Managing Foreign Exchange Risk

A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.28 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals—particularly in large, complex multinationals where myriad transactions may be pursued simultaneously—they should at least set guidelines for the firm’s subsidiaries to follow.

MANAGEMENT FOCUS Dealing with the Rising Euro

Udo Pfeiffer, the CEO of SMS Elotherm, a German manufacturer of machine tools to engineer crankshafts for cars, signed a deal in late November 2004 to supply the U.S. operations of Chrysler with $1.5 million worth of machines. The machines would be manufactured in Germany and exported to the United States. When the deal was signed, Pfeiffer calculated that at the agreed price, the machines would yield a profit of €30,000 each. Within three days, that profit had declined by €8,000! The dollar had slid precipitously against the euro. SMS would be paid in dollars by Chrysler, but when translated back into euros, the price had declined. Because the company’s costs were in euros, the declining revenues when expressed in euros were squeezing profit margins.

With the exchange rate standing at €1 = $1.33 in early December 2004, Pfeiffer was deeply worried. He knew that if the dollar declined further to around €1 = $1.50, SMS would be losing money on its sales to America. He could try to raise the dollar price of his products to compensate for the fall in the value of the dollar, but he knew that was unlikely to work. The market for machine tools was very competitive, and manufacturers were constantly pressuring machine tool companies to lower prices, not raise them.

Another small German supplier to U.S. automobile companies, Keiper, was faring somewhat better. In 2001 Keiper, which manufactures metal frames for automobile seats, opened a plant in London, Ontario, to supply the U.S. operations of Chrysler. At the time the investment was made, the exchange rate was €1 = $1. Management at Keiper had agonized over whether the investment made sense. Some in the company believed it was better to continue exporting from Germany. Others argued that Keiper would benefit from being close to a major customer. Now with the euro appreciating every day, it looked like a smart move. Keiper had a real hedge against the rising value of the euro. But the advantages of being based in Canada were tempered by two things; first, the U.S. dollar had also depreciated against the Canadian dollar, although not by as much as its depreciation against the euro. Second, Keiper was still importing parts from Germany, and the euro had also appreciated against the Canadian dollar, raising the costs at Keiper’s Ontario plant.

Source: Adapted from M. Landler, “Dollar’s Fall Drains Profit of European Small Business,” The New York Times, December 2, 2004, p. C1.

Second, firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.29 Firms need to develop strategies for dealing with economic exposure. For example, Stanley Black & Decker, the maker of power tools, has a strategy for actively managing its economic risk. The key to Stanley Black & Decker’s strategy is flexible sourcing. In response to foreign exchange movements, Stanley Black & Decker can move production from one location to another to offer the most competitive pricing. Stanley Black & Decker manufactures in more than a dozen locations around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of the company’s productive assets are based outside North America. Although each of Stanley Black & Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are able to switch rapidly from producing one product to producing another or to add a product. This allows a factory’s production to be changed in response to foreign exchange movements. For example, if the dollar depreciates against other currencies, the amount of imports into the United States from overseas subsidiaries can be reduced and the amount of exports from U.S. subsidiaries to other locations can be increased.30

Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw earlier in the chapter, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future.

Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered.

Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks.

Surprisingly, some of the largest and most sophisticated firms don’t take such precautionary steps, exposing themselves to very large foreign exchange risks. Thus, as we have seen in this chapter, Volkswagen suffered significant losses during the early 2000s due to a failure to adequately hedge its foreign exchange exposure.