Strong euro alters thinking on foreign currency hedging: with a strengthened euro--combined with implementing FAS 133--how's a company to hedge foreign currencies? Here are some alternatives.

• Author: Perkins, Daniel M.
• Position: Risk Management

When currencies trend in one direction, hedging the risk is easy. For almost three years, the European Union's (EU) new currency, the euro, weakened against the U.S. dollar. This provided corporate hedgers of their euro receipts and assets "gains" on their forward contracts when protecting a 90-day or quarterly cash flow.

As most CFOs and treasurers know, the "gains" on these contracts really are offsets to the underlying losses in value of the euro receipts and assets.

Since hedging under most corporate policies is used to smooth currency volatility on the company's financial statements, there is no real gain or loss, but hedging's major benefits is that it can reduce the potential of a catastrophic loss (or gain).

However, the test of a good hedging policy is not when the hedging instruments' (forwards or options) are "in the money" and providing cash settlement gains, but rather when a reversal in the trend occurs and the hedges at settlement or mark to market are "under water" or lose money.

While the underlying asset appreciated during this trend reversal, corporations must be diligent to show both sides of the ledger--the underlying risk and the hedge value at every reporting period. The hard part is to maintain the same strategy when the hedges purchased as risk avoidance actions can be second-guessed.

Pressure to abandon the hedging program can come from a number of sources:

* A board of directors uncomfortable or unfamiliar with the impact of hedging.

* A new CEO or CFO who either has an historic dislike of hedging or is inexperienced with hedging.

* The complexity of implementing FAS 133 accounting by the controller's department.

* The treasurer having to explain "losses" on contracts instead of "gains."

In light of the pressures, companies need to make sure the euro's recent strength does not weaken their resolve to hedge their currency risk.

By focusing on the euro since its inception, the value of hedging the risk for most multinationals are illustrated in Exhibits 2 and 3. The example assumes the company has a EUR-denominated asset worth 100 million EUR.

What should a company do in the face of these pressures to stop hedging its assets? The answer is to review its risk tolerance levels, measurement and reporting and its strategies and tools. These categories are detailed below.

Identifying Risk Tolerance Levels

First, look at possible risk tolerance levels. In the example in Exhibit 3, the 100 million without any hedging has...