Taming the currency tiger: some companies have controlled most of their currency risks through a mix of operating decisions and financial hedges. Active risk management sets them apart from those that passively accept whatever punches the currency markets throws.

• Author: Millman, Gregory J.
• Position: International Competition

Caterpillar Inc. announced a hefty second-quarter earnings increase in July, with machinery sales volume up $1.35 billion. But something was missing. Although many American companies were reporting sharp performance improvements, thanks largely to the dollar's weakness in 2003-2004, Caterpillar managed to gain only $116 million on the currency shift. Even more surprising, Cat's archrival, Japan's Komatsu Ltd., claims to have suffered little from the dollar's plunge.

It's no exaggeration to say that the dollar-yen rate used to be the single most important factor in the competitive duel between these two companies. In the early 1980s, when inflation-busting Federal Reserve Board Chairman Paul Volcker jacked up U.S. interest rates, he incidentally handed Komatsu a massive competitive advantage.

Caterpillar manufactured in the U.S. and priced its product in dollars, so the dollar's strength against other currencies meant that Cat's local currency prices surged in markets all over the world. The pain didn't begin to ease until 1985, when the G-7 countries met at New York's Plaza Hotel and announced a coordinated plan to send the dollar tumbling. Caterpillar gained, and Komatsu lost accordingly.

The markets give, the markets take away. But Caterpillar and Komatsu seem to have decided that it makes little sense to bet their businesses on the uncontrollable, perhaps unfathomable decisions of central bankers and currency traders. For the past two decades, they have been working steadily to minimize, if not eliminate, the impact of currency on their competitive duel. Recent performance demonstrates that they've succeeded.

Observes Caterpillar CFO Lynn McPheeters, "We were dollar-based and they were yen-based, and when currencies got out of whack, it created a significant competitive advantage for them. But now our position is to be the low-cost manufacturer in each currency zone. I've heard our chairman say more than once that if we take care of that, we take care of the currency competitiveness issues." Similarly, a spokesperson for Komatsu explains that his company locates its plants close to each equipment market and notes: "The global operation of Komatsu absorbs FX [foreign exchange] fluctuations of each currency in the world."

Caterpillar and Komatsu mirror each other in their manufacturing philosophy and in their hedging strategy. Both hedge short-term cash flow exposures and rely on natural hedges to mitigate the impact of currency on their long-term competitive position. Says McPheeters, "We still face regional competition that is euro-based, and...