Event risk has been extreme in the foreign exchange (FX) markets for some time now. Global manufacturers operating in multiple markets around the world are facing an especially complex FX landscape.
Consider just a few events from the past year that are impacting FX markets, beyond the pandemic-induced supply-chain disruptions that have resulted in cash flow uncertainty:
- The US Federal Reserve has moved faster and more aggressively than many of our trading partners to lift interest rates to reduce inflationary pressures
- The war in the Ukraine has sparked an energy crisis, hitting European nations hard
- Geopolitical tensions have created uncertainty across a spectrum of asset classes, including FX
As a result of these influences, the value of the dollar has soared this year, spending much of its time at its highest levels in 20 years against many currencies. The rapid and seemingly relentless appreciation of the US currency, combined with FX volatility, has created significant challenges for US manufacturers who import materials from foreign suppliers and for those who sell their finished products to customers abroad.
As treasurers and CFOs work on 2023 planning, many are taking time to assess their current FX strategies. If an overall FX strategy doesn’t exist, now is a great time to strongly consider creating one, or simply outline the measures that will guide those decisions for the next year. Companies who pay for their imports in foreign currency should evaluate their decision on when and why they might opt to hedge and when not to hedge, while those paying foreign suppliers in US dollars should be taking steps to renegotiate with suppliers who’ve not improved their pricing or have been slow to do so.
The same is true for US manufacturers who sell their products internationally. They have the same considerations about hedging foreign-denominated receivables and important considerations if they’re still invoicing foreign customers in US dollars, as the cost of their goods is now significantly more expensive to a foreign buyer.
Identifying Currency Risk
The identification of exposures is the best place to start because understanding where there is currency risk is critically important to the establishment of effective strategy. Manufacturers should consider five different sources of currency risk:
Earnings translation risk. For example, a US-based medical equipment manufacturer who is US-dollar functional, but has a European subsidiary who is euro-functional and sells their products in Europe ends up with euro-denominated revenue. As that revenue is on their consolidated income statement and needs to be converted back to US dollars, the manufacturer could have its earnings per share (EPS) impacted if the euro declines.
Forecast transactions or cash-flow hedging. The manufacturer forecasts revenue from sales paid in euros. As the euro gets weaker and the currency is converted back to dollars, gross revenues would be lower than what the firm forecasted.
Balance sheet remeasurement. The manufacturer has items on the balance sheet, like accounts receivable or payable, that need to be remeasured monthly at the current (spot) rate, making those worth more or less depending on the spot exchange rate.
Net investment risk. The manufacturer has equity in a foreign subsidiary. When assessing the value of that subsidiary, perhaps when anticipating a future dividend or divestiture, changes in exchange rates could impact the US dollar-equivalent value.
Event risk. For example, a manufacturer is looking to purchase a Canadian medical equipment manufacturer, in a sale that will be priced in Canadian dollars. If the value of the Canadian dollar increases before closing, it might require more US dollars to complete the transaction (this example is in the simplest terms; M&A transactions have many considerations that make currency risk management a critical component that should be addressed early in the due diligence process).
FX hedging can have a significant impact on a company’s performance. There are hedging tools that can be used to hedge the sources of risk just mentioned and could be in any manufacturer’s toolbox. Each could be used to minimize currency risk, but companies will need to assess their unique circumstances before choosing the right tool.
FX forwards. This is an agreement that a company will exchange one currency or another on a future date. For example, a manufacturer could agree to buy euro now that they need to pay a German supplier in three months. A forward contract allows the company to fix/lock in the exchange rate now, creating stability and predictability for their future expense.
Options. An option contract gives the buyer the right, but not the obligation, to exchange currencies on a future date at pre-established terms. For example, using the same example above, the manufacturer could use a call option to buy euro at a pre-determined exchange rate (strike price). The option offers protection at the pre-established (strike) price, but if the spot rate at expiration of the option three months from now is better, the company can buy the euro at the improved current (spot) rate. The option has a premium cost paid up front for the right, but not the obligation to settle at the strike price.
Cross Currency Swaps. Cross-currency swaps offer a means of creating foreign-denominated debt or converting foreign debt to USD debt.
When a company decides to hedge any of the risks identified above, they’ll typically develop a systematic hedging policy to guide their efforts throughout the year. A good hedging policy ensures: secured budget resources, timely sharing of complete exposure information, preparation of accurate forecasts, periodic measurement of risks and analysis of outcomes. It also ensures the company has considered their philosophy about currency risk and the goals they’re trying to achieve.
Managing currency risk has always been a factor for global manufacturers, but companies haven’t always put systematic policies in place. The absence of a policy or defined goals often result in inconsistent hedging practices or negative cash-flow implications. The strength of the dollar has brought new urgency to the practice. While there have been blips of currency volatility in recent years – eg Brexit, political elections – the currency markets usually smoothed out pretty quickly. What we’re experiencing now is different, and we expect currency volatility to be a consistent challenge for manufacturers throughout 2023. Now is the time for treasurers and CFOs to work with firm management to understand the currency risks they’ll face in the next year and determine when and how they’ll reduce that uncertainty.
Mary Henehan is a managing director at US Bank, where she co-leads a team of FX marketers focused on helping companies identify foreign exchange exposure and providing customized solutions to help manage associated risks. (The foregoing is for informational purposes only and does not constitute an offer, commitment or solicitation to engage in any product or transaction. Please be sure to engage your own financial, legal, tax, accounting and other professional advisors prior to engaging in any transaction.)