358 Planning and Forecasting
Experience indicates that such suppliers would expect to be compensated
for bearing this risk and would charge more for their products.^4 An alternative
approach, the use of various hedging procedures, is the more common method
employed to manage the risk of foreign-currency exposure.
RISK MANAGEMENT ALTERNATIVES
FOR FOREIGN-CURRENCY
DENOMINATED TRANSACTIONS
Hedging is designed to protect the dollar value of a foreign-currency asset po-
sition or to hold constant the dollar burden of a foreign-currency liability.^5 At
the same time, the volatility of a firm’s cash f low or earnings stream is also
reduced. This reduction is accomplished by maintaining an offsetting position
that produces gains when the asset or liability position is creating losses, and
vice versa. These offsetting positions may be created as a result of arrange-
ments involving internal offsetting balances created through operational activ-
ities, or they may entail specialized external transactions with financial firms
or markets.
Hedging with Internal Offsetting Balances
or Cash Flows
Firms generally attempt to close out as much foreign-currency exposure as pos-
sible by relying upon their own operations. These arrangements are often re-
ferred to as natural hedges.As an example, consider the following commentary
about currency exposure from the 1999 annual report of Air Canada:
Foreign exchange exposure on interest obligations in Swiss francs and Deutsche
marks is fully coveredby surplus cash f lows in European currencies, while yen-
denominated cash f low surpluses provide a natural hedgeto fully cover yen in-
terest expense.^6Air Canada is able to prevent net exposure in the identified foreign currencies
by having offsetting cash f lows in the same currencies or in currencies whose
values move in parallel to the currencies in which Air Canada has interest obli-
gations. With the full transition to the Euro in 2002, Air Canada’s currency ex-
posure should be markedly reduced because most of the European Community
countries will share the Euro as their currency.^7 This will not, of course, alter
their exposure in the case of Asian currencies.
A sampling of other arrangements that could be characterized as natural
hedgesis provided in Exhibit 12.2. Virtually all of these examples illustrate the
offsetting of exposure through the results of normal operations. In the cases of
Baldwin Technologies and Interface, the hedges could be seen to be seminat-
uralif they result from a conscious action to create offsetting exposure. That is,
does Baldwin Technology determine the cash balances to maintain after first