Applying Value-at-Risk to Corporate Treasury Departments

Currency risk, and risk in general, is usually measured by standard deviations (i.e., variability). Many believe that the purpose for hedging is to reduce these standard deviations, and therefore the risk is reduced. However, this assumes an incorrect understanding of risk. Risk cannot simply be measured by standard deviation. For example, you can play a game where you can either have a 100% chance of winning $5, or a 50/50 chance of either winning $10 or $100.  The latter choice plainly has a much greater degree of variance. However, one cannot say it is more risky. Risk addresses the uncertainty of achieving an objective.

Returning to currency risk with a better understanding of what exactly risk is, what then is the objective of the corporation? For the sake of simplicity, assume the objectives are survivorship of the company (due to violations of assumptions found in the Modigliani-Miller¹) and maximizing after-tax cash flow. Currency risk can increase the probability of bankruptcy and can impede managers’ flexibility in having sufficient capital to make positive investments. Does hedging reduce this risk? If there is a manager who has better-than-the-market forecasting abilities, she is highly unlikely to be found in a non-financial industry, considering the degree of remuneration for such knowledge. Accordingly, a non-financial firm should assume the currency futures markets are priced at the best available risk-neutral rate. Therefore, because of premiums, currency hedging has a negative NPV. How does a treasury department make a “negative NPV” non-risk-neutral decision in order to outweigh what can seem like a very nebulous concept of risk?

This concept can be laid out in matrix format:

If the company remains solvent independent of the currency exposure, the premiums for the hedge are lost and the firm is worse off. If the company hedges, and this hedge saves it from insolvency or a significant impairment to operations, the firm is clearly better off. If the company hedges, and the currency gain is significant enough to save the firm, or if the cost of the premium is sufficient to impair the firm in a given scenario, the firm is clearly worse off. A few lessons can be drawn from this simple matrix:
For a given currency risk, if the probability of the “Insolvent caused by hedge” cell exceeds the probability of the “Solvent because of hedge” cell, any hedging both increases risk and is an NPV negative decision. For example, a multinational company provides a $100M intercompany loan from its United States operations to a subsidiary in Mexico. Before making the decision to hedge the “currency exposure,” at the cost of millions of dollars, how many treasury departments would first create a variance analysis that compares the potential currency exchange loss with overall company cash flows in a recessionary or depression environment? If the currency loss and company cash flows when the firm is under duress are negatively correlated, a hedge of the intercompany loan actually increases the risk of the company, and it does so at the cost of millions of dollars. Many treasury departments engage in wasteful hedging activities because of a fundamental misunderstanding of risk.

Even if the probability of the “Solvent because of hedge” cell exceeds the probability of the “Insolvent caused by hedge” cell, it does not mean a full or even a partial hedge should be used, considering the loss of the premiums and the fact that hedging is a negative NPV non-risk neutral decision. Essentially a treasury department must decide that given the violations to the assumptions to Modigliani-Miller, to what extent should hedging be used? If the probability of the red cell is remote, even if it exceeds that of the green cell, hedging might not make sense given the premiums. If the probability of the “Insolvent caused by hedge” cell is significant, hedging begins to make more sense. For example, the significant probability of the “Insolvent caused by hedge” cell event explains why hedging is prevalent in the finance industry. However, outside of the financial industry, hedging makes less sense as the probability of the “Insolvent caused by hedge” event falls.

Bottom line:

This type of methodology and risk analysis, a form of Value-at-Risk, applies to non-financial firms and can assist corporate treasury departments make optimal decisions for currency risk, as well as apply this methodology to other treasury functions.

Operating an effective corporate treasury department in a multinational company requires theoretical knowledge, strong internal review and control, and solid execution. Blanket policies concerning hedging can cost the company millions in unnecessary premiums and increase the risk of financial impairment and insolvency.

¹ http://faculty.haas.berkeley.edu/parlour/Teaching/corp_intro.pdf  A brief but sufficient outline of Modigliani-Miller assumptions.