Western mining’s economic exposure management

Western mining’s economic exposure management

Kim, Suk H

It is critical for business executives to clearly understand the dynamic interaction of currency exposure and exposure management for their company’s long-term welfare (Kim and McElreach, 2001, Malindretos and Tsanacas, 1995, and VanderLinden, 1997). This case recounts how Western Mining Company (WMC) assessed its foreign exchange exposure and decided to hedge these exposures (Maloney, 1990). WMC is an Australian based mineral producer with business interests in nineteen countries. It is the world’s third largest nickel producer, owns 40 percent of the world’s largest alumina producer (Alcoa World Alumina and Chemicals), and is a major producer of copper, uranium, gold, fertilizer, and talc. WMC builds its business on large, low cost, and long life assets, which are globally competitive.

Most commodities produced by Australian mining companies, including WMC, are exported and priced in US dollars. Thus, these companies would suffer significantly and their Australian dollar revenue would drop if the Australian dollar appreciated sharply against the US dollar. Given such an exposure, the conventional wisdom held that borrowing in US dollars would provide a “natural” hedge against their dollar revenue stream. When forward markets began to develop in the mid-1970s, Australian mining companies often hedged up to 100 percent of forecasted revenues with a combination of debt servicing and forward contracts–often for periods up to ten years. In the early and mid-1980s, the Australian dollar declined sharply against the US dollar, and the “natural” hedge proved not to be a hedge at all, but rather an uncovered short position in the US dollar. As expected, the decline in the Australian dollar increased the cost of serving US dollar debt. And those companies that had also sold forward their expected dollar revenue stream also suffered further foreign exchange losses as these contracts matured. The positive effect of the stronger US dollar on dollar-denominated revenues was offset by a prolonged slump in mineral commodity prices.

Although WMC too experienced some currency losses, it fared better than many of its competitors for two reasons. First, it had relied more on the equity markets to finance capital expenditures. Second, it had not participated in new major projects in the early 1980s. In 1984, however, the company contemplated investment in new copper, uranium, and gold mine, with capital costs expected to be about $750 million. Under arrangements with a joint venture partner, the company planned to finance its share of the mine solely with debt, thereby increasing its total debt by a magnitude of two or three times.

When confronted with the need to decide the currency denomination of the debt, WMC concluded that taking a short position in US dollars, whether by borrowing or selling forwards, would not stabilize the volatility of its home country operating profits. Consequently, WMC decided to borrow in a basket of currencies that included Australian dollars, US dollars, Japanese yen, British pounds, and Deutsche marks. The company also decided to discontinue its practice of selling forward US dollar revenues, except when actual sales had been made.

Case Questions

I. Evaluate pros and cons of various exchange-hedging instruments and techniques.

2. What are the different types of foreign exchange risk WMC will encounter?

3. Explain why borrowings in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980s had backfired.

4. Explain why WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars.

5. What are two possible ways to hedge economic exposure?

6. Explain why WMC decided not to hedge its economic exposure.

TEACHING NOTES FOR WESTERN MINING’S ECONOMIC EXPOSURE MANAGEMENT

1. Evaluate pros and cons of various exchange– hedging instruments and techniques.

INSTRUMENTS. There are four instruments multinational companies can use for hedging their foreign exchange exposures: forwards, futures, options, and swaps.

Forwards are custom-made contracts to buy or sell foreign exchange in the future at a presently specific price. Maturity and size of contracts can be determined individually to almost exactly hedge the desired position. The hedging method uses up bank credit lines even when two forward contracts exactly offset each other.

Futures are ready-made contracts to buy or sell foreign exchange in the future at a presently specific price. Their advantages are: no credit lines required; easy access for small accounts; fairly low margin requirements; and contract’s liquidity guarantee by the exchange on which it is traded. Their disadvantages are: they are too structured (e.g., only four maturity dates per year); and margin requirements cause cash-flow uncertainty and use managerial resources.

Options are contracts that offer the right but not the obligation to buy or sell foreign exchange in the future at a presently specific price. Options allow hedging of contingent exposures and taking positions while limiting downside risk and retaining upside potential for profit. However, their benefits are not readily observable because options are like insurance coupled with an investment opportunity; thus, some may believe that options are too expensive.

Swaps are agreements to exchange one currency for another at specified dates and prices. They are versatile, allowing easy hedging of complex exposures. Documentation requirements may be extensive.

TECHNIQUES. There are four techniques multinational companies may use for hedging foreign exchange exposures: money-market hedge, commodity hedge, leads and lags, and balance-sheet hedge.

The money market hedge creates a synthetic forward by borrowing and lending at home and abroad. It is useful when forwards, futures, or swaps markets are thin, particularly for long dated maturities. Disadvantages include: they utilize costly managerial resources and may be prohibited by legal restrictions.

The commodity hedge involves “going short or long” a commodity contract denominated in a foreign currency to hedge a foreign exchange asset or liability. Commodity markets are usually deep, particularly for maturities up to a year. Price changes of commodities, in terms of home currency, may not exactly offset price changes in the asset or liability to be hedged.

Leads and lags involve equating foreign exchange assets and liabilities by speeding up or slowing down receivables or payables. This technique avoids unnecessary hedging costs. Disadvantages are: appropriate matches may not be available, and it may utilize costly managerial resources.

The balance-sheet hedge equates assets and liabilities denominated in each currency. This method avoids unnecessary hedging costs. However, appropriate matches may be not available.

2. What are the different types of foreign exchange risk WMC will encounter?

WMC will encounter all three major types of exchange risks: translation, transaction, and economic. First, because WMC operates in nineteen different countries and the Australian law requires the company to consolidate its global operations, it will be exposed to translation gains and losses. Second, because WMC borrows in foreign currencies and its foreign sales are priced in US dollars, it will be exposed to transaction gains and losses. Third, because MNC’s future sales will be priced in US dollars, it will face economic exposure.

3. Explain why borrowings in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980s had backfired.

If the Australian dollar increased sharply against the US dollar, the above strategy would have worked well for Australian mining companies. However, when the Australian dollar declined sharply against the US dollar in the 1980s, Australian mining companies suffered foreign exchange losses for several reasons. First, because Australian mining companies had borrowed in US dollars, the US dollar appreciation increased the amount of their Australian dollar loans and thus led to exchange losses. Second, because Australian mining companies had sold forward their expected dollar revenue stream, they suffered further exchange losses as these contracts matured. In other words, if Australian mining companies did not sell forward their expected US-dollar revenues, the US dollar appreciation would have enabled them to realize foreign exchange gains. Third, the positive effect of the strong US dollar on dollar– denominated revenues did not materialize because Australian mining companies had sold forward most or all of their expected dollar revenue stream for up to ten years.

4. Explain why WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars.

WMC decided to borrow in a basket of currencies for two major reasons. First, the Australian-dollar loan market was not extensive enough to meet all the needs of the company. Second, currency diversification provided by a basket of currencies will minimize or hedge foreign exchange risk associated with single– currency loans because different currencies in the basket are highly unlikely to move in the same direction.

5. What are two possible ways to hedge economic exposure?

There are basically two possible ways to hedge economic exposure: operational hedges and financial hedges. An example of an operational hedge, known as the balance-sheet hedge, is a change in sourcing to maintain the same amount of exposed cost and revenue in each currency. If a supplier can be changed with no compromise in quality, delivery, or reliability, then it probably makes sense to do so. The currency mix of a firm’s cost stream often can be altered by relocating a plant to a different country. Any decision to reduce currency exposure by means of operational changes in suppliers or plant location obviously must balance the potential reduction in foreign exchange exposure against many possible operating disadvantages.

Financial hedges using forward currency contracts or other derivative instruments may or may not be effective in reducing economic exposure; in some cases, they may even make the problem worse. The use of a long-term forward contract would freeze the nominal exchange rate but leave the inflation differential unaffected, thus introducing exposure where none existed. Such a hedge would represent a bet, in effect, on the direction of the inflation differential. Thus, the forward contract fixes one of two variables that tend to move counter to one another. It fixes the nominal exchange rate, leaving the inflation differential with no offsetting influence. As a result, a long-term financial hedge with forward contract may increase economic exposure rather than reduce it.

6. Explain why WMC decided not to hedge its economic exposure (i.e., future US-dollar revenues).

It is very difficult, if not impossible, for WMC or any other companies to hedge economic exposure for several reasons. The scope of economic exposure is broad because it can change a company’s competitiveness across many markets and products. A company always faces economic risks from competition. When based in foreign currencies, the risks are long-term, hard to quantify, and cannot be dealt with solely through financial hedging techniques. For example, currencies are so volatile that it would be impossible for forecast more than a few days or a few months into the future with a fair degree of accuracy.

The case stated that the use of forward contracts to hedge economic exposure by Australian mining companies in the 1980s had backfired mainly due to those reasons described above. Thus, WMC decided to hedge only its transaction exposure and to discontinue the use of forward contracts for its economic exposure. Thus, it is wise to use forward contracts when foreign currency cash flows are known (transaction exposure) and to use options when foreign currency cash flows are unknown (economic exposure).

REFERENCES

N. Abuaf, “The Nature and Management of Foreign Exchange Risk,” Journal of Applied Corporate Finance, Fall 1986, pp. 39-44.

Y.C. Kim and R. McElreach, “Manning Foreign Exposure,” Multinational Business Review, Spring 2001, pp. 21-26.

P.J. Maloney, “Managing Currency Exposure: The Case of Western Mining,” Journal ofApplied Corporate Finance, Winter 1990, pp. 29-34.

J. Malindretos and D. Tsanacas,” Multinational Business Review, Fall 1995, pp. 56-66.

D. VanderLinden, “After-Tax Transaction Exposure,” Multinational Business Review, Fall 1997, pp. 16-22.

Suk H. Kim (kimsuk@udmercy.edu)

University of Detroit Mercy

Joseph K. Winsen

University of Newcastle

Copyright College of Business Administration. University of Detroit Mercy Fall 2001

Provided by ProQuest Information and Learning Company. All rights Reserved