January 15th

Getting a better handle on currency risk

Recent swings in global currencies have brought exchange-rate risk back to the forefront for companies working with suppliers, production, or customers in different currencies. Although official, or “nominal,” exchange rates tend to draw the most attention, what really matters to companies are changes in real terms—that is, when currency changes are adjusted for differences in inflation. In an ideal world, if prices were to fall as currency values rose, or vice versa, then the purchasing power of companies’ cash flows would be stable, and there would be no real currency risk. That often works itself out over the long term, but not for all currencies and not necessarily in the short term.

Many companies seem to manage only the most visible risks, such as exposure from a large transaction in a developing nation, which can be hedged with financial instruments, including currency futures, swaps, or options. But these tactics don’t work for every currency risk—and companies often face far greater exposure from less obvious risks that are much more difficult to manage, including risk that stems from mismatches between costs and investments in one currency and revenues in another.

What follows is a refresher course of sorts on currency-risk management for companies seeking to get a better handle on the potential impact of currency-rate changes. The most important lesson is that managers can’t always hedge against every currency risk—and often shouldn’t try. But once managers understand how different risks work and interact, they can better measure and manage them with the help of a few general tips we’ve collected from experience.

Decide which currency risks to manage

Understanding where and how currency fluctuations affect a company’s cash flows is not straightforward. Many different factors—from macroeconomic trends across countries to competitive behavior within market segments—determine how currency rates affect a business’s cash flows. Mathematical risk-management tools1can help managers analyze their risk, but it is even more important to understand where and how exchange rates can distort the value of a company through portfolio risks, structural risks, and transaction risks. Each influences value and cash flows in different ways and requires a different approach for risk management.

Portfolio risks. Any company with business operations in foreign currencies will be exposed to so-called currency portfolio risks. Take, for instance, a Dutch food retailer operating stores in the Netherlands and the United States. Due to the nature of the supply chain, costs and revenues for its retail stores are mostly set in local currency—unexposed to exchange rates. But the company is inevitably exposed to portfolio risk because cash flows from its US operations will fluctuate with the exchange rate when translated into euros for financial statements, performance management, or investor communications.2Portfolio risk by itself is rarely large enough to cause financial distress for a company. In this case, a 5 percent change in the exchange rate, up or down, would lead to the same 5 percent change in the company’s cash flows from its foreign operations. It could not annihilate the cash flow or turn a positive cash flow into a negative one.3

Because portfolio risk is unlikely to cause financial distress, this is in general not a risk that companies need to actively manage.4In addition, the exposure is different for different shareholders, depending on their home currency. For example, it would be hard to decide whether a global company with global shareholders, such as consumer-goods company Unilever, should hedge its exposure measured in British pounds, euros, or dollars. Fortunately, shareholders can easily hedge Unilever’s portfolio currency exposure by themselves via futures positions, if they desire to do so.

Structural risks. These risks occur when a company’s cash inflows and outflows react differently to currency changes. Take, for example, a German brewing company’s beer exports to the United States. Because it generates sales in US dollars but incurs costs for these sales in euros, the company is exposed to both portfolio risk and to structural risk—which has a much bigger impact on its net cash flow from US operations (Exhibit 1). Let’s assume that the company’s US operations generate a cash margin of 15 percent of sales in dollars, with all costs in euros. In this hypothetical case, a mere 5 percent drop in the dollar would deflate the cash margin to 11 percent. In dollars, that would be a 28 percent decline in cash flow; in euros, it’s nearly 32 percent.