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Hedging Exchange Rate Risk

Firms with international operations are subject to exchange rate risk. As exchange rates fluctuate, the dollar value of the firm`s revenues or expenses also fluctuates. It helps to distinguish two types of exchange rate risk: contractual and noncontractual. By contractual risk, we mean that the firm is committed either to pay or to receive a known amount of foreign currency. For example, our VCR importer was committed to pay Р’Рµ100 million at the end of 12 months. If the value of the yen appreciates rapidly over this period, those VCRs will cost more dollars than the firm expected.

Noncontractual risk arises because exchange rate fluctuations can affect the competitive position of the firm. For example, during 1991 and 1992 the value of the deutschemark appreciated relative to that of other major currencies. As a result, Porsche and other

German luxury car manufacturers found it increasingly difficult to compete in the United States. American dealers that had a franchise to sell German luxury cars also took a bath. Thus the German car producers and their dealers in the United States were exposed to exchange rate changes even if they had no fixed obligations to pay or receive dollars.

Exchange rate changes can get companies into big trouble and therefore most companies aim to limit at least their contractual exposure to currency fluctuations. Let us look at an example of how this can be done.

In 1989 a British company, Enterprise Oil, bought some oil properties from Texas Eastern for $440 million.6 Since the payment was delayed a couple of months, Enterprise`s plans for financing the purchase could have been thrown out of kilter if the dollar had strengthened during this period.

Enterprise therefore decided to avoid, or hedge, this risk. It did so by borrowing pounds, which it converted into dollars at the current spot rate and invested for 2 months. In that way Enterprise guaranteed it would have just enough dollars available to pay for the purchase. Of course it was possible that the dollar would depreciate over the 2 months, in which case Enterprise would have regretted that it did not wait and buy the dollars spot. Unfortunately, you cannot have your cake and eat it too. By fixing its dollar cost, Enterprise forfeited the chance of pleasant as well as unpleasant surprises.

Was there any other way that Enterprise could hedge against exchange loss? Of course. It could buy $440 million 2 months forward. No cash would change hands immediately but Enterprise would fix the price at which it buys its dollars at the end of 2 months. It would therefore eliminate all exchange risk on the deal. Interest rate parity theory tells us that the difference between buying spot and buying forward is equal to the difference between the rate of interest that you pay at home and the interest that you earn overseas. In other words, the two methods of eliminating risk should be equivalent.

Let us check this. In March 1989 the 2-month interest rate in the United States was about 9.7 percent and the interest rate in the United Kingdom was 13.0 percent. The spot exchange rate was $1.743 to the pound and the 2-month forward rate was $1.730/Р’Рі. Table 6.8 shows that the cash flows from the two methods of hedging the dollar payment for Texas Eastern were almost identical.7

What is the cost of such a hedge? You sometimes hear managers say that it is equal to the difference between the forward rate and today`s spot rate. This is wrong. If Enterprise did not hedge, it would pay the spot rate for dollars at the time that the payment for Texas Eastern was due. Therefore, the cost of hedging is the difference between the

forward rate and the expected spot rate when payment is received.

Hedge or speculate? We generally vote for hedging. First, it makes life simpler for the firm and allows it to concentrate on its own business. Second, it does not cost much. (In fact the cost is zero if the forward rate equals the expected spot rate, as our simple relations imply.) Third, the foreign exchange market seems reasonably efficient, at least for the major currencies. Speculation should be a zero-sum game unless financial managers have superior information to the pros who make the market.