The Handbook of Corporate Financial Risk Management (2nd Edition)
First published:
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Currency Risk on Covenants
Currency Risk on Covenants
Foreword
Introduction
Theory and Practice of Corporate Risk Management
Theory and Practice of Optimal Capital Structure
Introduction to Funding and Capital Structure
How to Obtain a Credit Rating
Refinancing Risk and Optimal Debt Maturity
Optimal Cash Position
Optimal Leverage
Introduction to Interest Rate and Inflation Risks
How to Develop an Interest Rate Risk Management Policy
How to Improve Your Fixed-Floating Mix and Duration
Interest Rates: The Most Efficient Hedging Product
Do You Need Inflation-linked Debt?
Prehedging Interest Rate Risk
Pension Fund Asset and Liability Management
Introduction to Currency Risk
How to Develop Currency Risk Management Policy
Translation or Transaction: Netting Currency Risks
Early Warning Signals
How to Hedge High Carry Currencies
Currency Risk on Covenants
Optimal Currency Composition of Debt 1: Protect Book Value
Optimal Currency Composition of Debt 2: Protect Leverage
Cyclicality of Currencies and Use of Options to Manage Credit Utilisation
Managing the Depegging Risk
Currency Risk in Luxury Goods
Introduction to Credit Risk
Counterparty Risk Methodology
Counterparty Risk Protection
Optimal Deposit Composition
Prehedging Credit Risk
xVA Optimisation
Introduction to M&A-related Risks
Risk Management for M&A
Deal-contingent Hedging
Introduction to Commodity Risk
Managing Commodity-linked Revenues and Currency Risk
Managing Commodity-linked Costs and Currency Risk
Commodity Input and Resulting Currency Risk
Offsetting Carbon Emissions
Introduction to Equity Risk
Hedging Dilution Risk
Hedging Deferred Compensation
Stake-building
In this chapter, we return to the subject of financial constraints. One of the most important corporate constraints is financial leverage, commonly defined as total debt/EBITDA or net debt/EBITDA. Leverage is important as it impacts a company’s credit rating, cost of funding and sometimes is also explicitly restricted by loan covenants to not exceed a certain level.
There are three ways that leverage constraints can be endangered. The first is if the denominator, EBITDA, drops as a result of weaker business than originally envisaged. The second is if the debt rises due to higher funding needs. These two cases have to do with business risk, but the third one is the most interesting for us in the context of currency risk. If a significant part of EBITDA is in a foreign currency, EBITDA may fall, even though the underlying business is doing well, purely as a result of depreciation of the foreign currency against the reporting currency of the company. Similarly, if a part of debt is in a foreign currency, the overall debt will be impacted by currency fluctuations.
This kind of risk can be hedged against by matching the debt and assets by currency. For example, if a EUR company
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