VOLUME NO. 7
MANAGING LONG-TERM
CURRENCY AND FOREIGN
INTEREST RATE RISK
Global opportunity brings with it
global risk — particularly financial risk.
THE CHALLENGE
Increasingly, successful North American companies have been turning their attention to foreign
markets. Once the target of only the largest and most sophisticated firms, offshore investment
opportunities now draw interest from companies of all sizes. Lowered barriers to cross-border trade
and capital movement have made it easier than ever even for smaller companies to diversify
internationally. As the large companies learned early on, however, global opportunity brings with it
global risk – particularly financial risk.
Because more companies than ever are
investing, sourcing, and selling abroad,
this issue of Derivations considers
techniques for hedging long-term
currency and foreign interest rate risk.
Most corporate financial officers are used to dealing with short term currency exposure. Simple
currency risk management strategies include billing foreign sales in local currency, centralized netting
systems for foreign currency payables and receivables, and buying and selling FX forward and option
contracts to hedge short term exposures. Many treasurers have also become adept at managing the
firm's domestic interest rate exposure, using interest rate swaps, caps and options to adjust to changing
market conditions and balance sheet sensitivities.
Treasurers and CFOs are less familiar with techniques for coping with long term currency risk and
foreign interest rate risk even though these can be among the most pernicious financial exposures a
company encounters as it expands internationally.
FINANCING AND HEDGING A FOREIGN INVESTMENT
Buying a foreign company or building a plant abroad raises clear-cut long term financing and hedging
issues. Since such investments are usually made for the long haul, long term financing is appropriate.
However long term capital may not be available locally, or where available may be quite expensive and
inflexible compared to the investor's home market financing alternatives.
Hedging the net investment in a foreign operation using only the tools a treasurer would use to manage
short term trade exposures raises problems too – cash flow problems. Investment cash flows are long
term; short term hedge cash flows are not. This means that the hedgers may have to fund interim
losses on a hedged position even when the net position is risk-neutral. For example, while a strategy
of hedging a long term UK investment by rolling over short term pound sterling forward contracts can
look quite appealing on paper, rising sterling values will trigger significant hedge cash outflows.
When this happens companies are tempted to curtail or eliminate hedge positions – inevitably just
when the currency is about to turn around and the value of being hedged becomes critical.
Long-term cross currency interest rate swaps bridge the gap for hedgers. They allow for
acquisition/expansion financing to be raised in the most efficient market, they carry over the financing
advantages (cost, covenants, rate character) from the source to the target currency, and they eliminate
currency risk on a cash-flow neutral basis.
Cross currency swaps have been around for some time. Today, however, the range of currencies and
maturities available has expanded dramatically, while expanding liquidity has pushed down the cost of
hedging. In all major currencies (and many second-tier currencies) floating-floating, floating-fixed,
and fixed-fixed swap structures are routinely available, while hedges of popular structured debt
instruments (e.g. putable/callable notes) can easily be accommodated as well.
GAINING AN EDGE IN INTERNATIONAL SALES
Offering flexible financing terms is a popular way to incent buyers of big ticket items. Where the
markets are international, the availability of preferred-currency buyer finance programs can make a
substantial competitive difference. Depending on the product, such programs can be quite long term
(aircraft leases, for example, can run for twenty years or more). Cross currency swaps and foreign
currency denominated interest rate hedging tools give sellers the ability to offer long term rate
protected local currency financing alternatives without taking on undue market risk.
For example, a U.S. manufacturer of large scale electronic switching systems offers foreign buyers
(lessees) a choice of financing in 10 different currencies on a floating or fixed rate basis (buyer's
choice) for terms out to 10 years. The seller hedges the buyer's finance package by swapping it back
to dollars on a basis that matches the underlying debt (in this case commercial paper issuance and
LIBOR priced revolving bank debt). If the buyer selects 10-year financing denominated in fixed rate
DM, a fixed DM to floating USD swap (in which the hedger pays 10 year fixed DM and receives
floating rate USD) is executed to eliminate currency risk and match the interest rate character of the
asset to the seller's underlying working capital financing.
Alternatively, the buyer might opt for floating rate DM financing with the DM interest rate capped.
To hedge, the seller executes a floating to floating currency swap (paying floating rate DM and
receiving floating rate USD) and buys a DM interest rate cap to hedge the cap feature embedded in
the buyer finance contract. The financing and hedging cash flows are diagrammed in the inset below.
NEW WAYS TO HEDGE LONG-TERM FOREIGN CURRENCY RECEIVABLES AND PAYABLES
Long term multi-payment contracts and commitments denominated in foreign currencies can be
hedged in some interesting ways. For example:
Flat forwards provide for a constant exchange rate to be applied to a series of future exchanges. This
gives hedgers a simple way to take current advantage of abnormally steep forward currency discounts
or premiums. For example, where a currency is trading at a steep forward premium (when foreign
interest rates are substantially below domestic rates), hedging a receivables stream with a flat forward
contract raises the home currency value of near term receivables in exchange for reducing the value
of later dated receivables. This has the effect of eliminating exchange risk, smoothing income flows,
and raising current income.
Where a currency is trading at a steep forward discount (because foreign interest rates are higher than
domestic rates), using flat forwards to hedge a stream of payables has similar positive benefits –
exchange risk disappears, income flows are smoothed, and current income rises as the home currency
value of near dated payables is reduced.
Extendible flat forwards have the same risk reduction and income smoothing benefits as straight flat
forwards. However, because the hedge can be extended for some agreed period at the provider's
option, they can have an even more beneficial impact on current income for the buyer. For long-term
hedges of highly volatile currencies the extension feature can be particularly valuable – higher
volatility translates into a larger value for the embedded option.
Long-term FX collars establish a minimum (floor) and a maximum (cap) rate at which a series of
future currency exchanges will take place at predetermined dates. So long as spot rates remain inside
the band between the cap and the floor, the spot rate is applied to each conversion. But if the actual
spot rate is outside the band on any exchange date, the boundary (cap or floor) rate prevails. This
limits the hedger's exposure to price movements just to the area within the band. To keep things
simple, most collars set just one cap and one floor rate for the life of the hedge. As with interest rate
collars, zero premium hedges are the rule rather than the exception.
Collars are the preferred hedging strategy for companies hoping to benefit from short term
improvement in exchange rates while controlling the risk of large long term adverse swings.
For example, the French subsidiary of a US company recently applied a 3 year FX collar to hedge the
stream of future interest payments on USD fixed rate term debt provided by the parent. Because the
Frf was trading at steep forward premium, a collar could be constructed that locked in a worst case
Frf/USD conversion rate only 10 centimes above the spot rate at the time, while the floor rate was set
55 centimes below the spot. The collar provided a tight hedge against a weakening Frf, gave the
company considerable room to benefit if the Franc strengthened and carried a net premium of zero.
On consolidation, it also provided a partial hedge of the parent company's net investment in Frf.
SUMMING UP
While hedging day-to-day trade flows may get the lion's share of Treasury's attention, long term FX
exposures and opportunities need to be looked after too. Derivatives hedging tools are available today
to cover FX and offshore interest rate risk far out along the maturity spectrum. This translates into
more efficient hedging strategies for foreign investment risk and more appealing financial incentives
to promote export sales.
© Copyright Bank of Montreal 1998
This material is for general information purposes only and is not to be relied on as investment advice.
Readers should consult their own financial advisors before making any investment decisions.