Managing currency risk with foreign debt

Managing currency risk with foreign debt

Managing currency risk with foreign debt 1400 1236 Bondford FX

Hedging currency risk with derivative contracts such as forwards and options can be extremely effective, as tenor and notional can be set to match underlying risk exposures.

However, in some cases firms can reduce currency risk via ‘natural’ hedging.  In the simplest case this involves netting forecast foreign currency expenses against forecast foreign currency revenues.  Some firms will take this into consideration when structuring business operations, for example by installing a production cost base in the same region as a foreign currency revenue exposure.

A second method of naturally hedging currency exposure is to raise debt in foreign currency so foreign interest offsets foreign revenue.  It may make sense to issue foreign currency debt when the following criteria are met:

  1. The company actually needs to borrow
  2. Foreign currency interest rates are similar or lower than domestic rates and there is no material difference in credit spread for foreign currency borrowing
  3. Repayment terms (timing and size) provide suitable offset to exposure cashflows with minimal unintended consequences

Let’s examine each of these in turn:

  1. It doesn’t make sense to borrow to create offsetting liabilities unless there’s a business need to raise debt. Deciding on the optimal capital structure of any enterprise depends on multiple considerations, particularly the relative cost of capital. Raising debt in itself adds other risk in the form of interest rate risk and strict cashflow requirements to service. It would therefore be very unusual for this strategic financing decision to be driven by possible currency hedging benefits.
  2. Rates should be lower. Put simply it is unlikely to make sense to reduce currency risk via debt issuance if it comes at a significantly higher cost of borrowing. However, looking at it the other way around, if foreign interest rates are much lower, in itself this can be an excellent reason to take foreign debt. For example a corporate in a high interest rate environment (e.g. Philippines or India) borrows in a low interest rate currency such as USD or especially now, EUR. In certain cases these loans are taken out even if there’s no corresponding USD or EUR revenue, simply because the rate is far lower than domestic rates and even though this will create a new currency risk of the foreign liability.
  3. The repayment terms should be considered. On the one hand, issuing a short term (1-3yrs) amortizing loan could provide maximum revenue offset and minimum balance sheet remeasurement risk. However, this would leave the exposure unhedged at the end of the loan term.  Alternatively, a non-amortizing loan with a balloon repayment of principal at the end would more effectively provide longer term hedging but it would be subject to greater balance sheet remeasurement effects.  A key consideration here is whether the company has any long-term foreign currency investments to offset (assets, equity, physical assets, goodwill).  Companies that have overseas assets and foreign revenues are more likely to borrow overseas and benefit from hedging cashflow exposure (via coupons) as well as asset remeasurement (via principal liability remeasurement).

As with many aspects of currency risk management, in addition to the points above there are a variety of additional considerations to think about including extra administration and country risk associated with issuing foreign debt, overall leverage ratios and relative tax rates.

Many companies don’t fall into a ‘standard’ box and may desire input and analysis before deciding on the optimal course of action to manage foreign currency risks. Our approach at Bondford begins by identifying and quantifying exposures both in terms of cashflow and balance sheet. This exercise enables us to then and compare different mitigation strategies relative to objectives and KPIs (for example forwards vs. foreign debt issuance). With these tools we are able to then define and calibrate a suitable currency risk strategy for each client.