Who Hedges Currency Risk, And Why?
Companies, Investors, and Countries
A global company can earn and spend money in dozens of currencies, but it's going to report its results to investors in just one, and those investors, in turn, will measure the company's results in that currency. In some way, this can be liberating: nobody in Japan is complaining about how the Japanese market is doing right now in US dollar terms; they're happy that it's rallying when denominated in yen, because yen's what they earn, spend, and think in. (Right now, a Japan ETF denominated in dollars is up 17% year-to-date, while a similar ETF that hedges currency exposure is up 45%. Locals experience the 45% rally, not the 17% one.)
At a high level, companies are interested in hedging foreign currencies because currency exchange rates fluctuate, and those fluctuations impact profits denoted in their domestic currency. If a US investor owns a company in Turkey, and that company is doing well in local-currency terms, but its US dollar profits are declining fast, the US investor isn’t mollified by the knowledge that their profits can still go pretty far in Istanbul. But companies vary in how they think about hedging foreign exchange—which exposes some useful knowledge about how and why companies hedge in general.
As you can see, there’s even disagreement amongst the ten largest companies by market cap. In short, the best reason not to hedge is that it's expensive. The price of hedging a given currency reflects the market's best guess about how that currency will fluctuate in the future. Predicting currency movements like that is notoriously hard, but if there's any ability to get it directionally right, the banks offering hedges will probably have more of that skill than the companies hedging their revenue. And that's just the efficient market at work: if you know when to hedge your yen risk and when to let it ride, you can monetize that skill better as a full-time currency trader than as a corporate treasurer.
But not all hedges are composed of forward and option positions—there are also a few natural hedges out there! If a company does half of its revenue in the US and half outside, half of its revenue is naturally exposed to exchange rate fluctuations. But if half of the company's expenses are also denominated in that foreign currency, there's a built-in hedge, and the only money that's directly at risk is their profits.1
One practice some companies engage in is to just highlight metrics that exclude the impact of currency fluctuations. On the one hand, you can't eat those ex-FX profits. On the other hand, in the very long run any bet that there will be a material long-term difference between currency-adjusted and unadjusted numbers amounts to a discretionary bet on currency, so anyone who views this as an excessively optimistic or pessimistic take on the business's economics can better express that view by trading the currencies themselves.
In any case, all the discussion above starts with the implicit premise that the business in question is a US-based company that reports in dollars. And that’s pretty common given the US's 40%+ share of global market cap and likely higher share of global investor activity. The US is unique in that it's a large economy with relatively low dependence on trade and a hard-to-dislodge position as the issuer of a reserve currency. But the norms are a bit different for other countries.
Other countries have a few different worries. When a company operates in a developing market, and exports to the rich world, and it's sensitive to currency in a way that creates a natural hedge for the business. Any bad macroeconomic news in Turkey, for example, will tend to push the Turkish lira down. But many big Turkish companies are exporters to Europe, so a drop in the value of their home currency can mean a more-than-offsetting increase in revenue. In the last five years, the Turkish lira has lost about three quarters of its value, but shares in car exporter Ford Otomotiv Sanayi are up 1,750% in lira terms, so a dollar-denominated investor has made 35% annualized.
Longer-term, though, the picture is murkier. Manufacturers need raw materials and capital equipment, and if those are imported then they need to be paid for in a widely-accepted currency. So the cost component of the P&L has the opposite currency sensitivity as the revenue side. When the activity in question requires lots of imports, with labor adding a fairly small share of the value in the end, that currency tailwind for revenue is almost precisely matched by a currency headwind from costs. (On the flipside of this, Japanese exporters in particular tend to be in higher-margin industries, where the benefits of a cheap currency flow through faster than the costs.)
Currency volatility can impose another kind of cost, particularly in countries where the financial system is small, slow, or both. Consider a company that builds products with a long lead time; the manufacturer needs to source materials and pay wages, but may collect their money later. If their reporting currency is cheap when they're paying costs and expensive when they're receiving revenue, currency fluctuations can eliminate the profits of the business. They can also just as easily double them, of course, but a double-or-nothing bet is not one most companies enter into lightly.
One solution to this that's evolved over time is for governments to intervene, usually to keep the local currency stable and to retain a backup supply of dollars, euros, and yen for emergencies, and also generally (but not always) to keep the currency cheap so exports are more competitive.2 This intervention reduces the odds that a given country's financial system will fall apart because of a dollar shortage, but it never quite eliminates it.
How investors should respond to this depends in part on what your idea of a "simple solution" is: one straightforward approach is to hedge foreign stocks so you're capturing local returns, but this is tricky, because what you really want to hedge is each company’s economic exposure to currency, which isn't always reasonable to estimate. Another somewhat simple option is to concede that currency fluctuations are a risk, but that it's management's responsibility to figure out exactly what that risk is. On very long timelines, the expected value of currency-hedged and currency-unhedged exposure to foreign assets should be similar, but in any given investor's career their local currency will probably be either surprisingly weak or surprisingly strong; even if currency movements follow a random walk, they'll drift over time.
You could try to avoid currency risk entirely by investing only in local companies, and only in the ones that earn their revenue locally. But this turns out to mean investing mostly in small and mid-sized companies, and leaning away from tech. And even then, it's not perfect: a US-based retailer that earns 100% of its revenue in dollars is still affected by currency fluctuations in the countries where suppliers are located.
You can—and some people do—go in the opposite direction. Professional investors will sometimes devote a surprising amount of effort to precise currency impact estimates, especially since companies often guide in absolute dollar terms but report revenue and earnings that are driven by currency issues. Often the goal is not specifically to have an edge when the company reports, but to predict when analysts' models will revise expectations up or down based on how the dollar has performed recently. This can be an exhausting grind, but is a staple of high-turnover, catalyst-driven fundamental investing.3
Ultimately, currency risk is unavoidable. One way or another, what happens to other countries' economies affects investor returns. But this also falls into the category of risks investors get paid to take: currency fluctuations can reduce the near-term earning power of a company you invest in, or provide a windfall. It's hard to predict which. And when you buy a stock, one component of your return is from underwriting exactly this risk.
Read More in The Diff
The Diff has covered both currency in general and hedging in general, but hasn’t specifically focused on currency hedging much. (Further evidence that it’s not something big companies have to be too careful about, while for small companies where it could be the difference between solvency and insolvency, there are other issues that are bigger drivers.)
How airlines explain the economy looks at a few different aspects of the industry, but one is whether or not they hedge their fuel risk. This has natural applications to the currency hedging question.
This piece ($) looks more at what currency dynamics make the dollar special.
And in how to make another reserve currency ($) we look at why that role probably won’t change.
1. One result of this is that a company is naturally hedged when it has a profitable domestic business that it uses to subsidize the growth of a breakeven international one, but since hedging has to be done on a per-currency basis, that would only work if the international business were roughly breakeven in every jurisdiction in which it operated. It's more common for companies to have a larger share of costs than revenues in their home currency, i.e. to have more profits than revenue exposed to currency changes. Think of a tech company that does most of its R&D in the US, locates most of its executives there, and has some salespeople in the US and in every other country in which it operates. Since the fixed costs of the business are US-based, more of the costs are in dollars, whereas the international business is mostly taking an existing asset, the core product, and spending a bit of money on sales in order to amortize that fixed cost over more customers.
2. The big exception to this rule is that in some petrostates, where oil is sold for dollars and government officials are paid and bribed in local currency, there's an incentive to keep the currency expensive because it makes luxury goods more affordable to bribe recipients. This chokes off local manufacturing, but it's hard for manufacturing to be competitive with oil extraction in places that have a lot of oil; it can be cost-effective to build oil-specific infrastructure even if the rest of the country lacks ports, roads, and the like. The more natural resource wealth there is, the more money there is in either working in natural resources or providing non-tradable services to people who do.
3. It would be interesting to look at how company size predicts the impact of FX-driven earnings beats and misses. Analysts at large funds are often careful about this kind of thing, but the size cutoff for the stocks they track is high. On the other hand, smaller stocks tend to have less FX exposure, so perhaps there's just less opportunity there.
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