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The following appears in Jardine Matheson's 2020 annual report's Financial Review section:

Treasury Policy

The Group manages its exposure to financial risk using a variety of techniques and instruments. The main objectives are to limit foreign exchange and interest rate risks to provide a degree of certainty about costs. The investment of the Group’s cash resources is managed so as to minimise risk, while seeking to enhance yield. Appropriate credit guidelines are in place to manage counterparty risk.

When economically sensible to do so, borrowings are taken in local currency to hedge foreign exchange exposures on investments. A portion of borrowings is denominated in fixed rates. Adequate headroom in committed facilities is maintained to facilitate the Group’s capacity to pursue new investment opportunities and to provide some protection against market uncertainties. Overall, the Group’s funding arrangements are designed to keep an appropriate balance between equity and debt from banks and capital markets, both short and long term in tenor, to give flexibility to develop the business.

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Refer to the part in bold. How exactly does this hedging method work? How can borrowings in local currency be used to hedge foreign exchange exposure on investments?

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The phrase 'local currency' in the quoted section of your question refers to currency local to the same jurisdiction as the company's individual foreign investments. They are referring to the idea of borrowing funds in the same currency as where the revenue will come from.

Consider a US mega-corp with holdings around the world. Something that requires heavy investment wherever it expands operations, where it sells into the same local markets, meaning revenue for different operations is in these foreign 'local' currencies*. A good example would be manufacturing, in a case where the manufactured goods are expected to be sold locally.

You have two options to pay for this expansion, assuming you need to take on debt to do so: you could borrow your 'home' USD currency, and then sell it for CAD or whatever to pay local employees, or you could directly borrow CAD. Assume that for the first 5 years, total debt repayment [principal repayments + interest costs] on debt might eliminate all or nearly all of the anticipated revenue. This means that failing to put the debt repayment costs in the same currency as the anticipated revenue, can create a large fx risk.

If you have $100M in CAD revenue and $100M CAD in debt repayment, then you have 0 net USD cashflow, regardless of the fx rate. In 5 years, assume you pay off the debt, and you have $100M in CAD revenue. It is true that the USD-equivalent value of that cashflow will be volatile according to the exchange rate, but less so than a case where inflows and outflows are in different currency. ie: volatility in value of CAD, between 0.75 USD and 0.85 USD means that your net income in year 5 would be between 75M USD and 85M USD [ie: your net income has volatility of like 10-15%].

If you have $100M in CAD revenue but $80M in USD debt repayment, then a strengthening CAD gives you higher net cashflow, and a weakening CAD gives you lower net cashflow. If the value of CAD moves between .75 USD and .85 USD, then you could have anything from a loss of ~$5M USD to a gain of $5M USD [ie: your net income has volatility of like -100% to +100% This is proportionately a much larger degree of volatility than a shift of 10-15% as in the above 'hedged' example]. Once you pay down the debt, the risk is the same as above, but in the interim period, the risk is greater where the cost of debt is not offset naturally by the incoming revenue.

Matching your cash inflows and outflows in the same currency naturally offsets some of the fx risk associated with foreign expansion, without needing to undertake potentially more expensive hedging processes.

*Note that in some cases, location of the foreign investment won't impact revenues - for example in Oil & Gas, revenues would almost always be in USD by industry convention, so in a case like that, the relevant revenue currency to hedge with the correct debt currency would be USD [which for accounting purposes would likely be considered the 'local currency' anyway, and would be grouped as such in the broad statement in your question].

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Suppose you set up shop in the US and hire some staff. You see some activity in France that you’re sure will produce exceptional returns, so you convert all your USD into EUR to invest.

At the end of the month, your staff want their wages, but your capital is tied up in EUR and it needs just a bit more time to start generating cashflow. So you really don’t want to sell right now.

What you might do instead is to borrow USD against the EUR investment so that you have some funds with which to pay staff.

Note: if you're borrowing, you should expect that the lender will one day want their money back. If the EUR investment doesn't pay off, you might end up with a loan but no capital with which to repay. This would be bad. Don't engage in it without seeking competent financial advice.

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  • Could you elaborate more about the mechanics of borrowing USD against the EUR asset? What if the exchange rates move in such a way that the borrowed USD greatly exceeds the USD collateral value of the EUR asset?
    – Flux
    May 24, 2021 at 17:00
  • @Flux It's risky. I've added to my answer as requested.
    – Lawrence
    May 24, 2021 at 17:26
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    I think this answer is misinterpreting the phrase 'local currency'. See my answer below. May 26, 2021 at 13:48
  • @Grade’Eh’Bacon Although both can work, borrowing in the currency of the investment (your answer) makes more sense than borrowing with an FX exposure. But in that case, I don’t see how that can be described as hedging. It’s a completely unhedged exposure.
    – Lawrence
    May 27, 2021 at 5:56
  • I'm not understanding what you're saying - in my example where the borrowing is in the same currency as anticipated revenues [slightly different than saying currency of investment, but in the same vein], the exposure to volatility of future inflows is hedged. In your example, you have described how someone could take a speculative currency position [invest in EUR assets as a USD business], and still pay staff in USD [by borrowing a USD loan and using it to pay staff in USD]. If the EUR strengthens, the business earns fx income, and if the EUR weakens, it incurs fx losses. Where is the hedge? May 27, 2021 at 12:42

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