Currency Hedging Presentation

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Currency Risk Management, LLC

Best Practices inCurrency Risk Management

Protecting XYZ profits from Foreign Exchange (FX) Volatility

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I. What is FX Risk?II. What do Smart CFOs do about FX risk?III. What is Hedging?IV. Two Case StudiesV. Additional Benefits to HedgingVI. Getting StartedVII. Implementing a Hedging ProgramVIII. The Low Cost of HedgingIX. Summary

AgendaAgenda

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Impact on contract

+

-

Exchange Rate (foreign/home)

Exchange Rate at Time of Contract

The FX risk mechanism

As the exchange rate rises, the value of the contract rises.

Conversely, as the exchange rate falls, the value of the contract falls.

EUR/USD

USD/CAD

What is FX Risk?What is FX Risk?

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Fortune 100 companies lost ~$20B to unhedged currency moves in 2009:

• Google: $300M in Q3 ‘09

• Continental Airlines: $10m in Q2 2010

• EXFO: (Canadian optics company) $2M in Q2 2010, for net earnings of just $1.2M

• MDS Nordion: (Canadian international health services / products) $27M in Q2 2010

• Armstrong World: (global flooring producer) $19M (3% of revenue) in Q1 2010

And other companies around the world:

• Air Canada: $400M in 2009, $85M in Q1 2010

• Tata: (Indian consultancy) $44M

• NXP: (European semiconductor) $222M loss on revenues of $695M

FX Risk: RealityFX Risk: Reality

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Business Outlook worldwide survey of CFOs, top 10 concerns:

1. Consumer demand

2. Credit markets / interest rates

…then Currency volatility

“Forex Markets Show Companies Need Better Hedging”, WSJ -- July 28, 2010

“Currency Wars Seize IMF Stage”, Institutional Investor -- Oct 7, 2010

Economist, Oct 16th-22nd, 2010

FX Risk in the FX Risk in the NewsNews

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• In the G-10 currencies, volatility is normally 6-7% in a quarter, and this can translate into unwanted earnings surprises.

• In times of stress volatilities can easily double, severely impacting profit margins. Non-G-10 currencies (e.g. Mexican, Columbian and Chilean Peso, Brazilian Real) can be much higher.

• Stress is not rare. In 1998, the Asian meltdown and the Russian default, 9/11, Lehman Bros/AIG in 2008, the Greek debt crisis in Q2 2010, and last week’s Fed’s QEII all had profound effects on all exchange rates. There are plenty of risks on the horizon (e.g. Ireland, Portugal, Spain)

FX Risk: VolatilityFX Risk: Volatility

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FX Risk can be categorized as:

• Transactional – •When a customer or distributor is invoiced in a foreign currency, and there is delay between contract and payment. FX rate changes will increase or decrease the price paid or received. Easy to mitigate

• Operational- •Companies whose expenses are in one currency, and sales in another (e.g. Airbus). •Companies invoicing foreign customers (or distributors) in their home currency risks loss of business to any competitor willing to invoice in the customer’s currency. This is especially significant if the home currency is appreciating. Difficult to mitigate

• Translational• Foreign subsidiary income re-stated in home currency

Defining FX RiskDefining FX Risk

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1. Change any operational risk into transactional risk• Reduces customer or distributor pricing leverage • Increases competitiveness• Faster foreign cash transfers

2. Minimize net risk before hedging• Utilize natural hedges (foreign-based raw materials, manufacturing or debt)

3. Hedge remaining transactional risk• Hedge strategy and selection• Performance metrics

So what is hedging?

Handling FX RiskHandling FX Risk

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Impact on contract

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Exchange Rate (foreign/home)

Effect of Exchange Rate on contract value with hedging

Contract Value vs. Exchange Rate

Hedge Value vs. Exchange Rate

A perfect hedge moves opposite to the contract value, offsetting any changes in contract value.

Proper hedging does NOT involve prediction or trend analysis, and CRM does not do so.

What is Hedging?What is Hedging?

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• Options (1 Month to 1 Year)– Pricing determined by volatility, expiry – Expiry and strike selected by hedger

• Forwards/Futures (1 Month to 1 Year)– Pricing of both determined by interest rate differences (deposit rates)– Futures expiry and strike selected from discrete market offerings (e.g. CME)– Forwards expiry and strike set by contract, trade OTC

• Money Market (6 Months to 2 Years)– Pricing determined by interest rate differences (deposit rates)– Size and duration by contract (typical min $250k)

• Currency Swaps (2 to 10 Years)– Pricing determined by interest rate differences (deposit rates)– Size and duration by contract (typical min $250k)

Hedging Hedging MethodologiesMethodologies

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• Deal Points– XYZ to receive Euro-denominated payments

– Payments due or the current month total €35,663 EUR (50,000 USD)

– Due in 60 days net (Jan 7, 2011)

– Contract billed today, Nov 8.

• Financial Data– EUR/USD 12 month volatility = 13%– EUR/USD exchange rate = 1.4035– EUR/USD Risk Reversal skew = -1.15– EUR deposit rate 0.774%, USD deposit rate 0.313%– Resulting Forward rate 1.40267

With 13% 12-month Volatility, Value at Risk in 60 days is $3,200 (6.4%)

EUR/USD

XYZ Case Study XYZ Case Study #1#1

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Through hedging, the contract is essentially unaffected by FX rates

Exposure is $50,000 USDHedge is 5 long EUR puts/USD calls @ 1.4020

5 short EUR calls/USD puts @ 1.4030Max net loss -$185 + $250 fee = $435 (.8%), compared to $3,200 (6.4%) Value at Risk

XYZ Case Study #1, cont’dXYZ Case Study #1, cont’d

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• Deal Points– XYZ to receive AUD-denominated payment– Payment due for the current month total

$49,236 AUD ($50,000 USD)– Due in 60 days net (Jan 7, 2011)– Contract billed today, Nov 8.

• Financial Market Data– AUD/USD 12 month volatility = 13.8%– AUD/USD exchange rate = 1.0155– AUD/USD Risk Reversal skew = -2.40– AUD deposit rate 4.895%, USD deposit rate

0.313%– Resulting Forward rate 1.00824

With 13.8% 12-month Volatility, Value at Risk in 60 days is $3,625 (7.25%)

AUD/USD

XYZ Case Study XYZ Case Study #2#2

(AUD/USD 0.98 as of 11/18)

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Exposure is $50,000 USDHedge is a short future at 1.0080

Max net loss -$375 + $250 fee = $625 (1.1%), compared to $3,625 (7.25%) Value at Risk

Contract Impact with and without Hedge

-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2

Exchange Rate

Eff

ect

on

P&

L

Unhedged

Hedged

XYZ Case Study #2, XYZ Case Study #2, cont’dcont’d

Through hedging, the contract is essentially unaffected by FX rates

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Caution: Value at Risk underestimates risk

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-2.50% -2.00% -1.50% -1.00% -0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50%

•Value at Risk (VaR) assumes a “Gaussian” or Normal distribution of daily movements

•Actual movements exhibit “fat tails”

•Thus, VaR underestimates potential losses, especially during market dislocations

Vertical scale is number of days exhibiting a % changeRed line is a normal distributionBlue line is one year of actual EUR/USD data

Value at RiskValue at Risk

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If you were a banker, would you lend to Company A or Company B?

Company B Earnings Variation

-60000

-40000

-20000

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20000

40000

60000

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Months

Varia

tion

Company A: earnings of $US500k / month, unhedged (trailing 20 months, EUR/USD)

Company A Earnings Variation

-$60,000

-$40,000

-$20,000

$0

$20,000

$40,000

$60,000

0 5 10 15

Months

Var

iatio

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Other Benefits of Other Benefits of HedgingHedging

Company B: earnings of $US500k / month, hedged (trailing 20 months, EUR/USD)

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• Financial instruments are typically < 0.25% of transaction

• Hedge “Burden”

• Consulting fee (0.5% of contract size)

• Compliance with hedge accounting rules

Hedging is AffordableHedging is Affordable

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1. Establish a brokerage account to buy and sell currency options and futures• We can identify several major market providers for you. Your bank may already offer them. We

suggest providers based on excess ICAAP capitalization, bid-ask pricing, and our customer service experience.

2. Execute a consulting agreement with Currency Risk Management, LLC

3. Try One Hedge- • This can be a single transaction, or a single month’s royalty in one currency

Sleep at night, knowing your profits are insured against currency risk

Getting Started with Getting Started with HedgingHedging

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• To use the tools of hedging (forwards, options), a company must establish a trading account with a banking “counterparty”.

– US Bank, Wells Fargo, UBS and HSBC all offer the basic tools. Some offer more choices of currency or financial instruments.– The bank will require an application/underwriting process to determine level of client credit. – There will be some requirement for margin to be posted. The amount is dependent on credit, size of exposure and other factors. It is typically a small

fraction of the notional amount traded.

• The bank makes its profit from their bid-ask spread.– For example, a euro forward might be bid 1.3090, ask 1.3125 when the spot is 1.3100

• Depending on the company and account, a margin or performance bond may be required. This commonly 2-5% of the notional

Getting Started with HedgingGetting Started with Hedging

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Getting Started with HedgingGetting Started with Hedging

Euro Sales contract executed Oct 4, spot 1.3684

Contract paid, spot at 1.3073. Contract lost $15,275Hedge closed 1.3065, hedge gained $17,325

Option collar hedge executed Oct 5 spot 1.3758

Sample $250,000 contract

Contract up by $12,900, hedge down by $13,025A margin increase may be required

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– Involve Management • Establish FX risk management policies

• Establish internal communications processes (transparency)

• Commit resources (forecasting internal & external exposures)

– Define Your Program Strategy • Is it to protect profits (de-risk), or produce profits (speculative)

• Controls (VaR limit, book size, permitted instruments, open position limit)

• Leading, lagging, other strategies (speculative)

– Establish Performance Metrics and Benchmarks • Did the hedge work as intended?

– Implement the Necessary Accounting Processes • Tracking F/X exposure is covered in FAS 52, and hedge accounting is covered

in FAS 133

A Complete Hedging A Complete Hedging ProgramProgram

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Myths and MisstepsMyths and Missteps

• Hedging uncertain exposures • Use of inappropriate derivatives• Implementing a directional bias instead of a neutral view (see below for the challenge of that exercise!)

The performance of our FX top trades this year has been unsatisfactory- Goldman-Sachs, Dec 1, 2010

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• FX poses risks to the profits of international companies

• Transactional FX risk can be minimized by hedging

• Hedging transactional FX risk has additional benefits– Predictable income - no surprises– Enhanced company credit rating, lowering your cost of capital– Enables increased internal investment

• Outsourcing FX Risk Management is an excellent alternative for small to mid-sized companies

SummarySummary

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Paul Stafford Director•BS Engineering, UC Berkeley; MS Engineering, Stanford University•SEC series 65 (Investment Adviser, Series 22, 63 (Registered Representative)•Author, Trading Forex with Options; Publisher, Currency Briefing and FX Options Adviser

Kris Matthews

Client Relations •BS Engineering, UC Berkeley, PHD Engineering and Energy Economics, Cornell•Entrepreneur and Business Consultant•FX and Derivatives Trader, Author and Speaker

The CRM Team

Correspondents:

Europe, Switzerland Martin Horn UK Brian KeavenyAustralia John Levisohn

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Contact: Paul Stafford

Office 1.406.626.1546

Email: [email protected]

Website: www.CurrencyRiskManagement.com

Contact Information

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Scott Burke President, First Security Bank

Gerald McConnell CEO, Spectrum Products

Robert Bell Partner, Reep, Bell, Laird PC

Michael Harrington Assistant Dean, U of M Business School

Advisory Board

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• Your Commercial Bank• If it offers the financial instruments required

• US Bank• Tier 1 Capital ratio 10.3%• $192B in assets• Easiest for US-based clients

• Saxo Bank• 2009 Total Assets 16.0B DKK ($US2.7B), Total Equity 2.33B DKK ($US 395M)• ICAAP requires 8% capital adequacy, Saxo has 237% of require capital (a buffer of 861M DKK, $US146M)• Offices in Amsterdam, London, Singapore, Dubai, Athens, Tokyo, Beijing• Easiest for European and Asian-based clients

Banking

Currency Hedging Presentation

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