Why hedge against currency risk?

Netflix, the US streaming giant, has just announced stellar quarterly results. While operating income totalled $2.3bn 4Q 2024, the operating margin grew by five full points to 22%, despite the strengthening of the US dollar vs. most currencies.

Spencer Neuman, CFO at Netflix CFO, acknowledges the importance of the firm’s FX hedging program. The reason is clear: “Roughly 60% of our revenue is in non-U.S. dollar currencies.” The company only expects that proportion to grow in the future.

Netflix’s stance neatly illustrates the strategic importance of sound currency management in terms of enhancing the value of the firm. The firm’s market capitalisation is north of $430 billion: 

‍Other companies that actively hedge their exposure to currency risk are also seeing their market value expand. Recent cases include: 

• easyJet. The stock price jumped on the heels of the announcement of  £610 million in pre-tax earnings, including details about the airline’s FX hedging program.

• HBX Group. While actively running a comprehensive hedging program, the world’s leading wholesaler of hotels plans an IPO in Spain at a €5 billion valuation.

All of this leads to the question: What is FX hedging all about? And how does it contribute to firm value? Let us start by reviewing the basics of FX hedging.

The life-span of a commercial transactionAs they seek to manage currency risk, CFOs and treasurers are haunted by the variety of concepts and definitions regarding FX hedging. Should they care about the operating exposure, the transaction exposure or the accounting exposure?And how are profit margins and cash flows protected? A quick review of the life-span of typical FX-denominated transaction provides much needed clarity: 

Some definitions are in order: 

• Accounting exposure. It includes changes in balance sheet items that are caused by an exchange rate change. The resulting FX gains and losses are determined by accounting rules and are ‘paper’ only. This measurement is retrospective in nature and is based on activities that occurred in the past. 

• Transaction exposure. It arises from known, contractually binding future foreign-exchange denominated cash inflows or outflows. These are also known as firm commitments. Because the exchange rate fluctuates between the moment a transaction is agreed and its settlement, it gives rise to currency risk.

• Forecasted exposure. It measures the extent to which currency market fluctuations can alter a company’s future operating cash flows, i.e., its future revenues and costs. As such, it is not properly related to contractually binding transactions, but to forecasted revenues and expenditures. 

• Economic exposure. It comprises the sum of two cash flow exposures: the transaction exposure and the forecasted exposure. To the extent that the value of a firm reflects the present value of a firm’s expected cash flows, this is the exposure that needs to be protected from currency fluctuations. 

A variety of possible scenariosCFOs and treasurers need tools to effectively manage their firm’s economic exposure to currency risk. Specific hedging programs —and combinations of hedging programs— reflect each company’s situation, especially its pricing parameters.For firms where pure transactional risk is prevalent —like in the Travel industry, where prices are frequently updated—, the main challenge is to remove the FX risk in a large number of transactions, in many currency pairs. This is the case, for example, of HBX Group.But what about Netflix? As always, the choice of cash flow hedging programs mostly reflects the company’s pricing parameters. For basic customer segments, where the firm keeps prices as steady as possible, the finance team is likely to combine a forecast-based hedging program with a program to hedge incoming FX-denominated sales orders.Note that each currency pair displays a different scenario in terms of interest rate differentials to USD, Netflix’s functional currency. While a series like Class Act is mostly sold in EUR, Sintonia is sold in BRL.This means that the hedging program needs to be calibrated to reflect and manage the interest rate differentials between USD, EUR and BRL, a point that will be discussed in more detail in this series of blogs.

Why technology is neededSo far we’ ve stated two big issues or pain points for companies:The need to manage cash flow exposures. To protect the firm’s economic exposure to currency fluctuations, CFOs and treasurers need hedging programs that tackle two types of cash flow exposures: transactional and forecast-or budget-based. The inherent complexity of the process. A large number of FX-denominated transactions in different currency pairs, each with different interest rate differentials, makes it all but impossible to effectively manage currency risk with manual tools (*).Is there a way out of this convolutedness? The answer is a resounding Yes! Advances in cloud-based, real-time API connectivity are making it possible for currency managers both to remove transaction risk and to implement combinations of cash flow hedging programs. We will deal with these real-life situations in more detail in coming blogs. To anticipate what awaits use, the following table provides an overview of these possible scenarios:

Risk mitigation and growthCorporate finance textbooks take it for granted that risk mitigation is the ultimate goal of CFOs and treasurers in their capacity as currency managers. We beg to disagree. Currency management is about allowing finance teams to use more currencies in business operations and enhance the value of the firm by:Profitably increasing salesBeefing up profit marginsEnhancing competitivenessReducing credit riskReducing cash flow variability‍Once currency risk is confidently under control, these exciting opportunities lie wide open. A recent survey from Amadeus shows that 71% of customers spend more when shopping in their own currency and 80% of them prefer to shop in their own currency.This shows the extent to which effective currency risk management helps companies grow their sales. Note that, by buying in their client’s currencies, the credit risk in account receivables diminishes in proportion to the security that customers have as they pay in their own currency. In turn, when companies buy in more currencies, they can remove the burden of FX risk management off the shoulders of their suppliers, who otherwise would charge markups to manage the underlying risk. Depending on the level of profit margins, this can make or break a firm’s path to profitability.And this is not all. By effectively managing interest rate differentials between currencies, CFOs and treasurers put their firms in a position to profit from favourable scenarios —either to beef up profit margins or to price more competitively—, or to lower the cost of hedging in the face of unfavourable interest rate differentials. Finally, transactional hedging —especially when applied in combination with forecast-based hedging programs— can reduce the variability of long-term cash flows, allowing investors to apply a lower discount rate and arrive at a higher firm valuation. And that’s quite a lot!