ARE YOU TAKING THE WRONG FX RISK?

Focusing on transaction risks may be a mistake Structural and portfolio risks require more than hedging Companies need to understand not just correlate the relationship between foreign exchange movements and cashows

Bruno Copp Michael Graham Timothy M. Koller

article, Why derivatives dont reduce FX risk, Tom Copeland and Yash Joshi argue from a macro perspective that FX risks are oten swamped by other risks and that therefore using FX derivatives is not likely to substantially reduce a companys cash ow volatility. This article explores the topic from another angle. First, how should an individual company identify and measure its foreign exchange risk? Second, what can it do about it?
N THE COMPANION

Identifying and measuring FX risk is far from easy. Few CFOs, even among the best, measure more than a small portion of their overall risk. Many companies manage only visible and easily
Bruno Copp is a consultant and Michael Graham is a principal in McKinseys Brussels oce. Tim Koller is a partner in the Amsterdam oce. Copyright 1996 McKinsey & Company. All rights reserved.

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quantiable risks, such as exposure to foreign currency liabilities. And CFOs seldom comprehend all the risks in their business. They may not understand, say, the relationship between exchange rates and the local prices in the markets where they sell their products. Nor do many CFOs appreciate all the limitations of the tools they use to manage their risks. Swaps, for instance, require margin accounts to protect the counterparty from credit risk. These margin accounts may distort the cashows derived from the instrument. These gaps in understanding suggest there is a need for a systematic process for thinking about and examining risk. However well informed, intuition about where risks lurk can lead people badly astray. Indeed, close analysis reveals that even the most astute CFO or treasurer may nd their companys risk exposure is the opposite of what they suspected.

Three types of FX risk

Foreign exchange risk the impact of FX rate changes on the value of a company and/or on the volatility of its cashows is not really one thing, but three: structural risk, transaction risk, and portfolio risk. Breaking risk down in this way helps companies improve their understanding of the economics that drive FX exposure. This is particularly important for large multinationals with complex operations. Structural risk occurs when there is a mismatch between cash inows and outows, due either to diferences in the currencies in which those cashows are denominated or to the inuence of exchange rate uctuations. Take, in Few CFOs, even among the rst instance, the classic example of an the best, measure more exporter that produces goods in country A than a small portion of and sells them in country B at a price in Bs their overall risk currency. This exporter is competing for customers with producers that manufacture in country B and have costs in Bs currency. Or consider, in the second instance, the less obvious example of a paper company that is entirely domestic in its operations. Although it produces and sells its paper exclusively at home, its competitors may be importing from other countries and thus beneting from advantageous foreign exchange rates. Transaction risk derives from time lags. Suppose a company makes a purchase in a currency other than its normal operating currency and agrees to pay for the goods 10 days later. It has a transaction exposure because of the time lag between when it commits to pay in the foreign currency and when it actually makes the payment.

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Portfolio risk arises when businesses operate in several diferent currencies. Take McDonalds, which owns and operates restaurants around the world. Each restaurant tends to have as its natural currency the local currency in which it operates. Its revenues are denominated in the local currency, its purchases are mostly made in the local currency, and its competitors are mainly local competitors. In local currency terms, it has no foreign exchange risk. But to the extent that McDonalds shareholders are interested in, say, US dollars, they will be subject to foreign exchange risk when the companys prots and cashows from foreign operations Once a company has identied are translated back into US dollars. One way to think about the diference between structural and portfolio risk is that structural risk is about the risks within the income statement that arise out of mismatches between revenues and costs, while portfolio risk has to do with the translation of a companys prot and loss back into its home currency. Portfolio risk tends not to be related to a companys competitive position; structural risk is all about competitive position. These three diferent risks are also accounted for diferently. (This is important, since managers, rightly or wrongly, are oten inuenced by the accounting impact of their decisions.) Transaction risk shows up in a companys income statement as a line called foreign exchange gains or losses (which is oten the responsibility of the Treasury department). Structural risk shows up as higher or lower operating prots and margins and is not generally easy to trace. Portfolio risk, like structural risk, shows up as higher or lower operating prots once translated into the parent currency, though local-currency operating prots are not afected. In addition, some of the future impact of portfolio risk shows up in the cumulative translation adjustment in a companys equity accounts based on EuroIndustries operations the exchange rate impact on assets and liabilities. Shareholders
(Germany)

and measured its FX risk, it can turn to developing risk management strategies

Exhibit 1

Disaggregating the risks

Lets explore risk disaggregation by means of a simplied, disguised example. EuroIndustries is a German company that processes and sells commodity chemicals at home and in the United States (Exhibit 1). Both the products it sells and its primary raw materials are priced in US dollars, since

EuroIndustries HQ (Germany)

EuroIndustries (Germany) US$ US$ DM DM

EuroIndustries (United States) US$ US$ US$ US$

Revenues Raw materials Production costs Capital expenditures

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they are perceived as world commodities. The German and US sides of the business are equal in size and protability. EuroIndustries US operations have no structural risk; in other words, there is no mismatch between revenues and costs. Both are in US dollars, the natural currency for the US business.
Exhibit 2

EuroIndustries structural risk

Exchange rate
Index: 1990 = 1

Gross margin
DM

1.4 1.2 1.0 0.8 0.6 0.4 0.2 60 40 20 0

At rst glance, EuroIndustries German operations appear to have substantial structural risks. EuroIndustries Germany pays dollars for its raw materials, spends Deutschemarks on processing the chemicals in a factory in Germany that was purchased with Deutschemarks, and then sells the nished products for US dollars.

Closer examination, however, produces some surprising insights. 1990 1991 1992 1993 1994 1995 Although EuroIndustries Germanys revenues and a major portion of its costs are in US dollars, it faces virtually no US dollar risk. This is because the spread between its nished product prices and its raw materials costs is not correlated with the level of, or changes in, the dollar/Deutschemark exchange rate (Exhibit 2). How can this be?
0

First, the market for the raw materials that EuroIndustries purchases is truly international. Prices are the same worldwide. Second, the market for the nished products that EuroIndustries Germany sells in Europe is a European market, despite the fact that prices are quoted in US dollars. All EuroIndustries Germanys competitors are European companies with plants in Europe and costs in European currencies (except for raw materials costs). In fact, thanks to relatively high transportation costs, almost no nished product crosses the ocean between Europe and the United States. As a result, prices are not linked across the Atlantic.
Exhibit 3

EuroIndustries transaction risk (1)

Cash cycle Day 0 9 21 Pay for raw materials 28 Sell finished product and receive cash

Commit to Receive raw purchase materials, raw materials book purchase

EuroIndustries does, however, face a short-term transaction risk owing to mismatches in the timing of its German operations cashows. EuroIndustries Germany buys raw materials in US dollars about 21 days before it pays for them (Exhibit 3). It

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will thus experience an exchange gain or loss if the FX rate changes during this 21-day period. This gain or loss is both an accounting gain or loss and an economic gain or loss. Ofsetting this gain or loss is an inventory gain or loss. EuroIndustries takes about 28 days to process raw materials into nished goods and deliver them to customers. It sells these nished products at prices that reect the spot commodity price and spot exchange rate on the day of the sale. EuroIndustries has found that nished goods spot prices change almost immediately in response to uctuations in raw materials prices and exchange rates. Accordingly, it will experience an exchange gain or loss on its inventory. This gain or loss is a real economic gain or loss, but shows up in EuroIndustries accounting statements in the form of higher or lower operating margins. For simplicity, we will assume that EuroIndustries, like everyone else, prices its products in line with US dollar prices, but that it accepts payment in Deutschemarks at the spot rate at the time of sale. Hence the company experiences no FX gains or losses on its receivables.
Exhibit 4

EuroIndustries transaction risk (2)

Typical transaction
DM

Base case

Overall, EuroIndustries transaction risk equals the net of its inventory No need No need Hedge to hedge to hedge inventory less its dollar payables. Unfortunateafter payment ly, however, the accounting efects of EuroIndustries ofsetting exposures are recorded diferently. Inventory gains and losses are reected in operating prots, while gains and losses on payables show up as exchange gains and losses (Exhibit 4). Since EuroIndustries originally dened its risk as the accounting gains and losses it incurred, it considered itself to be short in dollars (because of its US payables), when in fact it was long in dollars (because its inventories exceeded its payables). Its accounting gains and losses do not corre- EuroIndustries transaction risk (3) spond to its economic exposure Accounting gains/losses are not the same as economic exposure (Exhibit 5). EuroIndustries is owned mainly by German shareholders who are ultimately interested in consuming in
Hedge policy Minimize reported FX gains and losses

Revenues Raw materials Gross profit FX gain Adjusted gross profit

300 270 30 0 30

US$ falls 10% before before booking raw material payment 286 286 256 270 30 16 0 14 30 30

after raw material payment 286 270 16 0 16

Exhibit 5

Action Hedge US$ payable by buying US$ from day 9 to day 21

Minimize economic gain or loss

Hedge inventory by selling US$ from day 21 to day 28

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EuroIndustries portfolio risk

Deutschemarks. From their perspective, the company faces portfolio DM EuroIndustries EuroIndustries risk because the cashows from its (United States) (Germany) US operations will vary with changes Base value of 1,000 EuroIndustries 500 500 in the dollar/Deutschemark exchange rate (Exhibit 6). About half of EuroEuroIndustries 975 after 5% decline 500 475 Industries value is exposed to such in US$ 2.5% changes. A 5 percent decline in the dollar would therefore produce a 2.5 percent decline in the companys present value expressed in Deutschemarks. (Whether or not shareholders or managers should be concerned about this risk is not addressed here.)

Exhibit 6

What to do
Once a company has identied and measured its foreign exchange risk, it can turn to developing risk management strategies. The bad news is that derivatives alone (despite the publicity) cannot meet all the risk management demands of a large multinational corporation. Transaction risk is easy to manage, but tends to be relatively small in scale. Structural and portThe bad news is that derivatives folio risk, however, can seldom be alone cannot meet all the risk fully managed at a reasonable cost management demands of a large with the nancial products currently multinational corporation available. A company can therefore either accept these risks, which may make sense if they pose no threat to its nancial health, or employ operating strategies to reduce them. If neither option appeals, it will have to search for other solutions. As we discuss possible ways to manage FX risk, keep in mind that the objectives of risk management are not universally agreed upon. At one extreme, few would argue that managers should not try to reduce the risk of nancial distress caused by FX uctuations. On the other hand, it is not clear whether or not there are benets from reducing small uctuations in cashow volatility or from attempting to hedge the net present value of a business.

Structural risk
In many ways, structural risk is the most important FX risk because a mismatch between cash inows and outows can cause nancial distress. But using nancial instruments to reduce structural risk may be inefective, particularly if a companys investment cycle in other words, the time it takes to increase or decrease capacity is long. Indeed, the length of its investment cycle may determine a companys ability to reduce structural risk.

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Since EuroIndustries has no structural risk, lets consider another company, Machine Co. It manufactures machine tools in Germany and sells them at home and in the United States. In the latter, it competes only against USbased manufacturers. All its costs are in Deutschemarks. As a result, Machine Co. faces signicant structural risk. A long-term decline in the dollar (relative to purchasing power parity) could transform its prots into losses. How can a company begin to manage such risks? To a limited extent, borrowing in the currency in which you are long can reduce your structural risk. Although it is a German company, Machine Co. should borrow in US dollars. Derivatives will do little to help companies with long investment cycles manage structural risk, for two reasons. First, the market for long-term derivatives is very illiquid and therefore expensive. Second, if a company were to purchase a large quantity of derivatives relative to its total value, these derivatives become a large portion of the companys total value and therefore represent a large credit risk to its counterparties. These counterparties, in turn, will expect to be compensated for this credit risk if they are willing to undertake it at all. Indeed, derivatives may not even substantially reduce the risk of nancial distress. In businesses with short investment cycles, however, they can be used to minimize short-term risks. Over the longer term, such companies do not face a high probability of nancial distress because they can reduce capacity quickly. All the same, they would probably not nd it economic to use Derivatives will do little derivatives to hedge the present value of to help companies with their business. Operating strategies such as shiting production facilities to tie in with customer markets may be needed in order to reduce the risk of nancial distress substantially. Such strategies are not, of course, always possible or competitively desirable.

long investment cycles manage structural risk

Transaction risk
This is the risk that many companies have in mind when they refer to FX risk management. But transaction risk is oten small. In EuroIndustries case, its transaction risk is only about a tenth the size of its portfolio risk. A 10 percent decline in the dollar would reduce the companys value by 2.5 percent through portfolio risk, but only 0.3 percent through transaction risk.

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Managing transaction risk is relatively straightforward because each transaction is identiable and generally short term. The easiest approach is to use derivatives to hedge each individual transaction. If a company has many FX transactions, however, this can lead to high personnel and systems costs, as well as substantial expenses in the form of spreads or commissions to nancial institutions. In many cases, a company can reduce these costs by hedging its net position rather than each individual transaction, in much the same way as nancial institutions manage their own positions. The problem with using derivatives to hedge transaction risk is that the correct hedges may be inconsistent with the companys structural risk. Though fairly simple in itself, transaction hedging can be efective only if it is informed by a comprehensive understanding of structural risks.

Portfolio risk
By itself, portfolio risk is unlikely to cause nancial distress or bankruptcy as long as a companys capital structure is aligned with its business portfolio. Consider EuroIndustries. If the dollar falls against the Deutschemark, its dollar cashows will be worth fewer Deutschemarks, but they will not turn negative. The decline in the Deutschemark value of each years cashow will be broadly proportionate to the decline in the dollar. As long as EuroIndustries borrowings are roughly in line with the currencies in which it generates cashow, its risk of nancial distress from exchange rate changes will be minimal. Borrowing in the currency of foreign cashows is an efective and inexpensive way to partly hedge the present value of foreign operations. This value will change roughly in proportion to the change in the value of the debt. Provided it is structured properly, borrowing in the currency of foreign operCorrectly using derivatives ations can also reduce cashow volatility. Using derivatives to manage portfolio risk may be very dicult. For a start, long-term nancial instruments are expensive. EuroIndustries US dollar cashows over the next ve years represent only about 20 percent of the present value of its US operations, and just 10 percent of total company value. For hedging its value to have a signicant impact, EuroIndustries would need to purchase instruments such as swaps or forwards with lives longer than ve years. These would probably be costly, for the reasons described in the discussion of structural risk. Moreover, projecting the value of cashows generated by a company like EuroIndustries is highly uncertain, making it dicult to determine how much to hedge. EuroIndustries might well nd, too, that other risk factors

to hedge transaction risk may be inconsistent with the companys structural risk

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such as commodity prices have a much greater impact on its value than do FX rates, further complicating the question of how many hedges to buy. Finally, hedging portfolio risk with nancial instruments is likely to have adverse accounting efects. Any long-term hedges will probably have to be marked to market every year because the cashows being hedged are uncertain. As a result, EuroIndustries could experience big swings in reported accounting exchange gains or losses from its hedges in the near term, even though these gains or losses will be ofset by operating gains or losses over the longer term.

Questions remain
Breaking risk down into these three categories and working systematically through each will clarify the risks that a company faces and suggest actions to reduce or moderate them. Such a strategy is certainly superior to current derivatives-focused approaches, but it is far from being the last word on the topic. Risk management is a highly complex eld, and there are still a number of fundamental questions that must be answered if it is to continue to evolve: 1. How should we quantify each type of risk? Should we use a value-at-risk concept, or a percent impact on value or cashows, or some combination of these? 2. Can we improve our understanding of FX rate behavior to the point where we know when we do not need to manage FX risk? If FX rates always moved to equilibrium levels (based on purchasing power parity) within ve years and we could predict these levels, for example, longer-term risk might not be that critical. 3. What should our risk management objectives be? Minimizing nancial distress as an objective is hard to dispute, but stabilizing the net present value of cashows might not benet shareholders if its cost is too high. 4. What are the true costs of hedging instruments? How can we understand them and relate them to the benets? 5. Finally, how can we ll in the gaps in our risk management strategies? Can we nd new nancial instruments to do the job?

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