How is foreignexchangerisk managed?

Anempiricalstudyappliedto two Swisscompanies.

Abstract
This paper investigateshow two Swiss companiesmanagetheir foreignexchangerisk and
comparesthe results to theoreticalfindings and to previous empirical research. We find
significant differencesin the foreign exchange risk managementpolicies, notably in the
choiceof the type of exposureto coverand in the hedginginstrumentsused. Consistent with
previous research, forwards and netting are the most used instrumentsand transaction
exposureis the most managedforeignexchangerisk. Surprisingly,translationand economic
exposuresare not well identifiedand managedmainlybecausefirmsbelieveit is unnecessary
or too complex. Finally, firms hedge their exposure but never fully due to high cost of
hedging.
Executive summary
Among the key findings are the following:
(1) Centralizationof foreign exchange(FX) risk managementis recommendedby the
theory. Logitechfollowsthis recommendationwhereasKudelskiuses a mixtureof a
centralized and non-centra lized organization.
(2) Most firms, includingLogitechand Kudelski,do hedge. Theorypresentsarguments
both in favor and against hedgingbut the view in favor of hedgingpredominates .
However,companiesnever hedge fully becauseit is expensiveand they prefer to
hedgein the short-term.
(3) Theoryargues that a firm shouldfirst use internalhedgingtechniquesand then, if
necessary,pass to externalhedgingtechniques . The main argumentis that external
hedgingis costly. In practice, firms follow this strategy; Logitechand Kudelski do
natural hedging whenever it is possible.
(4) Forwardsand naturalhedgingare the mostpopularinstrumentsto manageFX risk in
practice. Both Logitech and Kude lski state them as their main hedging techniques.
(5) Measuring FX risk can be very difficult and many firms decide to ignore it.
Nevertheless, it is highly recommended by theory.
(6) Transactionexposureappearsto be the most importantFX risk in practice whereas
economic exposure is considered as t he relevant exposure in theory.
(7) Translationexposureis often not hedged in practice and this correspondsto the
theory recommendation . However, Kudelski hedges and measures this kind of
exposur e.
Introduction
Foreign exchange (FX) risk management has become increasinglyimportant since the
abolishmentof the fixed exchangerate systemof BrettonWoods in 1976. This systemwas
replacedby a floatingrates systemin whichthe price of currenciesis determinedby supply
and demand of money. Given the frequent changes of supply and demand influencedby
numerousexternal factors, this new systemis responsiblefor currencyfluctuations . These
fluctuationsexposecompaniesto a foreignexchangerisk. Moreover,economiesare getting
more and more open with internationaltradingconstantlyincreasing,and companiesbecome
as a consequencemoreexposedto foreignexchangerate fluctuations .
Foreign exchange risk management is crucial for companies frequently trading in the
internationalmarket. Empirical research shows that profits of multinationalcompaniesare
affected by volatile floating foreign exchange rates. Nevertheless, small firms trading
exclusivelyon their domesticmarketsalso becomeincreasinglyexposedto foreigncurrency
fluctuations. Actually, small firms depend on the volatilityof the main currenciesbecause
many of them out-sourcetheir productionto foreign countries. This means that they incur
costs in a foreigncurrency (wages,taxes, material,etc.) and they also need to managethis
exposur e. Other small firms are exposedindirectlygiven that their strategicpositioncan be
affected by volatile FX rates.
The thesis is dividedinto two parts: the first part describesthe theoretical results about FX
risk management and the seconddealswithtwo real casestudies. Our purpose is to reviewthe
theory about foreign exchange risk managementand to compare it with what is done in
practice.
The aim of the theoretical part is to explain the importance of foreign exchange risk
managementfor a firm and to give a brief overviewof how this processis viewedin theory. It
is organizedas follows:In section1, we definerisk managementand we describethe three
main steps of the risk management process:identify,measureand manage. Section2 handles
with the rationalefor hedging. Section3 focuseson foreignexchangerisk and explainsthe
interactionbetweenthe sourcesof risk: interestrate, foreignexchangerate and inflationrate.
Section 4 deals with the transaction,economicand translationexposure. In section 5 we
explainthe tools used to measurethe risk. Section6 is devotedto the hedgingtechniquesa
firm can use. Finally, we discuss brieflythe effect of the introductionof the Euro on FX risk
management.
The practical part of the thesis deals with two real case studies. We observe the foreign
exchangerisk managementprocessin two Swiss companies KudelskiGroupand Logitech
SA. We begin in section1 by reviewingthe literatureon foreignexchangerisk management
practices. Section2 describesthe two firmsand theirforeignexchangemanagement . We want
to checkwhetherthe resultsfoundin the articlesdiscussedapplyalso to thesetwo companies
and if it is not the case, we try to find the reasons for this. Actually, we investigatehow
foreign exchange r isk management is executed in practice.
As a final remarkwe are awareof the fact that financialfirmsmay not hedgeforeigncurrency
exposurein the same way as non-financial(manufacturingor service)firms, since many of
the financialfirms are market makers. The two companiesthat we have contacted are non-
financialfirms and thus we will focus,as well in the theoreticalpart as in the practicalpart, on
non-financial firms foreign exchange risk management.
I. Theoretical part
1. Risk management
In order to approachforeignexchangerisk issues, we would like to start by introducingthe
more general concept of risk management . Each author has its own definition of risk
management. We selectedtwo that we considerto be the mostrelevant .
Risk managementis definedas a systematicprocess for the identificationand
evaluationof pure loss exposurefaced by an organizationor an individual,and for
the selectionand implementationof the most appropriatetechniquesfor treating
such exposure.(Radja, 1997, p.40)
Riskmanagementcan be describedas the performanceof activitiesdesignedto
minimize the negative impact (cost) of uncertainty (risk) regarding possible
losses.(Schmitand Roth,1990,p.457)
Two main conceptscan be extractedfrom these definitions:uncertaintyand process. We live
in a world of uncertainty, or said in other words, we cannot predict the future with accuracy.
Uncertaintyariseswhenan individualperceivesrisk; it pusheshim to controlor at least to be
preparedto the possible outcomes. For this reasona processis set in place, whichincludes
three steps: identify, measure and manage the risk.
Identification
The first step consists in the identificationof sources of risks. In order to identify these
sources,the risks need to be defined. Definitionand identificationwill be different for each
company. This is due to the fact that risk has alwaystwo sides:the real risk and the perception
of a risk. Anotherimportantfactor is the risk aversionof a companyor how much risk it is
willing to bear. Moreover, the objective assigned to risk management will affect the
identification of risks.
Variousactionsare undertakento achievethe identification:physicalinspection,risk analysis
questionnairesending, flow chart analysis, financial statement analysis, use of check list,
interactionwith other departmentsand historicaldata collecting. The sourcesof risk can be
various:physicalenvironment,social, political,legal, operationalor economical . Theserisks
can affect differentparts of the firm: physical,financialand humanassets. However, in our
thesis we will focus on financial assets.
Measurement
Onceidentified,a risk shouldbe measuredin orderto assessits importance . When measuring
a risk, two conceptsare crucial:loss frequencyand loss severity. The latter indicatesthe total
amountof loss that a companycouldface whereasloss frequencyshowshow oftena loss is
expected to occur. Multiplyingone by the other gives future expectedlosses. At this stage,
forecastingmodelsare usedto predictlossesas well as differentrates(exchange, inflationand
interest rate) and to est imate their influence on t he companys earnings and balance sheet.
Management
The third step is to select and implementthe appropriatetechniqueto managerisk. One first
possibilityis simply to avoid risk. However,this techniqueis often not applicable;a firm has
to accept certainlevel of risk and cant simplyavoid it. A secondoption is to control losses,
whichconsistsof tryingto reducethe frequencyand the severityof losses. A third technique
consistsin choosinga retentionlevel. The firm sets a level up to which it accepts to lose
money. It consistsin taking few risks with high frequencybut low severity. Theadvantageis
that it lowers the expenses,encouragesloss preventionand increasescash flows. A fourth
technique consists in transferring the risk. When transferring the risk to an insurance
company, the firm gets indemnified after a loss and can continue operating. The
disadvantagesare that the premiumrepresentsoften a large cost, it is time consumingto set
insurancecontractsand finally since losses are coveredrisk managersare less careful . In
order to choose a particulartechnique,a few factors have to be weighted, namely: cost,
liquidity requirements, accounting and tax implications and the risk itself.
Risk managementobjectives include survival of the firm, continuedoperating, stability of
earnings, continued growth and social responsibility. To conclude, organizations have
motives to address r isk and uncerta inty and this motivation gives rise to risk management.
2. Hedge or not?
Hereafterwe will focus on the dilemmawhethera firm shouldhedgeor not. Why does a firm
want to protect (hedge) against foreign exchange rate fluctuations?Modiglianiand Miller
(1958) show that, with no transactioncosts or taxes, corporatefinancingpolicyis irrelevant.
Since investorscan changetheir holdingsof risky assets to offset any change in the firms
hedging policy, the manager should not care about modifyingthe exposure. This idea is
furtherdevelopedin Logueand Oldfield(1977)and Hekman(1981). Logueand Oldfieldbase
their theory on two propositions. First, in efficient markets a ll information is included in stock
prices. Hedging translation exposure has only an accounting benefit, which should not
influence the investors view of the true economic value of the firm. Second, in efficient
markets,currenciespricesadjust instantaneouslyto the inflationrate differential(Purchasing
Power Parity
1
), thus leavingunchangedthe true economicexposureto foreignexchangerisk
of a firm. However,firms are facing taxes, financialdistress,agencyand transactioncosts.
This gives a rationale for hedging.
Taxes
Smith and Stulz (1985) show hedgingcan be worth becauseof the tax structure. Hedging
reducesthe volatilityof pre-taxfirm value,whichdecreasesthe expectedtaxes and increases
the expected post-tax value of the firm. In the insurance field Mayers and Smith (1982)
illustratedthat insurancecan lead to some tax advantages . A large uninsuredloss may drive
revenuebelowzero and the companyloses its tax savings. Insurancereducesthe fluctuation
in the taxable income.
Financial dist ress
A firm can face a large loss and this will push it to financial distress. Financialdistressis
costly for the firm and therefore it will try to avoid it. For Smith and Stulz (1985) hedging
reducesthe expectedcost of financialdistressand increasesthe expectedpayoffto the firms
claimholders. By reducing the likelihood of financial distress, hedging can increase the
expected value of the firm.
Managers risk aversion
Supposingthe manageris rewardedbased on the firms earnings,Smith and Stulz (1985)
show that the managersrisk aversioninfluencesthe hedgingpolicy. Assumingthe manager
is risk averse,he prefersto have stablerevenuesand will hedge. However,this hedgingwill
not be beneficfor the shareholders . Tufano(1996)developsfurtherthis argument . Managers
who are rewardedwith stocks prefer to hedge more, and those compensated with options
prefer to hedge less. The convexityof the options payoff induces the managers to take
greaterrisks (reducethe hedging)becauselowerrisk wouldreducethe volatilityand the value
of the expected ut ility of the option.
Agencycosts
After having issued debt, a companyhas an incentiveto invest in risky projects. This will
transfer the wealth from debtholders to shareholders . When the project is sucessful,
debtholdersget at most the nominal at maturity, but face most of the risks. To protect
themselvesfrom the wealthtransfer,bondholdersrequirethat the companyimplementssome
hedging (Mayer and Smith, 1982).
Investmentpolicy
External financingis seen to be more costly than internal financing(peckingorder theory),
due to asymmetric information. Underthis assumption,Froot et al. (1993)show that hedging
adds value, since it allows a corporationto reduce the volatilityof its cash flow, thereby
ensuring sufficient internal funds to invest in future projects.
Transaction costs
The existence of transaction costs implies that investors are not diversifyingcompletely
(Mayer and Smith, 1982). This impliesthat they are willingto accept lower returnon stocks
with lower risk, or said differently they are willing to pay more for a firm that hedges.
Signaling manage rial skill
In this setting, outside investorscannot evaluatemanagersskills. Thereforemanagerswill
engage in hedging because it is a way of communicatingtheir quality (Breeden and
Viswanathan, 1996).
We concludethat some authors see hedgingas adding value to the companyand others
consider it as irrelevant . Even though the theory is not unanimous,the practice indicates
clearly that firms hedge.
3. Foreign exchange risk
Foreignexchangerisk is commonlydefined as the additionalvariabilityexperiencedby a
multinationalcorporationin its worldwideconsolidatedearningsthat resultsfrom unexpected
currency fluctuations. It is generallyunderstoodthat this considerableearningsvariabilitycan
be eliminated partiallyor fully at a cost, the cost of ForeignExchangeRisk Management.
(Jacques, 1981, p81-82)
There are three main sourcesof risk
2
: interestrate, inflationrate and foreignexchangerate.
We can regroup these three risks in one general risk financial risk. There is a strong
relationshipbetween the foreign exchangemarket and the money market. Exchangerate,
interestrate and inflationrate changesare usuallyhighlycorrelatedand interdependent to the
extent that they often offset each other. This problemis even more complex since most
currenciesare indirectlylinked. If one currencydepreciatesthere is a high probabilitythat
anotherone also deprecia tes. Thesethree factorswill affect the demandfor a product . If one
of these three factors moves the price of the currencywill be affectedas well as the firms
value.
Let us analyzehow these componentsinteractwith each other
3
. Interestrate and exchange
rate are linkedthroughthe interestrate paritywhereasinflationand exchangerate are related
through the purchas ing power par ity.
Interest rate parity
A simple look at a newspaper indicates that the interest rate between two countries is
different. As cited in Derosas book Exchange rate risk is what permits differentialsin
interest rates to persist. We can define interest rate parity as a conditionunder which the
rates of interestdenominatedin two differentcurrenciesprovideequal expectedreturns,after
r
d
: domesticdenominatedrate of intereston deposits maturing in t months
r
f
: foreign denominatedrate of interest on deposits maturing in t months
S
0
: current spot rate given in domestic currenc y per foreign currenc y
E[S
t
] : expectedspot rate by time t
The idea of this formulais that the expectedreturn on deposit in domesticcurrencywill be
equal to the expectedreturn on foreign currency. In fact, when an investmentin a foreign
currencyis made, two investmentsare involved:one investmentin a foreignasset with a rate
of return of r
f
and one in the currency itself with an expected rate of return of E[S
t
] S
0
.
Coveredinterestrate arbitrage
This is a more specificversionof the interestrate parity; it takes into accountthe importance
of the forward rate to explain the differenceof interest rates betweentwo currencies . The
forwardrate has an importantrole since it allows hedgingthe currencychanges. It is called
coveredinterest rate arbitrage becausein order to take advantage between two interest rates
the investor locks the future spot rate with the forward rate. The aboveformulacan then be
restated as follows:
(1+ rd )= (1+ rf ) (2)
S
0
F
t
: t-monthforwardrate
This leads some authorsto claim that the forwardrate is an unbiasedestimator of the future
spot rate.
E
0
[S
t
]= F
t
(3)
(1)
]1
1
]
accounting for the expected changes in exchange rate between the two currencies .
(Campbell, p.310). Translated into mathe matical terms, it leads to:
E[S
t
(1+ rd
)= (1+ rf
)

S
0
1
1
]
F
t
Finally,a marketconventionon currenciesneedsto be restated. A foreigncurrencyis said to
be at premium(discount)if its interest rate is lower (higher)than the domesticinterest rate.
However,a currencycan be at premiumfor some maturityand at discountfor other maturity.
Fromthe interestrate parity,a forwardrate on a premiumcurrencymustexceedthe spot rate.
Purchasingpowerparity
The purchasingpowerparity(PPP) describes the relation between exchange rate and inflation .
It states that the price of a bundleof goods in one country must be equal to the price of the
same bundleof goodsin a differentcountrywhentakinginto accountthe exchangerate. The
absoluteform is the law of one price.It suggeststhat similarproductsin differentcountries
should be equally priced when measured in the same currency. In mathematical terms:
(4)
P
d
: Price of a bundleof goodsin a domesticcountry
: Price of a bundleof goodsin a foreign country
S
0
: Spotexchange rate
If this relationholds for current prices and spot rates it shouldalso hold for expectedprices
and forwardexchangerates. Thus:
E
0
[P
t
d
] F
t
= E
0
[P
t
f
] (5)
Combiningequation4 and 5 links the foreignexchangerate and the expectedpricechanges;
this is called the purchasing power par ity.
(6)
Which can be expressed as
f
P
d
S
0
= P
f
P
E
0
[P
t
d
] F
t
E
0
[P
t
f
]
=
f
P
d
S
0
P
_
,
f
= (1+ E
0
[ ]) (7)

F
t

(1+ E
0
[
d
])

S
0
Here the expression (1+ E
0
[
d
]) correspondsto 1 plus the expected inflation rate. The
formulashowsthat the differencebetweenthe forwardrate and the spot rate (F
t
S
0
) is linked
to the inflation difference between the two countries. If the expected inflation in both
countriesis the same E
0
[
d
]= E
0
[ ] then F
t
wouldequal S
0
and no premiumor discountis
includedin the forwardprice. Since the forwardrate must reflect the market expectation of
the future spot rate, the premiumor discount in the forwardrate can be seen as the market
expectationof the changein relativevalueof two currencies . Finally, under the assu mption of
purchasingpower parity, price movementswouldmatchexchangerate movementsand thus
therewouldbe no rationalfor hedgingexchangerate exposure.
International Fishereffect
The Fisher effect states that the nominalinterestrate is equal to the real rate of interest plus
the expected inf lation rate.
r
n
= r
r
+ E
0
[] (8)
Or rewritten
(1+ r
n
)= (1+ r
r
)(1+ E
0
[]) (9)
Restatedfor the domesticcountryit gives:
(10)
(11)
Whenreal ratesof returnbetweentwo countriesare equal,then dividing(10) by (11) leadsto
the internat ional Fisher effects.
(1 + rn
d
) (1 + E 0 [
d
])
( 1 2 )
(1+ r
n
f
)
=
(1 + E
0
[ ])
f
d
(1+ r
n
d
)= (1+ r
r
d
)(1+ E
0
[ ])
and for the foreign countr y
(1+ r
n
f
)= (1+ r
r
f
)(1+ E
0
[
])
f
f
What equation (13) shows is that the exchangerate and the interest rate are related to the
expected inflation rate.
Figure1: Exchange, inflation,and interest rate relation. Sources:Campbelland Kracaw,p.320
(1+ E0 [
d
])
(1 + E
0
[ ])
International Purchasing
Fisher effect PowerParity
This formulashowsthat differentialsin nominalinterestrates betweentwo countriesmay be
caused by differentialsin expected inflation rates. The internationalFisher effect theory
suggeststhat currencieswith higher interest rates will depreciatebecausethe higher rates
reflect higher expected inflation.
Combining the three parities we finally get that:
(13)
F
t
S
0
(1 + rn
d
)
(1+ r
n
f
)
Interest rate
Parity
(1 + E 0 [
d
])
=
Ft (1 + rn
d
)
=
f
f
4. Foreign exchange risk identification
Generally companies are exposed to three types of foreign exchange risk: translation
(accounting) exposure, transaction (commitment) exposure and economic (operational,
competitiveor cash flow) exposure. Here we brieflypresenteach type of exposureand later
we will discuss different techniques to manage these risks.
Transaction exposure
Transactionexposureoccurswhena companytrades,borrowsor lendsin a foreigncurrency,
or sells fixed assets of its subsidiariesin a foreigncountry. All these operationsinvolvetime
decay betweenthe commitmentof the transaction(sale of an asset, for example)and the
receipt or delivery of the payment . During this time interval exchange rates will most
probably change and the company is exposed to a r isk that could be positive or negative.
Imagine the case of a local Swiss importer and a foreign, let us say US supplier. If the
importerpays in the currencyof the supplier(US dollars)then it is the importerwho carries
the risk he has to buy dollarsin order to pay the supplier. Alternatively,if the importer pays
in its own currency(Swissfrancs)then the exporteris the one who carriesthe risk then it is
up to him to changethe Swissfrancsinto dollars. Usuallyit is the exporterwho is exposedto
the exchange rate r isk because usua lly he quotes t he price in the buyers currency.
Economic exposure
Economicexposuremeasuresthe changein the presentvalue of the firm resultingfrom any
changein the futurecash flowsof the firm causedby an unexpectedchangein the exchange
rates. Future cash flows can be divided into cash flows resulting from contractual
commitmentsand cash flows from anticipated future transactions . In a way, economic
exposureincludestransactionexposurein itself. Transactionexposureis the part of economic
exposur e comprising future cash flows resulting from contractual commitments and
denominatedin foreign currency. However, we should make a clear distinctionbetween
transaction exposur e and economic exposure. Transaction exposure arises from firm
contractualcommitmentsand the amountsto be paid or receivedare known. With economic
exposurethese amountsare uncertainand based on estimates . Economicexposurecan be
defined as the future effect of foreign exchangechanges on liquidity, operations,financial
structure and profit.
Economicrisk arises,for example,whena multinationalfirm incurscosts in one currencyand
generates sales in another . In this case, changes in foreign exchange rates affect the
competitivepositionof the firm. Profitsmay decreaseif the cost currencyappreciatesagainst
the sales currency it becomesmore expensiveto buy materialsand cheaperto sell finished
goods, for example. This will inevitablychangethe expectedfuture cash flows and thus the
value of the firm, which is the present value of these cash flows. Pricechangesare another
componentof a firms economicexposurebecausethey affect future cash flows. Economic
exposurecan arise becausethe competitivepositionof a companycould be affectedby a
givenexchange rate volatility . Differentfactorscan affect the futurecash flows of a company
and hence its economicexposure:the investmentpolicyof the company,or externalfactors
such as a political crisis in a countrythat would affect the level of sales, for example. It is
difficult to identify and quantifythis kind of risk as it may involve movementsin currencies
in which the company has no physical dealings
From a theoreticalpointof view,economicexposureshouldbe the relevantexposureconcept .
We will later see that companiesvary in the way they deal with transaction,translationand
economicrisk. However,it is more complexto cover economicexposurethan transaction
exposure.
Translation exposure
Translation exposure arises from converting financial statements expressed in foreign
currenciesinto the homecurrency. Whena companyconsolidatesthe resultsof all its foreign
subsidiaries, it has to presenta final reportto shareholdersand the numbersin this document
shouldbe expressedin one currency. All foreigncurrencydenominatedassets and liabilities
as well as revenuesand costs have to be translatedin one basic currency. Assets, liabilities,
and equityon a balancesheetare expressedin historicalvaluesand the foreignexchangerate
at which the currenciestrade at the end of the accountingperiod is most probablynot the
same foreign exchange rate when the accounts were booked. If a company does this
conversionat a new foreignexchangerate, exchangerate losses or profitswill result. Thus,
the questionis at what exchangerate the accounts should be translated: it could be at the rate
of exchangeat the balancesheet date, at the rate of exchangeat the time whenthe asset was
acquiredor the liabilityincurred,or at the rate of exchangemid-waythroughthe tradingyear,
for example.
Assetsand liabilitiestranslatedin currentexchangerate are exposed,and thosetranslatedat
historicalrate are not exposedbecausewe use the same rate in this case. The exposure
depends on the translation method to be used. The monetary/non-monetaryand the
current/non-curren t methodsare the most popularamong thesemethods. In the current / non-
currentmethod, current assetsand liabilities(shortterm debt)are translated at the current rate
(closingrate at the date of the balance sheet) and non-currentassets and liabilities(fixed
assetsand longterm debt)at historicalrates(the rate applyingwhenthe assetwas acquiredor
the liability incurred). Accordingto this methodonly currentassetsand liabilitiesare exposed
to foreignexchangerate fluctuations .
Monetary/non-monetarymethod translates monetaryassets and liabilities (all assets and
liabilities expressed in terms of a fixed number of foreign currency units - cash, bank
holdings,mostclaimsand debts)at the currentrate and non-monetaryassetsand liabilities(all
balancesheet items that are not monetary- inventories,machines,real estate) at historical
rates. According to this method only monetar y items are exposed to FX r isk.
Translationrisk recognisesonly items alreadyon an accountingbalancesheet. In practice,
translationexposuretendsnot to be hedgedby productsthat involvethe physicalexchangeof
currencyand sometimesnot at all hedged. Actually, losses and gains from this particular
exposureare only book losses and gains, and there is no cash flow effect in the short term
(they are not realisedover the reporting period). Cashflow gains and lossesoccur,however,
in case of liquidation. The recommendationof the financial literature is not to hedge
translationexposure. We will see later, in our practicalpart, that we find interestingresults
about trans lation exposure management in Logitech and Kudelski.
These are the three types of exposurethat a Treasurymanager needs to identify. Their
significance will vary from company to company, and while some firms will hedge, for
example,translationexposure,others will totallyignoreit, as we will see in the practicalpart
of our thesis.
Sources of FX risk
There are many potentialsourcesof foreignexchangeexposure. Havingassets or liabilities
with net payment streams denominatedin a foreign currencyis maybe the most obvious
source of risk. This risk is easy to identify and hedge: payment streams in the major
currenciescan be convertedinto domesticcurrencyusing currencyswaps, for example,or
paymentscan be matchedby naturalhedging. But havingassetsand liabilitiesabroadcan also
decrease a firms foreign exchange exposure.
Each companyengaged in internationaltrading is exposedto foreign exchangerisk since
foreignrevenues,for example,are generallydenominatedin foreigncurrency. Revenuesand
costsincurredin a foreigncurrencyare exposedto exchangerate risk. Oftenfirms have to pay
in a foreign currencyfor importedraw materialsand receive foreign currencyfor exported
finishedgoods. This problemgets more complicatedif the firms revenueexposureand cost
exposure are in different currencies.
Generallyspeaking, each investmentin a foreign country that generates cash inflows or
outflowsdenominatedin a foreigncurrencyis exposedto a foreignexchangerisk. Suchcash
flows can be revenuesfrom foreign operations,dividendsor royaltiescoming from foreign
subsidiaries, expenses pa id in a foreign countr y, etc.
A firm withoutany foreignassets or liabilities,or withoutany internationaltrade, can also be
exposedto currencyrisk. Exchangerate volatilitycan affect a firms competitivepositionon
its homemarketand as a consequenceits profitability. A cheaperJapaneseYen, for example,
means cheaperproduction cost for Japanesecar producers and it is a good opportunity for
them to export cheapercars to the USA. In this case, US car producerssee one part of their
local market shift to their Japanese co mpetitors.
Financialactivities,such as foreign-currencyborrowingor lending,guarantees,etc. represent
another kind of source of foreign exchange risk. Allayannis and Ofek (2001) find that
exchangerate exposureis positivelyand significantlyrelatedto the level of foreigndebt that
the firm has. At the same time, foreigndebt can be anotherway to hedge foreigncurrency
exposuresince it representsa cash outflowin a foreigncurrency. It can only be used as a
hedge when a firm has foreignrevenues. By contrast,imports,which also representa cash
outflow in a foreign currency, cannot be hedged through foreign debt.
Chamberlain,Howe and Popper (1996) try to explainforeignexchangerate exposureof 30
US bank holding companiesby the followingvariables:size (measuredby the log of total
assets),foreignassets(the dollarvalueof foreigndebt and foreignequitysecuritiesheld in the
investment portfolio and foreign commercial loans), foreign liabilities (the dollar value of
interest and non interest bearing deposits held in foreign offices), the Net (which is the
difference between foreign assets and foreign liabilities), foreign charge-offs (these are
foreignloans charged-off),dummyexchangecontracts(takeson a value of 1 if the company
reports non-zerovalues of the notionalvalue of foreignexchangecontractswhichmaturein
one year or less), and foreign currency translation(the cumulativetranslationeffects of
exchangerates on assetsand liabilitiesheld by the companyin businessunits with functional
currencies other than the dol lar).
These variablesexplain25-40 % of the estimatedforeignexchangeexposure. Theyobserve
that the more foreigndebt a bank has, the more it is exposedto foreignexchangerisk. They
also find that little foreignexchangeexposurecan be explainedby the use of off-balancesheet
hedging. The estimatedexposureis stronglycorrelatedwith most of the accountingmeasures,
and it is most highly correlatedwith the size of the firm. However,we think that size itself
cannotbe a source of exchangerate exposure . The biggerthe firm, the more foreigntradesit
has, and the smallerthe firm, the more it is focusedon its local market. So it is not surprising
to see biggerfirms (whichare most often multinationals)havinga biggerexposureto foreign
exchange risk.
5. Foreign exchange risk measurement
Forecastingexchangeratescan be usefulfor differentreasons. First, for hedgingdecisions,if
the forecastof the foreignexchangerate is that it will stay stable,the companycan decidenot
to hedge. Second,for financingdecisions,whenthe firm decidesto borrow,it can choosethe
currency. The ideal currencywill have a low interest rate and will depreciateover time. The
forecast will help to choose the potential currency exhibiting these features. Third, for
investmentdecisions,the ideal currencyshouldhave a high interestand appreciateover time.
Fourth, for budgeting decisions, when choosing to open a new subsidiary, the firm will
estimate the future cash flows and will therefore need an accurate forecast of foreign
exchange rate. Finally, for translation purpose, earnings from subsidiaries need to be
convertedin home currency. A forecastwill help to evaluatethe future earningsthat will be
reported.
When we talk about foreignexchangeexposuremeasurement,we shouldprecisethat only
transactionexposurecan be easily measured. Translationexposure as well as economic
exposure are much more difficult to measure.
Transactionexposuremeasurement
In orderto measuretransaction exposure,three techniquescan be used. The firm can measure
the variabilityof each currencyin whichit has some transactions . The first step is to identify
the currenciesin whichthe transactionswill be settled. Then it can measurethe volatilityof
each currencybased on historicaldata. This will give an idea of the exposure. For example,
considera firm with a transactionof an amount of 100 000 US dollars, the exchangerate
USD/CHFis at 1.50 and the historical measuredvolatilityis 10%. At the actual rate this
corresponds to 150 000 CHF. The volatilityimplies that the exchangerate can increaseor
decreaseby 10%, so move up to 1.65 or move down to 1.35. With a rate of 1.35 the firm will
have to pay less, around135 000 CHF, and with a rate of 1.65 the firm will need to pay 165
000 CHF. However,when using this approacha firm shouldbe cautious;historicalvolatility
is not an accuratepredictorof future volatility. Moreover,we cannot aggregate two different
exchangerate exposures . If we have, for example, an amount of money exposed to the
CHF/USdollar exchangerate, and anotherone exposedto the CHF/JapaneseYen exchange
rate, we cannot simplyadd these two amounts in order to obtain the total exposure. These
risks are differentbecausethese exchangerates representdifferentvolatilitiesand different
factors affect them.
The measurement based on the correlationbetweentwo currenciesis also used. The idea is
the same as for asset correlationsof a portfolio. Considerthree currencies,the US dollar,the
Euroand the SwissFranc(basecurrency) . Basedon historicaldata we can notice,let us say,
negative correlationbetween Euro and the US dollar. That means that when the dollar
increaseswith respect to the SwissFranc,we observea decreaseof the Eurowith respect to
the Swiss Franc. Negativecorrelationsare interestingfor the firm since an increasein one
currencyis offsetby a decreasein anothercurrency;thus thereis no needto hedgethesetwo
currencies. Even if appealing,this approachhas to be practicedwith caution,as for volatility
past correlations are not an accurate est imator of future corre lations.
Finally, an increasinglyimplementedtechniqueused for measurementis the VaR (Value-at-
Risk) model. Usingeitherpast data or simulation,the companycan estimatethe potentialloss
over the next days givena certainconfidenceinterval . The main advantageof this technique
is that it aggregates all data into one single number.
Economicexposuremeasurement
Economicexposurecan be measuredby two techniques:earningssensitivityto exchange
rates and cash flow sensitivityto exchangerates. To measure the earn ings sensitivity, the firm
needs to separateeach line of its incomestatementand analysethe effect of an increaseor
decreaseof currency. Considera Swiss firm selling a product in Germany(in Euro and in
Swiss Francs)and in Switzerland(in Swiss Francs),which wants to assess the impact of a
stronger Euro. Three main effects will appear on the cash inflows. First, local sales will
increasedue to a lower foreign competition(for Swiss customers Germanproductsappear
more expensive) . Second,the sales denominatedin Swiss Francsto Germanywill increase,
since the productsare getting less expensive . Third, even the Euro denominatedsales to
Germany could increase since the number of products sold may decrease but they are
translatedin homecurrencyat a higherrate. To conclude,the effectson economicalexposure
are difficult to est imate because of the nu merous interact ions between the para meters.
Cash flow sensitivitycan also be implemented. Sincefirm valuerepresentsthe presentvalue
of futurecash flows, exchangerate exposureis the sensitivityof firm valueto exchangerate
changes. Anotherapproachis to defineexchangerate exposurein termsof a regressionof the
firmstotal value(or stock return) on the exchangerate. Exchangerate exposurecouldbe thus
measuredas the slope coefficientbetweenthe firms value (or stockreturn)and the changes
in the exchange rate.
Translation exposure measurement
Translationexposureappearswhena firm has foreignsubsidiariesand needsto translatetheir
earningsinto its base currency. To measuretranslationexposurethe firm needs to estimate
future expectedearningsof each subsidiaryand then needs to applya sensitivityanalysisin
orderto evaluatethe potentialeffectof fluctuationsof exchangerates.
6. Foreign exchange risk management
Risk and in particularforeign exchangerisk can be managedin various manners. In this
sectionwe will focus on hedgingthe risk. FollowingPrindl (1976) we define hedgingas all
action taken to change the exposedpositionsof a companyin one currencyor in multiple
currencies.A distinctionbetweenthe hedgingtechniquescan be made:thereare internaland
external hedging techniques. The formerincludeall the techniquesthat do not require external
parties. External hedging techniquesdeal mainly with financial contracts such as futures,
forwards,options and swaps. When choosingbetween different types of hedging, the risk
manager must comparecosts, taxes, effects on accountingconventions(importantfor the
translation)and regulation(which may limit some transactions) . Severalobjectivescan be
assigned to risk management,the most commonones are: to minimizeforeign exchange
losses,to reducethe volatilityof cash flows,to protect earningsfluctuations, to hedgethe risk
irrespectiveof the views on foreign exchangerisk. Most corporations do not use only one
technique but rather determine which technique is the most suitable for a part icular case.
Internal hedging (natural hedging)
Beforepurchasingexternalhedges,the companyshouldfirst look for internalhedges. Internal
hedges have a relatively low cost.
1. Netting
Netting is probablyone of the most used methods. The idea is to reduce the number of
transactionsthat a firm needs to make in order to cover an exposure. It requires the firm to
have a centralizedorganizationof its cash management . The centralizationmeans that the
companycollectsforeigncurrencycash flowsbetweensubsidiariesand groupsthem together
so as an inflowoffsetsan outflowin the same currency. Two types of nettingexist: bilateral
and multilateralnetting. Let us illustratethe bilateral netting with an example. Considera
Swiss companywith two subsidiaries:one in Germanyand one in the USA. The German
subsidiaryowes the Americansubsidiary100 000 Euro. The Americansubsidiaryowes the
Germansubsidiary150 000 Euro. Nettingthis two flowsleavesthe companywith a payment
of 50 000 Euro from the Americanto the Germansubsidiary. Thusthe numberof transactions
has been reducedas well as the total amount of the exposure. This techniqueis repeatedfor
each currenc y to which the company is exposed.
Multilateralnetting is more complex, but follows the same rationale. The same Swiss firm
opens a third subsidiaryin Japan. Supposethe subsidiariesowe each other some amountas
reported in figure 2. When nettingthe payments,we obtain table 1. Rather than havingall
these transactionstaking place, only the netted amountsare exchangedthrougha netting
center (Figure 3). Netting is an appropriateand easy to implementtechniqueto hedge
transactionexposure.
Figure2: Before netting
50 000 EURO
German
subsidiar y
10 000 EURO
Japanes e
subsidiar y
Table 1: Multilateral netting
Swissparent
20 000 EURO
30 000 EURO 40 000 EURO
American
subsidiary 80 000 EURO
Net
+40 000
-30 000
-100 000
+90 000
0
Pays Receives
Swiss 40 000 80 000
German 60 000 30 000
Japanes e 110 000 10 000
American 30 000 120 000
Figure 3: Multilateral netting
German Swiss
subsidiary parent
30 000 EURO
Netting
center
100 000 EURO
40 000 EURO
90 000 EURO
Japanese American
subsidiary subsidiar y
2. Pre-payment
Import commitmentscan includean option to prepay. This is used if currencyis thoughtto
appreciate;then prepayingenablesthe companyto pay at a lowerrate. If the future rate f inally
depreciates,the firm is worse off than if it had done nothing. However,thereare somelimits
set by governments, which restrict the use of this method.
3. Leadingand lagging
Companiescan do the abovetechnique(accelerateor delaythe originalpayment)but within
its divisionsor subsidiaries . In this case it is called leadingand lagging. If the currencyof a
subsidiaryis sought to appreciateit may accelerateits payment (leading) and realize the
paymentbefore the currencyappreciates . The reverse is true if a currencyis expectedto
depreciate,then the companywill delayits payment(lagging) . However,the firm shouldnot
only take into accountthe gain or loss from the currencybut also the cost from increasing/
decreasingthe liquidity. This tool is widespreadfor hedging transactionexposuresince it
allows for liquidity and risk management at the same time.
4. Longterm structuralchanges
Restructuringis a morecomplextask than hedginga currencytransaction. However,once the
restructuringis finished,the reductionof the exposurehas a long-termeffect. The firm can act
on four parameters:change the sales, change the foreign suppliers, change the foreign
productionfactoriesor changethe foreigndebt. The idea is to changethe relationshipbetween
cash inflows and outflows. Restructuringis a very attractivetechniqueto manageeconomic
exposur e. However,a main disadvantageis that this tool is quite difficultto applyand cannot
be reversed immediately.
5. Priceadjustments
Price adjustmentscan be made in differentmanners. First, when the local currency of a
subsidiaryis devaluating,the subsidiarycan increasethe price, so as to cancelthe effect of
devaluation. This techniqueis particularlyused in countrieswhere devaluationis high and
where derivative markets are inefficient . On the side of the disadvantages,the difficult
implementationof this method needs to be signaled. Prices cannot be raised without any
considerationabout competitorsbecauseif the price increasestoo much the customerwill
choosean equivalentand cheaperproductfrom a competi tor. In the same logic, a firm can
increase the export price. But then the price adjustmentis even more complex,since the
companyhas to face not only local but also internationalcompetitors . Second,the company
can change the currency of billing. Third, the firm can use export currency of billing to
transfer profits from one affiliate to another. The purpose is to raise or lower intergroup
selling prices by billing rate adjustmentso that profits appear in hard currencyor low-tax
companies. This technique is very aggressive and can be forbidden by regulation.
6. Asset/liabilitymanagement
Asset liabilitymanagement(ALM) is related to leading/laggingand has the same rationale:
for currencieslikelyto appreciate,increaseassetsand reduceliabilities. For currencieslikely
to depreciate do the reverse. To illustrate,supposea currencyappreciates . A firm will then
increaseits assets by increasinginvestmentand reduce its liabilitiesby reducingthe short-
term debt. The long-termassets/liabilitiesare more difficultto change. Long-term debt cannot
be reduced easily and buildingscannot be sold promptly. ALM can be used for hedging
translation exposure .
External hedging
When internalhedgingis not enoughto managesuccessfullyexchangerate risk, companies
can get into contact with banksor go to the market and do externalhedging. External hedging
is more expensiveand more complicatedthan internal hedgingand not all companiescan
afford it, but it is quite successful and many firms use it.
External hedgingconsists in using foreignexchangederivativecontractssuch as forwards,
futures, options or swaps. We can regroupthese instrumentsinto two main categories:the
first categorycontainsinstrumentssuch as currencyforwardsand futures,and moneymarket
contracts. With these instrumentsthe exchangerate is fixed at the moment when the risk
appears . The main disadvantagewith these instrumentsis that they cannot benefit from a
favourablemovementof the exchangerate. The secondcategorycontainsinstrumentssuchas
currencyoptionsthat protect the companyfrom an unfavourablemovementof the exchange
rate and at the same time keep the possibilityof benefitingfrom a favourablemovementof
exchange rates . In the following lines, we give a brief description of these instruments.
1. Currencyforwards
The principlewhen hedgingwith forwardsand futuresis to take an oppositepositionto the
positionthe firm has on the spot market. An exporterwho has to receivemoneyis afraidof a
devaluationof the foreign currency. He will then sell forwards(or futures) in order to gain
from this possibledevaluationand thus compensatefor the loss incurred. On the other hand,
an importerhas a foreigncurrencydebt and he is afraid of an appreciationof this currency.
He will then buy forwards (or futures) and thus neutra lize the foreign exchange risk.
Foreign exchange forward contracts are usually traded with banks or other financial
institutionsin the over-the-countermarket. The underlyingasset is a currencyand the two
parties of the contractagree on a predeterminedexchangerate for a given future date. A
companyagrees to buy or sell an amountof a givencurrencyat a future date. The forward
exchangerates for a three months, six months or nine months contracts,for example,are
known now, and it costs nothing to enter into such an agreement. Nevertheless,the
commitmentis bindingfor the both sides of the contract . Thus,if a companyreceivingdollars
in three monthswants to be sure to get a givenamount of Swissfrancs,its Treasurerhas to
contact a bank and enter into a short forward contract or in other words, sell the dollars in
threemonthsto the bankat a givenpredeterminedexchangerate and receivethe Swissfrancs.
The bank in this exampleis said to have a long forwardcontractbecauseit shouldbuy the
dollars, and the underlying is the dollar currency.
Forwardcontractsare availablein most majorcurrenciesbut not in less traded or very volatile
currencies. Hedgingagainst exchangerate movementswith forwardsis not possible in all
countries especially in those t hat have no advanced money markets.
By covering in the forward exchange market, a firm is indifferent to the movements of
exchangerates. It avoids the risk of losing as a result of unfavourablemovementsin the
exchangerate but at the same time it gives up the chance of gaining in the case of a
favourablemovement . The companytakes a neutralpositionand this positioncosts nothing.
Moreover,forwardscan be attractivebecausethey typicallydo not show up on the balance
sheet. Forwards are well suited for hedging all three types of exposure .
2. Moneymarketcontracts
A companycan hedgein the same way by usingthe moneymarket. Lets take our previous
examplewith an exportingcompanyreceivingdollarsin three months. The treasurerdoes not
know what the dollars will be worth in three months. He could simply borrow dollars now
from a bank and convert these to Swiss francs at the spot rate on that date. Thushe has a
dollar debt, but that does not matter becausehe can repay this debt when he receivesthe
dollarsin threemonths. The companyis not concernedwith futureexchangerate movements .
It has the amountof Swissfrancsneededand can deposi t it in a bankand thus earn the three
monthsinterest. This operationpermitsthe firm to disposeimmediatelywith moneyand not
to wait three months for the dollars. In addition,the exchangerate risk is covered. The only
problemwith this is that it is not alwayseasy to borrowmoneyespeciallyfor small companies
and big amounts of funds.
The example above works well for an exporter but not for an importing company. An
importerhaving a foreigncurrencydebt can borrownow an amountequal to the amount of
the debt. Thus he can repay immediately his foreign counterpart . In three months,the importer
should buy foreign currencywith Swiss francs in order to reimburseits debt in the foreign
currency. For this reason, in this case the importeris not coveredagainst foreignexchange
rate fluctuations . This operationallows him to finance its importationsbefore resellingthe
importedgoods but does not providehim with a hedge. Nevertheless, the foreignexchange
rate risk can be coveredif the importeris an exporterat the sametime, and if the importsand
exports are in the same currency.
3. Currencyfutures
A similarcontractto the forwardis a futures contract. Currency futures exist since 1972 when
they were for the first time introduced. Nowadays,majorcurrencieson whichfuturesexistare
the Euro,the GBP,the CHF,the JapaneseYen,the Canadiandollarand the US dollar.
In practice,this contractis not oftenused to hedgeforeignexchangerisk. The LIFFE (London
InternationalFinancialFutures Exchange)closed down its futures currencymarket in 1990
becauseof a lack of business . Actually, futures contracts require the payment of margins
every day. The size and the maturityof futuresare standardizedand this makesmoredifficult
theiruse in hedgingstrategies . Anotherinconvenientof a futureis that it is ratherrare that the
amountof moneyto be coveredcorrespondsexactlyto a multipleof the size of the contract;
one part of the position thus remains unhedged .
Even though not frequentlyused, futures are more liquid, more regulatedand more secure
than forward contracts. Futurescarryno counter-partycreditrisk becausethe exchangeitself
imposesstrict credit requirements . While forwards are more flexible, they are often illiquid
due to their uniquestructure.
4. Currencyoptions
Options on foreigncurrenciesare an alternativeto hedgingin the forwardor moneymarkets.
Standard (plain vanilla) options, average rate options, barrier options, basket options,
contingentpremiumoptions and various option combinationsare availablein the over-the-
counter market. In our exampleabove, the exportingfirm can buy a put option giving it the
right but not the obligation to sell the dollars in three months. The writer of the option
(usuallya bank) agrees to purchasethe dollars in three months time at the exchangerate
agreed now (the strike price). If the dollar falls in value, the firm will exercise the option;
otherwise, the option will expire worthless and the firm will incur a loss limited to the
premiumpaid to get the option.
Options can be traded both on an organizedexchangetrade and on the over-the-counter
marketwith banks. Whilean exporterexpectingto receivean amountof foreigncurrencycan
hedge by buying a put option, an importer having a foreign currencydebt can hedge by
buying calls on this currency.
An interestingway to manageexchangerate risk is to implementa zero cost optionstrategy.
A companycan buy a call and at the same time sell a put or sell a call and at the same time
buy a put. On one hand, the companyreceivesa premium,and on the other hand, it pays a
premium. If these premiumsare equal, we get a zero cost option strategy. Moreover, with a
zero cost optionstrategy,thereis no cost and nothing appears in the financial statements.
Buyinga call and at the sametime sellinga put or sellinga call and at the sametime buyinga
put, blocksthe exchangerate betweena minimumand a maximumcorrespondingto the two
exercisepricesof the options. For example,an exportercan hedgeagainstthe devaluationof
the dollar by buyinga put on the USD and at the same time sellinga call on the USD. The
purchase of the put is financed by the premium received for the call.
5. Swaps
Anotherpopularinstrumentis the swap. In a swap, companiesexchangefundsdirectly. Two
companiesin two differentcountriesagree to sell each other their own home currenciesat
currentspot ratesand at the sametime they agreeto buy backthe currenciesat a givenfuture
date and a given exchangerate. It is like borrowingand lending at the same time with the
same counterpart. Swaps are currentlyvery popularand providea long-termflexiblehedge
with low transactioncosts. Moreover,they are off-balancesheetinstrumentsand do not show
up on the financial statements of a company.
We can distinguishbetweentwo kindsof swaps currencyswapand foreignexchangeswap.
With a currencyswap, a companysimultaneouslypurchasesand sells a given currencyat a
fixed exchangerate and then re-exchangesthosecurrenciesat a futuredate. Thus we hedge
foreign currencycash flows and foreign debt. Usually,a floatingrate is exchangedagainst
anotherfloatingrate. Firms exchangenotionalamountsat initiationof the swap and they re-
exchange them at maturity.
In a foreignexchangeswap, we have no interiminterest payments,but insteadthe notional
amountsare re-exchangedat a differentexchangerate. The foreignexchangeswapis like an
exchange of two zero coupon bonds in different currenc ies.
7. Effect of the introduction of the Euro on FX risk management
In January 1999, 12 European national currencies
4
were replaced by a common Euro
currency. As a result, transactionswere simplifiedand internationaltrade increased. Firms
with a high percentageof their foreignsales in the Euro area were amongthe most affected.
In addition, corporate port folios became easier to manage.
Some authorslike Madura(2000)were expectingthe volatilityof the Euro to be less than the
volatilityof the replacedcurrencies. The end of multiplecurrenciesand thus the vanishingof
the foreignexchangerisk in Europeancountriesshouldfavor the long-termbusinessamong
European firms. Transactionsshould increase, as the fear of exchange rate volatility is
reducedand it shouldallowfirms to concentratemore on their businesses . Finally,the cost
linkedto foreignexchangetransactionsand differences in interests among European countries
should disappear.
Shnke,Karolyiand Kleimeier(2002)studythe Impactof the Euro on foreignexchangerate
exposur e. They show that the introductionof the Euro reduced exchangerate volatilities,
whichled to a reductionof market risk in generalfor non-financialfirms in Europe,USA and
Japan. The reductionin market risk is significantlylarger for firms with high sales in Europe.
Moreover,they find that foreignexchangerate exposuresare reducedas well, especiallyfor
firms with high foreignsales in Europeor high foreignsales in general. Transactioncosts due
to hedgingFX exposurewerealso reducedafter the introductionof the Euro.
However, the reduction of foreign exchange rate risk affected firms differently across
countriesdependingon their foreignsales. Firms from the same countryhave differentstock
return volatilitiesdependingon their level of foreign Euro area sales. Firms that are less
exposed to the Euro had their stock return varianceincreasesignificantlymore than firms
with higher foreign Euro area sa les with the introduction of the Euro.
We can conclude by a citation by Shnke, Karolyi and Kleimeier:While it is not obvious
that corporatehedgingbehaviorhas significantlychangedafter the introductionof the Euro,
one can neverthelessobserve significantreductionsin market and foreign exchangerate
exposures of non-financial firms after 1999.
II. Empirical analysis
1. Empirical studies on FX risk management
In the followinglines we summarizethe main results found in empiricalstudies concerning
FX risk management . The purpose is to comparetheseresultsto the results that we find latter
in Logitech SA and Kudelski Group.
Organization of FX risk management
A generalconcernin the organizationof FX risk managementis whethermanagementshould
be centralizedor decentralized . Prindl(1976)recommendsa centralizedforeignexchangerisk
management. From the risk managementpoint of view, a centralizedorganizationis expected
to incur lower costs but has so me disadvantages like loss of autonomy of some units.
Importance of FX risk management
Most studiestend to show that FX risk is consideredas an important risk to manage. Marshall
(1999)finds that FX risk management is one of the most important financial activities in large
American,British and Asian firms. He states four main objectivesof FX risk management:
minimize foreign exchange losses, reduce the volatility of cash flows, protect earnings
fluctuations and hedge the risk irrespective of the views on foreign exchange risk.
Lodererand Pichler (2000) made a similar surveybut for Swiss companies . Theyobtainas
main reasons for managing currency risk guaranteeingthe cash flow, reducing financing
costs, simplifying planning, preventing losses and reducing taxes.
Do firms hedge?
Batten et al. (1993) find that all firms hedge foreignexchangeexposure. In their sample of
Australianfirms 21 out of 69 are fully hedged,48 are partiallyhedged. On their side, Bodnar,
Marstonand Hayts (1998) results reveal that the majorityof firms hedge less than 25% of
their perceived exposure s. This suggest s that foreign currency hedging, rather than
eliminatingcompletelyexposures,generallyonly reducesthem. Furthermore,they find that
firms show a clear preferencefor short-termhedging:82% of firms hedgewith maturityof 90
days or less.
In his studyabout the practiceof risk managementin the gold miningindustry,Tufano(1996)
finds that to the contraryto Modiglianiand Millers prediction,some firms of the gold mine
industry manage risk. He tests two hypothesesfor managingrisk. The first concerns the
financialdistressargumentand the seconddeals with managersrisk aversion. The financial
distresshypothesisis rejected. An explanationmay be the ability of the gold miningindustry
to shut down minesat a low cost. The managerialrisk aversionargumentis accepted. In fact,
risk is more frequentlymanagedwhen managershave stocksand less frequentlywhen they
have opt ions.
Are firms measuring FX exposure?
Lodererand Pichler (2000) analyzewhetherSwiss firms know their currencyrisk exposure.
They studytwo types of exposure-operationalcash flow and firm value exposure. They find
that less than 40% of firms are able to quantify the operationalcash flow sensibility to
currencyfluctuations . Moreover,only 33% are protectedagainst the changes in currency
rates,and most of them only protectthe directrisk and not the indirect.
The authorsask themselveswhyit is the case. They give the followingexplanations . (1) Firm
may not want to protect against currencyrisk. This argumentis rejected. (2) Firms cannot
appreciatethe importanceof knowingtheir risk exposure. The test rejectsthis explanation . (3)
Firms think that their currencyexposuremay be small. This seemsto be one of the reasons .
(4) Firms believe that unexpectedforeign exchangechangesmay be offsettingeach other.
This argumentworks but only to explainthe non-hedgingover the long term. (5) Firms are
more interestedin measuringother risk profilessuch as taxableincomesor operatingcash
flow. (6) Firms are unableto measureaccuratelytheir risk profile. This seemsto be another
reason. (7) The hedge may be too large. This turnsout not to be a valid reason.
In conclusion,only two of the abovereasonsexplainwhy firms do not measuretheir foreign
currencyexposure:measurethis risk is difficultand firms believethat their currencyexposure
may be small.
Market view and FX risk management
Different papers argue that market view influences foreign exchange risk management
strategy. Bodnar, Marston and Hayt (1998) find that many firms take into account their
marketview whenchoosinga risk managementstrategy. About 10% of firms in their sample
altered either the size or the t iming of hedges that t hey made because of their market view.
Are firms managing transaction, translation, economic exposure?
Battenet al.(1993)find that 61,1%of the Australianfirms managetransactionexposureonly,
8,3% both translation and transaction and 16,6% translation, transaction and economic
exposur e. For Swiss firms, Loderer and Pichler (2000) find that transactionexposureis the
most frequent ly hedged. Translation and econo mic exposures appear to be less important.
Transactionexposure
Marshall(1999)findsthat transactionrisk is perceivedby US, UK and Asiancompaniesto be
the most important risk to manage. Nettingand matchingseem to be the most frequently used
internalhedginginstrumentsin practiceto managetransactionexposure. Leading and lagging
is not very popular. For externa l hedging firms use forwards, opt ions, swaps and futures.
Economi c exposure
Froot and al (1994) show that there is no general framework for managing economic
exposur e. Managingand quantifyingeconomicexposureappears difficult . Marshall (1999)
finds that economicexposureimportancevaries across countries,with Asian firms paying
most attentionto this kind of exposure. He observesthat economicexposureis not managed
with derivativesbut rather with internalmethodslike pricingstrategyand raisingproductivity
(mainly used in Asia). Many firms do not manage this risk. The reason for not managing
economic exposure is the lack of effective tools and costs exceeding benefits.
Lodererand Pichler(2002)assertthat firmsoftenmanageeconomicexposureby lendingand
borrowingin foreign currencies. He cites the followingreasons for not hedging economic
exposure:firmsare unableto measurethe size and the currencyof futureexpectedcashflows
with much confidence,firms alreadyhedge transactionexposure,firms considerthat in the
long term currencyfluctuationsoffset each others. Surprisingly,the cost of hedgingeconomic
exposureis not an obstacle.
Translationexposure
Shapiro(1998) argues that translationrisk should not be managedbecauseit is purely an
accountingconcept . However, Rodriguez (1977) in empirical research confirms that US
companiesmanagetranslationexposure. Marshallfinds that similar instrumentsare used to
hedge translationexposureas for transactionexposure. However,more than 50% of Asian
and US firms do not manage trans lation exposure with external hedging instruments.
What instruments are firms using for hedging?
Allayannisand Ofek (2001) find significantevidencethat exportersprefer the use of foreign
currencyderivativesto the use of foreigncurrencydebt whenhedgingtheir operations . They
explain this by the nature of exporting,which can require customized,short-termcontracts
that are better servedby derivativesrather than by long-termforeigndebt. The advantageof
derivativesis that theyhavea predetermined cost and are accessible by all companies whereas
foreign debt is limited to large firms.
Bodnarand Gebhardt(1998)state that Germanand US firms prefer to use OTC instruments
(forwards, swaps and options) rather than exchangetraded instrumentssuch as futures.
Forwardsare recommendedfor firm commitmentswhereasoptions should be preferredfor
uncertain foreign currency denominatedfuture cash flows. When hedging more uncertain
exposuresfrom anticipatedtransactions,forwardsare the preferredinstrumentsbecausethe
uncertaintycan be taken into accountby adjustingthe hedge ratio with forwards. The most
frequentlyused derivativecontract to hedge transactionexposure is the currencyforward
contract.
Bodnar,Marstonand Hayt (1998)confirmthat optionsare less frequentlyused than forwards.
Furthermore,they foundthat optionsweremainlyused in longer-termexposures . Firms avoid
usingoptionseitherbecauseof the cost they incur in orderto get the options or becausethey
find another instrumentthat is better suited for the given exposure. For Australianfirms,
Batten et al., (1993) find similar results: the most used instrumentsto hedge are forwards,
options and currenc y swaps.
Marschall(1999) finds that US, UK and Asian firms use both internal hedgingand external
hedgingfor coveringtransactionexposure. For translationexposure,US and UK companies
use internaland externalhedgingas well whereasAsianfirms use mainlyinternalmethods.
Bodnar, Marstonand Hayt find that a majorityof firms use natural hedging. In Switzerland,
Loderer and Pichler (2000) demonstratethat firms use money market hedges, choice of
currencyof billing and currencyrisk sharingas internal hedgingtechniques. Pricing policy,
credit policy and choice of countries in which to buy inputs and sell goods are other
frequent ly used techniques.
Bodnar, Marstonand Hayt show that the most frequentlycited motivationfor using foreign
currencyderivativesis for hedgingshort-termobservableexposures . However,many firms
use foreigncurrencyderivativesat least sometimesto hedgelong term exposures . Few firms
use foreign currencyderivativesto hedge translationexposure. Accordingto Bodnar and
Gebhardt (1998), German and US companiesuse derivativesprimarilyto manage foreign
exchange(and interest rate) risk. They show that the main purposeof using derivativesin
exchangerate risk managementis to minimizethe variabilityin cash flows. They also show
that companiesprefer to use simpleforeignexchangeinstruments . Similarresults are found
by Bodnar, Marston and Hayt (1998)- 83% of derivativeusing firms use foreign currency
derivatives and 95% o f US manufacturing firms hedge foreign exchange risk with derivatives.
Allayannisand Weston(2001)find that from 1990to 1995 there is an increasein the number
of firms with foreignsales that use currencyderivatives . In contrast, the percentageof firms
with no foreign sales that use foreign currency derivatives is small.
Maturity horizon
Maturitystructureof hedgingis anotherinterestingissue. Bodnar, Marston and Hayt (1998)
show that short-termderivativesare used by a vast majority of firms. 82% of firms use
foreigncurrencyderivativeswith an originalmaturityof 90 days or less, and 77% use foreign
currencyderivativeswith an originalmaturityof 91-180days. Only 12% use foreigncurrency
derivativeswith maturitiesof more than 3 years. Firms tend to concentrate most of their
foreigncurrencyderivativesusageat the short horizon,especially90 days or less. Nearly one
quarter of the firms do all of their currency derivativeactivity in instrumentswith original
maturitiesof 180 days or less. Finally,the intensityof usagedecreasesdramaticallywith the
lengtheningof the maturity of the derivatives. Very few firms use any instruments with
maturitiesover 1 year. Thereis a small group, 7% of firms, all large firms, whichconcentrate
their foreign currency derivative usage only in the long horizon instruments.
2. Case studies: Kudelski Group and Logitech SA
In the followinglines, we examinethe FX risk managementpolicy of two Swiss firms that
can be qualifiedas mediumsize companies . Kudelskiand Logitechare clearlynon-financial
firms and we can evensay that theybelongto the sameindustry. Thesetwo firmshavemany
similaritiesbut it is interestingto find that in their FX risk managementpolicy they exhibit
some differences as well.
We proceededby interviewingthe personswho are responsiblefor the FX risk management
policiesin these companies- Mr. SantinoRumasuglia,TreasuryManagerat Kudelskiand Mr.
Jean-MarcZimmerli, CorporateTreasurer at Logitech. We sent them a questionnaire(see
appendix) and askedthem to answer28 questionsin orderto understandtheir way of dealing
with FX risk. We met these persons two t imes in order to c larify some of the answers .
Kudelski Group
Description of the firm
The KudelskiGroup was foundedin 1951. Its headquartersare in Cheseaux-sur-Lausanne in
Switzerlandand it has offices in the USA, Germany, Austria, UK, France, Brazil, Spain,
China,Singapore,Italy, the Netherlandsand Sweden. The Groupemploysover 1,200people
and between40 and 60% of them are workingabroad. The Kudelskistock is listed on the
SwissMarketIndex(since1986)and on the MorganStanleyCapitalInternationalIndex. The
Groupsprincipalshareholdersare the Kudelskifamily with 34% of the capital and 64% of
the votingrights and GroupeDassaul t with 6% of the capitaland 4% of the votingrights. The
company's market capitalization at 30.06.2003 was 1 147 million.
Kudelski is a world leader in the area of digital security. Its activities include two main
sectors: Security of Access to Information(Digital Televisionand broadbandInternet) and
Physical Access to Sites (Public Access Control) . The Groups core business is providing
advanced security and technology solutions. In 2001, the Group acquired several new
companies and enlarged its range of activities.
The Groupsmain competitoris NOS, whichis locatedin the USA. Kudelskis main products
are CAS (ConditionalAccessSystems),systemsthat ensurethat only subscriberswho have
paid for a servicecan haveaccessto it, and Physical Access products . The main customersof
the Groupare locatedin the USA (EchoStar)and in Germany(Premiere) . Majorsuppliersare
located in Europe and As ia.
More than 80% of the companys operating revenues are realized abroad (outside
Switzerland);actually,only 2% are realizedin Switzerland(the local market),52% in Europe,
33% in North America,12% in Asia and Australia,0.5% in Africa,and another0.5% in Latin
America. Between40 and 60% of the Groupsexpensesare incurredabroad. The companys
currencyof denomination is the CHF and it is the most exposedto the USD and the Euro
given that its major customers are situated in the USA and Ger many.
2002 was a particularly difficult year for Kudelski because of the crisis in the Digital
Televisionmarket in Europe. In addition, the Group was badly surprisedby the US dollar
depreciation,which had a negativeimpact on revenuesand marginsboth in the American
market and in the Asian market. In the first half of the year 2003, the US dollar was still
depreciatingand this had a negativeimpact on Kudelskisrevenues. However, Kudelskis
revenuescomingfrom the USA increasedduring the first months of 2003 but this increase
was limited and partly offset by the CHF/USD exchange rate movements . In order to
neutralizethe negativeeffect of the US dollar depreciation,the Groupdecidedto improveits
presenceon the Europeanmarket,and thus reduceits dependenceon US dollarrevenues . It
actuallysucceededin doingthis and becamethe leaderon the Europeanmarket . Moreover,
revenuesdenominatedin Euroand Swissfrancsincreased. By applyingthis restructuring,the
company decreased its US dollar exposure without using any external hedging methods.
Moreover,the Group reducedits costs incurredin the USA. With higher level of sales and
lower level of costs, the Group improved its operating profitability by CHF 7.8 million
compared to the first half of 2002. Given that some of the firms major suppliers are in
Europe, we wonder whether it was not better for Kudelskito transferits costs from Europe to
the USA and thus benefitfrom the depreciatingdollar. One reasonfor whichthe companydid
not do this couldbe that it expectsa future appreciation of the dollar. Anotherreasoncouldbe
that it alreadytransferredsomeof its coststo suppliersin Asia wherethe costsare incurredin
US dollars.
Herewe give somekey data on the size and the performanceof the company. These numbers
and data are taken fro m the companys Annual Report 2002.
Table 2: Consolidatedincomestatement for the year ended: sources financial statement 2002
in kCHF 2002 2001
Total income 402 355 455 445
Gross margin 250 033 269 794
EBIT, operating income -32 022 -82 973
Net income 13 019 71 594
Exchange rate risk management policy
The managementof financial risk and the responsibilityfor all treasuryoperationsare not
centralized in Kudelski. This meansthat each subsidiarymeasuresits FX exposure. The CFO
and the CEO define the foreign exchangerate risk managementpolicy and the Treasurer
implements it. Basedon the informationreceivedfrom the foreignsubsidiaries,the Treasurer
makes the overa ll companys exchange rate exposure report b y each currency.
Not surprising,transactionexposureis statedas the most importantforeignexchangerisk to
the Group. The Groupmeasuresits transactionexposureeach month. Translat ion exposure is
measuredsometimesand economicexposureis not at all measured. When hedging translation
exposure,they hedgelongerthan the maturityof the exposureand whenhedgingtransaction
exposurethey hedgethe maturityof the exposure. The main purposeof the foreignexchange
exposuremeasurementis to be able to hedge the risk. Overall,the companyhedgesabout
80% of the exchange rate exposure and the hedge is adjusted weekly or monthly .
Manycompaniestry to beat the marketand make their hedgingstrategiesaccordingto their
own view on the future developmentof foreignexchangerates. Kudelskiis not interestedin
speculationand it does not use any forecastingmodelsto predictthe evolutionof exchange,
interest or inflation rates.
Althoughthe foreignexchangerate risk managementpolicyis not centralized,the companyis
hedgingthe exchangerate risk by a centralunit. Derivativesare used to managetransaction
exposur e. Optionsand swapsare the most frequentlyused instrumentsto do this. Theyalso
use forwardsand cash flow matching. They often use natural hedgingto cover transaction
exposurebecausethereare no transactioncostsin doingso and becausethis is a rathersimple
technique. The companyneveruses futuresand asset liabilitymanagement . The reasonsthey
do not use these two techniquesare becausethey causeaccountingproblemsand/orthey do
not havethe desiredfeature.
The instrumentsused during the year to hedge foreign currency positions mainly include
forward foreign exchangecontracts, currency swaps and zero cost option strategies. The
swaps they do are of a short maturity: maximum3 months. Forwardsand options have a
longer maturity:from 3 to 6 months. Optionsare mainlyused whenthere is a big probability
that a particularcurrencywill increaseor decreaseabove (below)a certainlimit. Derivatives
are mainly used to hedge income and cost exposure in US do llars and Euro .
The followingtables present the notionalamountof some derivativecontracts. The notional
amount shows the vo lume of the under lying transact ion at balance sheet date .
Table3: Derivativefinancialinstruments . Sources:financialstatement2002
Table 4: Balance sheet derivative financial instruments at 31 December 2000. Sources:AnnualReport
2000.
Accordingto Mister Rumasugliathe introductionof the Euro had a positiveimpact both on
the Groupsrevenuesand costs, and it had no impact on the foreignexchangeexposure. The
Groupsexchangerate risk managementpolicywas not changedafter the introductionof the
Euro.
Assets, liabilitiesand all other financialstatementsfrom the balancesheet denominatedin
foreign currencies(other than Swiss francs) are translatedat year-endrates of exchange
(current rates). Revenuesand costs expressedin a foreigncurrencyare translatedusingthe
averagerate of exchangefor the year. Translationadjustmentsare includedin the translation
reserve in the consolidatedshareholdersequity. As stated in the financial report 2003,
Transactionsin foreign currenciesare convertedat the rate of exchangeprevailingat the
transactiondate. Other receivablesand payablesin foreigncurrenciesare translatedat year-
endrates. The resulting currency translation differences are included in net income.
Contractual Contractual
amounts amounts
2000 1999
---------------- KUSD 1,315
KEUR 5,000 ---------------
KUSD 20,000 -----------------
Forwardcurrencycontracts
(1 CHF = 1.55 USD)
Hedging options on currency
increase
Hedging options on currency
decrease
Logitech SA
Description of the firm
Logitech SA was created in 1981 and it listed its shares on the Swiss market in 1988.
Currently,it is listed on the Nasdaq(with US dollar denominatedshares) and on the Swiss
market (with Swiss Franc denominatedshares). The firms headquarteris set in its U.S.
subsidiary. Daniel Borel - founder, previous CEO and actual chairmanof the board, owns
6.8% of the shares of the company. In terms of market capitalization,Logitech can be
classifiedas a mediumfirm ($1500 million). In terms of revenues,it is more than twice as
large as Kudelski.
The company is active in personal interface products for PCs, mobile phones and game
consoles. Its productsrange from Internetimagingdevices,mice and trackballs,keyboards,
speakers and headsets,interactivegaming controllersand 3D control devices. It seeks to
develop further the interaction between the man and the machine.
For each of its productsLogitechhas differentcompetitors . For miceand keyboards,it has to
face Microsoft. Microsofthas an advantageover Logitechsince the companyis developing
the software and therefore knows before all other competitors how to adapt its product to the
software. For PC videocameras,the competi tors are CreativeLabs and Veo. The marketsin
whichLogitechis activeare highlycompetitive,and marketleadershipcan changefrequently
as a result of new productsand pricing. In the futurethe companyexpectsto be still exposed
to competitionand price pressureand for this reason wants to keep the advantage it has
established in design and advanced technologies.
Logitechsells to OEM (originalequipmentmanufacturers)and to retail (throughdistributors) .
For the OEM most of it transactions are set in US dollarswhereasfor the retail the sales are
done in Europe, USA, and Asia (50% dollars and 50% in Euro). The retail accountsfor 75-
80% of the total sales and the OEM for 15-20%. The table belowshows the geographical
repartition of Logitechs sales with Europe be ing the leading region.
Table5: Net salesto unaffiliatedcustomersby geographicregion. Sources:2003Financialstatement
The currencyused to pay suppliersis mostlythe US dollar, and less the Euro and the Yen.
The company is currentlyemployingaround 5000 persons of whom 3500 are located in
China, 500 in the U.S. and 400 in Europe. Concerningthe wage payments,it is exposedto
ChineseYuan,US dollars,Euro and CHF.
The structure of the firm is simple; it has a main holding based in Switzerlandand four
subsidiaries:one in the U.S. who takes care of the Americanmarket,one in Asia who takes
care of the production and one for the sales,and a fourthone in Europe. This simple structure
allows the company to effectivelyimplementthe natural hedging. In the table below, we
present some key financial data for the years 2002 and 2003.
in kUSD 2003
Total revenues 1 100 288
Gross margin 364 504
EBIT, operating income 123 882
Net income 98 843
2002
934 546
315 548
97 218
74 956
Table6: Consolidatedincomestatement . Sources:2003Financialstatement
Exchange rate risk management policy
The companymeasuresoftentransactionexposure,sometimeseconomicexposure,and never
translationexposure. The Treasurerhas a similar view as the one developedby Shapiro
(1998) who arguesthat translationrisk shouldnot be managedand is purelyan accounting
concept not related to cash flows. Furthermore,he finds it difficultto measurethis exposure
and there is no adequate instrumentto manage it. However, the company exceptionally
hedges translation exposure in case of liquidation.
Economic exposure appears difficult to hedge because of a timing problem, 90% of the
receivedoffersare cancelled. The idea here is not to cover the cost of sales but the margin.
Managing and quantifyingeconomicexposureappearsdifficult . It can be due to the impact
of exchangechangeson net cashflow, whichspreadsbeyondthe accountingperiod. Marshall
also finds that firms encounterdifficultiesin measuringeconomicalexposure. However, in
the literatureeconomicexposureis seenas an importantexposureto manage.
Logitechis concernedwith measuringthe transactionexposurefor each pair of currenciesto
whichit is exposed. The transactionexposureis summarizedin table 7, whichrepresentsthe
sensitivityanalysisthat we presentedin section5. Logitechseemsto pay specialattentionto
transactionexposure,which is consistentwith the study of Marshall(1999)who shows that
management focuses on th is risk exposure.
Table7: SourcesAnnualreport2003
Logitech does not want to use sophisticatedtools because of large administrativecosts.
However,the companyuses forecasts to adapt the hedge. Theymakea forecastby currency,
and hedge for 3 months (for each quarter), mostly in Euro/dollars.
The Board of Directors defines the foreign exchange risk management policy under
recommendationof the Treasurer . The Boarddefinesthe competencesof the CEO, the CFO
and the Treasurer . This is consistent with Tufano (1996) who finds that risk management
policyis being set, reviewed,and monitoredby a broad groupof directorsand not solelythe
CEO. Logitech has a centralizedexchange risk managementpolicy and the purpose of
exchangerate measurement is to hedgeand managethe risk. The treasurydepartmentis not
seen as a centerof profit and its main objectiveis to limit the fluctuationsof the sales margin.
The measurementis done on a monthlybasis, which correspondsto the internalintervalof
accountingclosing. Together with UBS SA they are implementinga VaR (Value-at-Risk)
program to assess the exposure. The companyuses forecastingmodel for exchangeand
interestrates but none for inflation. They considerthat the inflationis alreadyincludedin the
exchange and interest rates.
The companyfavors natural hedge wheneverit is possible. They use two techniques:the
change of currency of bills and the issue of CHF convertiblebond (reportingis done in
dollars). The companysold convertiblebonds for 170 millionCHF and used them to offset
the fluctuationof assetshold in Europeancurrencies . Until now the firm was able to generate
a small gain (around 7 million) by applying this internal hedging.
In termsof externalhedginginstruments,the companyuses mostlycash flow matching,asset-
liability management,forwards and swaps. It never uses futures and options. They use
forwardsto hedgetransactionexposureand moreprecisely,as explainedin the annualreport,
to hedgethe forecastedinventorypurchaseby subsidiaries . If no purchaseis made, then the
companyrecognizesthe losses. Therefore, in order to avoid losses, it is crucial for the
companyto obtainaccurateforecastsof inventorypurchase. The hedgedidntcauseany loss
last year. The notional amount of outstandingforeign exchangecontractswas $ 13 million
(comparedto the net exposedcurrencypositionof 42,264 million). The companyreports a
gain on foreign currency of $ 2.8 million.
The reasonsannouncedfor not usingoptionsare the expensiveness(for Logitech,the cost of
usingoptionsis around5% of the nominal),the complexityof the instrument,and the fact that
the optionsdont have the desiredfeature. As the Treasurymanagerexplainedus, the main
objectiveis to havestablecash flows,sincethe treasurydepartmentsobjectiveis not to make
gains but rather to ma intain the margin on the products.
Concerningthe maturity horizon, forwards and swaps have maturity less than 3 months.
Thesetwo instrumentsare used for dynamichedgingand the hedgeratio is around40-60%;
otherwisethe cost wouldbe too high.
The transaction and economicexposureare hedgedshorter or equal than the maturi ty of the
exposur e. The hedgeendsup beinglongerthan the maturityonlywhenthe companyproceeds
to a sale of a division. The hedgeis readjustedon a monthlybasis,or neverfor the particular
case of a convert ible.
The firm did not measurethe effectof the introductionof the Euro on FX managementpolicy.
The introductionof the Euro reducedthe amountof work but the policy stayed the sameand
the foreignexchangeexposuredid not decrease .
Conclusion
Many companiesview foreign exchange risk as an important risk, however they differ in
organizingand managingit. Logitechuses a centralizedorganizationfor foreign exchange
risk management. Moreover,it uses the multilateralnettingsystempresentedin the theoretical
part. Kudelski on its side uses a mixture between centralized and non-centralized
organization. This practiceof centralizationis consistentwith theoreticalview wherewe find
a clear preference for a centralized organization.
Most of the empiricalstudies and the financialliteratureare in favour of hedging. It seems
that Kudelskiand Logitechhave also adoptedthis view. Both companieshedgebut they do
not hedgethe sametype of FX risk. Theoryprovidesus with numerousargumentsfor hedging
whereas we found that Logitech and Kudelski hedge for mainly one reason to protect
margins. Moreover,firmspreferto hedgein the short-term(90 days or less) and Kudelskiand
Logitechconfirm this finding. Both companiesnever hedgefully, mainlybecauseof the cost
of hedging;the marginon the productof hedgingwouldthen decreaseto an intolerablelevel.
Kudelskihedgesaround80% whereasLogitechbetween40 and 60%. Finally, we can say that
hedging reduces FX exposure but does not co mpletely eliminate it.
Previousresearchfoundthat the morestocksmanagersare holding,the moretheyhedge. For
Kudelski,the CEO and founderof the groupholdstogetherwith his familyaround34% of the
shares. Therefore, it is of direct interest for him to manage foreign exchange risk. For
confidentialityreasons the amount of exposurewas not given, so we cannot evaluatehow
muchforeignexchangerisk is managed. However,this risk is activelymanagedand seriously
taken. The actual Chairmanof the Board and founder of Logitechholds around 7% of the
shares. This is less than in Kudelskiand may explainthe less advancedtoolsused by the firm
which tends to favor natural hedging.
Theoryrecommendscompaniesfirst to use internalhedgingtechniquesand then, if there is
need to do so, pass to externalhedgingtechniques,whichare more expensiveby definition.
Kudelski and Logitech follow this recommendation. Both firms engage mainly in natural
hedging they match inflows and outflowsin the same currency. We obtain the following
results about the hedg ing instruments enumerated below.
Naturalhedgingturnsout to be an appropriatetechniqueto manageeconomicexposure. It
is preferredto other instruments becauseit has no cost. Both Kudelskiand Logitechuse it
whenever it is possible. Empirical studies on other companies confirm that natural
hedging is a widespread tec hnique.
Forwardsseem to be the most popularinstrument used in practice to hedge FX risk. It
does not permit its holderto benefitfrom favourableFX rate movementsand it is a pure
hedging instrument but it is very flexible. Both Kudelski and Logitech state it as their
main hedging instrument in FX risk management.
Options are an expensivetool to manage FX risk. Both Kudelski and Logitech use it
rarely. An exception is the zero cost option strategy implemented by Kudelski .
Nevertheless,an option permits its holder to benefit from favourablemovementsof the
FX rate. We can concludethat in practice firms mainly use options if they have some
informationaboutthe future evolution of FX rates .
Otherinternaland externaltechniquesexist to manageFX exposurebut theyappearto be less
importantthan the onesdescribed above . To resume,forwardsand naturalhedgingseem to be
the most frequently used instruments in practice to hedge transaction, economic and
translationexposure. Forwardsare mainlyused for transactionexposureand options to cover
economic exposure.
Concerningthe FX risk managementprocess,the theorydescribesthree steps:identification,
measurement and management . In practice, most of the firms are able to identifyrisks, but
managementand especiallymeasurementare less frequentlydone. Kudelski and Logitech
clearly identify and manage FX risk (at least some types of it) but they are much less
systematic in measuring it. Both firms were not able to quantifythe exact amountof exposure.
It was not clear if it was for securityreasons(protectionfrom competitors)or simplybecause
they did not calculatethe exposure. Logitechuses a VaR (Value-at-Risk)modeldevelopedin
cooperation with UBS in orderto measureFX risk but we did not have accessto it. Therefore,
we concludethat the FX risk managementprocessis a theoreticalconcept . In practice,firms
do not alwaysfollowthesethreesteps. It happensthat firmsidentifytheir exposurebut do not
measure it, for example.
Most of the authorsand firms agree on the existence of three types of FX risk: transaction,
economic and translation exposur e. We summarize below the following conclusions
concerning these exposures:
In practice, transactionexposure is the most important type of FX risk. All firms are
concernedwith managingit. The theory predictsthat transactionrisk is mostly covered
with forwards. Kudelski Group uses forwards, options, swaps and natural hedging to
hedge transact ion exposure. Logitech uses forwards and natural hedging.
Theoryviewseconomicexposureas the most importantFX risk and it suggeststhe use of
all types of instruments,internal and external hedging techniques, to manage it. In
practice,by contrast,it is oftenunderestimatedor misunderstood . We can explainthis gap
betweentheoryand practiceby two facts: economicexposuredeals with uncertainfuture
cash flows and it has often an indirect effect on firms value. Comparedto transaction
exposure,economicexposureis muchmorecomplexto identifyand measureand this may
be the main reasonwhy Kudelskidoes not at all measureit. However,Logitechmanages
economic risk from time to time.
Accordingto empiricalresearch,translationexposureis oftennot hedged;in our study,we
found that Kudelski hedges and sometimesmeasures it whereas Logitechcompletely
ignoresit. This view of not hedgingtranslationexposureconfirmsthe theoreticalpoint of
view lossesor gainsrealisedfrom translationrisk are simplyaccountinglossesor gains.
We wonder why one firm decided to hedge this risk and the other did not. We do not
believe that the answer lies in the companies accounting methods, organizational
structuresor in the magnitudeof translationexposuresince Kudelskiand Logitechare
quitesimilarconcerningtheseissues. Theycan evenbe qualifiedas belongingto the same
industry. In our opinion, this difference in translation risk management policy rather
comes from subjectivefactors such as the Treasurymanagerspersonalopinionon this
issue.
The table belowresumesthe main resultsconcerningtransaction,economicand transaction
exposure management.
Which exposure to manage? Kudelski Logitech Theory
Transact ion Yes Yes Yes
Translation Yes No Yes and No
Economic No Yes Yes but difficult
Table8: Whichexposureto manage?
Finally,the Euro seemsto have the sameimpactfor Kudelskiand Logitech. There is certain ly
a positiveeffect on revenuesand costs, and less administrativeworkhas to be doneafter the
abolishmentof 12 nationalcurrencies . Both Treasurymanagersexpressthe view that since
the introductionof the Euro, the level of the FX exposurehas not been influencedand the FX
risk managementpolicy has not changed. These findings contradict previous empirical
research; some studies find that foreign exchange rate exposure is reduced after the
introductionof the Euro, especiallyfor firms with high foreignsales in Europeor high foreign
sales in general.
To conclude,each companyhas a differentapproachto foreignexchangerisk that is based
upon its industry, trade volumes, geographicalmarkets, market power, treasurersopinion,
etc. We think that to develop a good FX risk managementpolicy, a firm should know the
level of risk for all the currenciesand adapt its policy to the knowledgeof the managers
regardingthe instrumentsused. In our opinion,firms shouldmeasuretheir FX exposure;they
shouldidentifyall the componentsof their businessthat are exposedto foreignexchangerisk.
Then they shouldperforma sensitivityanalysis:calculatewhat wouldhappenif one currency
falls or rises by a certainamountagainstanothercurrency. Finally,firms shouldconsiderthe
timeframe for payables and receivables in order to implement the most suited FX risk
management policy.