As more businesses enter the global marketplace, the currency exchange rate is becoming a bigger player in their decision making. Companies want to know where the currency is heading. Many companies rely on their bank for this information, but as former Fed chairman Alan Greenspan once said, “To my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin.”
The currency markets are affected by economic growth expectations and interest rate differentials, and there is no way to predict how exchange rates will react to either of those events, says Don Lloyd, senior vice president, Capital Markets, Associated Bank.
“Today’s big drivers include the rising price of oil caused by unrest in North Africa and the Middle East,” says Lloyd. “Rising oil prices create fear that the U.S. economy will slow, which, in turn, drives the Federal Reserve to be accommodative. But U.S. interest rates are only part of the equation; the other side is the interest rates affecting the other countries you’re dealing with. Specifically, the interest rate differential and expected changes create changes in investment decisions.”
Smart Business spoke with Lloyd about hedging strategies to maximize opportunities and minimize risks.
What kinds of companies should consider a hedging strategy?
Any time there is a cross-border flow of funds, companies need to understand how foreign exchange hedging works and how it can reduce their risks. There are five types of businesses that should consider hedging.
First, any company buying or selling goods overseas is a good candidate, as an organization that makes or receives payments in more than one currency may benefit. Second are overseas subsidiaries of companies based in the U.S., which face two kinds of foreign exchange risk. There’s transactional risk, which applies to accounts payable and receivable. When money trades hands and two or more currencies are involved, a risk exists that could be mitigated with a hedging strategy. The other is translational risk, which applies to your balance sheet. For example, say an Illinois company pays for an overseas plant in foreign currency. At the end of each year, it has to value the plant in U.S. dollars for its balance sheet and may lose equity because of changes in the exchange rate. However, proper hedging can help eliminate this risk.
Third, local subsidiaries of foreign-owned companies can benefit, depending on whether the foreign exchange risk is handled by the parent company or the subsidiary. Fourth are firms that send payroll overseas, and, finally, anyone who invests overseas should consider hedging options.
What volatile markets do businesses need to be aware of?
China, a major trading partner for U.S. businesses, has a volatile currency. China is quickly developing its banking system and monetary policy but still has a ways to go. And changes in its interest rates tend to be extreme because the economy is growing so quickly. Over the next 10 years, volatility should decrease, but, for now, it remains a significant threat to China’s trading partners.
In Europe, the debt crisis facing countries such as Italy, Greece and Ireland affects all countries that use the euro, with uncertainty resulting in volatility. We will continue to see volatility in foreign exchange rates in 2011 and 2012 as the complicated global recovery takes its course.
