operations currency.
Capital investment in an external market depends largely upon the expected rate of return on the investment as measured relative to the investment currency. The expected return is derived almost entirely from volume projections, expenditure estimates, and the resulting cash flow in the operations currency. These projections are then translated into the investment currency for comparison with other capital investment opportunities on an equivalent basis. As a result, investment decisions rely almost entirely on translations exposure when considering currency risk.
Transactions exposure takes an entirely different perspective in the investment risk assessment. In addition to normal economic risks which are present within a specific external market, transactions risk between markets is involved in an investment decision.
The transactions exposure for capital investment comprises two main factors:
- Changing intercurrency exchange rates between the time the investment is under consideration, and the time the investment currency is converted to the operations currency.
- Changing intercurrency exchange rates for dividend remittances converted from the operations currency to the base investment currency spanning an indefinite period.
Once a commitment is made to a long-term market presence, management of exchange risk transfers from a focus on translations exposure to one based on transactions exposure. The external market operations can then be assessed according to the inherent economic risk factors (rates of market growth, price trends, technology developments, and product competition) attributable to the local market. The total investment exposure to exchange rate fluctuations is limited to the appropriations decision period and to the discounted dividend stream.
Economic Analysis
Critics often cite economic projections as inaccurate and unavailing for business operations. This criticism is so pervasive that economists themselves have come to evaluate their own performance by the degree to which specific predictions match actual results. This fixation with the accuracy of economic predictions reflects the prominence of short term results over long term development.
The situation in international commerce and finance reflects many of the same characteristics. Many in the field tend to view international operations and the world market as abstractions. Even those who normally function in a global environment perceive it through the filter of electronic media, continuously updated and flashed upon a screen terminal.
Concepts which are familiar to the financial economist in planning for international business operations may not be readily apparent to specific functional units. Diminishing returns may seem to have little bearing in meeting sales quotas; marginal productivity is rarely evoked during cost reduction consolidations; and, elasticity of demand is hardly mentioned when preparing for facilities expansion.
The value of economic analysis is the assessment of a given course of action and a determination of the probability that a decision will generate positive incremental economic activity. Economic activity is characterized by a number of concepts relevant to operating in international markets, and tied to the opportunities and risks associated with the generation of wealth across national boundaries.
It recognizes the fact that there are many factors beyond the control of the individual decision maker. If it were possible to accurately predict the effect of these externalities, there would be little if any need for anyone to carry out normal daily business decisions, since the results of these decisions would have already been predetermined. The ability to achieve the desired economic results depends largely on the skill with which the associated risk is managed.
Liquidity and Valuation
When proceeds from financial instruments traded on one market are transferred to another market using a different market currency, the resulting investment is subject to intercurrency transactions exposure. Capital flows between world financial markets are subject to the same intercurrency transactions exposure as commercial operations. Yet the high liquidity of securities traded on financial markets reflects a significantly greater frequency and aggregate value of these transactions.
The income derived from investment instruments traded on an external financial market is measured from the standpoint of the currency of reference established by the individual investor. A divergence in portfolio valuation occurs when the intercurrency exchange rate between the market currency and the reference currency moves in a different direction (or at a different rate) than the native financial market securities prices.
Investors measuring income in a reference currency other than the market currency are concerned with two primary issues relating to the transactions exposure of their investment positions:
- Conversion of the instrument price from the market currency to the reference currency; and,
- Dividend and interest proceeds converted from the market currency to the reference currency.
In some cases, however, the currency transactions exposure exhibits opposite characteristics. This involves equity securities which are traded on a financial market having a market currency different from the reference currency for the underlying assets of the instruments.
A large number of publicly traded equity securities are listed in more than one financial market around the globe, where they are traded in the respective market currency. The financial market with the largest trading volume in a specific equity security generally determines the base trading price of the issue; arbitrage then results in a direct conversion at the prevailing exchange rate in other markets.
In these cases, the individual investors trading in a reference currency native to the market currency, are subject to transactions exposure without engaging in intercurrency transactions.
Organizations which issue securities in financial markets, with market currencies different from the issuer's reference currency, often have tangible fixed assets and business operations in the same territory as the external financial market. The related equity securities traded in these markets, however, are rarely secured by the assets situated in the same market territory.
A given trading price for an equity security is a composite of all segments of the issuing organization (exclusive of factors specific to the financial market) and includes those business segments conducted in markets other than the reference currency. Variances between market capitalization and fundamental valuation of an equity security arise when the world-wide assets pertaining to the equity appreciate, or depreciate in value.
Fundamental valuation of the equity security is thus subject to intercurrency transactions exposure relating to:
- Sensitivity to exchange exposure relating to the internal cash flow of the issuing organization; and,
- Correlated demand for the products of the issuing organization transacted in the world market.
As the exposure to exchange risk increases, the exposure to share price volatility should also increase. Investors would agree that it is not feasible to identify the price of a specific security as a basket of fundamental equity values. (Who would trade in a security priced as: 15 Dollars + 1,000 Yen + 5 Pounds Sterling? Which commercial organization would remit dividends in similar proportions?) Clearly, it is the investor who assumes the risk of currency exposure from the standpoint of the investment currency.
Whereas conventional economic risk factors are specific to an individual market, currency risk relates to exchanges between markets. The volume and magnitude of intercurrency transactions makes it by far the largest market in the world. It thus assumes a unique significance when compared to other economic variables affecting the course of commercial relations.
Historically, no currency has remained resolute to any specific marketplace, its acceptance determined by the willingness to conclude transactions with a standard of value. As a measure of wealth, its exchange value becomes a universal language in economic relations.
