Handling the Risky Dollar

Exporters and Importers Need to Formulate Hedging Strategies

By John Schweizer

The value of the U.S. dollar concluded 2004 at annualized lows relative to numerous foreign currencies. 

Reflecting back on the year it seemed as though the dollar was under constant pressure.  In reality the main decline of the currency occurred in the last quarter, reversing strength witnessed during the first half of the year. 

As an example, from January to December 2004, the decline in the dollar versus the euro was slightly more than 7 percent.  From May to December 2004, the dollar gave up approximately 13.5 percent.  During the first half of 2004, the dollar found some support or traded in tight ranges off the back of a slowly improving economy and expectation of Federal Reserve action to increase interest rates from historic lows.  The later half of the year saw the dollar give up value more rapidly as the U.S. recovery was put into question as oil prices surged.  The dollar was unable to regain value by year end as the markets began to focus on structural and diversification concerns.

Keeping The Pressure On

The fundamental concerns which have been affecting the dollar and are expected to continue can be broken down into a few key areas.

Asian central banks portfolios of foreign assets have been switching reserves into euro fixed income securities and reduced support for U.S. Treasuries.  This trend stems from central bank diversification away from large scale U.S. asset holding and in response to U.S. opposition to significant intervention in the currency markets to support the dollar.  There have also been recent shifts in U.S. dollar deposits held in the OPEC countries out of dollars and into the euro and other currencies.

Foreign Direct Investment flows into the U.S. are not increasing because production costs are higher here than in Asia, Eastern and Central Europe.  With manufacturing costs considerably lower in those regions, particularly in China, and what has been an ever increasing demand for finished goods by U.S. consumers, investment flows to the lower cost producers will probably continue.  The purchase of those finished goods has increased U.S. debt, which in turn has been purchased by Asian central banks to keep their currencies pegged. 

Expectations are for a revaluation of the Chinese yuan by mid-2005 which could adjust for cost imbalances.  However, it is speculated the revaluation will probably adjust the currency peg towards a basket weighting of the currency, diversifying the weighting away from the dollar into greater positions of Japanese yen and euros, which in turn will keep pressure on the dollar.

The U.S. goods and services trade gap continues to increase as U.S. growth is still import-oriented and economists suggest there is little room for a smaller deficit over the next year.  It is estimated the trade gap will trend at an average of $53 billion per month in the year ahead.  A narrower gap is required to help the dollar.  The trade imbalance with Asia has typically been the largest and without continued funding of the deficit through Asian central bank purchases of U.S. Treasury instruments, the dollar is likely to continue to weaken.

U.S. interest rate hikes are expected to continue into 2005.  This action in 2004 by the Federal Reserve, increasing the federal funds rate from 1 to 2.25 percent, should create a yield attraction into dollars and away from euros and yen, although this has yet to have a significant effect on the dollar value.  Should flows into U.S. Treasuries on the back of higher rates show a reduction or at least stabilization in the deficit, the dollar may regain value in the near term.  However, there are prospects for higher European rates in the later half of 2005 which would limit dollar gains.

Managing the Risks

Many companies have already or are in the process of hedged dollar positions for 2005; however most are not likely to be fully hedged, which implies that there will be more corporate hedge selling of the dollar.  This activity will probably keep pressure on the dollar as more hedges are entered into.

The weaker dollar has presented exporters with the opportunity to sell goods more competitively against the low-cost producers in Asia and Eastern Europe or retain increased margins.  Conversely, importers have struggled with the increased cost of purchasing goods or services overseas.  While recent policies and practices outlined earlier may be to the benefit of the exporter, it is clear that the U.S. economy retains an import bias.  It is important for both exporters and importers to assess the risks associated with foreign exchange and take steps to formulate an effective strategy or hedge to lock in favorable gains or protect against loss or the possibility of a loss.

It is important for companies with currency exposures to formulate a foreign exchange strategy.  In doing so, it is important to understand why hedging can be effective.  By not hedging, risks are probably ignored or not recognized.  Doing nothing can be seen as making a decision or speculating, as it provides no certainty.  Hedging is done to reduce speculation and volatility by minimizing the impact of adverse currency movements.  By doing so a company’s value may increase through improved cash flow, which improves the budgeting process.

There are a number of steps a company should take to formulate a hedging strategy.

Identify the exposure by determining what kind of currency risk exists.  Transactional risk exists when one currency is exchanged for another and translational or balance sheet risk exists when assets, liabilities and cash flows of one currency are converted to another for reporting purposes.

Formulate a reliable determination of the volumes of currency exposure, when they occur and how the flows of currency may be netted. 

Understand the effect of a change in the exchange rate to the bottom line.  Remember the purpose of hedging is to create a level of predictability by reducing variations in performance created by exchange rate fluctuations and to protect gross margin.

A risk management policy accepted by the company management should outline an acceptable budget rate.  In doing so the company should budget an average exchange rate based on expected cash flows allowing for differences. 

Assume that 100 percent of the activity will not be hedged and determine how much risk tolerance there is for unhedged activity.  Determine who within the company will manage the hedging strategy and how much time and expertise will be devoted.  This individual or group will probably develop a market view which in conjunction with the flows and tolerances will determine what hedging products are best suited to the exposure.

Finally, understand the hedging products that are available, and how they work, in order to create the most appropriate solution based on flows and risk tolerance.  Different products create different opportunities and it is important to understand the associated costs and benefits.  The market can provide numerous solutions from simple outright rate of a forward contract to more complex option contracts which affect the rate you deal at under a variety of spot outcomes.  After solutions are implemented the strategy should be continually reviewed, revisited and revised based on market changes or new information, maximizing the effectiveness of the hedge.  Using the advice, products and services of a bank’s foreign exchange advisor is an effective method of developing a beneficial strategy.

John Schweizer, a vice president at Banknorth International Banking, is responsible for the sale of foreign exchange and international payment products with a focus on assisting corporate and small business clients develop foreign exchange risk management solutions to help reduce the impact of adverse currency movements.