Hedging the Balance Sheet
While corporate Treasury is usually active in hedging transaction currency risk, it rarely considers translation risk — or hedging the balance sheet. This is largely because balance sheet risk is largely made up of foreign direct investment or the debt structure of the corporation. In the first case, the management has a natural and instinctive objection to the idea of hedging the balance sheet risk, involving a direct investment abroad, since that would seem to negate the reason for the initial investment. For this very reason, many corporations do not hedge translation or balance sheet risk because of:
The long-term nature of their investments in subsidiaries
The perceived zero-sum nature of currency risk over the long term
Accounting and tax issues
Cash flow impacts
A further disincentive is that currency translation affects the balance sheet rather than the income statement, which may make it less of an immediate priority for management. Equity analysts tend to focus on EBIT (or EBITDA) before debt/equity ratios. Eventually, however, the deterioration in balance sheet ratios can impact the corporation’s average cost of capital and ultimately its valuation in the market place.
July 3rd, 2009