depreciation of the Euro–zloty exchange rate. Notehowever that as the Euro–zloty exchange rate has depreciated for this and other reasons sothe value of the original investment in the Polish factory has increased in Euro terms. Thus:EUR–PLN ↓ = EUR translation value of Polish subsidiary ↑Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficialfor the manufacturer’s translation value of the Polish factory/subsidiary when the financialstatements are consolidated at the end of the accounting period. The translation benefit to the
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balance sheet will depend on the accounting method of translation. Conversely, were the Euroever to rally on a sustained basis, this might cause the Euro–zloty exchange rate to rally, thus inturn reducing the translation value of the corporation’s Polish subsidiary. The consolidation offinancial statements would mean that this not only has an impact on the Euro value of the Polishsubsidiary but also on the balance sheet of the parent, Euro-based manufacturer. The risk of asudden balance sheet deterioration of this kind is not negligible where corporations have a broadrange of foreign subsidiaries, with accompanying transactional and translational currency risk.7.2.3 Economic RiskThe translation of foreign subsidiaries concerns the consolidated group balance sheet. However,this does not affect the real “economic” value or exposure of the subsidiary. Economic riskfocuses on how exchange rate moves change the real economic value of the corporation,focusing on the present value of future operating cash flows and how this changes in linewith exchange rate changes. More specifically, the economic risk of a corporation reflects theeffect of exchange rate changes on items such as export and domestic sales, and the cost ofdomestic and imported inputs. As with translation risk, calculating economic risk is complex,but clearly necessary to be able to assess how exchange rate changes can affect the presentvalue of foreign subsidiaries. Economic risk is usually applied to the present value of futureoperating cash flows of a corporation’s foreign subsidiaries. However, it can also be appliedto the parent company’s operations and how the present value of those change in line withexchange rate changes.Summarizing this part, transaction risk deals with the effect of exchange rate moves ontransactional exposure such as accounts receivable/payable or dividends. Translation risk focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore thevaluation of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value of future operating cash flows, focusingon the “currency of determination” of revenues and operating expenses. Here it is importantto differentiate between the currency in which cash flows are denominated and the currencythat may determine the nature and size of those cash flows. The two are not necessarily thesame. To complicate the issue further, there is the small matter of the parent company’s currency, which is used to consolidate the financial statements. If a parent company has foreigncurrency-denominated debt, this is recorded in the parent company’s currency, but the valueof its legal obligation remains in the currency denomination of the debt. In sum, transactionrisk is just the tip of the iceberg!Of necessity, the reality of currency risk is very case-specific. That said, there has been anattempt by the academic and economic communities to apply the traditional exchange ratemodels to the corporate world for the purpose of demonstrating how exchange rates impact acorporation. More specifically, the models typically used for this purpose have been those ofPPP, the international Fisher effect and the unbiased forward rate theory, which we looked atin Chapter 1. To recap:
r PPP (or the law of one price) suggests that price differentials of the same good in differentcountries require an exchange rate adjustment to offset them.
r The international Fisher effect suggests that the expected change in the exchange rate isequal to the interest rate differential.
r The unbiased forward rate theory suggests that the forward exchange rate is equal to theexpected exchange rate.
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Generally, these theories are grounded in the efficient market hypothesis and thereforeflawed at best. Over the long term, these traditional “rules” of exchange rate theory suggestthat competition and arbitrage should neutralize the effect of exchange rate changes on returnsand on the valuation of the corporation. Equally, locking into the forward rate should, accordingto the unbiased forward rate theory, offer the same return as remaining exposed to currencyrisk, as this theory suggests that the distribution of probability should be equal on either sideof the forward rate.The unfortunate thing about such models, however worthy the attempt, is that they do notand cannot deal with the practical realities of managing currency risk. What academics regardas “temporary deviations” from where the model suggests the exchange rate should be canbe sufficient and substantial enough to cause painful and intolerable deterioration to both theP&L and the balance sheet.To conclude this part, a corporation should define and seek to quantify the types of currencyrisk to which it is exposed in order then to be able to go about creating a strategy for managingthat currency risk.
7.3 MANAGING CURRENCY RISKTransactional currency risk can be hedged tactically or strategically by the corporate Treasuryto preserve cash flow and earnings, depending on their currency view.Translational currency risk is usually hedged opportunistically rather than systematically,notably to try to avoid emerging market-related shocks to net assets, usually focusing on eitherlong-term foreign investment or debt structure.Hedging economic risk is complex, requiring the corporation to forecast its revenue and coststreams over a given period and then to analyse the potential impact on these of an exchangerate deviation from the rate used in calculating revenue and cost. For the debt structure, thecurrency of denomination must be chosen, the amount of debt estimated in that currency andthe average interest period determined. The effect on cash flow should be netted out overproduct lines and across markets. What’s left from this process is the economic risk that hasto be managed. For large multinationals, the net economic risk may in fact be quite smallbecause of offsetting effects. However, economic risk can be substantial for corporations thathave invested in only one or two foreign markets.The first two steps of this process appear to have been accomplished. Firstly, we have definedvery specifically the types of currency risk that a corporation is exposed to. Secondly, we havelooked at broad strategy, the brushstrokes of managing that currency risk. Yet, while thiscurrency risk may be defined, it must also be quantified. Quantifying an amount of currencymay be easy for transaction risk, but for translation or economic risk it is no easy task. Just aswith other types of risk management, the most popular way of doing this is to use a “VaR” model.
7.4 MEASURING CURRENCY RISK – VAR AND BEYONDValue at risk is defined as:The maximum loss for a given exposure over a given time horizon with x% confidence VaRhelps a user to define the maximum loss on an exposure for a given confidence level and hashelped investors and corporations in managing their risk. VaR is on the face of it an excellent riskmanagement tool, which can be used to measure a variety of risk types.
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However, it should be noted that:VaR does not define the worst-case scenarioIt may give the maximum loss for an exposure with 99% confidence using a 3000-iterationMonte Carlo simulation. The question remains however, what happens to the exposure for that1% point of confidence? The frank truth is a VaR model is incapable of answering that question.Thus, a degree of both care and common sense is needed. The more sophisticated corporateTreasuries frequently seek to refine their VaR model to go beyond the natural confidence levellimit to try and define the maximum loss with 100% confidence. A practical way of trying toachieve this is to impose operational limits (such as in terms of number of contracts, nominalamount, sensitivities or stop loss orders) in addition to VaR limits. That relates to the aspect ofcare. The common sense aspect relates to never trusting your risk to a computer model alone.If you cannot quantify it itself without use of the model, you have a problem.
7.5 CORE PRINCIPLES FOR MANAGING CURRENCY RISKSo far we have examined currency risk, how to manage and quantify it. Before we go on fromtheory into practice, it may well be useful to establish a framework, a reference for corporateTreasury of core principles of managing currency risk. There have been several notable effortsalong these lines, most notably of course the “Core Principles of Managing Currency Risk”set out by the Group of 31 (US multinational corporations) and Greenwich Treasury Advisors.Clearly, there is a danger in attempting anything even approaching best practice for corporateTreasury as corporations vary so significantly in terms of their exposures, requirements andfocus. Such concerns notwithstanding, the importance of the issue equally requires that theattempt be made to create a reference from which individual corporations can perhaps takewhat might be appropriate to them. Thus, what follows is my own tentative suggestion of whatany such list of core principles of managing currency risk should contain:1. Determine the types of currency risk to which the corporation is exposed – Break thesedown into transaction, translation and economic risk, making specific reference to whatcurrencies are related to each type of currency risk.2. Establish a strategic currency risk management policy – Once currency risk types havebeen agreed on, corporate Treasury should establish and document a strategic currencyrisk management policy to deal with these types of risks. This policy should include thecorporation’s general approach to currency risk, whether it wants to hedge or trade that riskand its core hedging objectives.3. Create a mission statement for Treasury – It is crucial to create a set of values and principles which embody the specific approach taken by the Treasury towards managing currencyrisk, agreed upon by senior management at the time of establishing and documenting therisk management policy.4. Detail currency hedging approach – Having established the overall currency risk management policy, the corporation should detail how that policy is to be executed in practice,including the types of financial instruments that could be used for hedging, the process bywhich currency hedging would be executed and monitored and procedures for monitoringand reviewing existing currency hedges.5. Centralizing Treasury operations as a single centre of excellence – Treasury operationscan be more effectively and efficiently managed if they are centralized. This makes it easierto ensure all personnel are clear about the Treasury’s mission statement and hedging approach. Thus, the Treasury can be run as a single centre of excellence within the corporation,
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ensuring the quality of individual members. Large multinational corporations should consider creating a position of chief dealer to manage the dealing team, as the demands of aTreasurer often exceed the ability to manage all positions and exposures on a real-time basis.The currency dealing team must have the same level of expertise as their counterparty banks.6. Adopt uniform standards for accounting for currency risk – In line with the centralizingof Treasury operations, uniform accounting procedures with regard to currency risk shouldbe adopted, creating and ensuring transparency of risk. Create benchmarks for measuringthe performance of currency hedging.7. Have in-house modelling and forecasting capacity – Currency forecasting is as importantas execution. While Treasury may rely on its core banks for forecasting exchange ratesrelative to its needs, it should also have its own forecasting ability, linked in with itsoperational observations which are frequently more real time than any bank is capableof. Treasury should also be able to model all its hedging positions using VaR and othersophisticated modelling systems.8. Create a risk oversight committee – In addition to the safeguard of a chief dealer positionfor larger multinational corporations, a risk oversight committee should be establishedto approve position taking above established thresholds and review the risk managementpolicy on a regular basis.Clearly, this list of core principles of managing currency risk is aimed at the larger multinational corporations that have the means and the business requirements for such a sophisticatedTreasury operation. That said, such a list can also be used as a benchmark for those who, whilethey cannot or do not need to comply with all elements, can still find some useful. Corporationsof whatever size and sophistication must balance the real cost of implementing such an approachto managing currency risk against the possible cost of not doing so. The first cost is tangible,the second intangible – but by the time the second becomes tangible it is too late! That isprecisely what we are trying to avoid.It may be useful for a corporation to split currency risk management into two parts – thefirst part focusing on the overall approach towards managing of currency risk, the seconddealing with the actual execution of currency risk management. Many corporations have thiskind of division of labour, whether or not they formalize it. However rigorous a currencyrisk management policy is, it still runs the risk of being bypassed by events, technology andinnovation. Thus, it is very important to have a regular review process to ensure the currencyrisk management policy remains up-to-date and in line with the corporation’s needs. In thisreview process, important questions to be raised may include:
r Do the currency risk management policy and the Treasury’s mission statement still representthe corporation’s business needs? Should the corporation maintain or change its approachtowards managing currency risk?r How has currency hedging performed relative to the established benchmarks? How can thecosts of currency hedging be reduced?r Are VaR or credit limits, or the financial instruments relating to currency risk management,still appropriate?
7.6 HEDGING – MANAGEMENT RELUCTANCEAND INTERNAL METHODSHaving looked in detail at the issue of managing currency risk, we should now be lookingat the specifics of how to hedge that risk. Before we do that, we first have to examine the
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issue of management reluctance to hedge a risk many see as merely an operational hazardof international investment. Some may dismiss this section, either because it is irrelevant tothem or because they view any such approach as inappropriate. While I too share the viewthat currency risk should be managed, such management reluctance should not be ignored, butinstead should be understood and thereafter combated. Three key reasons for this reluctancewhich come up time and again are the following:
r Management does not understand active currency management methodsr Management thinks currency risk cannot be measured accuratelyr Management sees active currency management as outside of core business
Some of these points are reasonable. Currency forwards and options may well be outsidethe field of expertise of a corporation’s management, and will certainly be outside the corebusiness operations. Many managements consider such financial instruments as speculative.However, it is the job of Treasury to explain that not managing currency risk actively leaves thecorporation vulnerable to major exchange rate movements, which can cause substantial swingsin the company’s value. Using forwards or options may indeed be speculative, depending onwhat they are used for. However, not hedging currency risk may be even more speculative.Active currency management is a necessary byproduct of a corporation’s overseas investmentsand operations. Again, it is the job of the Treasury to educate the management and ultimatelythe board on the need for active currency management, not least to maintain and ensure thecorporation’s equity market value. A corporation may not be able to boost shareholder valuesignificantly through active currency risk management, but it can certainly damage it by notmanaging currency risk.When management says it is difficult to measure currency risk it is correct, but that doesnot mean such risk cannot be quantified. Imprecision is not an excuse for indecision in thecorporation’s underlying business. Neither should it be tolerated with regard to currency riskmanagement.Even if a management is willing to consider currency hedging, there are ways of “natural”or internal hedging that it may consider first, such as:
r Netting (debt, receivables and payables are netted out between group companies)r Matching (intragroup foreign currency inflows and outflows)r Leading and lagging (adjustment of credit terms before and after due date)r Price adjustment (raising/lowering selling prices to counter exchange rate moves)r Invoicing in foreign currency (this cuts out transactional exposure)r Asset/liability management (for balance sheet, income or cash flow exposure)
Netting involves the settling of intragroup debt, receivables and payables for the net amount.The simplest form of this is bilateral netting between two affiliates. Matching is similar but canbe applied both to intragroup and third-party flows. Here, a corporation “matches” its foreigncurrency inflows and outflows with respect to amount and timing.Leading and lagging refer to adjusting credit terms between group companies, where “leading” means paying an obligation in advance of the due date and “lagging” means after thedue date. This is a tactic aimed at capturing expected currency appreciation or depreciation.Price adjustment involves increasing selling prices to counter exchange rate moves. Invoicingin foreign currency reduces transaction risk relating specifically to exports and imports.Asset and liability management can be used to manage the balance sheet, income statementor cash flow exposure. Corporations can adopt either an active or a passive approach to asset
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and liability management, depending on their currency and interest rate risk managementpolicy.Finally one can hedge internally by increasing corporate gearing. Leverage shields corporations from taxes because interest is tax-deductible whereas dividends are not. However, theextent to which one can increase gearing or leverage is limited by costs. That said, if currencyhedging reduces taxes, shareholders benefit.For practical purposes, three questions capture the extent of a corporation’s currency risk:1. How quickly can a corporation adjust prices to offset exchange rate impact on profit margins?2. How quickly can a corporation adjust sources for inputs and markets for outputs?3. To what extent do exchange rate moves have an impact on the value of assets?Within a corporation, it is usually the case that those who can come up with the best answersto these questions are directly involved in such tasks as purchasing and production. Thus,finance executives who focus exclusively on the credit and currency markets can in fact missthe real essence of a corporation’s currency risk. Furthermore, the exact answers to thesequestions need to be known not only by the oversight or risk committee, but preferably by theCEO as well. If they don’t, they effectively don’t know both the value and the exposure of thecorporation.
7.7 KEY OPERATIONAL CONTROLS FOR TREASURYAssuming the corporation has accepted the need to manage currency risk, appointed a risk oroversight committee and in the case of large multinational corporations a chief dealer as well,it needs then to establish a set of operational controls in order to be able to monitor that risk andensure inappropriate positions are not being taken. The importance of doing this is underlinedevery time the news headlines show another corporation has lost millions of pounds, dollars oryen by not putting such controls in place, or rather by not ensuring their enforcement. Thereare other operational controls that are important, but among the key ones to put in place arethe following:
r Position limits – Positions above a certain limit or threshold should not be undertaken withoutthe written authorization of the chief dealer, Treasurer, oversight committee and the board.
r Position monitoring – Treasury must have the technological and manpower capability tomonitor and mark-to-market all the currency and interest rate positions it has taken on atany one time.r Performance benchmarks should be established – For corporations that only participate in thecurrency market for hedging purposes, currency hedging benchmarks should be established.For those that are allowed to trade in the currency market, a trading budget should beestablished at the start of the year and the performance monitored on a monthly or quarterlybasis.
7.8 TOOLS FOR MANAGING CURRENCY RISKThe board has given Treasury free rein to manage the corporation’s currency risk within theparameters set out in the currency risk management policy. Within that policy, there shouldbe a section on what financial instruments can be used for this purpose. Hedging currencyrisk in no longer a simple matter of using vanilla forwards and options. As the needs of the
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Table 7.1 Traditional hedging structuresInstrument
Definition
Advantages
Disadvantages
Plain vanilla call
Buy an upside strike inSimplicity, cheaper than Higher cost than morean exchange rate withthe forward and thesophisticatedno obligation tomaximum loss is thestructuresexercisepremiumPlain vanilla forward Buy a currency contract You are 100% hedgedHigh cost and risk of thefor future delivery at aexchange rate movingprice set todayagainst youCall spreadBuy an at-the-moneyLower cost than a vanilla Allows cover only forcall (ATMF) and sell acallmodest exchange ratelow delta callappreciation asdictated by strikesCalendar spreadBuy a 3M call and sell a Allows you to capture a Leaves you vulnerable to1M call (of the sametiming view on FXadverse moves in onedelta)movesof the legsWriting the 25 delta putRisk reversalBuy a 25 delta call, sell a Risk reversals captureleaves you vulnerable25 delta putthe market’s “skew”to an adverse move inthus they offerspot which may causebuying/sellinga spike higher in volopportunity relative tonot offset by thehistorical riskhigher vol in the callreversals; can bestructured to be low orzero cost“Seagull”Buy an ATMF call, sell a Can be structured to beUnless structured in alow delta call and sellzero costratio, leaves you neta downside putshort vol; not coveredagainst a major spotmove
modern corporation have changed, so the tools or structures for hedging that risk have changedaccordingly, consisting of ever greater specificity and flexibility to meet those needs. Most ofthe development within this field has happened in financial options, given the more flexiblenature of the option instrument relative to the forward. Thus, I present a pair of tables lookingfor the most part at the types of option structures that corporations are using today, breakingthese down into “traditional” (Table 7.1) and “enhanced” (Table 7.2) structures, relating totheir degree of sophistication.
7.9 HEDGING STRATEGIES7.9.1 Hedging Transaction RiskThe unbiased forward rate theory suggests the expected spot exchange rate is the forwardrate. If this worked, it would mean that failing to hedge currency risk would yield similarresults in the long run to hedging. There are two problems with this. First, the Treasurer wouldprobably be fired before the “long run” arrived. Second, the unbiased forward rate theory isa poor predictor of future exchange rates in practice. Basically it does not work. Therefore,
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Table 7.2 Enhanced hedging structuresInstrument
Definition
Advantages
Disadvantages
Knock-out
Buy a 30 delta call with adownside knockout(down-and-out)
Knock-in
Buy a 30 delta call withupside knock-in(up-and-in)Buy a double knock-out
Reduces cost of call; letsyou re-hedge lowerdown in the exchangerateReduces the cost; you arenot hedged untilknocked-inGives you leveragepremium, expectingrange tradingLets your currency viewbe “wrong” a numberof timesAllows you to “fade in”to the call for a period,thus giving you morecost and timeflexibilityConverts to forward atagreed rate; client cantake advantage of acontrarian move inspot up to the KIIf the currency stayswithin an agreed range,the rate is significantlyimproved relative thevanilla forward
If knocked-out you arenot hedged andvulnerable to anadverse FX moveIf knocked-in, you arethen vulnerable to aspot reversalIf knocked-out, you willhave to re-hedge
Range binaryWindow optionFade-in option
Buy the right to buy a30 delta call in a givennumber of periodsBuy a 30 delta call andfade into the callincrementally over agiven period of time
Convertibleforward
Buy a call, sell adown-and-in put
Enhancedforward
Buy an up-and-in–downand-in call/sell anup-and-in–downand-in put; buy anup-and-out–downand-out call/buy anup-and-out–down-and-out putBuy a currency swap andat the same time payfixed and receivefloatingBuy a currency swap, atthe same time payfloating interest in acurrency and receivefloating in another
Cross-currencycoupon swapCross-currencybasis swap
Lets you manage FX andinterest rate risk inmarkets suited to thecorporationCurrency risk is the sameas a standard currencyswap, but the basiscurrency swap allowsyou to capture interestrate differentials
Higher cost than thevanilla callIf spot moves while youare fading in, you donot capture as much ofthe move as with avanilla callThe strike is moreexpensive than theforward and must bepaid if structure isknocked-inIf spot goes outside of therange, the forward rateto be paid becomesmore expensive
Leaves the buyervulnerable to bothcurrency and interestrate riskThe risk in this structureis interest rate riskrather than currencyrisk
a corporation should use market-based currency forecasting in addition to the forward rateto predict future exchange rates. The discretionary aspect to the currency forecast means thecorporation has the choice of hedging:
r Tactically and selectivelyr Strategicallyr Passively
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Corporations vary in their attitude towards transaction hedging. Some hedge passively,that is to say they maintain the same hedging structure and execute over regular periodsduring the financial year. This type of transaction hedging does not involve the corporation“taking a (currency) view”. The other two types of hedging strategy do indeed involve taking acurrency view. Strategic hedging involves the corporation taking a view for a longer period thanimmediate transaction receivables and payables might require. In January 1999, I rememberwave after wave of European corporations hedging both developed and emerging marketcurrency risk as far out as one year. Corporations who usually called in USD20–30 millionto hedge very short-term receivables were calling for prices in a number of emerging marketcurrency pairs in USD200–300 million. The Russian crisis of August 1998 and the collapse ofLTCM had clearly scared global financial markets. With the threat looming of devaluation inBrazil (which indeed happened in January 1999), many European corporations were apparentlytaking advantage of the relaxation in global market tensions and reduced risk premiums in themarket in the wake of the Fed’s extraordinary monetary easing of August and September, withthree interest rate cuts in quick succession to hedge their transactional currency risk as far outas they could go. That is an example of strategic hedging. Finally, tactical and selective hedgingof transactional currency risk is the usual business that a corporate dealing desk does with itsclients. A bank’s clients may choose to allow certain currency exposures to be translated atthe period end, and others they may choose to hedge, depending crucially on their currencyview. Typically, it makes sense for a corporation to use the tactical and selective approach formost transactional currency risks and only occasionally to pull the trigger on strategic hedgingshould the need arise. While passive hedging may appeal to some, it hurts flexibility, not onlywith regard to the hedging strategy but also with regard to domestic pricing.7.9.2 Hedging the Balance SheetWhile corporate Treasury is usually active in hedging transaction currency risk, it rarely considers translation risk – or hedging the balance sheet. This is largely because balance sheet riskis largely made up of foreign direct investment or the debt structure of the corporation. In thefirst case, the management has a natural and instinctive objection to the idea of hedgingthe balance sheet risk, involving a direct investment abroad, since that would seem to negatethe reason for the initial investment. For this very reason, many corporations do not hedgetranslation or balance sheet risk because of:
r The long-term nature of their investments in subsidiariesr The perceived zero-sum nature of currency risk over the long termr Accounting and tax issuesr Cash flow impacts
A further disincentive is that currency translation affects the balance sheet rather than theincome statement, which may make it less of an immediate priority for management. Equityanalysts tend to focus on EBIT (or EBITDA) before debt/equity ratios. Eventually, however,the deterioration in balance sheet ratios can impact the corporation’s average cost of capitaland ultimately its valuation in the market place.ExampleEuropean exporters with US subsidiaries have seen two major benefits as a result of the Euro’sweakness against the US dollar over the last two years. Firstly, at the direct level, this Euro
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weakness has made their exports cheaper to the US, allowing them to lower export prices andthus gain market share. Secondly, Euro weakness has, just as we saw with the previous Polishexample, boosted the Euro value of their US subsidiaries. At some stage, the Euro’s declineagainst the dollar may reverse. How would the corporate Treasury best cope with this? Theexport question concerns transaction exposure. The question of the subsidiary’s value whentranslated back into Euros is one of translation currency risk or exposure. In this case, bothtypes of “polar” hedge – zero or 100% hedged – seem inappropriate. The risk of the Eurorallying on a sustained basis against the dollar may be seen by many as small, but it is notzero. Therefore it would be inappropriate to have a zero-rate balance sheet hedge to coverthe risk of valuation loss in the subsidiary. On the other hand, it would also seem extremeto hedge 100% of the subsidiary’s value. A neat way round this dilemma might be to use avariable hedge ratio for net balance sheet exposures, which are triggered by the interest ratedifferential. Remember that when hedging balance sheet risk, what you are hedging is the netassets (gross assets less liabilities) of the subsidiary or subsidiaries that may be affected byan adverse exchange rate move. Thus, important considerations are the financing, net cashflows and intangibles relating to those subsidiaries. The corporation’s debt structure is alsoan important consideration. Corporations with higher local tax rates tend to debt finance theirinvestments in order to reduce their average cost of capital.There are two parts to this issue however. Up to now, we have looked at the idea of hedging the risk within the consolidated balance sheet relating to foreign investment. The otherpart of this issue relates to the corporation’s debt profile. The risk this represents is broadlyaffected by the debt’s currency and maturity composition. The corporation can change thiscurrency and maturity composition to reduce the degree to which exchange rates are ableto cause volatility in net equity and earnings. Optimization can be used for this purpose,though this will not completely eliminate currency risk and tactical hedging may be needed inaddition.There is no question that hedging balance sheet risk is more easily quantifiable than isthe case with economic risk. That said, hedging the remaining currency exposure after youoptimize the debt composition remains a controversial subject because it can be expensive, thecorporation may regret the decision to hedge if exchange rates do not move in the anticipateddirection and balance sheet hedging may cause either cash flow or earnings volatility, which isin fact what you are trying to avoid. Ultimately, the decision whether or not to hedge balancesheet risk must be a function of weighing the real costs of hedging against the intangible costsof not hedging. This is certainly not science. That should not be an excuse however for ignoringbalance sheet risk.7.9.3 Hedging Economic ExposureEconomic risk or exposure reflects the degree to which the present value of future cash flowsmay be affected by exchange rate moves. However, exchange rate moves are themselvesrelated through PPP to differences in inflation rates. A corporation whose foreign subsidiaryexperiences cost inflation exactly in line with the general inflation rate should see its originalvalue restored by exchange rate moves in line with PPP. In that case, some may argue economicexposure does not matter. However, most corporations experience cost inflation that differs fromthe general inflation rate, which in turn affects their competitiveness relative to competitors.In this case, economic exposure clearly does matter and the best way to hedge it is to financeoperations in the currency to which the corporation’s value is sensitive.
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7.10 OPTIMIZATIONAs with investors, corporations can use an “optimization