” model to create an “efficient frontier”of hedging strategies to manage their currency risk. This measures the cost of the hedge againstthe degree of risk hedged. Thus, the most efficient hedging strategy is that which is the cheapestfor the most risk hedged. This is a very efficient and useful tool for hedging currency risk ina more sophisticated way than just buying a vanilla hedge and “hoping” it is the appropriatestrategy. Hedging optimizers frequently compare the following strategies to find the optimalone for the given currency view and exposure:
r 100% hedged using vanilla forwardsr 100% unhedgedr Option risk reversalr Option call spreadr Option low-delta callWhile such an approach to managing risk is extremely helpful in providing the cheapesthedging structure for a given risk profile, it is not perfect and relies on a discretionary exchangerate view. Further research needs to be done in turning a corporation’s risk profile into amathematical answer rather than a discretionary view. A starting point for this may be foundin the type of equity market profile the corporation wants to create – value, income, defensiveand so forth. From this, it may be possible to suggest an optimal profit stream the corporationshould generate according to this profile and from this in turn we may be able to extrapolatea more exact hedging strategy to maintain that profit stream than simply a discretionary viewmight give.As it is, optimization, using a corporate risk optimizer (CROP), can be undertaken fortransaction, translation or economic currency risk as long as one knows the risks entailed andgives a specific currency view within that. For example, if a corporation is looking for thebest and most efficient hedging strategy in emerging market currencies, a CROP model canintegrate the specific characteristics of those currencies together with the size of the exposureand hedging objectives (efficient frontier, performance maximization, risk minimization). Performance can be measured as P&L, an effective hedging rate or a distance to a given budgetrate. The risk embedded in the hedge is expressed as a VaR number that will be consistentwith the performance measure. While most CROP models do not provide a hedging processfor basket currency hedging, they are very useful for finding the most efficient hedge for individual currency exposures. A CROP model is thus a tool for optimizing hedging strategies forcurrency-denominated cash flows.Users of a CROP model are able to define the nature of their specific exposure and hedgingobjectives. The model also allows for scenario building, whether it be a neutral market view,the incorporation of budget/benchmark rates or the jump risk associated with emerging marketcurrencies. If the objective is risk reduction, an efficient frontier can be created to find themost efficient hedge, which incorporates the cheapest hedge, which offsets the most risk. Bothperformance and VaR are measured as effective rates.Emerging markets are an example where corporate hedging used to adopt a binary approach –that is, to hedge or not to hedge. Options are a perfect tool for hedging, taking account of longperiods when emerging market currencies do nothing and also capturing dramatic moves whenthey occur. They are cheaper and leave the corporation less exposed to an adverse exchangerate move. Furthermore, a CROP model can give the optimal hedging strategy using options
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or forwards for a given currency view and a given currency exposure. The way this works isas follows:
r Determine a possible exchange rate scenario over a specified time period, say six months.r Run a random distribution within the scenario specified.r Calculate the effective hedge rate for each hedging instrument used and the risk in localcurrency points.
r Solve to find the hedging strategy with the lowest possible effective hedge rate for variousaccepted levels of uncertainty.It should of course be noted that it is not possible to choose a single optimal hedging strategywithout defining the risk one is allowed or willing to take. In scenarios reflecting a perceptionof volatility or jump risk, options will always produce a better or similar effective hedge rate atlower uncertainty than the unhedged position. Where the local currency has a relatively highyield and low volatility, options will almost always produce a better effective hedging rate thanforward hedging.
7.11 HEDGING EMERGING MARKET CURRENCY RISKEmerging market currencies have important characteristics which a corporation needs to takeaccount of with specific regard to a currency hedging programme:
r Liquidity risk,r Convertibility risk,r Event risk,r Jump risk.r Discontinuous price action.r Implied volatility is a very poor guide to future spot price action.r In emerging market currency crises, the exchange rate weakens in at least two waves afteran event, with the maximum devaluation usually found in the first nine months (and thisperiod seems to be decreasing, that is the market “learns”).r Interest rates often peak just prior to such an event unless a new exchange rate regime hasbeen attempted or the spot move is really large.r Interest rates become an estimate of the size of the final event, making short-term interestrates the most volatile.r Whenever the implied emerging market volatility is below the implied vol of a major (i.e.when the Euro–zloty implied is below Euro–dollar) this has proven to be unsustainable inthe past and a very good level to buy.r Besides range trading, emerging market implied vol tends to fall only when the emergingmarket currency is strengthening.r Implied vol always increases on emerging market currency weakness.
7.12 BENCHMARKS FOR CURRENCY RISK MANAGEMENTCorporations can use a variety of hedging benchmarks to manage their hedging strategiesmore rigorously. Aside from the hedging level as the benchmark (e.g. 75%), corporationswhich want to limit fluctuation in net equity use the reporting period as the benchmark forforward hedging. Typically, US companies hedge quarterly whereas European corporations
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use 12-month benchmarks given different disclosure requirements. Accounting rules have amajor impact on what hedging benchmarks corporations use. Budget rates are also used todefine the benchmark hedging performance and tenor of a hedge, as these would generallymatch cash flow requirements.Using a benchmark enables the performance of an individual hedge to be measured againstthe standard set for the company as a whole, which should be set out within the currency riskmanagement policy.
7.13 BUDGET RATESThe setting of budget rates is crucially important for a corporation as it can drive not only thecorporation’s hedging but also its pricing strategy as well. Budget exchange rates can be set inseveral ways. The benchmark or budget rate for an investment in a foreign subsidiary shouldnormally be the exchange rate at the close of the previous fiscal period, often referred to asthe accounting rate. On the other hand, when dealing with forecasted cash flows, the issuebecomes more complex. Theoretically, the budget exchange rate should be derived from thedomestic sales price, which is the operating cost plus the desired profit margin, as an expressionof the foreign subsidiary sales price. Thus, if the parent sales price for a good is USD10 andthe Euro area sales price is EUR15, the budget rate should be 0.67. The actual exchange ratefor Euro–dollar may be some way away from that. Thus, the corporation needs to evaluate thedegree of demand for its product relative to changes in the product’s Euro price to see whetheror not it has leeway to cut its Euro price without also reducing margin substantially in order toset a budget rate that is closer to the spot exchange rate. If there is a major difference betweenthe spot and budget exchange rates, either the hedging or the pricing strategy may have to bereconsidered.Corporations can also set the budget rate so as to link in with their sales calendar and thustheir hedging strategy. If a corporation has a quarterly sales calendar it may want to hedge insuch a way that its foreign currency sales in one quarter is no less than that of the same quarterone year before, implying that it should make four hedges per year, each of one-year tenor.Alternatively, instead of hedging at the end of a period, thus using the end-of-period exchangerate as its budget rate, the corporation may choose to set a daily average rate as its budget rate.In this case, if the corporation chooses as its budget rate the daily average rate for the previousfiscal year, it only needs to execute one hedge. It stands to reason that the best way of achievingthis in the market place is to use an average-based instrument such as an option or a syntheticforward, entered into on the last day of the previous fiscal year, with its starting day being thefirst day of the new fiscal year. Of late, an option structure known as a double average rate option(DARO) has become increasingly popular among multinational corporations. This allows acorporation to protect the average value of a foreign currency cash flow over a specified timeperiod relative to another period. This is a simple way of passive currency hedging, taking outdiscretionary uncertainties and instead putting the hedging programme on auto pilot where itcan be more easily monitored.Whether a corporation hedges currency risk passively or actively, once the budget rate isset the Treasury is responsible for securing an appropriate hedge rate and ensuring there isminimal slippage relative to that hedge rate. Timing and the instruments used are key to beingable to achieve that. The last point to make on budget rates is that they flow naturally fromrelative price differentials. This however is also the heart of the concept of PPP, which statesthat exchange rates should adjust for relative price differentials of the same good between two
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countries. While PPP models are of relatively little use in forecasting short-term exchange ratemoves, they have a substantially better record in forecasting exchange rates over the long term.Thus, a corporation could do worse than setting the budget rate with a PPP model in mind,albeit with the realization that tactical hedging may be necessary either side of that budgetrate over the short term in order to capture exchange rate deviation from where PPP suggestsit should be. Finally, it is important to underline that budget rates can provide companieswith one thing only: a level of reference. Set up randomly, they are of very little use. And atsome point, prolonged currency moves against the functional currency must be passed on, orstrategic positioning and hedging must be addressed; in any case two topics well beyond ourbudget rates discussion. In the end, while the process of setting budget rates cannot resolve allof a corporation’s issues, it can be dramatically improved by clearly defining the company’ssensitivities and benchmarking priorities. The hedging frequency as well as the choice of thehedge instrument will naturally flow from this process.
7.14 THE CORPORATION AND PREDICTING EXCHANGE RATESA key aspect of corporate pricing strategy is forecasting future exchange rates. Aside fromusing banks to help them do this, the internal models corporations use are typically one ormore of the following kinds:
r Political event analysisr Fundamentalr Technical
For the reasons we have mentioned earlier in this chapter, it is not a good idea for corporationsto use the forward rate as a predictor of the future spot rate because of “forward rate bias” –the idea that the unbiased forward rate theory does not in fact work. Academics argue thatmarkets are efficient and therefore there is no point in corporations trying to “beat the market”by forecasting future exchange rates. This supposition is premised on a falsehood – marketsmay be efficient over the long term, but they are inherently inefficient over short time periods.The latter can be substantial enough to make a material impact on the corporation’s incomestatement were it to assume a perfectly efficient market and use unbiased forward rate theoryaccordingly.The importance of market-based forecasts for the corporation is derived from comparingthese to anticipated net cash flows. For the corporation, the crucial question is how will thesecash flows respond if the future spot exchange rate is not equal to the forecast? The nature of thiskind of forecast is completely different from trying to outguess the foreign exchange markets.
7.15 SUMMARYIn this chapter, we have taken a detailed look at some of the advanced approaches to corporatestrategy with regard to exchange rates. Managing currency risk is not a luxury but a necessityfor multinational corporations. That said, just realizing it is a necessity does not make thepractical reality of hedging any easier. The field of how corporations hedge specific typesof currency risk has become increasingly sophisticated in the last few years. The issue oftransaction risk hedging is merely the tip of the iceberg! Below the water line, translation andeconomic currency risk are real issues, which ultimately can affect the profitability and themarket’s valuation of the corporation. Boards ignore these issues at their peril.
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Having taken a look at the corporate world, we switch now to that of the institutionalinvestor. Just as with corporations, there is a reluctance within some investors to hedge ormanage currency risk and for the same reasons, not least that participating in the currencymarket is seen as being outside of the investor’s core competence. This may well be so, butthe reality is that the investor is a participant in the currency market whether they like it or not.Moreover, currency risk can make up a significant portion of the investor’s portfolio volatilityand return. It is to this world of the investor that we now turn.
ADDITIONAL SECTION FOR THE SECOND EDITIONIn Chapter 7, we examined some of the basics of managing currency risk for a corporation. Inthis additional section, we do so in more detail and look at the key issues on which corporationtreasuries are focused and the latest risk management strategies they are adopting.Hedge AccountingBefore dealing with specific risk management strategies for corporate treasury, we first haveto deal with one of the most pertinent and timely issues, which is hedge accounting. Overthe past few years, there have been several well-publicised instances of significant financiallosses incurred by corporations as a result of FX trading or hedging. This, together with thepreviously widespread use of off-balance sheet derivatives, appears to have encouraged theFinancial Accounting Standards Board (FASB) and the International Accounting StandardsBoard (IASB) to introduce hedge accounting regulations.There is a clear message behind this move: corporations should use financial derivativesfor the most part to hedge “natural” business exposures. These should not primarily be fortrading rather than hedging purposes. In addition to the message, there is a supposition that allderivatives should be treated as trading instruments unless they meet the requisite standards tobe treated as appropriate hedging instruments under the hedge accounting regulations. Finally,in addition to the message and the supposition, there is an aim: greater transparency in corporatehedging activity. Should hedging instruments not meet the requisite standards to receive hedgeaccounting treatment, they will have to be marked to market on a regular basis and that figurehas to be included in the income statement. Hedge accounting regulations have served as a clearwarning, both for corporate treasury and for corporate boards. Inappropriate hedging activitycan result in earnings – and thus share price – volatility. Not surprisingly, this warning hasresulted in a significant reappraisal of hedging strategies – and in the short term has frequentlyhas led to a sharp drop off in the use of derivatives ahead of regulation implementation.The two best-known and arguably the two most important examples of hedge accountingare probably FAS133 and IAS39. Not surprisingly, there are significant similarities betweenthe two, although it is important to point out that IAS39 is not just a more international versionof FAS133. Rather, the aim of the IAS regulations is to establish an international frameworkof accounting regulations to replace national standards such as FAS133.At its most basic, IAS39 is a regulation that creates clear guidelines for accounting forhedging derivatives and, when necessary, measuring their fair value. Derivative hedges mustbe marked to market and that figure is included in the P&L or income statement unless thosehedges meet the requisite standards of hedge accounting regulations and therefore receivehedge accounting treatment. If a corporation is unsure of receiving hedge accounting treatment, they consequently face the dilemma of potentially risking increased earnings volatilityor scrapping those hedges entirely. As a result of this kind of (unpleasant) dilemma, which
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corporate treasurers are increasingly faced with wherever hedge accounting has been implemented, a significant change in the hedging behaviour of corporate treasury has taken place.The reaction of corporate treasury to hedge accounting in general and, most recently, toIAS39 in particular can be broken down into three specific types: corporations who preparewell in advance and adopt the new regulations at an early stage; corporations who do somepreparation ahead of time, but for the most part wait to see what their competitors do becausethey do not want to be at a competitive disadvantage; and, finally, corporations who make nopreparation ahead of time and are thus technically non-compliant with the new regulations. Ifwe look at the implementation of IAS39 in Europe as a typical example of the trend, the usualreaction of corporate treasury to this rule is to curtail sharply the usage of financial derivativesahead of implementation until such time as they have a much better understanding of how tomeet hedge accounting treatment requirements. This results in a significant decline in the usageof financial derivatives by corporations. This kind of decline in the use of financial derivativesby corporations ahead of implementation of hedge accounting regulations has not only beenseen in Europe. It has also been seen to some extent in Australia and Hong Kong and it is alsobeing seen in Taiwan ahead of implementation of their IAS39 equivalent in SFAS34 (State ofFinancial Accounting Standard 34) in January 2006.Refraining from the use of such financial derivatives may have the short-term benefit ofmaking the issue of whether or not the corporation is meeting hedge accounting standardsredundant. However, it also has the cost of leaving the exposure less than optimally hedged inmany cases. Moreover, the issue of dealing with hedge accounting standards has to be dealtwith at some stage. The lesson of IAS39 is clear: better to do so early than late. In addition,just because hedge accounting regulations may potentially add to earnings volatility, this doesnot relieve corporate treasury from its primary duty of managing currency and interest raterisk. Were new regulations to be imposed on corporate debt, it would still not be acceptable forcorporate treasury to abandon its role of maintaining appropriate debt management for the corporation. The same must be the case with regard to currency and interest rate risk management.If hedges do not meet hedge accounting standards and therefore are not given hedge accounting treatment, they have to be marked to market and that figure has to be included in the P&Lor income statement. The result is a potential increase in the volatility of corporate earnings.However, it is important to point out that there is little evidence to suggest that such lack ofhedge accounting treatment leads to either a significant or a sustained increase in earningsvolatility. Comparing earnings volatility before and after the hedge may after all not be theappropriate comparison. The underlying exposure should also be taken into account. If thatis the case, the resulting volatility in earnings from not receiving hedge accounting treatmentand having to mark to market those hedges is significantly reduced.Under most hedge accounting regulations, including IAS39, hedges have to be tested for their“effectiveness” in covering natural business exposures. A key consideration in this regard isthat changes in market conditions and prices can potentially change the perceived effectivenessof a hedge. Hedging instruments therefore need to have embedded flexibility in order to retaintheir “effectiveness” despite changing market conditions. Seeking hedge accounting treatmentmust of necessity be the overriding aim of corporate treasury. It is this realization that has ledto a shift away from simply reducing the usage of financial derivatives towards developinga strategy for ensuring that whatever derivatives are used for hedging purposes meet hedgeaccounting regulations and therefore receive hedge accounting treatment. In those cases whenchanging market conditions significantly impact the “effectiveness” of derivative hedges – andtherefore risk not meeting hedge accounting standards – corporate treasury should considerwhether or not more vanilla hedges would be more appropriate. That said, there is always a
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trade-off to be considered between using more vanilla hedges and ensuring that the exposureis still appropriately covered. Ultimately, the corporation should have in place a clear strategyfor undertaking cost benefit analysis in each case, comparing the benefits of meeting hedgeaccounting standards with the potential costs of not doing so.In 2005, Europe, Hong Kong, Singapore and Australia have already gone through this process with regard to IAS39. As mentioned above, Taiwan is in the process of going through thisnow with the implementation approach of SFAS34 from January 2006. As a result, Taiwanesecorporations will be obliged to fair value and, when necessary, mark to market financial derivatives. Ahead of this, there has been a predictable decline in the usage of financial derivatives byTaiwanese corporations and a greater focus on more vanilla hedges. However, just as was thecase with FAS133 and IAS39, it seems highly likely that as Taiwanese corporations get usedto SFAS34 and refine their hedging strategies accordingly, they will gradually move back tousing derivative hedges on a case by case basis, with the focus on meeting hedge accountingstandards.Currency Hedging and the Budget RateWe looked at the issue of the budget rate rather briefly in the original version of this chapter.Here, we look at it in rather more detail and at a more sophisticated level. In theory, of course,an MNC’s budget exchange rate is its hedging benchmark for exchange rate, the minimumexchange rate required for a given anticipated exposure to secure a given product sales pricein local currency terms. Depending on the MNC’s hedging policy, the budget rate can becreated on the basis of exchange rate forecasts, currency forwards, currency spot rates or somecombination of the these with the MNC’s pricing strategy. Whatever the methodology, the keything to remember is that the budget rate is used to translate forecast foreign currency cashflows back into expected domestic earnings.Clearly, it is important for a corporation to have a clear and well-defined process for setting,managing and executing the budget rate. Among the key considerations in this regard are thefollowing:
r Establish a clear hedging strategy as part of the MNC’s core principles for managing exchange rate risk.
r Establish the budget rate strategy, defining the budget rate’s purpose to meet anticipateddomestic earnings.
r Forecast foreign currency cash flows for the fiscal year based on demand, pricing strategyand competition.
r Estimate price/demand elasticity for a series of exchange rate scenarios.r Link the budget rate setting process to hedging strategy and execution.r Run hedging scenario analysis to compare different kinds of hedging strategies for slippageto the budget rate and FX forecasts.
r The budget rate should be generated from the weighted average of exposures and hedges,which should mean zero annual slippage.The key requirements for currency hedging using the budget rate are:
r Minimized or zero slippage to the budget rater Hedging instrument flexibility to maximize potential upsider Hedging instrument flexibility to incorporate an average rate structure
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Such requirements appear to lend themselves to the use of options. More specifically, synthetic forwards or average rate options (AROs) have proved very popular with MNCs as theyprovide the required hedging cover – with varying constraints – while matching the averagerate nature of exposures. AROs can be structured according to period or weighting as required.Forecasting ErrorsClearly, the major driver of the budget rate is the original forecast. However, if that containserrors, the whole process may be flawed. In this section, we look at ways of seeking to minimizeerrors from the original forecast through the budget rate to the final hedging strategy.Going back to the section on hedge accounting, we remember that a key consideration in order to meet hedge accounting standards and receive hedge accounting treatment is that hedgeshave significant “effectiveness” in covering “natural” business exposures despite changingmarket conditions. In this regard, forecasting errors can result in potentially significant reductions in hedge “effectiveness”, which can in turn have implications on hedge accountingtreatment. The best way to minimize the resulting “ineffectiveness” is to match the hedginginstrument with the hedging exposure. However, this is not always practical. Here too, thetrade-offs must be weighed between “effective” hedging of exposures and how they are treatedfor hedge accounting purposes. Intuitively, we know that if the change in the fair value ofthe hedge is less than that of the exposure, the hedge is fully “effective” and should meethedge accounting standards. This can theoretically be achieved by having a derivative hedgeposition for less than the value of the underlying exposure. As a result, changes in the fairvalue of the first should logically be less than the second, thus meeting “effectiveness” criteria.However, this does not come without associated risks, notably that the underlying exposure isnow potentially insufficiently hedged.Effective hedges, which meet hedge accounting standards and thus receive hedge accountingtreatment, should therefore minimize forecasting error. The tenor of the hedges is a furtherimportant consideration. If a corporation has a large number of short-term hedges, it runs therisk of making more forecasting errors. In turn, the greater the number of forecasting errors, thegreater the risk that the hedges will be seen as “ineffective” and that hedge accounting treatmentwill be taken away from these. Increasing the tenor on the hedge may help to minimize this,say, from monthly to quarterly. Indeed, it makes sense to do forecasting, testing for hedgeeffectiveness and actual hedging all on a quarterly basis. Another way of reducing forecastingerror risk is progressive or incremental hedging via layers or tiers ahead of the maturity date.For instance, a corporation can start off with a relatively low hedge ratio of the whole exposureof around 20% and gradually increase it towards 100%, as confidence in the forecast increases,ahead of the maturity date.Forecasting error is an important consideration for corporate treasury and is closely linkedwith the issue of hedge accounting. As such, the two issues should be examined together andan appropriate policy towards these formulated within the overall hedging strategy.Currency Hedging and Bid-to-Award RiskCurrency risk may relate to expected cash flows (transaction risk), the impact of changesin net asset value of a subsidiary on the consolidated balance sheet (translation or balancesheet risk) or the impact of unexpected exchange rate moves on a corporation’s competitiveoperational exposure (economic risk). However, there is a fourth type of exchange rate risk
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relating to specific events such as the bidding for and the award of specific contracts, ormergers and acquisitions. This is typically called “bid-to-award” risk. It is interesting to notethat a relatively small proportion of MNCs hedge their bid-to-award risk. This may reflect arelative lack of knowledge of how to do so, or it may reflect the view by corporate treasurythat it is not it appropriate to hedge cash flows related to such uncertain events as contract bids.Whatever the case, corporate treasury would do well to consider hedging bid-to-award risk aspart of its overall hedging strategy and policy.In theory, the potential award of a contract represents a future cash flow, which should behedged. After all, even if the corporation wins the bid, the value of that contract in its owncurrency may have changed significantly from when the bid was first made and may, in turn,impact the value of winning the contract in the first place. It is this risk that should be minimizedvia hedging. In addition, just as some transaction risk hedges may have to be managed activelyand dynamically, the same may be true for bid-to-award risk hedges. All this is fine in theory;however, it has to be acknowledged that future cash flows from bid awards differ in two keyways from normal expected cash flows relating to transaction risk:
r They tend to be on an all or nothing basis.r It may not be known when the award will be made, which in turn significantly increases theuncertainty over the likely exchange rate at the time of the award.
Exchange rates can, as we know, fluctuate significantly between the time that a bid is madeand the award announced. As a result, an MNC may potentially be taking on significantexchange rate risk by making a bid for a contract that it subsequently does not hedge. If itsbid is accepted and it is awarded the contract, the MNC may potentially be faced with theprospect that adverse exchange rate moves have significantly reduced the expected cash flowin its own currency terms, in turn reducing the profitability to the MNC of the deal. On theother hand, if the MNC does hedge the bid, but its bid is not accepted and it does not winthe contract, it faces the unwelcome cost of unwinding the hedge – assuming, of course, thatcorporate treasury hedging policy is focused on risk reduction rather than profit generation.When an MNC establishes its hedging policy for transaction, translation and economic risk, itshould also include within this policy bid-to-award risk.The concept of value at risk (VaR) would seem particularly suited for considering theuncertainty aspect within bid-to-award risk. If we look at exchange rate risk in terms of VaR,we can then consider bid-to-award risk in terms of the probability of winning the bid. Corporatetreasury can then use quantitative techniques, either from in-house resources or from a bank’squantitative analysis department, such as historic scenario analysis, to examine previous casesof bids and awards and how hedging bid-to-award risk might have impacted the VaR of the bid.To do this, corporate treasury would compare the probability of winning the bid (at the time itwas made) with the bid’s resulting VaR from various hedging solutions. To start off, treasurycan use three simple solutions: un-hedged, 100% option hedged and 100% forward hedged.The results of these comparisons should yield a number of important conclusions. Firstly,hedging bid-to-award risk consistently reduces the VaR of an outstanding foreign currencybid. Indeed, we can say that the higher the probability of winning the bid, the greater the riskreduction by hedging. Optimal forward hedging can be created by adjusting the hedge ratio tothe probability of winning the bid. In turn, optimal option hedging can be created by adjustingthe premium cost of the option to the probability of winning the bid and the VaR from forwardhedging. Option hedging typically reduces the VaR of the bid more than forward for anythingother than 100% probability. It is important to point out that bid-to-award risk hedges may
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have to be managed dynamically and actively as the probability of winning the bid changes.A final consideration is that corporate treasury should incorporate bid-to-award risk hedgingwithin its overall policy as regards hedge accounting.Strategic HedgingAn MNC’s approach to transaction hedging within the overall hedging policy should focuson short-term transaction risk. However, there are times when corporations can and do takea longer-term, more strategic approach to transaction risk. In regard to this, MNC treasuriesshould consider currency valuation. More specifically, they should be aware of significantcurrency valuation misalignments in order to either take advantage or guard against these. Intheory, incorporating such awareness within an MNC’s overall hedging strategy and policycan potentially add significant value over time. In practice, however, the issue of currencyvaluation is far from simple – as we saw in Chapter 1. Before establishing a strategy to dealwith strategic hedging and currency valuation, there are three key issues to focus on. Firstly,corporate treasury needs to be clear on which currency valuation model or models they will beusing and why. Secondly, corporate treasury also has consider the types of hedges for which itmight use this currency valuation model – as in, for transaction risk, translation risk, economicrisk or bid-to-award risk? Finally, corporate treasury also has to define the process by which acurrency valuation misalignment might trigger changes in the appropriate hedging programmeor programmes. In short, there is a lot of work to be done if corporate treasury is to be able touse a currency valuation model for strategic hedging purposes!The first part of this is probably the most critical: deciding on what currency valuationmodel or models to use. Treasury should examine a number of different long-term equilibriumexchange rate models in order to get a better idea of how their definitions of “fair value” relateto the corporation’