Should Companies Hedge Currency Risk?

Given the high volatility in currency markets in the last couple of years, companies may see protecting against currency risks through hedging as a no brainer. But it’s not. The hedging decision is more than simply running a mathematical model to see when it’s less costly to buy currency “insurance” using a hedge, versus taking the risk that rates could swing against you in a big way, say experts at Wharton and PwC.

Companies use currency hedging for many purposes – from guaranteeing that a foreign subsidiary’s income will not take a big hit in the home currency as a result of a huge currency move, to ensuring that various payables or receivables do not veer far from projections, and significantly disrupt cash flows, revenues or expenses.

So hedging can be a great tool in financial planning. But when it comes to deciding when to hedge, however, some considerations can significantly alter a straight-forward, quantitative decision process. One of the most notable considerations: the reaction of stock analysts.

On the one hand, using a currency hedge – or swap – can greatly reduce financial risks, which is something analysts on balance should welcome — but do not always. And the reason, according to Chris Rhodes, director of transactional services at PricewaterhouseCoopers (PwC), is that “although many analysts would immediately grasp the sophisticated currency-hedging procedures that were key to the plan, others might not.” Some analysts simply balk at any complexity in financial statements that is out of the norm, and that can end up devaluing a stock price. When that happens, it can increase the cost of capital to a company so much that it offsets any perceived gains from hedging.

And there are additional considerations when it comes to the to-hedge-or-not-to-hedge decision. “There is no simple answer,” notes Catherine M. Schrand, a Wharton accounting professor. “The risks, from political uncertainty, to global funding flows, to the timing of revenue collections and other transactional activity, may be difficult to predict.”

Still, once all that is taken into account, and the rewards from hedging appear to be too high to pass up, management could invest the time needed to improve on its explanations of its hedging trades, in order to mollify more analysts. One potential avenue is through meetings or conference calls with the analysts and investors, suggests Wharton accounting professor Brian Bushee.

“It would be best to do it at a time separate from regular earnings announcements or other disclosures, so that everyone can focus on the issue and not have it be confounded with performance numbers or forecasts.” The only downside would be “potential proprietary costs if this is an open meeting, such as a freely available conference call or webcast” where “competitors could potentially listen in and gain competitive information. So perhaps a better venue would be an investor conference, or even a private meeting.”

Learn more about the challenges inherent in currency hedging in this white paper, “Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues,” a collaborative effort by Knowledge@Wharton and PwC.

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