The surge in currency volatility over the past few quarters has increased concern among corporate finance executives about currency exposures, and it’s encouraging companies to re-examine their hedging strategies.
The effects of the currency volatility have been highlighted by the steady parade of big U.S. corporations reporting damage from foreign exchange (FX) moves in their first-quarter earnings. Procter & Gamble blamed FX for a 2% drop in its sales. McDonald’s said currency moves took $700 million off of its Q1 revenue, and Pepsi said FX was likely to trim 11% from its earnings per share in 2015.
“The companies that are taking the earnings hits derive a large portion of their sales from outside the U.S.,” said Sanjay Thoppil, a solution consultant at technology provider Reval. “Most organizations do a great job of hedging their exposure, but currency volatility and a strong dollar mean a hit to earnings.”
A Deloitte survey of 96 North American CFOs found the finance executives are increasingly worried about foreign exchange moves, particularly “the impact of a strong U.S. dollar on exports and on the value of overseas earnings.”
A survey conducted in March by Chatham Financial suggests that finance teams are considering a variety of measures.
Fifty percent of the finance executives surveyed said the dollar’s moves have had a negative impact on their financial forecast for 2015. Thirty-four percent said they don’t have a hedging program but plan to implement one.
“There are more and more companies that are putting in place hedging programs to mitigate their currency risk,” said Amol Dhargalkar, a managing director at Chatham Financial. “In the last nine months, maybe six months, we’ve seen more companies doing that than we had seen in maybe the prior two years.”
Forty-two percent of the executives surveyed by Chatham said they plan to expand their hedging program, while 15% said they will switch to different hedging instruments.
Thoppil said that given the volatility, companies that are already hedging currency risk “may want to consider longer-term hedges and more frequent management of exposure changes, as well as a review of their layered hedging strategies program.
“You are definitely going to see more frequent monitoring,” he added.
Companies that are reconsidering their currency risk management efforts should begin by looking back, Thoppil said. “They can start reviewing what they did the prior year and what could have been done differently by doing a what-if analysis,” he said. “It will provide some insight into what happens if the organization makes changes going forward.”
Dhargalkar distinguished between companies’ hedging of two types of transactions, with different time frames: balance sheet items, such as short-term receivables or payables, and forecasted revenues or expenses, which might go out one or two years.
“It’s difficult to track, but I would say there has been a general increase in the tenor of hedging programs,” said Dhargalkar, pictured at left. “We are seeing a general expansion of companies’ hedging programs from a shorter-term focus to longer-term, primarily for meeting the objective of being able to do better forecasting to investors and being able to reduce their overall volatility of reported financial results or whatever the key metrics within the organization might be.”
He said a factor limiting the effectiveness of hedging strategies is that some companies focus on hedging from the standpoint of their subsidiaries, rather than the parent company.
Hedging at the subsidiary level “is reducing some of the risk, but it doesn’t reduce all of the organization’s risk,” he said. “We are seeing more and more companies that are realizing that that focus on hedging at the subsidiary level is not really solving the problem. It’s only a piece of the problem, not the entire solution.”
Peter Frank, a partner at PwC and leader of its corporate treasury consulting group in the U.S., said the currency volatility has led companies to reassess how they’re dealing with FX risk.
But Frank said he isn’t seeing companies making big changes to their hedging strategies.
“Most of the clients we speak to have gone through a reevaluation of their strategies but have largely concluded the strategies are fundamentally sound,” he said. “Where we are seeing some tweaks really is in some of the parameters.”
For example, a company that hedges 50% of its exposures might decide to hedge a higher portion, such as 70% or 80%, he said. And companies that use a laddering approach, in which they hedge a greater portion of near-term exposures and smaller portions of exposures that are two or three quarters out, are starting to “hedge a little more than they might have done a little farther out,” Frank added.
Translating Back to Dollars
The news stories about U.S. companies’ earnings being affected by foreign exchange moves reflect “translation impacts,” Dhargalkar said. In other words, the dollar’s strength has made companies’ overseas revenues look less impressive when they’re converted back into dollars.
“There were many companies that previously weren’t hedging translation risk,” he said. “We are seeing a lot of companies now say that what we really want to do is protect the U.S. dollar financials of our parents.”
Some 18% of the respondents in the Chatham survey said they plan to incorporate translation hedging into their programs.
“The larger the company, I’d say, the more likely the company is to start to look at translation risk as a key driver of what they’re trying to achieve in their hedging program,” Dhargalkar added.
Frank noted that few companies currently hedge translation risk, and he questioned whether large numbers of companies will begin doing so.
“That is a pure accounting exposure companies have on operations or business outside of their home country,” he said.
Companies don’t hedge translation risk because it doesn’t qualify for hedge accounting, he said. “The accounting treatment may actually result in a situation where they would increase their volatility rather than mitigate it.”
In addition, “there is a real economic cost to hedging,” Frank said. “Companies don’t want to spend real dollars to hedge what are basically accounting exposures.”
Instead, companies are trying to reframe the way that they explain their earnings and explain the effect of currency movements on their earnings.
“It’s almost being viewed more as an investor relations problem than a hedging problem,” he said. “You’re seeing things like more careful description of earnings results on what companies sometimes refer to as a constant currency basis,” showing earnings without the currency fluctuation.
A company might report that its earnings per share had dropped, but note that on a constant currency basis, earnings would have come in higher, he said.