Hedging Foreign Exchange Translation Exposure: The Dilemma
The translation exposure of a corporate can be defined as the net foreign investment exposure held in foreign currencies that must be translated into group reporting currency at the end of each financial reporting period. It differs from transaction exposure, which is the exposure to foreign currency cashflows, typically sales and from economic exposure, where foreign exchange movements can be of benefit to you or your competitors depending on the relative strength or weakness of the currencies in which the respective cost and revenue centres are.
Translation exposure remains a non-cash item in balance sheet exposure in other comprehensive income (OCI)/net equity until the asset is sold, and has no impact on the profit and loss account or earnings per share (EPS) until this point. Typically, the corporate CFO and treasurer will note that equity analysts are principally focused on EPS and that multinationals will always maintain foreign net assets via foreign subsidiaries, and so in the very long term ‘it is all a wash’, which is a very valid point to a degree.
Detailed academic research on translation exposure, beyond text book theory, is relatively limited1 and concludes that hedging translation exposure is key if a corporate is highly leveraged to protect banking covenants, and also that credit rating agencies have added some focus on large movements in corporate OCI/net equity reserves.
It is certainly the case that there is a very diverse approach to hedging translation exposure in practice and shortly we will consider some specific examples, however the following points need to be considered:
From publicly available information, Reckitt & Benckiser, Kellogg’s, IBM, Johnson & Johnson, Black & Decker and Electrolux are companies who identify and selectively manage their translation exposure. As of November 2008, these six companies have the same or higher credit rating than in 2000 and their share price has risen by an average 60% since then, while the S&P 500 during the same period fell 40%.
An example of a company, which didn’t historically actively manage translation exposure, is Coca Cola. At the end of 2002, Coca Cola had US$2.7bn of accumulated foreign exchange (FX) translation exposure losses, a sum which at the time was approximately the same as the company’s long term debt and not insignificant compared to Coca Cola’s US$11.8bn of net equity. In 2003, Coca Cola reported translation exposure gains of US$0.9bn, creating huge swings in OCI/net equity. Coca Cola is now more actively involved in net investment (translation exposure) hedging of foreign subsidiaries.
Given volatile FX markets in 2008, many multinational companies will likely report significant changes in OCI/net equity in this financial year resulting from translation exposure. The information sources for the above are from Bloomberg and SEC10K Filings.
Whether a corporate treasury decides to hedge or not their translation exposure, they should certainly identify the risks involved, understand what this potentially means for the business and quantify them with a value-at-risk (VaR) analysis.
As noted earlier, translation exposure is a non-cash item until an asset is sold (when it does impact cash flow/profit and loss and EPS) and it does not make sense to hedge a non-cash item with a cash instrument, such as an FX outright forward, as this could lead to potentially significant cash flow mismatches over time. A cross-currency swap can be a suitable instrument but is essentially similar to the FX forward outright if in a fixed/fixed format and if either leg is floating this is effectively taking a view on interest rates.
Raising local debt in foreign (non-group reporting) currencies effectively matches assets and liabilities in the foreign subsidiary but then the parent company will likely have to issue guarantees as these subsidiaries will have themselves limited net equity. Additionally, unless you are a truly global brand, there may be additional costs from debt issuer spread outside of your home country.
Reviewing your group reporting currency can be another way of reducing translation exposure. Given that many emerging market countries are pegged to the US dollar, this often means that many companies actually have a much higher exposure to the US dollar than is apparent at face value. In Switzerland: Novartis, Syngenta, Synthes, ABB, Zurich Insurance, Glencore and Logitech all report in US dollars, while Richemont, Adecco and Nobel Biocare report in euros. It can also potentially assist with analyst benchmarking and economic exposure issues.
Buying longer dated currency options with an asymmetric risk profile, however, can be a very suitable instrument for hedging translation exposure, especially when utilised in a form such as multi-year compound options or an option on an FX forward. Liquidity in dollar cash settled emerging market options has also developed significantly on a global basis (i.e. Brazil), even where there is a no onshore deliverable currency market and NDFs are the only other alternative. Volatilities can often be below those of G10 currencies. Longer dated option premiums can often be relatively small, on an annualised basis, to avoid accounting designation.
Translation exposure is an important issue, even for those companies, which have high levels of net equity/OCI. Examples have been provided of very successful companies who have translation exposure on the radar. It is important to understand what your VaR is and what the potential consequences of not hedging are.
As for implementing translation exposure hedging, there are several tools that can be used and also ways in which translation exposure, where appropriate, can be potentially reduced by reviewing group functional currency. Once minimised, buying longer dated currency options, with their asymmetric risk profile, including for emerging markets, can be one of the most effective instruments available.
However, hedging application needs to be done tactically and consistently in line with a defined treasury policy. Buying insurance (options) when the house is already on fire, will not be the most cost effective strategy. Some reference also needs to be taken to the predetermined purchasing power parity of a currency and perhaps when there is 30% to 40% undervaluation of your group reporting currency, extra vigilance needs to be observed.
1 Academic References: Hagelin, Niclas and Pramborg, Bengt “Hedging Foreign Exchange Exposure: Risk Reduction from Transaction and Translation Hedging” (May 28th , 2002); Bonini, Stefano, Dallocchio, Maurizio, Raimbourg, Philippe and Salvi, Antonio,Do Firms Hedge Translation Risk?(May 12, 2007).