Keeping It Natural
I am old enough to remember a time when companies actually managed foreign exchange exposure without using derivatives. Outlandish as it may seem, multinationals of that Stone-like Age would establish operations and sales within the same country, hoping to mitigate any currency mismatch through a “natural hedge”. Moreover, since firing, hiring, relocating and investing tended to require approvals, these rebels elevated FX risk management to an executive- and board-level undertaking. Executive participation thus involved several officers and not just the CFO while board-level oversight required more than just an approval of a stale and boring FX risk management policy.
Fast forward 6 or 7 financial crises to the present and companies are revisiting the natural hedging strategy—though perhaps bucking social convention. Just days ago, Japanese automaker Nissan announced publicly that it would shift much of its production and support functions to “dollar linked” economies, including the US and China.[i] In a similar move, LG Chem of Korea opened factories in the US this summer, allowing the possibility of doing the same elsewhere, should it need to stabilize supply prices.[ii] Clearly the Nissan and LG Chem CFOs have not taken thought of how these actions might affect whether they are invited to the Derivatives Week Christmas party.
In all seriousness, natural hedging strategies could represent smart moves, particularly in this market environment. However, the question remains, will the executive teams and boards of such companies—both in Asia and elsewhere—be prepared for the additional oversight task? Study after study suggests perhaps not. Both executives and board members worldwide are critically undereducated about risk.[iii] More damning is the empirical evidence that inadequate risk and poor institutional education among bank corporate boards (yes, the guys that supply the derivatives) was a major cause of the current financial crisis.[iv] While natural hedging could be simpler than financial (i.e., derivatives) hedging, implementing either and certainly balancing the two, requires some knowledge of risk.
The upshot to this apparent pandemic of risk-ignorance is that regulations requiring the education and beefing up of risk awareness on boards is actively coming into form. The Corporate Governance Code in the UK now requires risk education for board members. The SEC now mandates board-level risk frameworks for companies listing in the US while other measures around the globe are sure to follow. Should companies adhere to the new measures and enhance their risk oversight capabilities, the important question then becomes whether they should engage in natural hedging in the first place and, if so, how?
Answering such questions requires first understanding why the Stone Age has returned. One reason is that financial hedging is becoming much more costly. Fallout from the current financial crisis has led banks to incorporate potential counterparty credit risk into their derivative pricing.[v] New regulatory measures, such as the Dodd-Frank Wall Street Reform Act and similar European initiatives are also raising costs. Korea’s recent cap on hedge ratios for corporates and its new derivative limits for foreign banks adds Asian flavor to the story. [vi],[vii] Regardless of what has actually led to the rise in costs, however, natural hedging, once perceived as too expensive, is coming into favor.
Other motivations for natural hedging abound. One in particular may explain why such strategies could actually be good to pursue. Currency volatility has increased dramatically since the fourth quarter of 2008 and first quarter of 2009. During almost the same period, foreign exchange market growth slowed by more than two-thirds, year-on-year.[viii] Ordinarily, this combination of events would not make sense, given that option contracts, which increase in value during volatile periods, could be used to great hedging benefit. Ordinarily, that is, unless companies justifiably stand in fear of derivatives usage.
Fear of derivatives is nothing new. Usage paralysis, however, is a post-crisis condition stemming from 2008/2009 losses. In need of post-traumatic therapy, the very Zen thing for company leaders to do is to execute strategies that remove their enterprises from the volatility of the markets. Natural hedging offers precisely this. It does so by allowing the corporate heads to hedge in a way that falls perfectly in line with the core business. It is also transparent; everyone down to the janitor can understand the hedge logic, its function and their role within it, even if that means being fired because of it. Contrast this with financial hedging: an opaque, removed-from-the-business-purpose undertaking that is external, variable and well, unnatural.
Go with what you know
Such anti-growth conservatism would normally receive a rubber hose beating from any management guru. However, one undeniable, aforementioned fact looms: executives and their boards remain risk-ignorant. Steering clear of excess derivative exposure, consciously understanding this fact, at least while markets pass through a bit of turmoil, is not just understandable but downright prudent. Nothing could damage a company more than a bunch of executives blindly playing pin the tail on the exchange rate with their bankers.
So the alternative is to “go with what you know”. The executive team should undertake a hedging strategy that it can most confidently and competently execute. With the current knowledge deficit that strategy looks like natural hedging. Certainly unpopular with investors (and derivative salesmen) executive teams have to stand their ground and realize that investor egging for returns on is what encouraged so many companies for so long to become over-leveraged. The buck can only stop with a sober management team and a sober board and that board must understand its oversight limitations. For even a company possessing a fully, derivative-competent CFO and treasury group, but a risk-ignorant board, is a drunken disaster waiting to happen.
A mix and a juggle
On balance, however, natural hedging is unlikely to completely replace financial hedging. More likely a mix and juggle of hedging methods is in order. For not all companies can relocate their operations and not all businesses can withstand the political fire of replacing thousands of workers at home with thousands abroad. The question then becomes, what is that mix and juggle? Both market and academic evidence[ix] suggest that the answer lies in dividing the hedging process into two, distinct, time horizons: short-term and long-term. Just to be difficult, I will add a third: the transition-term.
Most CFOs would agree that financial hedging is a short-term strategy; thus, short-term exposures can be addressed using derivatives. By contrast, natural hedging is quite clearly a long-term undertaking. For fully diversified businesses then, the mix and juggle between short- and long-term hedging is thus easy enough to identify. For more complex businesses, however, the transition-term becomes important, for during this phase, risk-governance and oversight education take place while the natural hedging strategy is taking form.
Let us then consider an example. A company with a risk-ignorant board decides to hedge FX exposure with 3 month, fixed-price contracts—a crude but reasonable short-term strategy (that is quite popular). During this time a risk-governance education program is executed for the board and executive team. The CFO, the COO and the CEO simultaneously begin working together to execute the natural hedge (involving say, the leasing and staffing of overseas premises, relocation of a management team, etc.) 3 months hence, a plain vanilla financial hedge is established as substitute for the fixed-price agreements. 6 months later, a fully natural hedge is combined with a fully functional and reasonably transparent financial hedging program. Finally, in deciding the complexity of the financial hedging program, the CFO considers only hedging structures and instruments on par with the board’s (post-training) understanding.
The most important lesson to be drawn is that a company facing FX exposure must develop its hedging (and more broadly, its risk management) program in step with the oversight abilities of its executive team and board. Thus, the often tempting idea of bringing in a ‘crack’, derivative-expert CFO, a team of expensive consultants or fancy software in the hopes of beefing up risk management could, in fact, have the opposite effect: distorting and disrupting the company’s core business. Far better is the policy of knowing hedging in step with the board’s capabilities and the core business operations, slowly, organically, naturally.
[i] “Nissan to Shift Output to Dollar Economies”, Financial Times, November 21, 2010.
[ii] “Charging Ahead”, Wall Street Journal, November 8, 2010.
[iii] See, for example, Davies, H. The Financial Crisis: Who is to Blame? Polity Press. Cambridge, 2010; Horwood, C. Board Stupid, Euromoney Magazine, February, 2008; Papakonstantinou, F. Boards of Directors: The Value of Industry Experience. Princeton presentation. March, 2007, as well as Walker, D. A Review of Corporate Governance in UK Banks and other Financial Industry Entities, HM Treasury, July 2009. See also an AON study of 316 companies in Singapore suggesting that Asian companies are not immune to board-level ignorance of risk management, http://www.aon.com/thought-leadership/asia-connect/2010-sep/boards-take-leading-role-in-risk-governance.jsp.
[iv] Hau, H, J. Steinbrecher and M. Thum. Board (In)competence and the Subprime Crisis, VOX, January 2009.
[v] “The Hedge Costs Explosion”, FX Week, February 3rd, 2010.
[vi] “US Derivatives Regulation will Impact Asian Treasurers”, FinanceAsia, June 22, 2010.
[vii] “Korea Moves to Restrict FX Derivative Usage”, FX Week, June 15, 2010.
[viii] See the most recent (April, 2010) Bank of International Settlements triennial Central Bank Survey, “Foreign Exchange and Derivatives Market Activity in April, 2010: Preliminary Results.” Bank of International Settlements, September, 2010.
[ix] “Risk Management and Operational Hedging: An Overview”, Van Mieghem, J. A., Handbook of Integrated Risk Management of Global Supply Chains (submission), Kouvelis, P., et al. (eds.), December, 2009.