HEDGING CURRENCY RISK IN INTERNATIONAL INVESTMENT AND TRADE

Abstract

International investing and trade has one unintended consequence; namely, the creation of currency risk which causes the local currency value of the foreign receivables or investments to fluctuate dramatically because of pure currency movements. The academic literature on currencies has typically misunderstood currency risk and suggested that currencies have no long term return, are difficult to predict, and difficult to take advantage of as the markets are extremely liquid. Hence, typical recommendations include either that companies and investors should remove this uncompensated volatility by naively hedging back into the base currency or leaving the risk unhedged (which is often misinterpreted and, as a result, left unmanaged). The effective financial management of such cash flows or investments provides a completely different perspective as naïve hedging (unhedging) of currency risk implies a strong view that the base currency will appreciate (depreciate) against the foreign currency. Moreover, the currency market has many non-profit participants and while exact currency levels cannot be predicted, the future direction of currencies can be anticipated through relatively simple models and non-profit participants can be exploited. We demonstrate how Japanese corporations and investors can develop a much more robust and SMART (Systematic Management of Assets Using a Rules Based Technique) approach to manage currency risk, thereby adding value from currency fluctuations while managing currency risk. In short, they can easily improve performance, risk management and governance. Such transactions are easy to implement with currency forwards and while the current paper focuses on USD exposures, a more general multi-currency approach can be developed for a more comprehensive analysis.