Topic: Risk Management

Subject: "Hedging is too expensive"
Didier Louvet
Member: 2014
Posts:2
Submitted on 01-27-15 9:53 pm
Message:
So said the CFO of a global, US based corporation (with its European HQ in Switzerland), when asked why the company was not hedging its foreign exchange exposure. That, of course, was before the the second half of 2014 - when the euro dropped 20% against the dollar and 25% against the swiss franc.

Recent volatility in the FX markets should encourage us to revisit common wisdom about hedging.

Common wisdom: Hedging is speculation. Truth: Not hedging is as speculative as hedging. The above CFO made a bet that the euro would stay strong, and lost. "Hedging" when used correctly provides important benefits in the form of short term insurance and visibility. To avoid risk of speculation, senior management should proactively assess and discuss its foreign exchange exposure, and take (or not take) appropriate mitigating actions based on thorough analysis.

Common wisdom: Hedging is expensive. Truth: Hedging through forwards or swaps is free, because you are getting rid of your downside risk by giving up your upside potential. Hedging by purchasing options is equivalent to buying insurance. In a relatively efficient market, option pricing should mirror the market's perception of the risk being hedged, and can generally be considered as "fair".

Common wisdom: Hedging is unnecessary because asset prices move up and down around their "fair value". Truth: some assets never come back to their "fair value". And even if they do, the resulting volatility of reported results is a problem for common shareholders looking for steady performance. Hedging to reduce volatility of results is a source of real value to the common shareholder, who does not always have the will or the means to consider results "net of FX impact".

Bottom line : In today's world, most large companies are exposed to foreign exchange risks. Hedging, as a tool to manage such risks, cannot be subject to definitive statements such as "it's too expensive". On the contrary, it should serve as a catalyst to understand the company's various FX exposures. How does your company measure and mitigate its FX risk ?

Didier Louvet, NYC, 01/27/2014
 
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