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Managing foreign currency risk: Why some companies hedge more than others

  • sid basu headshot

    Authors

    Siddharth Basu

    Director
    Treasury Advisory and Technology

    Corporates | Denver, CO

Summary

Chatham Financial’s benchmarking study assessed the risk management practices of U.S. corporations and found that, while FX risk was the second most common type of financial risk faced after interest rate risk, more companies choose to hedge and manage FX risk.

Key takeaways

  • Companies with revenues greater than $20 billion are more likely to maintain a hedging program compared with smaller companies where only about a third manage risks through hedging.
  • Manufacturing, information technology, and natural resources and mining companies tend to face the most FX risk exposure.
  • Forwards generally serve as the hedging instrument of choice for most. However, a growing minority of companies are considering other products, such as collars and options.
  • In today's volatile market post COVID, companies face numerous challenges that require proactive FX risk mitigation strategies.

As an overwhelmingly large number of U.S. companies seek growth beyond our shores, diversify their supply chains, and focus on managing volatility amidst a global pandemic, senior leadership has increasingly been calling on treasury managers to adopt innovative yet effective solutions against currency risk. Chatham Financial’s recent benchmarking study assessed the risk management practices of U.S. corporations and found that while foreign currency (FX) risk was the second most common type of financial risk faced behind interest rate risk, more companies choose to hedge and manage FX risk.

Larger companies hedge more

Does this mean the approach to FX risk is the same across industries and revenue categories? Not necessarily. Chatham sees a wide disparity in the percentage hedging between companies of different sizes . Most of the largest companies (revenues greater than $20 billion) maintain a hedging program compared with smaller companies (between $0.5 and $1 billion) where only about a third manage risks through hedging. This diminishing scale of hedging based on the size of the company makes sense, especially as we consider that an average Fortune 500 company expects about half of its revenues from outside the U.S. while smaller companies may have indirect currency exposure through suppliers, entities, or a smaller subset of transactions. In addition, larger companies tend to have more robust treasury teams with in-house expertise to identify, manage, and monitor currency impact.

Industry categories impact hedging

Manufacturing, information technology, and natural resources and mining companies tend to face the most FX risk exposure, although each tends to feel the sources and impacts of its risk differently. Manufacturing and information technology companies, face FX risk both on the purchases related to their products as well as on sales to customers worldwide. Their exposure profiles tend to span a more diverse global footprint. Natural Resources and mining companies, on the other hand, tend to face exposure to fewer currencies and generally feel the impact on either their revenues or their expenses, seldom both. Leisure and hospitality organizations hedge the least even though more than half of the companies in this sector have FX risk. The most common explanation for this relates to their ability to pass on the impact of FX noise to the ultimate customer — airlines and hotels updating prices to adjust for FX movement, for example.

Multiple factors influence hedging success

More companies hedge FX risk now than ever before. In our third study reviewing FX hedging practices, we found that close to 60% of companies hedge FX compared with 55% a few years ago . Most of this has been driven by a stronger dollar, emerging market currency volatility, and a geographically diverse supply chain. While many took proactive steps to mitigate financial statement impact from currency volatility, however, some found they face either unreliable forecasts or extremely high costs of hedging, which preclude any meaningful action. To combat these challenges, companies should place emphasis on understanding the transaction lifecycle and putting processes and technology in place that lead to seamless data aggregation and decision making. Statistical risk quantification can also be very insightful in identifying the key sources of risk and their potential impact, enabling treasury teams to pursue the most effective hedging strategies.

New hedging instruments gain traction

As hedging costs mount and financial statement impact faces more scrutiny, hedging strategy and product selection gains even more prominence. Forwards generally serve as the instrument of choice for most; however, a growing minority of companies are now looking into other products, such as collars and options, to position themselves well. With the new hedge accounting guidance, we have also seen a sizeable increase in the application of hedge accounting and early adoption of the standard. In fact, 70% of companies hedging FX now apply hedge accounting compared to 63% a few years ago.

Increased FX volatility requires proactive strategies

2020 has turned out to be an incredibly volatile year for both earnings and currencies. While companies adapt to the new normal of working remotely, access to technology and tools has become an imperative. Companies face a host of decisions and considerations that present unique challenges. These require proactive, well thought out strategies to mitigate FX risk. As the world’s largest and most experienced independent financial risk management advisor, Chatham Financial can empower your team to make informed hedging decisions that help you achieve your objectives.

Chatham Financial corporate treasury advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.


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About the author

  • Siddharth Basu

    Director
    Treasury Advisory and Technology

    Corporates | Denver, CO


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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