Why FX Risk Management Is Broken–and What Boards Need to Know to Fix It

• Date: 01 March 2016
• Author: Alf Alviniussen,Lars Oxelheim,Håkan Jankensgård
• DOI: http://doi.org/10.1111/jacf.12158
• Published date: 01 March 2016

In This Issue: Risk Management

Risk Management—the Revealing Hand 8Robert S. Kaplan, Harvard Business School,

and Anette Mikes, HEC Lausanne

Bankers Trust and the Birth of Modern Risk Management 19 Gene D. Guill, GPS Risk Management Advisors, LLC

University of Texas Roundtable

Financing and Managing Energy Investments in a Low-Price Environment

30 Marshall Adkins, Raymond James; Greg Beard, Apollo

Global Management; Bernard Clark, Haynes and Boone;

Gene Shepherd, Brigham Resources; and George Vaughan,

ConocoPhillips. Moderated by Sheridan Titman, University of

Texas McCombs School of Business.

Why FX Risk Management Is Broken—and What Boards Need to Know to Fix It 46 Håkan Jankensgård, Lund University, Alf Alviniussen,

Lars Oxelheim, University of Agder, and

Research Institute of Industrial Economics

Derivatives: Understanding Their Usefulness and Their Role in the Financial Crisis 62 Bruce Tuckman, New York University Stern School

of Business

Opaque Financial Contracting and Toxic Term Sheets in Venture Capital 72 Keith C. Brown and Kenneth W. Wiles, University of Texas

McCombs School of Business

Three Approaches to Risk Management—and How and Why

Swedish Companies Use Them

86 Niklas Amberg and Richard Friberg, Stockholm

School of Economics

Are U.S. Companies Really Holding That Much Cash—And If So, Why? 95 Mar c Zenner, Evan Junek, and Ram Chivukula,

J.P. Morgan

Seeking Capital Abroad: Motivations, Process, and Suggestions for Success 104 Greg Bell, University of Dallas, and Abdul A. Rasheed,

University of Texas at Arlington

The Beliefs of Central Bankers About Ination and the Business Cycle—

and Some Reasons to Question the Faith

114 Brian Kantor, Investec Wealth and Investment

VOLUME 28 | NUMBER 1 | WINTER 2016

APPLIED CORPORATE FINANCE

Journal of

46 Journal of Applied Corporate Finance • Volume 28 Number 1 Winter 2016

Why FX Risk Management Is Broken–

and What Boards Need to Know to Fix It

* The authors would like to thank Don Chew (the editor), John McCormack, Tom

Aabo, Niclas Andrén, David Carter, and participants at the 2015 FMA Applied Finance

in New York for valuable comments. Jankensgård gratefully acknowledges the nancial

support of the Jan Wallander and Tom Hedelius foundation. Oxelheim gratefully acknowl-

edges the nancial support of the NasdaqOMX Nordic Foundation.

1. The standard textbook denition of FXRM encompasses the activities of managing

the currency composition of the rm’s debt and the hedging of FX exposures using de-

rivatives. A broader denition of FXRM would include also the management of the cur-

rency composition of the rm’s future cash ows, including the choice of production fa-

cilities, sourcing of raw materials, and so on. We dene FXRM as a process that, in

addition to these activities, comprehends the quantication of exposures to FX risk as

well as the communication of FX risk to investors.

I

n one of its recent quarterly reports, a large Sc an-

dinavian industri al company disclosed a foreign

exchange-related loss of some $200 mil lion.

While not life-thre atening for the company,

the loss appeared to be serious, given t hat it was more than

three times the size of its reporte d net income (before nan-

cial items) in the same quarter of about $60 mi llion. e

reported loss had several cau ses, but most of it resulted from

the revaluation of bala nce sheet items, as well as derivative s

and other o-balance sheet items, that is now required by

mark-to-market accounting ru les. e revaluation of exter

-

nal and internal loa ns and intercompany accounts also h ad

a major impact, and these eect s were the result largely of

changes in cross- currency rates that did not involve the home

currency of the company. In fact, the large st contributor to

the $200 million cur rency loss was internal loans provided by

one of the company’s EUR-based subsidiaries in U.S. dollars

to subsidiaries whose accounti ng was denominated in a third

currency. And as these exa mples are mea nt to suggest, the

company’s FX loss had very little (if any) eect on its oper-

ating cash ow or cash holdings; it was instead essentia lly

mainly a “paper” loss that resulted in large part from tra ns-

actions within the corporate group.

But along with these accounti ng eects (which some

would argue are lar gely inconsequential), currency cha nges

can also have major “real” eects on the operating cash

ows—and hence on the expe cted future protability a nd

value—of not only large multi national companies, but even

wholly domestic companies that face foreign competitors

in their home markets. And for such compan ies, foreign

exchange risk ma nagement (which we hereafter refer to as

“FXR M”)

1

can thus be a very c omplicated undertaking— one

that requires anticipating a nd taking account of both “paper”

and “real” eects, and determining how much importa nce

to assign to each.

Given this complexity of the ta sk, one might well ask the

following question: Are the FX r isks of today’s large multi-

national companies, wit h all their nancial exper tise and the

sometimes substantial re sources dedicated to FXRM, gener-

ally manage d in such a way as to contribute to the attainment

of corporate objectives, including the goal of long-run va lue

maximization?

For a surprisingly large proportion of companies, our

answer to this question is no. In the pages that follow, we

describe six ways in which we bel ieve that most existing

FXR M programs are seriously awed. e root cause of the

gap between what is and what should be done appears to us

to be the complexity of both organiz ations and the global

economic environment, which has outpaced companies’

ability to deal with it. To a signicant degre e FXR M can

be considered a legacy activit y, in much the way that former

GE corporate leader Jack Welsh characterized corporate

budgets: they exist in their current form only because t hey

have become “institutions” in their own rig ht whose justica-

tion is never questioned but simply taken for granted.

In this art icle, we argue that the cost s of a poorly

conceived FXR M have increased in a world that has shown

a clear tendency to put higher values on tra nsparent and lean

organizations. In our v iew, corporate boards of directors

should rethink the F XRM function and how it is organi zed,

while attempting to get as clea r and complete a picture as

possible of the costs and benets of this act ivity. As repre-

sentatives of the shareholders, boards of directors have the

ultimate responsibility for monitoring the rm’s business

activities, and for overseeing its risk-tak ing. It is the duty of

directors to ensure that the r m has a sound process in place

for managing risk, a nd one that doe s so without wasting the

organization’s resources. Current FXR M practices are often

decient on both these accounts, and d irectors are in a unique

position to provide the impetus for change.

One of the main challenge s, however, is boards’ lack

of expertise as well a s the detailed informat ion required to

understand FX exposure management in an internat ional

rm. Because of the techn ica l complexity of derivative s and

by Håkan Jankensgård, Lund University, Alf Alviniussen, Independent Consultant,

Lars Oxelheim, University of Agder, and Research Institute of Industrial Economics*