This issue’s question

“With currency volatility approaching record levels, a growing number of multinationals have seen currency translation negatively impact top line growth figures. Should corporates hedge translation risk?”

Karlien Porre

Director, Corporate Finance Treasury Advisory

Deloitte

In considering this question one needs to understand why corporates have historically hedged (or not) translation risk and whether a change in volatility should cause a review of the underlying drivers of hedging decisions. In essence, organisations need to first establish what is important to them and what their risk appetite is, for example, whether revenue or earnings volatility is critical or protecting covenants – then they can determine the appropriate way for managing these risks.

As a first observation, global organisations often align the currency of their debt (actual debt or through swaps) to the currency of their value drivers to provide some protection of equity value against FX volatility. This is typically profits but could also be the balance sheet. However, an approach like this alone is unlikely to protect top line numbers as the impact will depend on quantum and accounting treatment.

For a typical company, FX hedging objectives often aim to protect either or both cash flows and local currency profits. As a result, transaction exposures are the main exposures that are hedged, whereas pure translation exposures are less routinely hedged for a number of reasons. A key reason being that translation of overseas profits does not generate a cash flow until they are repatriated as part of dividends or in the repayment of loans. Additionally, hedging translation risk with derivatives (such as forwards or swaps) which have a net cash impact, poses the risk of introducing a new cash flow risk.

Another key reason relates to investors’ expectations and communication. Those investing in global businesses should know and understand the exposures involved – assuming there has been clear communication from the business on the manner in which the exposures are or are not hedged. Investors may welcome the currency exposures and can manage their own currency risks. There are, however, situations where hedging of translation risk may be beneficial, or even necessary. For example, when there is the need to protect reserves or tight covenants, such as maximum gearing or minimum tangible net worth. For some industries with a key focus on certain earnings KPIs, such as earnings per share (EPS), hedging translation risk may also be critical. In both cases, the accounting treatment will need to be carefully considered to ensure the desired accounting objective is achieved. Even in these cases, it would be rare for a company to hedge consolidation of its top line, eg revenue. Focus would typically be on the balance sheet, profit measure, or both.

Any major change in hedging framework in response to volatility changes is yet to be seen. Despite this, it is a trigger for many to re-consider the long- and short-term impacts on the factors that drive their current hedging strategy. Companies with a quantitative approach might find that the higher volatility or movements in FX rates have resulted in (increased) hedging triggers being reached. Other responses may also be triggered – for example, the negotiation of a more neutral definition of certain covenants to remove inconsistency between FX rates used for balance sheet and, respectively, income statement translation. Likewise, development of new dialogue with investors to reconfirm their understanding and appetite for the currency risks presented. Ultimately, unless corporates feel their original policy is no longer applicable, or was not as robust as it should have been, a change in volatility should not change the reasons to hedge translation risk.

One of the most discussed FX subjects in corporate treasury at the moment is how to understand and also mitigate specific translation risk. This might come as a surprise, as in the past firms tended to manage most categories of translation risk only passively, and whatever hedging did occur was only through necessity. This is because corporate treasuries were keen to prevent losses on the shareholder’s equity (capital) account, wanted to protect its credit rating or the exit value of a specific sale of an asset, for example.

This passive approach towards translation risk for fixed asset items, eg buildings and equipment, by and large, continues to be unchanged. It makes sense thanks to factors such as hedging costs due to interest rate differentials and changes in exposure value due to FX being predominately recorded in the cumulative translation account (CTA) within shareholder’s equity, in addition to the general view that, over the long run, exchange rates are mean reverting. Hence, hedging can potentially impose a negative impact on cash flows.

Although applying the theory of mean reversion as a basis for translation risk policy certainly has merit, recent emerging market (EM) volatility should flag caution to its validity, especially for those corporations who adopt a similar approach and have significant translation exposures in the emerging markets.

But then, what has been the catalyst for change? What type of translation risk is of concern? A change in the market environment, led by a strong USD cycle and higher FX volatility, has triggered a significant number of discussions among corporate treasurers relating to intercompany loans – especially in the emerging markets (EM). Specifically, these discussions have centered upon how intercompany exposures have impacted, or can potentially impact, earnings at both the subsidiary level and in consolidation at the parent level.

Furthermore, the breach of local capitalisation rules, potential regulatory requirements stipulating the need to re-capitalise the local subsidiary due to FX losses, as well as tax consequences have also raised questions. Cause and effect vary from firm to firm, but frequently subsidiaries have experienced difficulties in raising local EM working capital. This may be due to local regulations, lack of EM liquidity or other associated costs.

Under these conditions, many subsidiaries have turned to the parent for financing, often in hard currency, as this is perceived to be the most cost-effective solution. This method of financing is by no means uncommon and has been practiced for years by global corporate treasuries. So then what is the concern?

In practice, there really should be no concerns as translation risk is hedged either by the local subsidiary or parent, or where the funding is designated as long term in nature (and as a consequence changes in value due to FX would stay in CTA). But problems have surfaced when neither of the above applies and where the hard currency loan from the parent remains either partially or entirely unhedged. Under this scenario, all changes in the value of the liability/loan due to spot FX would impact the income statement of the subsidiary and, ultimately, the parent. Unfortunately, a number of corporations are experiencing the latter case and as a result have seen large and unexpected losses in their earnings.

Consequently, many treasurers have recognised the need to re-examine their current FX policies. For many, this exercise is not limited to translation exposures but rather encompasses a broader scope of FX risk management. The goal being to assess if current risk management practices are actually aligned with company objectives. A good place to start may be with the EM.

There is no “one size fits all” answer. It depends on multiple factors, such as shareholders and board risk appetite, existence of covenants or ratios that may require protection. There’s also the cost of hedging, the portfolio of currencies or commodities that may provide a natural offset, and cash flow variability due to realised gains or losses when derivatives are used. Most recently, it’s the translation of profits that has caused the greater concern, particularly for listed groups generating large profit in Europe.

Once the decision whether to hedge or not has been made, many other questions remain to be answered. For example, what instrument should be used, should it be limited to debt instruments, long-term derivatives or shorter-term forward contracts or even options? Is it profit translation, dividends, net asset value of foreign operations or all of the above? How far forward should the hedge be and how much should be hedged? Should the book or the economic value be subject to the hedge? Does it matter if the interest differential is favourable?

When all of these questions have been answered, groups still need to monitor very carefully how those hedging policies are affected by movements in the marketplace. Many UK groups were caught by major cash outflows when forward contracts, hedging euro or USD operations matured at the apex of the last financial crisis, creating major liquidity issues and interest cost.

So, should a company hedge or not? Where a group has debts, it appears appropriate to incur the debt in sterling and foreign currencies, in proportion to the market value of the group’s assets. While accounts carrying value is a limited surrogate for market value, pro-rating debt in proportion to net assets still seems more logically appealing than incurring all borrowing in sterling. Alternatively, and for groups with a greater focus on profit, it would also appear appropriate to incur the debt in proportion to the currency profile of profit. Unfortunately, both can very rarely be achieved in practice at the same time.

There is an argument that in the long run foreign exchange rates reflect purchasing power parity and the intervening fluctuations (albeit sometimes very long lived) represent nothing more than noise. As a hedging strategy inevitably involves some element of external costs, this would point towards not hedging at all. However, one needs to be willing to take a long-term view, which may be longer than the time horizons of most shareholders or finance directors and therefore not very popular.

If the foreign operations are so major that the accounting effect of translating those foreign operations into sterling is to produce undesirable accounting volatility, and are predominantly in one foreign currency, a good solution may be for the UK group and hence the parent to adopt the foreign currency, usually the dollar, as the currency of its accounts. This has indeed been done by several companies in the oil sector and also by some in the banking sector in the past. But of course, you then need to consider whether to hedge the group’s sterling operations, illustrating the complexity of the situation.