Currency hedging in Norwegian non-financial firms.

• Author: Borsum, Oystein G.

Fluctuations in global foreign exchange markets in recent years have again shown that many Norwegian enterprises are sensitive to changes in exchange rates, in both a positive and negative sense. The question naturally arises as to how companies can best hedge against such fluctuations and what hedging techniques that are actually used by Norwegian enterprises. This article summarises the results of a survey conducted by Norges Bank in summer 2004. The survey focused on the use of currency derivatives, but also posed more general questions regarding hedging.

The article starts with a brief description of exchange rate risk and the most relevant risk management instruments, followed by some comments regarding the theory of companies' derivatives usage and an overview of international empirical studies in the field, before presenting the most important results of the Norwegian survey.

**********

1 Exchange rate risk

This article looks at exchange rate risk and currency exposure. A company is exposed to exchange rate risk if the company's value is affected by fluctuations in one or more exchange rates. The effect may be direct or indirect. The most obvious sources of direct impact are import and export prices. A Norwegian exporter selling in USD will immediately experience a fall in Norwegian income if the USD exchange rate depreciates, whereas a Norwegian importer buying in USD will register a reduction in purchasing costs. These examples show the direct effect of a depreciation of the USD exchange rate on the bottom line. However, it is not only such direct effects that are relevant. Changes in the exchange rate can just as often have an effect through indirect channels. For example, take a Norwegian cooker manufacturer: the company uses Norwegian labour, its most important commodities are Norwegian and it sells all its products in Norway. At first glance, the manufacturer may appear to be insulated from the effects of exchange rate variations. But what if the company's most important competitor is Swedish, and the Swedish krone falls in relation to the Norwegian krone? Swedish cookers will then become cheaper in Norway and the Norwegian manufacturer's competitive situation will deteriorate. This is a typical example of an indirect effect. Another is electricity production. Norwegian hydroelectric power plants compete with oil-fuelled power plants in continental Europe. Even if the oil price is constant, as oil is quoted in USD, foreign electricity prices tend to be cheaper as a result of a fall in the USD exchange rate. On the basis of these observations, we can conclude that most companies in Norway are potentially sensitive to exchange rate variations, with the exception of some sheltered sectors.

The 'exposure' concept was introduced in order to measure the extent to which a company is affected by exchange rate risk. A company's exposure is equal to how much the company's value will be affected by a change in the exchange rate.

Change in company's value = Exposure x Change in exchange rate

As the company's value is, in principle, the present value of future cash flows, exposure can be operationalised by looking at changes in cash flows.

Change in cash flows = Exposure x Change in exchange rate

Empirical estimation of exposure is difficult. There are two commonly used approaches. (2) One method involves breaking down the company's cash flow into its various components, calculating the exposure of each component and then aggregating this as an expression of the company's exposure. For given quantities, exposure can be easily estimated by multiplying the given quantity by the change in the exchange rate. Unfortunately, quantities normally change as a result of exchange rate fluctuations, for example, if there is a change in competitors' prices.

The other method is more indirect. By looking at the company's market capitalisation and using historical market price data and historical exchange rate movements, it is possible to estimate the extent to which market capitalisation changes as a result of exchange rate fluctuations. The advantage of this method is that it is less demanding in terms of available data, but the problem is that there is greater uncertainty involved as estimations are based on market data that may have been affected by many other factors in addition to currency.

Exposure can be broken down in different ways. For the purposes of this article, it is sufficient to divide exposure broadly into two categories according to time horizon: short-term or long-term. (3) Obviously, it is easier to estimate exposure in the short term than it is in the long term. Short-term risk is usually easy to identify, as it is linked to transactions that have already been initiated. For given prices and quantities, exposure is proportional to the change in the exchange rate. In the longer term, there are more variables that may change over which one has varying degrees of control. Price and quantity can vary on both the input and the sales side. Thus it is more difficult to estimate long-term exposure, but possibly more important to do so. This type of long-term exposure is often called strategic exposure.

One key concept in any discussion about exposure measurement is natural hedging. This term is used for situations where income and expenses are denominated in the same currency. A Norwegian shipping firm operating in an international market will usually have both income and expenses in USD, which would only involve currency exposure if the profit is taken out in NOK. It is important to take account of natural hedges when measuring exposure as it is the net value of income and expenses in the same currency that is relevant for exposure. In a number of instances, the company can influence the degree of natural hedging, for example, by buying input factors in foreign currency rather than NOK.

In cases where there is no such natural hedge, it is possible to change exposure by buying financial derivatives. We will now give a brief overview of the relevant instruments.

2 Instruments for exchange rate risk management

Currency derivatives markets are some of the most active financial derivatives markets and have a long history. The most important instruments for risk management in the derivatives markets are forward agreements, swaps and options. An outright forward fixes the future exchange rate at a given value (the forward exchange rate) and a given future transaction date (the contract expiry date). Currency swaps also fall under this umbrella. A swap is closely related to a forward agreement. In both cases, future cash flows are fixed, but with a swap, both parties formally 'swap' cash flows. The easiest way to show the similarity with outright forwards is to say that a swap is equivalent to a portfolio of forward agreements. Options are the most advanced risk management instrument. An option is also an agreement that guarantees a set exchange rate at a set future date for a set amount of currency, but the holder may to choose to use the option or not. Options are thus asymmetrical instruments in that they can be used to hedge against negative results, but also give the holder the opportunity to benefit from positive results. This flexibility is reflected in option premiums.

The most recent study on derivatives by the Bank for International Settlements (BIS, 2004) shows that traditional instruments are the most widely used instruments. Table 1 summarises figures for daily turnover in global foreign exchange markets by transaction type.

As the table shows, forward exchange agreements have the highest turnover. The umbrella term includes different types of agreement, outright forwards and swaps. Globally, there has been a marked increase in the use of currency options. This is not reflected in the figures for Norway for technical reasons, as options agreements are signed with counterparties that do not report to Norges Bank. In addition to these instruments, other derivatives are also traded and are included in the group "other" in Table 1. (4)

A common feature of most financial foreign exchange agreements is that they are not traded on an organised exchange. They are bilateral agreements between two parties that generally involve large banks as either a broker or one of the parties to the agreement.

For the purposes of this article, it is not necessary to know how derivative instruments are priced. It is sufficient to note that active markets such as global foreign exchange markets will involve more or less free competition so that the price of a hedging transaction will be very close to the transaction's "fair value."

3 Companies' exchange rate risk management

We will now look at the possibilities and motives companies may have for hedging exchange rate risk. Loderer & Pichler (2000) provide a useful classification into four possible strategies for corporate exchange rate risk management:

--Avoid risk, for example by invoicing in domestic currency or avoiding transactions that expose the company to exchange rate risk. The latter is difficult in an economy as open as the Norwegian economy.

--Reduce the risk of loss. A Norwegian exporter exporting to the EU can, for example, move production to the euro area. This is not the same as avoiding risk, as profits are exposed to risk when they are transferred back to Norway.

--Pass on risk to others. In this case there are three possible strategies:

* Hedge, e.g. by means of forward agreements.

* Insure, e.g. by means of currency options.

* Diversify, e.g. by spreading exchange rate risk over several currencies.

--Choose to bear the risk. Choosing to assume risk is a rational decision as long as the risk is deemed to be acceptable.

This list shows the possibilities a company has to change its risk exposure, but not the motives a company may have for making such choices. Many people think that the term hedging is synonymous with the elimination of all risk or...