How is foreign exchange risk managed? An empirical study applied to two Swiss companies.
Abstract This paper investigates how two Swiss companies manage their foreign exchange risk and compares the results to theoretical findings and to previous empirical research. We find significant differences in the foreign exchange risk management policies, notably in the choice of the type of exposure to cover and in the hedging instruments used. Consistent with previous research, forwards and netting are the most used instruments and transaction exposure is the most managed foreign exchange risk. Surprisingly, translation and economic exposures are not well identified and managed mainly because firms believe it is unnecessary or too complex. Finally, firms hedge their exposure but never fully due to high cost of hedging.
Keywords: Foreign currency risk management, Hedging, Transaction exposure, Translation exposure, Economic exposure, Empirical studies, Options, Forwards, Swaps, Futures, Natural hedging. JEL classification: G15; G30.
* University of Lausanne, Master of Science in Banking and Finance. We would like to express our deep gratitude to our tutor, Professor Fran;ois Lhabitant, as well as to the companies Kudelski Group, Logitech SA and UBS for their kind assistance. A special gratitude is expressed to Mr. Santino Rumasuglia, Treasury Manager at Kudelski Group, and to Mr. Jean-Marc Zimmerli, Corporate Treasurer at Logitech SA, for all the support and information that they have given us.
1. Case studies: Kudelski Group and Logitech SA
In the following lines, we examine the FX risk management policy of two Swiss firms that can be qualified as medium size companies. Kudelski and Logitech are clearly non-financial firms and we can even say that they belong to the same industry. These two firms have many similarities but it is interesting to find that in their FX risk management policy they exhibit some differences as well.
We proceeded by interviewing the persons who are responsible for the FX risk management policies in these companies - Mr. Santino Rumasuglia, Treasury Manager at Kudelski and Mr. Jean-Marc Zimmerli, Corporate Treasurer at Logitech. We sent them a questionnaire (see appendix ) and asked them to answer 28 questions in order to understand their way of dealing with FX risk. We met these persons two times in order to clarify some of the answers.
Kudelski Group Description of the firm
The Kudelski Group was founded in 1951. Its headquarters are in Cheseaux-sur-Lausanne in Switzerland and it has offices in the USA, Germany, Austria, UK, France, Brazil, Spain, China, Singapore, Italy, the Netherlands and Sweden. The Group employs over 1,200 people and between 40 and 60% of them are working abroad. The Kudelski stock is listed on the Swiss Market Index (since 1986) and on the Morgan Stanley Capital International Index. The Group's principal shareholders are the Kudelski family with 34% of the capital and 64% of the voting rights and Groupe Dassault with 6% of the capital and 4% of the voting rights. The company's market capitalization at 30.06.2003 was 1 147 million.
Kudelski is a world leader in the area of digital security. Its activities include two main sectors: Security of Access to Information (Digital Television and broadband Internet) and Physical Access to Sites (Public Access Control). The Group's core business is providing
2
advanced security and technology solutions. In 2001, the Group acquired several new companies and enlarged its range of activities.
The Group's main competitor is NOS, which is located in the USA. Kudelski's main products are CAS (Conditional Access Systems), systems that ensure that only subscribers who have paid for a service can have access to it, and Physical Access products. The main customers of the Group are located in the USA (EchoStar) and in Germany (Premiere). Major suppliers are located in Europe and Asia.
More than 80% of the company's operating revenues are realized abroad (outside Switzerland); actually, only 2% are realized in Switzerland (the local market), 52% in Europe, 33% in North America, 12% in Asia and Australia, 0.5% in Africa, and another 0.5% in Latin America. Between 40 and 60% of the Group's expenses are incurred abroad. The company's currency of denomination is the CHF and it is the most exposed to the USD and the Euro given that its major customers are situated in the USA and Germany.
2002 was a particularly difficult year for Kudelski because of the crisis in the Digital Television market in Europe. In addition, the Group was badly surprised by the US dollar depreciation, which had a negative impact on revenues and margins both in the American market and in the Asian market. In the first half of the year 2003, the US dollar was still depreciating and this had a negative impact on Kudelski's revenues. However, Kudelski's revenues coming from the USA increased during the first months of 2003 but this increase was limited and partly offset by the CHF/USD exchange rate movements. In order to neutralize the negative effect of the US dollar depreciation, the Group decided to improve its presence on the European market, and thus reduce its dependence on US dollar revenues. It actually succeeded in doing this and became the leader on the European market. Moreover, revenues denominated in Euro and Swiss francs increased. By applying this restructuring, the company decreased its US dollar exposure without using any external hedging methods.
Moreover, the Group reduced its costs incurred in the USA. With higher level of sales and lower level of costs, the Group improved its operating profitability by CHF 7.8 million compared to the first half of 2002. Given that some of the firm's major suppliers are in Europe, we wonder whether it was not better for Kudelski to transfer its costs from Europe to the USA and thus benefit from the depreciating dollar. One reason for which the company did 3
not do this could be that it expects a future appreciation of the dollar. Another reason could be that it already transferred some of its costs to suppliers in Asia where the costs are incurred in US dollars.
Here we give some key data on the size and the performance of the company. These numbers and data are taken from the company's Annual Report 2002.
Table 2: Consolidated income statement for the year ended: sources financial statement 2002
in kCHF
2002
2001
Total income Gross margin EBIT, operating income Net income
402 355 250 033 -32 022 13 019
455 445 269 794 -82 973 71 594
Exchange rate risk management policy
The management of financial risk and the responsibility for all treasury operations are not centralized in Kudelski. This means that each subsidiary measures its FX exposure. The CFO and the CEO define the foreign exchange rate risk management policy and the Treasurer implements it. Based on the information received from the foreign subsidiaries, the Treasurer makes the overall company's exchange rate exposure report by each currency.
Not surprising, transaction exposure is stated as the most important foreign exchange risk to the Group. The Group measures its transaction exposure each month. Translation exposure is measured sometimes and economic exposure is not at all measured. When hedging translation exposure, they hedge longer than the maturity of the exposure and when hedging transaction exposure they hedge the maturity of the exposure. The main purpose of the foreign exchange exposure measurement is to be able to hedge the risk. Overall, the company hedges about 80% of the exchange rate exposure and the hedge is adjusted weekly or monthly.
Many companies try to beat the market and make their hedging strategies according to their own view on the future development of foreign exchange rates. Kudelski is not interested in
4
speculation and it does not use any forecasting models to predict the evolution of exchange, interest or inflation rates.
Although the foreign exchange rate risk management policy is not centralized, the company is hedging the exchange rate risk by a central unit. Derivatives are used to manage transaction exposure. Options and swaps are the most frequently used instruments to do this. They also use forwards and cash flow matching. They often use natural hedging to cover transaction
exposure because there are no transaction costs in doing so and because this is a rather simple technique. The company never uses futures and asset liability management. The reasons they do not use these two techniques are because they cause accounting problems and/or they do not have the desired feature.
The instruments used during the year to hedge foreign currency positions mainly include forward foreign exchange contracts, currency swaps and zero cost option strategies. The swaps they do are of a short maturity: maximum 3 months. Forwards and options have a longer maturity: from 3 to 6 months. Options are mainly used when there is a big probability that a particular currency will increase or decrease above (below) a certain limit. Derivatives are mainly used to hedge income and cost exposure in US dollars and Euro.
The following tables present the notional amount of some derivative contracts. The notional amount shows the volume of the underlying transaction at balance sheet date.
Table 3: Derivative financial instruments. Sources: financial statement 2002
5
Contractual amounts 2000 Forward currency contracts (1 CHF 1.55 USD) KEUR 5,000 ----------------
Contractual amounts 1999 KUSD 1,315
Hedging options on currency increase Hedging options on currency decrease
---------------
KUSD 20,000
-----------------
Table 4: Balance sheet derivative financial instruments at 31 December 2000. Sources: Annual Report 2000.
According to Mister Rumasuglia the introduction of the Euro had a positive impact both on the Group's revenues and costs, and it had no impact on the foreign exchange exposure. The Group's exchange rate risk management policy was not changed after the introduction of the Euro.
Assets, liabilities and all other financial statements from the balance sheet denominated in foreign currencies (other than Swiss francs) are translated at year-end rates of exchange (current rates). Revenues and costs expressed in a foreign currency are translated using the average rate of exchange for the year. Translation adjustments are included in the translation reserve in the consolidated shareholders' equity. As stated in the financial report 2003, "Transactions in foreign currencies are converted at the rate of exchange prevailing at the transaction date. Other receivables and payables in foreign currencies are translated at yearend rates. The resulting currency translation differences are included in net income."
6
Logitech SA Description of the firm
Logitech SA was created in 1981 and it listed its shares on the Swiss market in 1988. Currently, it is listed on the Nasdaq (with US dollar denominated shares) and on the Swiss market (with Swiss Franc denominated shares). The firm's headquarter is set in its U.S. subsidiary. Daniel Borel - founder, previous CEO and actual chairman of the board, owns 6.8% of the shares of the company. In terms of market capitalization, Logitech can be classified as a medium firm ($1500 million). In terms of revenues, it is more than twice as large as Kudelski.
The company is active in personal interface products for PCs, mobile phones and game consoles. Its products range from Internet imaging devices, mice and trackballs, keyboards, speakers and headsets, interactive gaming controllers and 3D control devices. It seeks to develop further the interaction between the man and the machine.
For each of its products Logitech has different competitors. For mice and keyboards, it has to face Microsoft. Microsoft has an advantage over Logitech since the company is developing the software and therefore knows before all other competitors how to adapt its product to the software. For PC video cameras, the competitors are Creative Labs and Veo. The markets in which Logitech is active are highly competitive, and market leadership can change frequently as a result of new products and pricing. In the future the company expects to be still exposed to competition and price pressure and for this reason wants to keep the advantage it has established in design and advanced technologies.
Logitech sells to OEM (original equipment manufacturers) and to retail (through distributors). For the OEM most of it transactions are set in US dollars whereas for the retail the sales are done in Europe, USA, and Asia (50% dollars and 50% in Euro). The retail accounts for 7580% of the total sales and the OEM for 15-20%. The table below shows the geographical repartition of Logitech's sales with Europe being the leading region.
7
Table 5: Net sales to unaffiliated customers by geographic region. Sources: 2003 Financial statement
The currency used to pay suppliers is mostly the US dollar, and less the Euro and the Yen. The company is currently employing around 5000 persons of whom 3500 are located in China, 500 in the U.S. and 400 in Europe. Concerning the wage payments, it is exposed to Chinese Yuan, US dollars, Euro and CHF.
The structure of the firm is simple; it has a main holding based in Switzerland and four subsidiaries: one in the U.S. who takes care of the American market, one in Asia who takes care of the production and one for the sales, and a fourth one in Europe. This simple structure allows the company to effectively implement the natural hedging. In the table below, we present some key financial data for the years 2002 and 2003.
in kUSD
2003
2002
Total revenues Gross margin EBIT, operating income Net income
1 100 288 364 504 123 882 98 843
934 546 315 548 97 218 74 956
Table 6: Consolidated income statement. Sources: 2003 Financial statement
Exchange rate risk management policy
The company measures often transaction exposure, sometimes economic exposure, and never translation exposure. The Treasurer has a similar view as the one developed by Shapiro (1998) who argues that translation risk should not be managed and is purely an accounting concept not related to cash flows. Furthermore, he finds it difficult to measure this exposure
8
and there is no adequate instrument to manage it. However, the company exceptionally hedges translation exposure in case of liquidation.
Economic exposure appears difficult to hedge because of a timing problem, 90% of the received offers are cancelled. The idea here is not to cover the cost of sales but the margin. Managing and quantifying economic exposure appears difficult. It can be due to the impact of exchange changes on net cash flow, which spreads beyond the accounting period. Marshall also finds that firms encounter difficulties in measuring economical exposure. However, in the literature economic exposure is seen as an important exposure to manage.
Logitech is concerned with measuring the transaction exposure for each pair of currencies to which it is exposed. The transaction exposure is summarized in table 7, which represents the sensitivity analysis that we presented in section 5. Logitech seems to pay special attention to transaction exposure, which is consistent with the study of Marshall (1999) who shows that management focuses on this risk exposure.
Table 7: Sources Annual report 2003
Logitech does not want to use sophisticated tools because of large administrative costs. However, the company uses forecasts to adapt the hedge. They make a forecast by currency, and hedge for 3 months (for each quarter), mostly in Euro/dollars.
The Board of Directors defines the foreign exchange risk management policy under recommendation of the Treasurer. The Board defines the competences of the CEO, the CFO and the Treasurer. This is consistent with Tufano (1996) who finds that risk management policy is being set, reviewed, and monitored by a broad group of directors and not solely the CEO. Logitech has a centralized exchange risk management policy and the purpose of
9
exchange rate measurement is to hedge and manage the risk. The treasury department is not seen as a center of profit and its main objective is to limit the fluctuations of the sales margin. The measurement is done on a monthly basis, which corresponds to the internal interval of accounting closing. Together with UBS SA they are implementing a VaR (Value-at-Risk) program to assess the exposure. The company uses forecasting model for exchange and interest rates but none for inflation. They consider that the inflation is already included in the exchange and interest rates.
The company favors natural hedge whenever it is possible. They use two techniques: the change of currency of bills and the issue of CHF convertible bond (reporting is done in dollars). The company sold convertible bonds for 170 million CHF and used them to offset the fluctuation of assets hold in European currencies. Until now the firm was able to generate a small gain (around 7 million) by applying this internal hedging.
In terms of external hedging instruments, the company uses mostly cash flow matching, assetliability management, forwards and swaps. It never uses futures and options. They use forwards to hedge transaction exposure and more precisely, as explained in the annual report, to hedge the forecasted inventory purchase by subsidiaries. If no purchase is made, then the company recognizes the losses. Therefore, in order to avoid losses, it is crucial for the company to obtain accurate forecasts of inventory purchase. The hedge didn't cause any loss last year. The notional amount of outstanding foreign exchange contracts was $ 13 million (compared to the net exposed currency position of 42,264 million). The company reports a gain on foreign currency of $ 2.8 million.
The reasons announced for not using options are the expensiveness (for Logitech, the cost of using options is around 5% of the nominal), the complexity of the instrument, and the fact that the options don't have the desired feature. As the Treasury manager explained us, the main objective is to have stable cash flows, since the treasury department's objective is not to make gains but rather to maintain the margin on the products.
Concerning the maturity horizon, forwards and swaps have maturity less than 3 months. These two instruments are used for dynamic hedging and the hedge ratio is around 40-60%; otherwise the cost would be too high.
10
The transaction and economic exposure are hedged shorter or equal than the maturity of the exposure. The hedge ends up being longer than the maturity only when the company proceeds to a sale of a division. The hedge is readjusted on a monthly basis, or never for the particular case of a convertible.
The firm did not measure the effect of the introduction of the Euro on FX management policy. The introduction of the Euro reduced the amount of work but the policy stayed the same and the foreign exchange exposure did not decrease.
11
doc_116023073.docx
Abstract This paper investigates how two Swiss companies manage their foreign exchange risk and compares the results to theoretical findings and to previous empirical research. We find significant differences in the foreign exchange risk management policies, notably in the choice of the type of exposure to cover and in the hedging instruments used. Consistent with previous research, forwards and netting are the most used instruments and transaction exposure is the most managed foreign exchange risk. Surprisingly, translation and economic exposures are not well identified and managed mainly because firms believe it is unnecessary or too complex. Finally, firms hedge their exposure but never fully due to high cost of hedging.
Keywords: Foreign currency risk management, Hedging, Transaction exposure, Translation exposure, Economic exposure, Empirical studies, Options, Forwards, Swaps, Futures, Natural hedging. JEL classification: G15; G30.
* University of Lausanne, Master of Science in Banking and Finance. We would like to express our deep gratitude to our tutor, Professor Fran;ois Lhabitant, as well as to the companies Kudelski Group, Logitech SA and UBS for their kind assistance. A special gratitude is expressed to Mr. Santino Rumasuglia, Treasury Manager at Kudelski Group, and to Mr. Jean-Marc Zimmerli, Corporate Treasurer at Logitech SA, for all the support and information that they have given us.
1. Case studies: Kudelski Group and Logitech SA
In the following lines, we examine the FX risk management policy of two Swiss firms that can be qualified as medium size companies. Kudelski and Logitech are clearly non-financial firms and we can even say that they belong to the same industry. These two firms have many similarities but it is interesting to find that in their FX risk management policy they exhibit some differences as well.
We proceeded by interviewing the persons who are responsible for the FX risk management policies in these companies - Mr. Santino Rumasuglia, Treasury Manager at Kudelski and Mr. Jean-Marc Zimmerli, Corporate Treasurer at Logitech. We sent them a questionnaire (see appendix ) and asked them to answer 28 questions in order to understand their way of dealing with FX risk. We met these persons two times in order to clarify some of the answers.
Kudelski Group Description of the firm
The Kudelski Group was founded in 1951. Its headquarters are in Cheseaux-sur-Lausanne in Switzerland and it has offices in the USA, Germany, Austria, UK, France, Brazil, Spain, China, Singapore, Italy, the Netherlands and Sweden. The Group employs over 1,200 people and between 40 and 60% of them are working abroad. The Kudelski stock is listed on the Swiss Market Index (since 1986) and on the Morgan Stanley Capital International Index. The Group's principal shareholders are the Kudelski family with 34% of the capital and 64% of the voting rights and Groupe Dassault with 6% of the capital and 4% of the voting rights. The company's market capitalization at 30.06.2003 was 1 147 million.
Kudelski is a world leader in the area of digital security. Its activities include two main sectors: Security of Access to Information (Digital Television and broadband Internet) and Physical Access to Sites (Public Access Control). The Group's core business is providing
2
advanced security and technology solutions. In 2001, the Group acquired several new companies and enlarged its range of activities.
The Group's main competitor is NOS, which is located in the USA. Kudelski's main products are CAS (Conditional Access Systems), systems that ensure that only subscribers who have paid for a service can have access to it, and Physical Access products. The main customers of the Group are located in the USA (EchoStar) and in Germany (Premiere). Major suppliers are located in Europe and Asia.
More than 80% of the company's operating revenues are realized abroad (outside Switzerland); actually, only 2% are realized in Switzerland (the local market), 52% in Europe, 33% in North America, 12% in Asia and Australia, 0.5% in Africa, and another 0.5% in Latin America. Between 40 and 60% of the Group's expenses are incurred abroad. The company's currency of denomination is the CHF and it is the most exposed to the USD and the Euro given that its major customers are situated in the USA and Germany.
2002 was a particularly difficult year for Kudelski because of the crisis in the Digital Television market in Europe. In addition, the Group was badly surprised by the US dollar depreciation, which had a negative impact on revenues and margins both in the American market and in the Asian market. In the first half of the year 2003, the US dollar was still depreciating and this had a negative impact on Kudelski's revenues. However, Kudelski's revenues coming from the USA increased during the first months of 2003 but this increase was limited and partly offset by the CHF/USD exchange rate movements. In order to neutralize the negative effect of the US dollar depreciation, the Group decided to improve its presence on the European market, and thus reduce its dependence on US dollar revenues. It actually succeeded in doing this and became the leader on the European market. Moreover, revenues denominated in Euro and Swiss francs increased. By applying this restructuring, the company decreased its US dollar exposure without using any external hedging methods.
Moreover, the Group reduced its costs incurred in the USA. With higher level of sales and lower level of costs, the Group improved its operating profitability by CHF 7.8 million compared to the first half of 2002. Given that some of the firm's major suppliers are in Europe, we wonder whether it was not better for Kudelski to transfer its costs from Europe to the USA and thus benefit from the depreciating dollar. One reason for which the company did 3
not do this could be that it expects a future appreciation of the dollar. Another reason could be that it already transferred some of its costs to suppliers in Asia where the costs are incurred in US dollars.
Here we give some key data on the size and the performance of the company. These numbers and data are taken from the company's Annual Report 2002.
Table 2: Consolidated income statement for the year ended: sources financial statement 2002
in kCHF
2002
2001
Total income Gross margin EBIT, operating income Net income
402 355 250 033 -32 022 13 019
455 445 269 794 -82 973 71 594
Exchange rate risk management policy
The management of financial risk and the responsibility for all treasury operations are not centralized in Kudelski. This means that each subsidiary measures its FX exposure. The CFO and the CEO define the foreign exchange rate risk management policy and the Treasurer implements it. Based on the information received from the foreign subsidiaries, the Treasurer makes the overall company's exchange rate exposure report by each currency.
Not surprising, transaction exposure is stated as the most important foreign exchange risk to the Group. The Group measures its transaction exposure each month. Translation exposure is measured sometimes and economic exposure is not at all measured. When hedging translation exposure, they hedge longer than the maturity of the exposure and when hedging transaction exposure they hedge the maturity of the exposure. The main purpose of the foreign exchange exposure measurement is to be able to hedge the risk. Overall, the company hedges about 80% of the exchange rate exposure and the hedge is adjusted weekly or monthly.
Many companies try to beat the market and make their hedging strategies according to their own view on the future development of foreign exchange rates. Kudelski is not interested in
4
speculation and it does not use any forecasting models to predict the evolution of exchange, interest or inflation rates.
Although the foreign exchange rate risk management policy is not centralized, the company is hedging the exchange rate risk by a central unit. Derivatives are used to manage transaction exposure. Options and swaps are the most frequently used instruments to do this. They also use forwards and cash flow matching. They often use natural hedging to cover transaction
exposure because there are no transaction costs in doing so and because this is a rather simple technique. The company never uses futures and asset liability management. The reasons they do not use these two techniques are because they cause accounting problems and/or they do not have the desired feature.
The instruments used during the year to hedge foreign currency positions mainly include forward foreign exchange contracts, currency swaps and zero cost option strategies. The swaps they do are of a short maturity: maximum 3 months. Forwards and options have a longer maturity: from 3 to 6 months. Options are mainly used when there is a big probability that a particular currency will increase or decrease above (below) a certain limit. Derivatives are mainly used to hedge income and cost exposure in US dollars and Euro.
The following tables present the notional amount of some derivative contracts. The notional amount shows the volume of the underlying transaction at balance sheet date.
Table 3: Derivative financial instruments. Sources: financial statement 2002
5
Contractual amounts 2000 Forward currency contracts (1 CHF 1.55 USD) KEUR 5,000 ----------------
Contractual amounts 1999 KUSD 1,315
Hedging options on currency increase Hedging options on currency decrease
---------------
KUSD 20,000
-----------------
Table 4: Balance sheet derivative financial instruments at 31 December 2000. Sources: Annual Report 2000.
According to Mister Rumasuglia the introduction of the Euro had a positive impact both on the Group's revenues and costs, and it had no impact on the foreign exchange exposure. The Group's exchange rate risk management policy was not changed after the introduction of the Euro.
Assets, liabilities and all other financial statements from the balance sheet denominated in foreign currencies (other than Swiss francs) are translated at year-end rates of exchange (current rates). Revenues and costs expressed in a foreign currency are translated using the average rate of exchange for the year. Translation adjustments are included in the translation reserve in the consolidated shareholders' equity. As stated in the financial report 2003, "Transactions in foreign currencies are converted at the rate of exchange prevailing at the transaction date. Other receivables and payables in foreign currencies are translated at yearend rates. The resulting currency translation differences are included in net income."
6
Logitech SA Description of the firm
Logitech SA was created in 1981 and it listed its shares on the Swiss market in 1988. Currently, it is listed on the Nasdaq (with US dollar denominated shares) and on the Swiss market (with Swiss Franc denominated shares). The firm's headquarter is set in its U.S. subsidiary. Daniel Borel - founder, previous CEO and actual chairman of the board, owns 6.8% of the shares of the company. In terms of market capitalization, Logitech can be classified as a medium firm ($1500 million). In terms of revenues, it is more than twice as large as Kudelski.
The company is active in personal interface products for PCs, mobile phones and game consoles. Its products range from Internet imaging devices, mice and trackballs, keyboards, speakers and headsets, interactive gaming controllers and 3D control devices. It seeks to develop further the interaction between the man and the machine.
For each of its products Logitech has different competitors. For mice and keyboards, it has to face Microsoft. Microsoft has an advantage over Logitech since the company is developing the software and therefore knows before all other competitors how to adapt its product to the software. For PC video cameras, the competitors are Creative Labs and Veo. The markets in which Logitech is active are highly competitive, and market leadership can change frequently as a result of new products and pricing. In the future the company expects to be still exposed to competition and price pressure and for this reason wants to keep the advantage it has established in design and advanced technologies.
Logitech sells to OEM (original equipment manufacturers) and to retail (through distributors). For the OEM most of it transactions are set in US dollars whereas for the retail the sales are done in Europe, USA, and Asia (50% dollars and 50% in Euro). The retail accounts for 7580% of the total sales and the OEM for 15-20%. The table below shows the geographical repartition of Logitech's sales with Europe being the leading region.
7
Table 5: Net sales to unaffiliated customers by geographic region. Sources: 2003 Financial statement
The currency used to pay suppliers is mostly the US dollar, and less the Euro and the Yen. The company is currently employing around 5000 persons of whom 3500 are located in China, 500 in the U.S. and 400 in Europe. Concerning the wage payments, it is exposed to Chinese Yuan, US dollars, Euro and CHF.
The structure of the firm is simple; it has a main holding based in Switzerland and four subsidiaries: one in the U.S. who takes care of the American market, one in Asia who takes care of the production and one for the sales, and a fourth one in Europe. This simple structure allows the company to effectively implement the natural hedging. In the table below, we present some key financial data for the years 2002 and 2003.
in kUSD
2003
2002
Total revenues Gross margin EBIT, operating income Net income
1 100 288 364 504 123 882 98 843
934 546 315 548 97 218 74 956
Table 6: Consolidated income statement. Sources: 2003 Financial statement
Exchange rate risk management policy
The company measures often transaction exposure, sometimes economic exposure, and never translation exposure. The Treasurer has a similar view as the one developed by Shapiro (1998) who argues that translation risk should not be managed and is purely an accounting concept not related to cash flows. Furthermore, he finds it difficult to measure this exposure
8
and there is no adequate instrument to manage it. However, the company exceptionally hedges translation exposure in case of liquidation.
Economic exposure appears difficult to hedge because of a timing problem, 90% of the received offers are cancelled. The idea here is not to cover the cost of sales but the margin. Managing and quantifying economic exposure appears difficult. It can be due to the impact of exchange changes on net cash flow, which spreads beyond the accounting period. Marshall also finds that firms encounter difficulties in measuring economical exposure. However, in the literature economic exposure is seen as an important exposure to manage.
Logitech is concerned with measuring the transaction exposure for each pair of currencies to which it is exposed. The transaction exposure is summarized in table 7, which represents the sensitivity analysis that we presented in section 5. Logitech seems to pay special attention to transaction exposure, which is consistent with the study of Marshall (1999) who shows that management focuses on this risk exposure.
Table 7: Sources Annual report 2003
Logitech does not want to use sophisticated tools because of large administrative costs. However, the company uses forecasts to adapt the hedge. They make a forecast by currency, and hedge for 3 months (for each quarter), mostly in Euro/dollars.
The Board of Directors defines the foreign exchange risk management policy under recommendation of the Treasurer. The Board defines the competences of the CEO, the CFO and the Treasurer. This is consistent with Tufano (1996) who finds that risk management policy is being set, reviewed, and monitored by a broad group of directors and not solely the CEO. Logitech has a centralized exchange risk management policy and the purpose of
9
exchange rate measurement is to hedge and manage the risk. The treasury department is not seen as a center of profit and its main objective is to limit the fluctuations of the sales margin. The measurement is done on a monthly basis, which corresponds to the internal interval of accounting closing. Together with UBS SA they are implementing a VaR (Value-at-Risk) program to assess the exposure. The company uses forecasting model for exchange and interest rates but none for inflation. They consider that the inflation is already included in the exchange and interest rates.
The company favors natural hedge whenever it is possible. They use two techniques: the change of currency of bills and the issue of CHF convertible bond (reporting is done in dollars). The company sold convertible bonds for 170 million CHF and used them to offset the fluctuation of assets hold in European currencies. Until now the firm was able to generate a small gain (around 7 million) by applying this internal hedging.
In terms of external hedging instruments, the company uses mostly cash flow matching, assetliability management, forwards and swaps. It never uses futures and options. They use forwards to hedge transaction exposure and more precisely, as explained in the annual report, to hedge the forecasted inventory purchase by subsidiaries. If no purchase is made, then the company recognizes the losses. Therefore, in order to avoid losses, it is crucial for the company to obtain accurate forecasts of inventory purchase. The hedge didn't cause any loss last year. The notional amount of outstanding foreign exchange contracts was $ 13 million (compared to the net exposed currency position of 42,264 million). The company reports a gain on foreign currency of $ 2.8 million.
The reasons announced for not using options are the expensiveness (for Logitech, the cost of using options is around 5% of the nominal), the complexity of the instrument, and the fact that the options don't have the desired feature. As the Treasury manager explained us, the main objective is to have stable cash flows, since the treasury department's objective is not to make gains but rather to maintain the margin on the products.
Concerning the maturity horizon, forwards and swaps have maturity less than 3 months. These two instruments are used for dynamic hedging and the hedge ratio is around 40-60%; otherwise the cost would be too high.
10
The transaction and economic exposure are hedged shorter or equal than the maturity of the exposure. The hedge ends up being longer than the maturity only when the company proceeds to a sale of a division. The hedge is readjusted on a monthly basis, or never for the particular case of a convertible.
The firm did not measure the effect of the introduction of the Euro on FX management policy. The introduction of the Euro reduced the amount of work but the policy stayed the same and the foreign exchange exposure did not decrease.
11
doc_116023073.docx