Should companies hedge against translation risk?

My last posting looked at the tax rules that apply when a company hedges translation risk. As promised then, I am writing to discuss whether companies should hedge translation risk at all.

This posting is adapted from my article in the October 2005 edition of Financial Instruments Tax and Accounting Review.

Some time ago, I asked myself whether there was a theoretically correct answer regarding the approach that should be taken to translation risk.  A search of the literature found a large number of articles on the subject, many quite old.  The scarcity of recent articles perhaps indicates that the issue is now regarded as familiar and no longer worthy of additional research.  The articles tended to either simply explain translation risk or to be surveys of the actual practice of corporates regarding whether or not to hedge.  However, I could not find anything addressing the issue on theoretical grounds.

In this posting, I have tackled the issue from first principles, by spending some time thinking about a highly simplified theoretical example. As I ended up with a fairly long piece, with a large number of numerical tables, it is best read in printed form so I have attached it as a PDF document.

While sharing calculations always feels risky, I have also attached the spreadsheet which underlies the numbers, in case anyone wishes to test out the numbers. Please let me know of any errors.

The conclusions I reached from the exercise were as follows:

• Sometimes, for company specific reasons such as net worth covenants at risk of being breached, it is vital to hedge against translation risk.
• With a subsidiary company, the theoretically preferred approach of projecting the cash flows that the UK parent company will receive from the subsidiary, and forward selling those into sterling, is not feasible. Unless the subsidiary is to be sold soon, the time horizon is essentially infinite. As well as making forecasting impossible, there is no scope for buying currency forward for indefinite future periods.
• The approach that I find most theoretically appealing is to estimate the market value of the foreign subsidiary in its foreign currency, and to then hedge that amount into sterling. The market value of the subsidiary will rarely coincide with the accounts carrying value, except on or shortly after it is first purchased. Where the market value is similar to the accounts carrying value, this hedging strategy will look like translation risk hedging, and indeed for accounting purposes the parent company may choose to designate (all or a part of) the hedging instrument as a “net investment hedge” in the group accounts. However, the logic behind the approach is to hedge the market value, not the accounts value.
• If a hedge is taken out, whether to hedge the accounts carrying value or the market value, the company needs to ensure that it will not face any cash-flow problems when the hedge needs to be rolled over.
• Where a group has debts, it appears appropriate to incur the debt in sterling and foreign currencies, in proportion to the market value of the group’s assets. While accounts carrying value is a limited surrogate for market value, pro-rating debt in proportion to net assets still seems more logically appealing than incurring all borrowing in sterling.
• I am attracted by the argument that in the long run foreign exchange rates reflect purchasing power parity and the intervening fluctuations (albeit sometimes very long lived) represent nothing more than noise. As a hedging strategy inevitably involves some element of external costs, this would point towards not hedging at all. However, one needs to be willing to take a long term view, which may be longer than the time horizons of most shareholders or finance directors. At a purely personal level, I do not hedge my own US share portfolio.
• If the foreign operations are so major that the accounting effect of translating those foreign operations into sterling is to produce undesirable accounting volatility, and are predominantly in one foreign currency, a good solution may be for the UK group and hence the parent to adopt the foreign currency, usually the dollar, as the currency of its accounts.  This has indeed been done by several large oil companies and by a UK based global bank. Of course, you then need to consider whether to hedge the group’s sterling operations!

I would appreciate any comments, and in particular views, either private or public, regarding how your group decides what approach to take regarding translation risk hedging.

Download Translation risk hedging PDF

Download Translation risk hedging Excel spreadsheet

Mohammed Amin