Introduction
American Express (Amex) is an American company headquartered in New York and listed in Fortune 500 as the provider of multinational financial services since its inception in 1850. The company offers global services in payment, expense, and travel management solutions with a wide range of products subdivided into three major categories, namely, charge cards, credit cards, and traveler’s related businesses (American Express, 2017).
In its market expansion, Amex established joint ventures with steamships, railroads, and air transport. The company has expanded its product line to include marketing and point-of-sale and information products and services. Amex sells its products to diverse customers, including small businesses and large corporations, through mailing, third party, and online applications (American Express, 2017).
Although product-line expansion and joint ventures promote continuous growth and sustainable business development, the company faces diverse challenges in its investment strategies. In this view, this research paper discusses different economic hedging techniques utilized by American Express, currencies borrowed besides U.S dollars, the foreign currency offset of economic exposures that curb fluctuation risks and stabilize business activities, and the various hedging techniques adopted by other companies.
Hedging Techniques
Forward Contracts
Currency fluctuations negatively affect global business and reduce the profitability of global firms. Forward contracts provide flexible exchange engagements that effectively protect businesses from the risk posed by forex uncertainty and market volatility. In striking its foreign business agreements and travel businesses, Amex utilizes forward contracts to set exchange rates and establish invoiced payments. The period of the forward contract has a limit maximum of a year from the day of the agreement. The approach stabilizes business operations and provides market certainty over the value of a foreign invoice, resulting in the effective management of currency risk.
The hedging technique allows Amex to plan its pricing strategy and business diversification within the known margins of sales with predictable financial gains. Additionally, to tap the benefit of a possible improvement in the exchange rate, the company utilizes forward window contracts that have greater flexibility, hence allowing multiple foreign payments on an agreed percentage of the invoice with the remaining percentage exchanged at the market rate on the day of the transaction. The flexibility of payment allows Amex to determine the least value of payment it intends to receive while still planning for extra income. Overall, the technique protects the company’s cash-flow margins and enables accurate budgeting and financial planning.
Interest Swaps
Due to the interest rate exposure charged on cards and fixed-rate lending products, the company utilizes interest rate swaps to convert fixed-rate debt to a variable rate and vice versa. Amex employs an interest rate technique to manage its charge card business in the foreign market. Interest swaps provide the company with a diversified investment plan involving risk and return features that dictate the cash flow (Bhargava et al., 2016). The economic technique guards the company against interest rate risk on existing debts through its influence of floating and fixed funding. The principle of this technique is to serve as a reference for determining cash flows and set a price level that is appropriate for stable income and customer satisfaction.
Table I: Amex’s Financial Activity1
1The table shows the annual financial activity of Amex during 2014, 2015, and 2016 by highlighting net income, cash flows, and total assets (Yahoo Finance, 2017).
From the Amex’s financial activity table (Table I), the net borrowings experienced in 2014, 2015, and 2016 vary greatly with a comparable amount of exchange rate changes. The net borrowing of -136,000, -7,928,000, and 1,878,000 relates to the exchange rate changes of -114,000, -276,000, and -232,000 accounted in 2014, 2015, and 2016 respectively (Yahoo Finance, 2017). Given the global market variability in interest rates and foreign currency rates, a rate swap enables the company, through intensified exposure to interest rate fluctuation risk, to mitigate the future financial risk associated with political and economic instability. Additionally, the technique enhances Amex market competition by building a strong relationship with clients through trust, reliability, and long-term financial contracts.
Options
A forex option is a contract for future delivery of the currency in exchange for another that runs for a specified period, which allows the purchaser of the right to trade at the agreed strike price. Options provide the right to buy or sell a specified amount of currency at a given exchange rate. However, a trader does not have an obligation to purchase an option before reaching an agreed price.
Amex exercises purchase and sales of options both on a maturity date on European markets and at any time up to its maturity date in America. However, since the American option permits its holders to exercise the free money-option before the due date, it fails to protect Amex from foreign currency exchange risk. On the contrary, the option creates more opportunities for gaining benefit from favorable exchange rate movements.
The approach provides an income to the company and acts as a form of insurance against foreign exchange risk. The forex option provides an opportunity to tailor foreign exchange risk management to individual needs. Given that the forex option protects businesses from adverse exchange rate movements while accruing benefit from favorableones, as it does not lock future currency that can result in loses, this technique is a strategy that allows Amex to share the benefits of an arrangement before or on a trigger rate.
Currencies Borrowed Besides U.s Dollar
Global market growth continues to be an attractive venture despite the many regulatory and economic challenges attached. From the table, the American Express global operations show a high fluctuation on growth rate with yearly net income growth calculated to 4.75% and -12% in 2016 and 2015, respectively.Álvarez-Díez et al. (2016) hold that the adoption of multiple currencies enables risk managers to evaluate and plan a predictable exchange rate forecast, which reduces the risk of currency collapse and economic exposure.
Thus, it is arguable that the high net income decrease in 2015 was a result of the economic effects of Brexit in the Eurozone. Amex offers a range of charge cards in only two different currencies, with charges billed in the currency of the card account. Apart from the US dollar, the company trades in Euros for its international businesses.
Table II: Annual Percentage Growth Rate of Income1
1Fluctuation of net income in the last three years, 2014, 2015, and 2016 (Yahoo Finance, 2017)
The limitation is beneficial in regulating and improving the convenience of settling payments. Given the global market acceptability, Euro facilitates currency transfers within and outside the European boundaries and reduces the cost of transfer. Additionally, forex traders trade on Euro currency depending on information of national economies of the countries in Eurozone. Thus, the adoption of Euro currency by Amex is essential in stimulating trade activities with many clients in the global markets and sustaining its growth.
Foreign Currency Offset of Economic Exposure
Euro is the second largest foreign currency in the world after the US dollar that offers high exchange rates. Drakopoulou (2015) argues that the use of strong currencies enables Amexto offset economic exposure risks due to its stability, high exchange rate, and acceptability in the global market. As shown in Table II, the company realized quick recovery from the previous year net income depreciation of 12% in 2015 to a 4.7%increase in 2016. The quick recovery is attributable to the Euro currency and Eurozone economic stability, which lowers transaction costs, promotes price transparency, eliminates exchange rate uncertainty, lowers interest rates, and improves trade and inflation performance.
Additionally, Euro stability improves inflation performance and eliminates volatile exchange rate. Given that Amex has invested in the Euro currency and accepted markets to facilitate convenience through the establishment of its subsidiaries and joint ventures, the company enjoys the benefit of reduced trading banking, bonds, and equity assets. Therefore, trading in Euro currency by Amex effectively mitigates economic exposure by offsetting the variable rate exposure with the variable rate revenue from the subsidiary.
Hedging Techniques Across Different Companies
Debt
Debt refers to borrowing in the currency exposed in the market or investing in interest-bearing assets intended to offset a foreign currency payment. According to Lenkey (2016), corporate managers utilize tradeoff information in establishing regulations and strategies to moderate volatile currency and improve business activities. In this technique, due to rate uncertainties, a company trading with its customer in a foreign market with different currency takes a loan from the financial market providers and changes it in the spot market to foreign customer currency for the period equal to the maturity of the contract forwards waiting for customer payments. When the company receives the payment, it proceeds to pay down the debt and incurs only the cost of rate difference.
Currency Futures
Currency futures are contracts for a delivery of a standard amount of foreign currency at some time at a future date with its set price determined at the initial stretch of the contract. Ischuk et al. (2016) explain that unpredictable hedging techniques significantly affect the exposure level of businesses to economic risks. Futures contracts have standardized delivery dates allowing the contract to be more reliable and predictable.
Additionally, companies trade futures in organized exchange frameworks in clearinghouses such as LIFFE, IMM, and SIMEX independent of individual customers’ private agreements. Given that futures contracts undergo evaluation each day at their market values, as gains or losses determine the margin balance. The involvement of clearinghouses in fixing futures contracts helps to minimize the default risk in the market, establish uniformity, and promote liquidity of the market.
Conclusion
Hedging is an essential economic technique that involves taking an offsetting position in investment to reduce the risk associated with adverse price movements of a commodity. In Amex, corporate managers construct hedging processes based on their risk exposure, exchange rates, and interest rates. Hedging techniques comprisewell-designed programs such as forward contracts, interest swaps, and currency options. Moreover, other hedging techniques utilized by different companies in the market to reduce risk exposure and operation cost include futures contract and debts. Overall, hedging increases shareholders value by decreasing the cost of capital invested and stabilizing the projected returns.
References
Álvarez-Díez et al. (2016) Hedging Foreign Exchange Rate Risk: Multi-currency Diversification, European Journal of Management and Business Economics, 1, 2-7.
American Express. (2017) Our Company. Web.
Bhargava et al. (2016) Volatility Spillovers across the Markets: Evidence from US, Australian, and Japanese Swap Markets, International Journal of Bonds and Derivatives, 4, 59-86.
Drakopoulou, V. (2015) Bank Holding Companies’ Accounting versus Economic Hedging Activities in the SFAS 133 Framework, Universal Journal of Accounting and Finance, 1, 30-44.
Ischuk, et al. (2016) Gold as a Tool for Hedging Financial Risks, Earth and Environmental Science, 11, 1-5.
Lenkey, S. (2016) Information-Hedging Disclosures and Insider Trading, Journal of Business Finance & Accounting, 10, 1280-1296.
Yahoo Finance. (2017) American Express Company (AXP). Web.