[MUSIC] In this video, we examine five non-financial foreign exchange hedging strategies. Recall that there are two main types of forex hedging strategies. There are non financial strategies and financial strategies. In this video we focus on non financial hedging strategies, which include cashflow netting, accounting strategies, marketing strategies, supply chain strategies and production strategies. The best way to reduce both forex expense and forex, is to reduce the need for currency exchange in the first place. One excellent way to do this is with cash flow netting. This method is best suited for multinational companies that have offices, subsidiaries, customers and vendors in multiple countries using different currencies. The goal of cash flow netting is to minimize the size and number of foreign exchange transactions by consolidating and reconciling cash flows between countries. There are two ways to undertake cash flow netting. The easier is bilateral netting where foreign exchange transactions are reconciled between office pairs. And more complexes multinational or multilateral netting, or forex transactions are reconciled between multiple offices. Because of its complexity, a centralized forex clearing function is often required for multilateral netting. As an example of cash flow netting, suppose we have a US company that does business in the US, Canada, the UK and Germany, with offices in each. At the end of the month the company has payables and receivables as shown here. And that the amount shown could be thousands, tens of thousands, hundreds of thousands or even millions of dollars, doesn't matter for our example. Looking at the German office it has payables of $20 to the UK payable in pound sterling. $10 owed to Canada payable in Canadian dollars, and $35 payable in US in US dollars. All values are shown in US dollars at the current exchange rate whatever that is. The German office also has receivables of $10 from the US, 25 from Canada and 30 from the UK all payable in euros. These six foreign exchange transactions for the German office total $130. And the 12 forex transactions for the entire company total $350, $350,000 or whatever the units are. That's a lot of forex, how to manage it? First and most easily the firm can use bilateral netting to significantly boosts its forex transactions. Bilateral netting simply subtracts payables from receivables for each country pair as shown here. Looking again at German operations in aggregate the German office owes the US a net of, $25, is $35 minus $10. Canada owes Germany a net $15 that's 25 out or owed versus 2015 coming in. And Germany should receive a net of $10 from the UK, 30 minus 20. Across the country, bilateral netting reduces the number of forex transactions from 12 to 6, quite a significant improvement. But further improvements are available with multinational betting when all currency flows are considered together. Examining the bilateral solution, we see that the US should receive a total of $55. Canada owes a total of $15 and the UK owes $40 and Germany owes nothing and receives nothing. Rearranging all the cash flows accordingly as shown in this third diagram, we can reduce the total number of forex transactions to only 2, with values to be exchanged of only $55. This reduction in foreign exchange from 350 to only $55 is a huge improvement over the original. This example shows that cash flow netting can greatly reduce the forex exposure of large organizations operating in multiple countries. For these large organizations netting can be complex requiring sophisticated accounting and information systems. But can pay large dividends by reducing forex transactions and expenses. Another means of reducing forex exposure is to adjust cross-border payments and receipts given currency exchange forecast. For example, if a foreign currency is expected to strengthen, and pay foreign currency payables before they are due, and delay collection of foreign currency receivables. If a foreign currency is expected to weaken, then delay payment of foreign currency payables, and collect foreign currency receivables before they are due. These strategies assume that customers and vendors will cooperate by adjusting their payables and receivables as requested, and that currency movements can be accurately forecast perhaps optimistic. These are optimistic assumptions so lead and lag behind accounting strategies may be difficult to implement in practice. Long term currency exchange rates move up or down, marketing strategies can be adjusted in response. For example, markets with favorable forex rates can be grown while markets with deteriorating forex can be allowed to decline. Prices can be adjusted down below market share when there are forex gains and adjusted up to recover forex losses. As an aside, empirical research shows that with increased forex costs, companies will pass through about 50% to 70% of their increased cost to customers. Similarly, promotional strategies can be quickly adjusted in reaction to medium term forex movements. For example, if the British Pound weekend's versus the Euro, then vacation promotions can focus on travel to England since English vacations have become cheaper than European vacations. Another effective way to manage forex risk is with supply chain strategies. Supply chain hedging is accomplished by changing the location of operations to minimize forex risk. This can be done in several ways. For example, diversify sources of supply by creating a portfolio of suppliers with different home currencies, and then rebalance purchasing locations when forex rates change. Similarly, create a portfolio of transportation carriers with different home currencies and then rebalance currencies or carriers rather when forex rates change. A final non financial means of hedging for us forex risk is to relocate and diversify production facilities. This is perhaps the most effective long term strategy to minimize forex risk, but it is time consuming and expensive. This method is often called natural hedging. As an example, the US market is one of the largest for BMW automobiles. BMW experienced significant US dollar euro foreign exchange exposure after the euro was first introduced in 1999. BMWs expenses were in euros but it's large us revenues were of course in US dollars, which exposed it to very significant forex operating exposure. So in 2010, BMW greatly expanded its US assembly plant operations in Spartanburg, South Carolina to manufacture BMWs for the US market. Expenses at the Spartanburg plant are in US dollars and sales of autos are in US dollars as well, thereby eliminating or at least mitigating forex exposure for US sales. By the way, Spartanburg is now BMWs largest plant and coincidentally it is the largest auto assembly plant in the United States of any brand. In summary, there are five important non financial methods of reducing forex exposure. Cashflow netting, which works to minimize forex transactions altogether. Accounting strategies that is adjusted time, accounts payable and accounts receivable. Marketing strategies that are just focused on foreign markets depending on forex rates. Supply chain strategies that use vendors and carriers in countries with attractive forex rates. And production strategies where manufacturing and services are relocated to reduce forex transactions. In the next video, we'll explore several financial strategies to reduce forex exposure. Stay tuned and we'll see you there. [MUSIC]
