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Hedging and Invoicing Strategies to Reduce Foreign Exchange Risk

Introduction

The media has continued to voice concerns about the impact of the increased exchange rate of the euro to the US dollar on euro-area exports. The exchange rates of the euro to the US dollar in 2007 was said to be the highest. According to Dohring (2008), such a high exchange rate makes firms realize unexpected losses. In the recent years, the euro-area reports have held up in a positive manner into the euro appreciation. Furthermore, the fluctuations in the euro may not be avoided due to the intensity of the global trade. When the invoicing of exports is done in domestic currency, the exchange rate risk is not borne by the exporter but the importer. Dohring (2008) argues that it is vital to know the conditions under which it is possible to have such a shifting of the risk and optimal for the firm that is exporting. Hedging can also be done through the operational set-up of the firm that is being involved in exportation. In the current world, the standard tools for hedging risks that are related to interest rates, exchange rates, or commodity prices are financial derivatives. This paper takes a microeconomic approach, but it is worth noting that there are some macroeconomic consequences of hedging and invoicing strategies by firms.

The impact of exchange rate risk on exporting firms

According to Dohring (2008), the exchange rate risks are categorized into three, namely transaction risk, economic risk, and translation risk. Usually, the time frame for transactions that are committed is relatively short. According to Dohring (2008), the economic risks is the impact of the movements of the exchange rate on the present value of future cash flows that are definitely uncertain. The translation risks is the impact of the changes in the exchange rates and they affect the balance sheet of companies.  

Exchange rate risk is also faced by importing firms (Dohring, 2008). Transaction risk may arise from imports that are dominated by foreign currencies, like the case for exports that are dominated by foreign currencies.  According to Dohring (2008), an importing firm is subjected to an economic risk that concerns the variation of its costs, which are induced by the fluctuations in the exchange rates. In practice, most multinational firms act as both importers and exporters of different produce at the same time. Dohring (2008) argues that translation risk may thus arise from the holding of foreign assets irrespective of whether there is importation or exportation.

The impact of exchange rate risks can be found from the various studies that has been done in the past. A certain study of 817 multinational firms that deal in euro was used to estimate the impact of the exchange rate variations in the company’s stock market returns. This sample was used to estimate the exposure of these multinational firms to the variability of exchange rates. In this study, it was noted that most of the companies are exposed to the GDP exchange rate significantly. The exposure of a firm, however, is dependent on whether the firm is a net importer or the firm is a net exporter. Moreover, the exposure of a firm increases over a time horizon that is being considered. According to Dohring (2008), the short-term exposures of firms are seen to be more hedged effectively than exposures that are long term. Companies that are in Germany, France, and the Netherlands is exposed significantly than companies that are in other parts of the world.

Instruments to reduce the exposure to exchange rate risks

According to Dohring (2008), there are several instruments that can be used to reduce the exposure to the exchange rate risks. The exporter does not have a strong interest when the domestic currency is invoiced due to the fact that both the market structures and the economic risks are taken into consideration.

Traditionally, the experts have preferred to trade with countries with similar monetary stability and impose his currency to enjoy the benefit from the first mover advantage. The other theoretical method of euro invoicing is the exporter model and the equilibrium models that are mostly applied to the invoicing currency. In these models, the sticky prices are some of the key features that help to avoid the economic risks (Dohring, 2008).

Hedge design is also another instrument that can be used to reduce the exposure to the exchange rate risks. According to Dohring (2008), most of the hedge designs are linked to the operational and the financial hedges. Operational hedges entail the diversification across the operational expenditure and the matching revenues. Due to the uncertainty linked with the cash flows, the hedging for the long term may be challenging. On the other hand, under-hedging indicates that some underlying cash flows may not be covered. The hedging strategies are not that 100% effective since even the perfect derivative hedges can result in some losses. The derivative instruments used in reducing the exposure to exchange rate risks entails the forwards and the futures, options, and swaps.

According to Dohring (2008), there exists a relationship between hedging and invoicing. The relationship exists since the domestic currency invoicing allows for the elimination of various transactional risks in a similar manner to the exchange rate forward. In this regard, the invoicing acts as a substitute of derivative hedging.

Evidence on firms’ strategies

The role of the euro as an invoicing currency increased tremendously in the early years. Almost one-half of the euro area exporters are done by the euro as the dominant invoicing currency. For the exports outside the EU, the U.S dollar plays an import role as the invoicing currency. Interestingly, less is known concerning the hedging strategies of the European companies since most research focus on the American companies. The microeconomics literature provides little knowledge on the effects. The microeconomic literature evidences that exchange rate volatility has little or no impact on the trades for the countries where the hedging instruments are available. Most of the firms studied were found to use a mixture of options, forwards, and swaps. However, Dohring (2008) believes that the dominantly used derivative tool was the exchange rate forwards as companies use them to hedge the future cash flows that are subjected to high risks.  Most firms tend to use the exchange rate options on an occasional basis, especially for estimate future cash flows that are hedge uncertain. Finally, the swaps majorly used for hedging longer term regular transactions such as cash arising from debt financing.

Conclusion

It is beneficial for companies to be 100% hedged to enable them to reduce the risk of foreign exchange variations and to increase the profitability of their cash flows. However, my view is that companies need not to speculate on the foreign exchange variations and should concentrate on their core business. First, there are high risks involved in the currency speculations and the companies may lose in the course of the business. On the other hand, it is evident that the hedging strategies are not that 100% effective since even the perfect derivative hedges can result in some losses. Therefore, it would be better to maximize their core mandate and make profits from their normal business operations. Actually, there is a very big difference in speculations and concentrating on the core business objective of the company. By concentrating on the company objectives, the company will be investing in its long term benefit as opposed to short term benefits. Besides, currency speculation is more of a short term affair than a long term business. The company may benefit from speculation, but the risks involved are very high compared to concentrating on the business mandate. It is evident that no hedging strategy works for the long term basis. Due to the uncertainty linked with the cash flows, the hedging for the long term may be challenging. Whereas the profit gain from long term strategies may be low, they will eventually increase with time. Therefore, my opinion is for the companies to build a diversified and more stable business program that would reduce the possible risks associated with their line of business.

Bibliography

Dohring, B. (2008). Hedging and invoicing strategies to reduce exchange rate exposure: a euroca-area perspective. Economic Paper 229. Available from http://ec.europa.eu/economy_finance/publications [Accessed 02/12/2016]

RELATED: Interest Rate, Liquidity, and Operational Risks

 

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