ISSUES

Introduction

One issue faced by each of our clients is maintaining a reliable, predictable stream of earnings in its home currency — for example, euros, yen, British pounds, Australian dollars, Hong Kong dollars, or Brazilian reals. Since these currencies can fluctuate greatly in U.S.-dollar terms, hedging against such currency volatility is often advised.

Expectedly, a client's U.S. exports will generate revenue in U.S. dollars. Regardless of how quickly revenues are collected from American purchasers, and regardless of how quickly a client's bank converts the dollars into the client's home currency, the fluctuations can have unexpected results that can impact a client's cash flow and profitability. The likelihood of a positive impact is as high as a negative one, but most clients prefer not to bear such risks.

Necessity

If some or all of a client's U.S. dollars can be spent or invested in the United States, for purposes that may or may not be related to the venture that generated these dollar receipts, then little or no currency hedging will be needed. Naturally, if such expenditures or investments in the U.S. are projected to exceed the dollar receipts, then the client ought to hedge against an increase in the dollar; without doing so, the net conversion of the home currency into dollars could prove costly.

Meanwhile, clients exporting to the U.S. in low absolute volumes and whose businesses are not directly tied to any commodities will face only minimal exposure to U.S. dollar fluctuations, and will likely find that the transaction costs (commissions and administration) of an ideally structured currency hedge will be prohibitively high. Such clients, remaining exposed to dollar fluctuations, will take comfort in the dollar's relative stability.

Political, Military, and Economic Factors

This currency stability is owed in part to American political structure and military force. While crises could threaten these bulwarks, the currency would not be equally imperiled. Ironically, the dollar may gain value in a catastrophe; it has been and will continue to be seen as a safe haven, preferred by some even to gold for such purposes.

The dollar is also bolstered by a domestic economy that is not only the largest in the world (GDP of roughly $12.8 trillion in 2006) but also heavily diversified across industries. Furthermore, a continually gridlocked European fiscal policy and an anemic Japanese banking system make for weak rival currencies; the dollar's position as the preeminent currency remains, for the time being, unthreatened.

Recent Fluctuations

Notwithstanding this relative long-term stability of the U.S. dollar, fluctuations have taken place and will continue to do so.

At the start of each year, the dollar's value in euros has moved from 0.995€ in 2000, up to 1.062€ in 2001, and up again to 1.128€ in 2002. Then, after having plummeted to 0.953€ by the start of 2003, the greenback fell even further — reaching 0.794€ by the beginning of 2004 and 0.739€ by 2005. The dollar recovered slightly in 2005, rising to 0.844€ by the start of 2006.

Priced in British pounds, the dollar in 2000-2006 charts a similar up-and-down course: £0.619, £0.670, £0.688, £0.621, £0.560, £0.521, and £0.581.

Meanwhile, the dollar's value in yen, over the same period, has ranged from ¥102.1 in 2000, to ¥114.4 in 2001, to ¥131.7 in 2002, to ¥118.8 in 2003, and finally to ¥107.2 in 2004. The greenback fell further during 2004, dropping to ¥102.6 by the start of 2005, and climbing back to a multi-year high of ¥118.1 by the start of 2006.

Unlike with these currencies, 2002 saw the Brazilian real (R$) lose value even against a weakening U.S. dollar; from the start of 2000 through the start of 2003, the greenback moved from R$1.86 to R$1.95 to R$2.32 to R$3.54. However, as Brazil's economic reforms and its export-led economy firmed up the real, the dollar plunged to R$2.89 by the beginning of 2004, then to R$2.65 a year later, and finally down to R$2.34 by the start of 2006.

Commodities and the Dollar

Above and beyond any revenues generated from U.S. exports, any client that either produces or consumes significant commodities (petroleum, metals, agriculture, etc.) will encounter changes to its revenues or costs (thus its bottom line) whenever these commodities fluctuate. Most commodities, regardless of who trades them and where they trade, are quoted in U.S. dollars.

If a client needs to hedge against, say, copper volatility (perhaps the client is using copper, perhaps the client is mining it), the optimal basket of copper contracts will ultimately realize a gain or loss that will offset the impact of copper's price swings on the client's operating profit. With both the risk and the hedge priced in dollars, no currency risk will exist, so no currency hedge will be needed.

However, if, in the course of the client's business arrangements, the price of copper is agreed upon in the client's home currency, then the dollar-based copper hedges will fail to fully offset the potential impact on operating profits, and a hedge against dollar volatility — in addition to the hedge against copper volatility — will be needed.

Impact on Profitability and on Business Decisions

When the U.S. dollar weakens against a client's home currency (as it did with most of Europe and Asia in both 2002 and 2003), the home-currency value of U.S.-based receipts increases. This effectively reduces the client's home-currency earnings in two ways. First, U.S.-based sales that are already generated but either uncollected or simply not yet exchanged into the home currency will be repatriated at the less favorable exchange rate. And second, this new exchange rate will render future U.S. exports less competitive and thus less profitable, as the following example demonstrates.

Imagine a bottle of Bordeaux sold to an American wine distributor for $100, and assume, for ease of argument, an inflation rate of zero. At the start of 2002, the vineyard back in France would have generated roughly 113€ in revenue for this sale, whereas the same sale generated two years later would generate around 79€ — a 30% decline. Meanwhile, most of the costs of such a product (harvesting, processing, bottling), having taken place in Europe, would not enjoy the same decline.

If American consumers would readily substitute a domestic wine (or a product, such as Mexican tequila, whose home currency is at least as weakened as the dollar) for this French wine, then the relative decline of the dollar will make the export no longer worthwhile. If, on the other hand, absolutely no true substitute is demanded by American consumers — or if absolutely no true substitute can be supplied by producers at home or overseas — then the French wine will demand a proportionally higher price in dollar terms and no impact will be felt by the French vineyard.

In practice, however, the Bordeaux, a product with some degree of elasticity, will face neither a perfect substitute nor a perfect absence of one. The price of the exported Bordeaux wine, in dollar terms, will rise, albeit not as sharply as the dollar falls. Correspondingly, the volume of this exported Bordeaux will decline, albeit not to zero.

Accounting for the Effects of Currency Fluctuation

Hedging against currency fluctuations, if done at all, can never be done perfectly, and a profit or loss will result. Most accounting standards demand that this profit or loss, even before realized (i.e., converted into the home currency), be treated as a change to shareholders' (or partners') equity rather than as a change to current income.

However, if a client carries out its American business through a separate corporate entity that it owns, then this affiliate can keep its revenues and expenditures in dollars. The translation of dollar exposure (into the foreign-based currency of the parent company) is simply deferred until the affiliate, presumably for the sake of distributing its profits to the parent company, actually converts its dollar holdings into the parent company's currency.