Following my last article on Foreign Exchange Exposure, I want to detail how to use Natural Hedges to protect a business from currency fluctuations. As previously mentioned I do not favor using financial instruments to hedge companies against foreign exchange exposure. There is a place for those types of hedging instruments in certain circumstances in the financial industry, for example, but they are also expensive to purchase so it needs to be justified.
I was reading an article on the internet recently and the author spoke about using financial instruments to hedge against translation exposure. Translation exposure? Why would you want to hedge against translation exposure when it is not real and just part of a reporting exercise! I can understand hedging against transaction exposure but not translation exposure (see my previous article on Foreign Exchange Exposure for these definitions).
Regardless, there may be other ways to solve this issue by using natural hedges. A natural hedge involving foreign currencies is defined as matching foreign currency revenues with foreign currency expenses thus eliminating most exchange rate risk (transaction risk). I was once involved with a company that manufactured in several Asian countries. They sold their products to purchasers primarily in the US and they were pricing those products in the currency of origin country (Philippine Pesos, Malaysian Ringgits, Thai Baht, etc.) because that was the way their Accounting department recorded the revenue. The currencies in those countries were fluctuating constantly against the US Dollar and the company was always faced with transaction exposure. In order to protect against foreign currency exposure I proposed that they change their pricing contracts to USD for the buyers in the US. The company only needed to price enough revenue in local currency to cover the local costs in those countries. Just because their Accounting department had a practice of recording revenue in local currency doesn’t mean they had to price their contracts in the same currency.
The company changed its pricing contracts to USD and were able to naturally hedge their exposure by balancing USD-based contracts with USD expenses (R&D, logistics, corporate offices, IT systems, etc.). Also, the buyers in the US liked this idea because it locked them into stable USD pricing against their USD budgets. In the end it was a win-win for everybody, and that is how you can naturally hedge your business using pricing techniques without purchasing currency swaps or other financial instruments. The only people who lost out were the financial brokers!
Lastly, I want to talk about cash flows. As many of you may know, the Income Statements (P&Ls) and Cash Flow Statements can be very different especially when buyers and sellers are in different countries. Sales are often recorded in the country of origin but cash flows are received in the country of payor. It is very possible that a company may record $10 million in sales in Country A but only receive $2 million in cash flow in the same country. The other $8 million may be received in Country B from the purchasers. Country B may need to remit funds back to Country A to help cover expenses incurred at origin. This is where transaction exposure comes into play, when a foreign currency transaction actually occurs. At a minimum, foreign currency hedging techniques whether natural or otherwise should primarily be designed to protect foreign currency cash flows (transactions). If you can also use natural hedging techniques to protect your P&Ls then that is an added bonus.
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