IN-DEPTH: Hedging Currency Risks

Russia’s economy has operated mostly in US dollars for many years, with the US currency fulfilling more functions of money in Russia than the ruble. Meanwhile, the USD exchange rate dynamics against the euro and ruble over the past 18 months has, if not prompted businesses to take active financial risk management steps, then at least made them ponder how such risks ought to be managed and if it is altogether worth wasting the money and effort on hedging such risks.

Some companies switched to euro settlements, others introduced the average weighted rate for the ruble, calculated as a cross between the dollar rate and the euro rate.

Russian authorities have consistently pursued a policy of ‘de-dollarizing’ the economy, pledging to make the Russian ruble fully convertible by 2007 and to liberalize capital flows. These days, considering the decreasing inflation, higher availability of ruble-denominated loan capital and the development of the ruble investment market, the question arises: what currency will the Russian economy, including its real estate sector, use in the future?

Financial Risks and Hedging

The risks businesses are exposed to as regards to currency exchange rate dynamics fall into two categories, i.e. risks emerging during the effecting of a certain transaction and macroeconomic risks. As for transactions, currency risks emerge, for instance, in cases of deferred payments effected in a foreign currency.

The longer the period of time between the date the deal is closed and the date when the payment is due the higher the risk of exposure to changes in the currency exchange rate, resulting from which the amount paid in the long run will differ from the original amount in terms of the national currency.

On the macroeconomic level currency risks emerge when, as a result of changes in the currency exchange rate, goods and services sold at prices denominated in the currency of one country become more expensive or cheaper than similar goods and services sold at prices denominated in another currency.

Hedging currency risks is most difficult in a situation where the real currency ratio changes, with inflation rates being different.

Anticipating and hedging currency risks on the transaction level is easier than on the macroeconomic level. For instance, if a company operating in the ruble zone sells goods or services with a deferment of payment in dollars, to hedge the risk it suffices to enter into a forward deal and to sell the amount in dollars which the company is to get from its buyers. Or to raise a loan in dollars, the ruble cost of servicing which would change concurrently with the dollar exchange rate.

On the macroeconomic level, for instance, resulting from an increase in the euro rate against the dollar European-made cars grew in price as compared with US-cars, produced in the dollar zone, which, naturally, brought about a certain decline in demand for European cars. Of course, changes in currency rates are affected by government policies, especially in what concerns restrictions imposed on capital flow and the practice of intervention by state banks.

Hedging risks is an operation whereby a company seeking to hedge a certain risk accepts an ‘opposite’ risk. For instance, if a company plans to receive dollars within a short time period and is concerned about the possible slump in the dollar rate, it can sell dollars in a forward deal and in doing so to fix the rate in advance.

Hedging is, as a rule, a financial operation with the net present value close to zero, which is why making a profit on hedging risk is virtually impossible if the financial market is efficient and the company has no special data on future rate changes, unknown to the currency market.

It is necessary to clearly distinguish between hedging risks by non-financial companies and speculating on the currency market, in which participants of the professional financial market are engaged. Hedging only helps companies to stabilize its cash flow. Subsequently, with stable cash flows the company has funds to finance investment projects with a positive NPV. That is why hedging helps to divide operational solutions and anticipated currency risks.

Currency and Real Estate

Throughout the past thirteen years the Moscow real estate market has operated almost exclusively in dollars and hence property owners have not had to hedge risk. The cost of development, as well as prices and rental charges were measured in dollars. Thus, the sector was protected against currency risks.

It is deemed highly inexpedient for a real estate market player to attempt to derive extra benefit from its business at the expense of anticipated changes in the currency rate.

This is hardly feasible as regards the lease, since lease agreements are usually long-term, with the method of payment being fixed throughout the duration of the agreement. To begin with, it is unpractical to change the conventional currency unit from dollars into euros and back each time the rate changes considerably.

With an agreement being signed for a term of 3-5 years and more, its general terms and conditions are being fixed for that period and the parties proceed from the invariability of terms, which suits both the landlord and the tenant.

An attempt to change the method of payment during the execution of an agreement may lead to a revision of the main terms or to a rescission of the contract altogether.

Secondly, introducing average weighted units calculated as an average rate between the dollar and euro rates is unreasonable as well, because such a strategy is based on the assumption that the euro will remain strong against dollar for a lengthy period of time, and hence, the average weighted rate will exceed the rate of the dollar to the ruble.

Hedging may be necessary if, for example, a developer pays shareholders and banks in a currency different from the currency his business operates – for instance, a development company that raises a loan in euros and raises an office building.

Tenants then pay rental charges at the dollar equivalent, while the developer uses the yield for loan repayments. The currency risk arises from the fact that the developer’s liabilities are calculated in euros, and his assets – in dollars. The easiest way to hedge the risks in this case is either to collect rent in the euro equivalent or to borrow in dollars.

But only a few owners of office centers in Moscow, especially those from Western Europe, charge their tenants in euros.

If it is impossible to charge tenants the euro equivalent – for instance, if a European investor purchases an office building rented by tenants who pay in dollars – then other hedging schemes may be applied. For instance, a landlord who collects rent in dollars, may borrow in dollars, buy euros at a current rate and invest euros in European securities with an interest yield.

Looking to the Future

The changing dollar rate against the euro and ruble over the past year and a half has made market participants ponder the question of which currency the market will use in the future.

The ruble still lacks the qualities that the real estate market in its mid-term development needs; therefore, in the near future the choice will be between the euro and the dollar.

In the long-term outlook – some 7-10 years – the forecast, as regards to whether the ruble will replace the conventional currency unit, will depend on how successfully Russia implements the reforms that it has proclaimed and if the ruble becomes a hard currency, as the Russian government promises.