Hedging to help protect against foreign-currency risks

Capital One’s Brandon Turcotte explains how companies can prepare for the unexpected impacts that come with doing business in multiple currencies.

In an increasingly interconnected global market, corporate treasury departments need an effective strategy for managing foreign currency fluctuations. To understand how those strategies should be designed and implemented, and how they can help companies navigate risk, fluctuating interest rates and even the complexity of cross-border mergers, we talked with Brandon Turcotte, Capital One’s managing director for foreign exchange (FX) derivatives. 

How does FX risk affect businesses, and why should they be concerned? 

Many of our clients do business in other countries or operate as multinational corporations, and that presents currency risks to our client base. If these businesses are not properly managing that risk, it could negatively impact their financial results—regardless if there's heightened volatility or just normal currency movements on a day-over-day or even month-over-month basis. 

How can businesses address FX risk? 

The goal of mitigating financial risk is to reduce volatility in earnings and preserve the value of any nonfunctional currency cash flow(s) and/or asset valuation(s). For corporate treasury teams, the focus of any currency hedging program should be on creating greater certainty with cash flows, asset/liability valuations, and ultimately profitability to ensure risk is mitigated or, at the very least, “smoothed” out over the period in question, which ultimately creates financial stability.

What is a nonfunctional currency? 

It’s any currency exposure other than the one in which a business declares and records their financial statements. For example, a U.S. multinational corporation may record and report its consolidated financial statements in U.S. dollars, so any non-US dollar exposure, whether it's an asset/liability or a cash flow, would represent a non-functional currency as that exposure (e.g. in Euros) must be translated into US Dollars for reporting purposes.

Given the recent fluctuations in global markets, what should companies be looking for? 

Uncertainty in financial markets and subsequent volatility in currencies may negatively impact corporates’ financials. If a company doesn’t have a strategy to mitigate and address the impact from currency fluctuations, it could be viewed by equity analysts and the board of directors as a failure of the management team to properly manage their income and balance sheet statements and preserve the value of the firm. Too often, companies don’t discuss FX hedging programs until they’ve been negatively impacted. It’s better to be proactive vs. reactive, and properly identify, quantify, and if deemed appropriate, employ an FX hedging strategy to mitigate potential negative financial impacts.  

What about broader economic concerns, such as geopolitical risk or interest rates? 

If you think about currencies, they're driven by a multitude of factors. If there's a geopolitical concern for a region, you may see some depreciation in those specific currencies. Conversely, if you have volatility in interest rates or divergence between central bank policy between two regions this will have a dramatic impact on how their currencies trade. There is normally a high correlation of increased/higher volatility in currencies when there is interest-rate divergence and heightened geopolitical concerns. Thus, a greater likelihood of being negatively impacted from this volatility.

How should companies hedge against this risk?

We take an agnostic approach to volatility when it comes to an FX hedging program. The fundamental construction of any risk management program can usually be broken down into five core areas:

1. Identifying the risks—transactional or translational

2. Quantifying the risks—putting a value on the potential impact by running value at risk analysis 

3. Establishing risk-management policies: a company should have an internal policy that defines its hedging objectives while also allowing for flexibility

4. Strategy implementation—defining whether a program is more systematic, opportunistic, or a mixture of both

5. Review & rebalance—no strategy is perfect indefinitely, so reviewing and rebalancing may be appropriate from time to time

What are clients focused on with their FX-hedging programs? 

A currency risk management program can be focused around three core exposures. The first is transactional risk. That's forecasting nonfunctional currency revenues and expenses and, in some cases, intercompany loans. Second is translational risk. This is about net income on foreign subsidiaries or net investment in nonfunctional currency subsidiaries. About 95% of our conversations are around transactional risk, actual cash flows, translational risk, and how companies are marking/valuing their books for their nonfunctional assets and liabilities.

And the third exposure? 

That’s event-driven transactions. It comes into play with things like cross-border mergers and acquisitions. With an acquisition, the purchase price could be denominated in a currency that’s different from the funding source, which creates uncertainty around the actual US dollar cost to purchase the target company in its local currency. The same thing can happen with a divestiture, such as a multinational corporation that’s looking to spin off a foreign subsidiary. The sale price might be denominated in a currency different from the desired functional currency of the parent company that’s selling. 

What should companies consider when implementing a hedging strategy? 

It's important to think about the economic and accounting impacts. When we discuss with a corporate treasury team about hedging these types of exposures, it's not specific to one event. We really want to take a holistic view of the overall exposure. What does their income statement look like? What does the balance sheet look like? Keeping it simple can sometimes be the best strategy. 

For transactional and translation risks, it's important to use the FX hedging products that best match the underlying exposures. They should also match how those exposures are being marked-to-market on the financials—whether they use month-end closing rates or daily average rates, for example. There are various foreign-exchange product sets that best align to create an effective hedge. 

And then, as I mentioned before, event-driven transactions may have more complexity, given the ever changing nature associated with mergers and acquisitions. What's the certainty of this deal closing? When's the right point to hedge? Do they need the flexibility to get out of the hedge if the deal falls apart? Regardless of the FX exposure, having a formalized strategy that aligns with industry best-practices allows corporate treasury teams to provide stability to their financials and more importantly to the bottom-line.

To learn more about our derivatives and hedging capabilities, click here.