Netting is a currency risk management method, which is adapted to multinational companies willing to reduce their currency hedging costs engendered by the transactions that take place between their subsidiaries.
Indeed multinational companies have to optimise on a regular basis financial flows that take place between their subsidiaries. This consists essentially in offsetting inverse positions, which could be bilateral or multilateral.
Let ‘s take the example of a Japanese multinational with a Spanish and Chinese subsidiary. Let’s consider that the Spanish subsidiary must pay 500 000 USD to the Chinese subsidiary while in turn, the Chinese subsidiary must pay 300 000 USD to the Spanish subsidiary at the same date. (See figure 1)
In this case, the Japanese multinational can reduce its hedging costs by offsetting the positions. Indeed, by hedging 200 000 USD (500 000 – 300 000) instead of 800 000 USD (500 000 + 300 000), the relative foreign exchange exposure is reduced.
Providing that 3% fees is necessary for hedging the foreign currency, we can see that in this example the associated cost would have been reduced from 24000 USD (800 000 * 3%) to 6000 USD (200 000 * 3%)
In other words, bilateral netting consists in covering net exposures instead of gross exposures.
Multilateral Netting with multiple currencies
Multilateral Netting is a cost-effective way to optimise global cash management and currency risks, especially when numerous subsidiaries operate with each other by using several foreign currencies.
Here, a Netting centre which will act, as an internal clearinghouse will be created. As a result, Multinational corporations can neutralise their foreign currency exposure by reducing their hedging costs.
Let’s take the example of a multinational, which has 4 subsidiaries operating in 4 currencies. (See figure 2 below)
Based on those figures the net position for each subsidiary is as follows :
Exchange rate adopted:
EUR / USD: 1.0524
EUR / GBP: 0.8559
EUR / JPY: 119.909
Net exposure on Italian subsidiary: + 201.092 EUR
390+120+360 – (300/119.909+480/1.0524+180/0.8559)= + 201.092
Net exposure on Japanese Subsidiary: -100 296,7347 JPY
Net exposure on U.S subsidiary: +433.9906 USD
180+480+400- (360*1.0524+140/119.909* 1.0524+200/0.8559*1.0524) =
Net exposure on UK subsidiary: +190.8363 GBP
200+240+180 – (120*0.8559+160/119.909*0.8559+400/1.0524*0.8559) =
As we can see, the final currency exposure of this multinational becomes 0
201.092 EUR – (100 296,7347/119.909)+(433.9906 /1.0524)+ (190.8363/0.8559) = 0!!!!!!!
In this example, although each subsidiary does have an exposure to foreign currency risks, it is in the best interest of the multinational to centralise the risk management at the group level via a clearinghouse.
Indeed, by doing so the currency risks, the associated hedging costs as well as the duplicate purchases and sales of foreign currencies are avoided.
However it must be highlighted that netting requires a high level of coordination between subsidiaries since the foreign currency offsetting is only possible with payments, which have the same payment maturity. In other words, this method depends to a significant extent on technologies, which provide an access to financial information at the multinational level and as a result, enable subsidiaries to adjust and monitor payment maturities Internationally.