Hedging Transaction Risk
The unbiased forward rate theory suggests the expected spot exchange rate is the forward rate. If this worked, it would mean that failing to hedge currency risk would yield similar results in the long run to hedging. There are two problems with this. First, the Treasurer would probably be fired before the “long run” arrived. Second, the unbiased forward rate theory is a poor predictor of future exchange rates in practice. Basically it does not work. Therefore, a corporation should use market-based currency forecasting in addition to the forward rate to predict future exchange rates. The discretionary aspect to the currency forecast means the corporation has the choice of hedging:
Tactically and selectively
Strategically
Passively
Corporations vary in their attitude towards transaction hedging. Some hedge passively, that is to say they maintain the same hedging structure and execute over regular periods during the financial year. This type of transaction hedging does not involve the corporation “taking a (currency) view”. The other two types of hedging strategy do indeed involve taking a currency view. Strategic hedging involves the corporation taking a view for a longer period than immediate transaction receivables and payables might require. In January 1999, I remember wave after wave of European corporations hedging both developed and emerging market currency risk as far out as one year. Corporations who usually called in USD20–30 million to hedge very short-term receivables were calling for prices in a number of emerging market currency pairs in USD200–300 million. The Russian crisis of August 1998 and the collapse of LTCM had clearly scared global financial markets. With the threat looming of devaluation in Brazil (which indeed happened in January 1999), many European corporations were apparently taking advantage of the relaxation in global market tensions and reduced risk premiums in the market in the wake of the Fed’s extraordinary monetary easing of August and September, with three interest rate cuts in quick succession to hedge their transactional currency risk as far out as they could go. That is an example of strategic hedging. Finally, tactical and selective hedging of transactional currency risk is the usual business that a corporate dealing desk does with its clients. A bank’s clients may choose to allow certain currency exposures to be translated at the period end, and others they may choose to hedge, depending crucially on their currency view. Typically, it makes sense for a corporation to use the tactical and selective approach for most transactional currency risks and only occasionally to pull the trigger on strategic hedging should the need arise. While passive hedging may appeal to some, it hurts flexibility, not only with regard to the hedging strategy but also with regard to domestic pricing.
July 2nd, 2009