Hedging Currency Exposures in a Multinational Corporation
ABSTRACT OF THE MASTER’S THESIS
Financial theory offers several rationales for financial risk management. Hedging enables firms to maintain their access to internal funds as well as reduces the costs of financial distress. The theoretical framework offers, however, few tools for currency risk identification and for choosing a proper hedging instrument. This Thesis seeks to help firms manage risks better by defining the currency risk exposures of a multinational corporation, by describing their effects on the cash flows, profit and loss and balance sheet of the corporation as well as by comparing the applicability of currency forwards and currency options in hedging these exposures. The exposure framework is constructed based on an extensive literature review of financial risk management articles. The effects of currency exposures on cash flows, profit and loss and balance sheet are modeled. The model further takes into account current accounting standards regarding derivatives. The model is applied on a stock-listed corporation by conducting a historical simulation of its EURUSD currency risk. The simulation makes it possible to study the effects of currency rate movements and the differences between hedging strategies. The exposures identified include currency risk in contracted as well as anticipated cash flows, in competitive environment, in foreign net assets and consolidated profits, in loans and investments as well as in loan covenants. The model shows that different exposures and, similarly, different hedging instruments, have differing effects. An important observation is that the most commonly used hedging instrument, a currency forward, performs optimally only in the case of one exposure – contracted cash flows. When hedging other exposures forward hedging creates challenges – for example it may tie large amounts of liquidity. Conversely, a purchased currency option performs satisfactorily throughout the study – it is never much worse than the forward
Financial theory offers several rationales for financial risk management. Hedging enables firms to maintain their access to internal funds as well as reduces the costs of financial distress. The theoretical framework offers, however, few tools for currency risk identification and for choosing a proper hedging instrument. This Thesis seeks to help firms manage risks better by defining the currency risk exposures of a multinational corporation, by describing their effects on the cash flows, profit and loss and balance sheet of the corporation as well as by comparing the applicability of currency forwards and currency options in hedging these exposures. The exposure framework is constructed based on an extensive literature review of financial risk management articles. The effects of currency exposures on cash flows, profit and loss and balance sheet are modeled. The model further takes into account current accounting standards regarding derivatives. The model is applied on a stock-listed corporation by conducting a historical simulation of its EURUSD currency risk. The simulation makes it possible to study the effects of currency rate movements and the differences between hedging strategies. The exposures identified include currency risk in contracted as well as anticipated cash flows, in competitive environment, in foreign net assets and consolidated profits, in loans and investments as well as in loan covenants. The model shows that different exposures and, similarly, different hedging instruments, have differing effects. An important observation is that the most commonly used hedging instrument, a currency forward, performs optimally only in the case of one exposure – contracted cash flows. When hedging other exposures forward hedging creates challenges – for example it may tie large amounts of liquidity. Conversely, a purchased currency option performs satisfactorily throughout the study – it is never much worse than the forward
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