Forty-eight percent of nonfinancial companies listed on U.S. stock exchanges remained exposed to volatility in foreign exchange rates, commodity prices and interest rates in 2012 because they did not hedge them, according to a new study by Chatham Financial.
The interest-rate and currency risk adviser studied a sample of 1,075 companies ranging from $500 million to $20 billion in revenue. The nearly half that did not use financial instruments to hedge their exposures demurred despite the threat the risks posed to both the balance sheets and reported earnings (see chart at bottom). “That was surprising, knowing the pressure senior management teams and treasury feel around identifying ways to reduce risk to factors within their control so business can focus on other areas,”Amol Dhargalkar, managing director for corporate advisory at Chatham, says.
Fifty-two percent of firms with exposure to global currency fluctuations hedged FX risk, the firm found. Data released in September by the Bank for International Settlements showed a continuing decline in forex transactions for nonfinancial customers. Transaction dollar volume fell to $465 billion in 2013 from $532 billion in 2010.
The failure to hedge commodity price fluctuations could be driven by many factors. Fifty-three percent of the 1,075 randomly selected companies had exposure to commodity price risk, but less than half (43%) are hedging it using financial contracts. While commodity price swings can dent earnings even more than currency volatility, companies may seem underhedged on commodities because commodity risk management is often owned by the procurement department, says Dhargalkar. Also, though, hedging commodity prices is more complex than hedging FX or interest-rate risk.Companies sometimes have seemingly logical reasons to reduce or drop hedging programs. Currencies of the major developed economies have traded in a relatively tight range much of the past two years, reducing the use of currency hedges like forward contracts, for example. But that might not last. Finance departments may become more attuned to currency fluctuations the rest of 2013 and 2014 due to currency devaluations in Japan and Latin America and high volatility in emerging-market currencies like the Indian rupee and the Russian ruble.
Most CFOs and treasurers feel comfortable with interest-rate and currency derivatives but the commodities market is much more nuanced, points out Dhargalkar. “For example,” he says, “with fuel it matters where in the country you are filling up and what kind of fuel you are using.” In the case of product production costs, if a company’s input costs are partially driven by the price of copper, gold or silver, “how do you strip out the impact of other factors from the impact of underlying commodity prices?” Dhargalkar asks.
Only 41 percent of the sample companies hedged interest-rate risk. In 2012, Chatham explained in its report, companies expected interest rates to stay consistent over a long period, and rates on bond issuances were breaking through all-time lows. Both factors gave companies less motivation to change the fixed to floating mix of their existing debt portfolios, according to Chatham, which is usually the aim of interest-rate hedges.
A “gating factor” for all hedging is hedge accounting, which can prevent a less-sophisticated finance department from hedging FX and commodity risks at all, says Dhargalkar.
“If a business doesn’t apply hedge accounting, it actually can introduce more volatility into earnings,” says Dhargalkar. “The business might enter into the right set of hedges that reduce cash-flow risk but actually increase its earnings at risk, because of the volatility of the derivative showing up in earnings per share.” That could lead to the CFO having to provide a lengthy explanation on an earnings conference call.
Chatham’s study excluded sectors of the financial services industry and used information from companies’ latest form 10-Ks.
