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The lost art of hedging

Even as the euro clips earnings, U.S. companies question whether they should hedge their exposures.

Even as the euro clips earnings, U.S. companies question whether they should hedge their exposures.

By Scott McMurray
December 2000
Institutional Investor Magazine

July 20 was a happy day at Baxter International headquarters in suburban Chicago. Buoyed by strong sales of intravenous and renal care products, CEO Harry Jansen Kraemer announced better-than-expected second-quarter earnings and confidently predicted that the global medical products and services company not only would meet its sales and earnings targets for the year but also that, in 2001, thanks to continued strong sales, it "would grow earnings in the mid-teens."

Barely three months later, when Baxter released its third-quarter figures, a chastened Jansen Kraemer had a less optimistic story to tell. Year 2000 earnings were still on track, but the company was scaling back its growth target for 2001 to the low double digits, estimating that projected operating earnings would dip by $100 million, or about 7 percent. Oops. Stockholders took the news hard, driving share prices down by $10.37 and trimming $3.1 billion, or 12 percent, off Baxter,s market capitalization within hours.

The main culprit, Jansen Kraemer explained, was the continued weakness of the euro; at 83 cents to the dollar, it was off 10 percent since the summer. And Baxter, which generates about $2 billion, or 27 percent of total sales, in Europe, had plenty of company among U.S. multinationals. One blue chip after another , from Compaq Computer Corp., Intel Corp. and Microsoft Corp. to Caterpillar, Delphi Automotive Systems, Dow Chemical Co., DuPont Co., Eastman Kodak Co., Gillette Co., Lexmark International Group, McDonalds Corp., Procter & Gamble Co. and TRW , all blamed the weak euro for setbacks in their most recent quarterly results. Many say that the euro, which has lost about 30 percent of its value since its introduction 23 months ago, may continue to depress results for at least the next quarter or two (see graph).



Coupled with signs of slowing U.S. economic growth that are softening earnings, the euro weakness packed a wallop. Overall, Merrill Lynch & Co. chief economist Bruce Steinberg calculates, the decline in the euro cut Standard & Poor's 500 companies, operating profits by at least 3 percent in the third quarter. "That compares to a negligible impact of 0 to 1 percent a year over the previous two years," he says.

"The euro is one of the biggest risk factors confronting corporate America," says veteran risk management strategist Kelsey Biggers, president of New York,based Measurisk.com.

Certainly, the parade of corporate euro victims raises an immediate question. What happened to companies, reducing their exposure to foreign currency transactions through active hedging programs? After all, isn,t this the era of souped-up financial engineering, when the likelihood of damage from everything ranging from hurricanes to earthquakes can be modeled and hedged, with the risk laid off on someone else?

The answer isn,t a simple one. Most companies continue to hedge, and some were therefore spared even greater damage from their exposure to the volatile new currency. But in fact, a growing number of companies intentionally limit hedging or don,t hedge at all. Derivatives markets may be thriving as never before, and risk-control tools abound, but hedging remains an art, not a science. And not everyone agrees that it makes sense to practice the art in the first place. Dissenters argue that hedging is an unnecessary expense in a global economy where, over time, currency fluctuations tend to offset each other. McDonald,s, for instance, has taken to reporting quarterly results in "constant currencies" alongside its actual results. This lets investors view its progress excluding the effect of currency translation. McDonald's reported that third-quarter diluted net income of $548.5 million, or 41 cents a share, increased 5 percent, but, ignoring foreign currency translation effects, the results marked a 10 percent increase in "constant currencies."

Still, even treasurers and CFOs inclined to hedge have gotten clipped by the euro. Every company's story is different, of course, but several factors contributed to the third quarter's euro wreck. The increased cost of hedging as the euro lost value prompted a number of companies to reduce their activity. Other companies pulled back as they weighed the impact of Financial Accounting Standard No. 133, which for most of them takes effect January 1, 2001. The rule will require these businesses to mark their hedging transactions to market and reflect them on their balance sheets. Microsoft adopted the rules in its first quarter of fiscal 2001, ended September 30. The result: a $375 million aftertax charge to net income.

Many companies began actively hedging much of their euro exposure when the currency was launched in January 1999, using derivatives such as options and forward contracts. They also hedged their exposure "naturally" by manufacturing in the 11-country euro zone those products to be sold in euros. But as the euro dropped in value, hedging programs grew increasingly expensive; heightened volatility sent the cost of options and forward contracts skyrocketing. As the euro slide accelerated this fall, companies chose to trim their activities rather than pay the up-front cost. In essence, they chose to bet that the currency couldn,t possibly go much lower. Their hit to earnings depended on when they placed that bet.

Consider what happened to Baxter. The company has long been among the more active corporate hedgers against currency fluctuations. But at some point , the company won,t say exactly when , as the euro plunged from about 95 cents to below 85 cents to the dollar, Baxter threw in the towel on hedging all but a small amount of its euro exposure into 2001.

"We efficiently managed the euro's decline through most of 2000, but you reach a point where economically it doesn,t make sense," says Baxter treasurer Steven Meyer. That point carries real consequences: Baxter will try to offset $60 million of the anticipated $100 million drop in its top line by cutting costs and sourcing more products in the euro zone. But it decided it couldn,t offset the remaining $40 million without cutting expenses such as R&D that are crucial to future growth.

Should the euro rebound next year, the unhedged Baxter would benefit nicely. And although that's not a game corporate financial executives generally want to play, many are doing so. "A lot of companies are hedged in the euro through 2000," says Lynn Corsetti, head of corporate foreign exchange sales in the Americas for Deutsche Banc Alex. Brown. "Depending on the industry, only about 50 percent are hedged through midyear 2001. The volatility in the euro caught some people off guard."

The soaring volatility in the options market was the main factor that caused Baxter to pull back from its hedging program. "With the euro at 83 to 84 cents, volatility is in the 17 to 18 percent range," says Meyer. In a typical hedging program for Baxter, volatility runs in the 9 to 10 percent range , or at the outside, "maybe 12 percent."

"With twice the volatility, the cost of hedging is double to triple what it normally is , we,re literally talking tens of millions of dollars," Meyer says. That additional premium effectively reduced the exchange rate to the mid-70s. Meyer, with a view that the euro was finally near a bottom, chose to unwind rather than pay the exorbitant hedging costs. "We believe that the euro could go down some. But a year from now we don,t think we,re going to be below 75 cents to the euro," he says.

Where the euro will be in a year , or even a month , is anyone's guess. Capital is still flowing swiftly from Europe to the U.S., lifting the dollar. On the other hand, a softening U.S. economy could give the euro a boost, and the European Central Bank, which recently has intervened three times in the markets, seems determined to prop up the faltering currency.

Should companies try to prognosticate at all? Certainly, they have to plan. TRW, a leading supplier to the automotive and aerospace industries, says that Europe accounts for 46 percent of its sales. It had planned in late 1999 for a euro averaging $1.08 in 2000, or roughly flat with 1999, and a British pound at about 1999's average of $1.62, a spokesman says. Instead, for the first ten months of 2000, the euro averaged closer to 92 cents and the pound $1.50, costing TRW about 30 cents a share in profit for the first nine months of 2000, or $38 million. Overall net income for the nine months was $441 million, or $3.52 a share on $13 billion in sales.

TRW doesn,t hedge this "translation" risk, since it doesn,t have an impact on cash flow, the spokesman says. But the company does actively hedge its "transaction" risk, mainly involving its aeronautics parts business in the U.K. International aeronautics contracts are typically denominated in dollars and are often for ten-year durations. But most of the unit,s parts and labor costs are booked in pounds. So TRW hedges its sterling exposure in the forward market. The company wouldn,t comment on the specifics of its hedging program, but its 10-Q filing with the Securities and Exchange Commission for the first nine months of 2000 notes that it had $45 million in unrealized losses on foreign currency hedges and $70 million "related to unrealized foreign exchange losses on hedges of anticipated transactions."

The irony is that business for TRW is booming , especially in Europe. TRW president David Cote quipped at a meeting with reporters on the eve of the Paris auto show in early October that "if I could report in euros, we would be having a bang-up year."

Inside many companies there's a healthy and growing debate about the value of hedging. A financial officer of a major software company in Silicon Valley says that it also had pulled back from actively hedging its euro exposure this fall, as an internal faction argued that it was too expensive to justify the rising cost. But the pro-hedging group, including this executive, who asked to remain unnamed, made the case for hedging again even though the euro had fallen so far. "We,ll be laying in hedges; it,ll be rocky, but it's the right thing to do," the officer says.

Some executives may arrive at the decision not to hedge by questioning the value of such activity on principle. But many appear to have stopped merely on an assumption that the euro couldn,t possibly fall any lower. That's a risky posture at any time, but it,s particularly dangerous with such a fledgling currency as the euro. "There's nothing historic about 22 months, worth of trading data," points out Paul Podolsky, chief currency strategist at FleetBoston Financial Corp.

To get a sense of how far the euro could potentially fall, Podolsky says he created a "synthetic" euro based on historical prices for the individual currencies that were combined to create the currency. He then calculated where this synthetic euro would have been trading in 1985, just before central banks agreed in the Plaza Accords to drive down the dollar's value. At the time, the dollar bought 3.5 deutsche marks. Podolsky found that if the euro had been in existence, it would have traded at a mere 56 cents to the dollar , quite a fall from its low of 83 in late October 2000.

Podolsky, a longtime euro bear, doesn,t say that the currency is headed toward the half-dollar neighborhood based on any trends he can ascertain. But, he cautions, "the risk of a weaker euro shouldn,t be ignored."

Action by the ECB on November 3 briefly pushed the euro up to about 88 cents, but by the middle of the month it was back to 85. If the value were to break below 82, Podolsky argues, then the next technical support level for the currency would be 74. Measurisk.com's Biggers says that with the euro in the mid-80s, his models indicate that corporations would need to hedge against the possibility of a fall to the mid-70s.

FAS No. 133 will only add confusion to the hedging debate. Any financial officer who doubts that the new accounting rule will have a big impact on corporate America has only to look at Microsoft's $375 million aftertax charge in the third quarter. To be sure, trying to calculate what the impact will be on another company is next to impossible in light of the different ways that companies structure hedges. As Microsoft said in its earnings release, the rule "requires that all derivatives be recognized as either assets or liabilities measured at fair value. The accounting for changes in the fair value of a derivative depends on the use of the derivative."

A lot of corporate hair is being pulled out as a result. As the company official says: "This is going to introduce a tremendous amount of volatility to corporate balance sheets. You might have to mark to market the entire option premium paid one quarter and then back it out the next, depending on volatility."

Further clouding the impact of FAS No. 133 is the fact that companies can apply the costs of hedging to any of a number of lines on their income statements. Says the software company executive: "We even hear that some people are booking hedging costs to cost of goods sold. That's very strange."

DuPont is among the global giants apparently putting a damper on hedging activities as it figures out how to cope with the accounting regulation. Through a spokesman, DuPont treasurer Susan Stalnecker says, "We are in the process of evaluating how to respond to FAS No. 133." While the chemicals company wasn,t willing to quantify its hedging activities, the spokesman noted that DuPont actively hedges its exposure to energy, foreign currency and other markets.

An easier alternative to figuring out how to deal with FAS No. 133 might be to not hedge at all. And rising productivity appears to lessen the need for hedging. Greg Mount, senior international economist for Bank One Corp., notes that the impact of the falling euro in the third quarter has been partially offset by productivity gains on the part of U.S. exporters, driven by increased use of technology and more efficient manufacturing and distribution processes. In the third quarter, U.S. export industry productivity jumped 9.2 percent from a year earlier , well above the 2 to 4 percent gains registered through much of the 1990s and nearly offsetting September's 10 percent plunge in the euro versus the dollar.

For U.S. industry as a whole, productivity in the third quarter increased a more moderate 4.8 percent. "The widespread productivity gains are one of the main reasons the surging dollar hasn,t wreaked havoc on the U.S. export industry the way it did in the early 1980s," Mount adds.

The rising tide of U.S. productivity hasn,t gone unnoticed across the pond, he notes. "Nearly two thirds of the U.S. current-account deficit is financed by European companies and individuals investing in American companies," Mount says. "They,re trading in their euros to buy dollars and invest them in the U.S. They are investing in or buying companies that for the most part are driving productivity increases in the U.S."

Even though he thinks that many U.S. corporate finance officers overlook the impact of productivity gains when gauging their exposure to foreign currency swings, Mount doesn,t advocate doing away with forex hedging altogether. "If you,re running an S&P 500 company, you want to hedge at least partially against exchange rate volatility," he says. "That's especially true if your U.S. export competition is more productive than you are."

Baxter's Meyer says that if the euro were to return to the mid-90s and volatility were back under control, then the company would be likely to resume actively hedging its exposure to the currency. But he concedes that he hasn,t come to this conclusion from hours of number-crunching. "There's a little art, a little science involved here," he adds.



Hedging your best



For companies trying to decide whether to continue to hedge their euro exposure in volatile markets, Paul Podolsky, chief currency strategist at FleetBoston Financial Corp., offers this piece of advice: "Not hedging is taking a market position." The question corporate officers ought to be asking, he says, is, What structure do you put in place to stop the pain and to benefit from a rebounding euro?

He recommends structured options that are funded by selling off sections of volatility, much the way a traditional "collar" options trade is structured. "You trade a portion of the upside from an appreciating euro in return for downside protection," he says. Using a hypothetical "forward extra" with the euro at 83.5, for instance, a company could buy protection below 78 cents and keep the benefit up to 90 cents. It would give up the benefit over 90 cents to the options-writing institution. "The higher the options volatility costs, the more beneficial the selling off of upside protection," he adds.

Lynn Corsetti, head of corporate foreign exchange sales in the Americas for Deutsche Banc Alex. Brown, recommends a structured options product known as a "seagull." A company buys an out-of-the-money euro put and sells an out-of-the-money euro call. To protect against the risk of the call position, the company would buy an even further out-of-the-money call.

Many companies are looking at such structured, or multilegged, options to satisfying the demands of the new Financial Accounting Standard No. 133. Says Corsetti: "Under 133 you can mitigate high [options] volatility with combination and structured options. They can be used as long as there is a net premium paid. Most multinationals must consider the economic as well as the accounting impact of their foreign exchange risk management program on the company's underlying business."

Measurisk.com analyst Yitzi Stern says that U.S. multinationals shouldn,t overlook plain-vanilla strategies such as put spreads. A company could go long an at-the-money euro put,U.S. dollar call combination and hedge a E1 million ($850,000) exposure for a cost of about $39,000. It could then short a euro put,U.S. dollar call combo at a strike price of about 75 cents, with proceeds of $8,000. The total cost of the transaction: about $31,000. Essentially, the company is going long the euro at 75 cents with this trade. Measurisk says its risk models indicate with 90 percent confidence that over the course of the next year, the euro will remain above 75 cents some 90 percent of the time.

Podolsky reasons that as many U.S. companies generate an increasing share of their revenues abroad in an environment of stiff competition, they will become increasingly more likely to adopt such hedging strategies.

"European treasurers have grown up in the context of international trade. They are much more comfortable managing risk," he says. Too often the typical American approach to hedging foreign exchange exposure encourages excess caution. "The way a lot of U.S. treasurers, departments work is that if you make money on forex, you get a pat on the back. If you lose money, you may lose your job," he says.