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Do You Know Where Your Company's Currency Hedges Are?

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Merck's small hit from euro exposure could be a harbinger of bigger things to come.

When Merck said Tuesday that currency moves would push first quarter earnings slightly lower than expected, investors were left wondering whether there were other shoes to drop. The answer, says David McAlvany, chief executive of McAlvany Financial Group, is a resounding yes.

"This is the natural outworking of companies moving from a domestic base to being full fledged multinationals," he told me. Companies don't always get hedges right - and they don't even necessarily hedge all their currency exposure, he says. "A multinational company with operations in several different places - not only do you have operations there, but you have to show how it benefits you in your own currency. This is part and parcel of being a true multinational."

Not only that, McAlvany thinks exchange rates will have a greater effect on many multinationals' earnings in the coming quarters. The culprit, he says, is other countries' growing willingness to settle bilateral trades in currencies other than the dollar. U.S. multinationals that have benefited from less currency risk because of dollar settlements will lose that advantage in countries that change their practices, he says.

Firms in China used to settle all bilateral transactions in U.S. dollars, but that meant each side was taking currency risk in two forms - dollars and the trading partner's currency. "Now they're saying, 'Why are we taking on this double risk?' That's why they're moving toward a simplification of trade settlements," he told me.

This shift is especially bad news for large U.S. companies, in McAlvany's view.

"Most of these multinationals have risk in dollars, other revenues are euro driven, and on balance you lose here and win over here and it kind of works out over time. Some of these structural changes may shift that," he continues. "I think this is one of the most significant trends in the currency markets in 40 years. We're acting as if it's still status quo. We still live with the privileges of Bretton Woods, and the rest of the world is saying this really doesn't work for us."

China's changing rules may soon affect other markets as well. Late last month, a senior banking official said China should push to use the yuan to settle oil trade from central Asia, Russia, and the Middle East.

Still, not every U.S. multinational is going to take a hit. Tony Butler, an analyst at Barclays Capital who follows Merck and other pharmaceutical companies, says that while the large companies in his universe may feel currency effects in their revenues, they manage to hedge so that the ultimate effect on earnings is negligible. As for the changes in bilateral trading practices, Butler says the vast majority of drugmakers' overseas exposure is in euros and yen, so a change in Chinese firms' trade settlement practices will not make much difference.

"We try to forecast revenues at the end of the quarter, what the euro-dollar rate tends to be, and yen-dollar, and we adjust our predictions and revenue estimates. We've changed top lines a lot," he told me, but "we've never changed the bottom line."

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