Academic journal article The McKinsey Quarterly

Why Derivatives Don't Reduce FX Risk

Academic journal article The McKinsey Quarterly

Why Derivatives Don't Reduce FX Risk

Article excerpt

For a hedging program to work, it must increase the "times to ruin"

The goal is to reduce the variability of cashflows

A new study shows that few companies succeed

The sad truth about foreign exchange risk management programs is that,most would not pass the doctor s basic test, First, do no harm." A study of nearly 200 large companies yielded enough evidence to cast serious doubt on the economic benefits of FX hedging programs. Even the most superbly designed and executed programs seem not to reduce cashflow volatility significantly for most firms. Given the scarce management time and substantial capital sums currently devoted to hedging, it is clear that many programs destroy value instead of protecting it.

How can it be that hedging programs that appear so elegant in theory don't work in practice? The reason, we believe, is that the theory assumes a static world in which all factors apart from FX rates stay exactly the same. In real life, however, a host of other variables - demand for parts and products, supply of raw materials, regulatory frameworks, cost and productivity of labor and capital - all change just as FX rates change.

Moreover, the relationships between all these factors are constantly shifting. Hard enough to understand in hindsight, they are virtually impossible to predict in advance. All told, FX winds up as only one of many drivers of total cashflow - and a small one at that.

Of all the variables that influence a firm's financial performance, FX is but a minor contributor to total risk, except in the event of catastrophic currency failures like that of the Mexican peso in 1995, which standard hedging programs are not in any case designed to cope with. This means that even eliminating FX risk completely - a practical impossibility - would hardly budge the needle on the total risk faced by a firm. A notable exception may be commodity and commodity-related businesses, where total cashflow is far more closely correlated to exchange rates or easily hedgeable commodities.(*)

Below, we evaluate FX risk management programs that are based on the use of financial derivatives. The details apply only to corporations looking to manage FX risk. However, the principles and methodology are also relevant to other kinds of risk management, such as interest rate risk management or commodity hedging.

Why manage risk, anyway?

The logic behind FX hedging is intuitively appealing. Consider the Japanese unit of a US firm that buys its goods from the United States for dollars and sells them in Japan for yen. When the yen weakens, it needs to pay more in yen for the US goods. This reduces its profits unless prices are raised. In addition, the weaker yen means that these smaller yen profits get translated into even fewer dollars. This one-two punch can have a dramatic effect on dollar profits [ILLUSTRATION FOR EXHIBIT 1 OMITTED].

Thus, when the yen FX rate changes, the firm's profits and cashflows fluctuate. The higher the costs in dollars, the bigger the cashflow fluctuation will be.

The Japanese affiliate could limit its own FX risk by buying goods from the US firm in yen rather than dollars. This would eliminate the second bar in Exhibit 1. However, it would also increase risk for the US company, which would receive revenues in yen but still incur costs in dollars. So a change in billing policy simply shifts the risk from the Japanese affiliate to the US parent, without altering the total FX exposure.

Value creation

The primary purpose of FX hedging is to reduce the cashflow volatility caused by precisely these kinds of FX movements. In turn, the reduction in FX-induced volatility is expected to dampen the volatility of a firm's total cashflow. This smoothing effect may create value in a number of ways:

* By reducing the probability of business disruption costs. Large swings in cash flows can lead to liquidity crises when cashflows turn negative unexpectedly. …

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