Hedging Bets On Foreign Operations
Offshore production often yields clear benefits. Lower labor costs and less stringent regulations can generate higher margins — or at least keep a manufacturer in the game as the “China Price” of a given product drops lower.
Some offshore challenges are well-known, too, from inadequate infrastructure to shifts in political climate.
At the Mercy of Money Changers
Another significant risk is posed by currency fluctuation. A U.S. manufacturer could score big productivity gains with a plant in China or Argentina, but lose at the exchange counter when the yen or the peso buys fewer dollars than anticipated.
Some currency exposure provides useful diversification in a portfolio. Money is less volatile than equity, and tends not to correlate with other assets. But too strong a position in foreign currency can be dangerous.
It’s sometimes said that foreign exchange risk diminishes over the long run. But over the last 150 years, the British pound has lost 80 percent of its value against the dollar — and the yen and the mark both reached rock bottom, although both have been reconstituted.
How can a manufacturer protect itself against this kind of risk? One method is by hedging foreign currencies.
The Hedge as Insurance Policy
Hedging is a special kind of diversification. Investors hedge one position by investing in another, expecting that a gain or loss in the first will be countered by a change in the second.
For example, an early automotive investor might have hedged his Detroit shares with an interest in a wagon shop. If the new-fangled automobile turned out not to be such a miracle after all, the wagons could be expected to perform better.
Things turned out differently, of course, and today wagon works are but a fading memory. But that doesn’t mean the hedge was a foolish investment.
In a hedge, as with standard insurance, a company trades some assets in order to reduce a risk. By hedging its exposure in a currency, a manufacturer can narrow the range of potential damage that currency’s fluctuation can cause. The hedge, by rendering the risk more knowable, makes it easier to plan for.
Some currency hedging options are straightforward. A company with exposure in yen, for example, might protect against that currency’s decline by establishing a contract with a financial institution guaranteeing it the right to buy yen at a locked-in rate in the future.
Other hedges can involve complex financial instruments. Choosing among them and finding the optimal hedge ratio require close analysis.
Experts stress one important caveat: The purpose of a hedge is to reduce the range of a risk, not to reap great returns.
For more information about our services to inventory based businesses,
Contact: Mark Walker, Partner, Director of Inventory Based Businesses Practice at 817.882.7724.
The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.