Cross Functional Communication Key to Successful Hedging Programs

Transcription

1 Cross Functional Communication Key to Successful Hedging Programs April 26, 2013

2 Agenda Foreign Exchange Interest Rate & Commodity Current Topics Derivatives & Hedging 2

3 Cross Functional Partners Treasury works closely with many cross functional partners for its hedging program Process Exposure Identification, Funding Req. & Forecast Review & Approval of Hedges Trade Execution Confirmation /Accounting /Settlement Review of FX Results Who FP&A Accounting Tax FP&A Accounting Treasury Treasury FP&A Accounting Treasury FP&A Accounting Treasury Senior Management / Audit Committee Internal Audit 3

4 Accounting Process Exposure Identification, Funding Req. & Forecast Review & Approval of Hedges Trade Execution Confirmation /Accounting /Settlement Review of FX Results Identification of exposures or changing exposures Determination of functional currencies of new entities or when business changes Local currency functional vs. USD functional - optimize hedging program Use of natural hedging Trades are approved by accounting prior to execution Confirmation / Settlement / Accounting entries Timing: Auto confirmation using trading platform since trades are approved prior to execution Accounting can only be done once underlying exposures are finalized for cash flow hedging Review of accounting results Requirements of hedge accounting Identification of booking errors with each monthly close External auditors 4

5 FP&A Process Exposure Identification, Funding Req. & Forecast Review & Approval of Hedges Trade Execution Confirmation /Accounting /Settlement Review of FX Results Treasury provides forecast visibility/smoothing of rates time for FP&A to plan FP&A forecasts P&L with Treasury FX rates (often hedge rates) and Treasury forecasts FX exposures with FP&A P&L forecasts. The two are joined at the hip. Need to integrate rate details with FP&A or don t bother Treasury provides unbiased rates can t use one rate for revenues and one for expenses Accurate forecast is critical Poor data => Poor hedging Could have significant impact on whether company qualifies for hedge accounting Track monthly/quarterly variances and communication; Translate variance to $ impact; Hold accountable, i.e. scorecards Trades are approved by accounting prior to execution FP&A need to understand basics of hedge accounting Protect Margin or Revenue/Cost - Gross or Net Timing Geography 5

6 Tax Process Exposure Identification, Funding Req. & Forecast Review & Approval of Hedges Trade Execution Confirmation /Accounting /Settlement Review of FX Results Tax planning actions could significantly alter exposures Buy/Sell model vs. Cost-Plus model Long term vs. short term intercompany loans / repayments / conversion to equity / cash repatriation These activities should be included in the forecast from FP&A Timing is critical Too late to hedge if already implemented Timing of information: rate at which forward executed rate at which asset/liability created Regular, periodic meetings to update Treasury, Accounting & FP&A 6

7 Internal Audit Oversight of the entire hedging process Ensure controls are effective and efficient Rationalize the number of controls and focus on key controls Internal audit as Treasury s advocate to external financial, SOX and IT auditors Upfront training is important Get them up to speed on automation/technology i.e. Straight through processing using Capella and FXall strengthens control environment 7

8 Senior Management Providing management with a FX program assessment can be challenging: Management s knowledge of currency influence on financial statements typically varies Identifying / confirming FX variances can be challenging because of the data mining Losing dollars on hedges is the best outcome which seems counter intuitive Management expectations of what an FX program may not be realistic What hedging can do: Protect Margin Provide revenue/cost predictability Reduce volatility in FX gain/(loss) in Other Income & Expense What hedging cannot do: Guarantee the best rate Fix bad forecasting Protect a plan or forecast rate that is better than the market rate Return a zero to the FX gain/(loss) line 8

9 Communicating with All Stakeholders Quarterly review with all stakeholders CFO, Controller, Treasury, Head of FP&A Report Margin and Op Expense rate realized against program objective Explain delta from rate objective Forecast miss - Can cause carryover Unhedged amount (confidence factor) Setting Expectations Continuously educate management on agreed upon objectives and what is achievable with the program Integrate hedging responsibility with forecasting responsibility and operations management All changes to FX policy have to be approved by stakeholders and Audit Committee. Policy is reviewed at least annually. 9

10 Example of FX Rates Report EUR GBP JPY Wtd. Average Rate Blended Hedge Rate Quarterly Target Rate Wtd. Average Rate Blended Hedge Rate Quarterly Target Rate Wtd. Average Rate Blended Hedge Rate Quarterly Target Rate Actuals Forecast Q1'12 Q2'12 Q3'12 Q4'12 Q1'13 Q2'13 Q3'13 Q4'13 10

11 Communicating with All Stakeholders (cont.) FX Gain/(Loss) or Other Income and Expense Assures management there is a complete understanding and control of the exposures and trading activity Detail net FX G/(L) (after hedging) Show FX G/(L) with and without hedging, excluding unhedged currencies FX G/(L) - Mitigation not elimination Familiarize management with sources of FX G/(L) Forecast variances Forward points Unhedged exposures (because of size or cost) Unhedgeable exposures (because of functional currency, market liquidity, etc.) Timing (accounting rate vs. hedge rate, etc.) Dumping ground 11

12 Example of FX G/(L) Variance Analysis $ in 000s Q1'12 Q2'12 Q3'12 Q4'12 Q1'13 Controllable? Forecast Variance Comments Unhedged Conversions Forward Points Other Total Abs. Value 12

13 Managing Interest Rate Risk Policy and process for interest rate hedging Recent Developments relating to interest rate derivatives and hedging 13

14 Entity Considerations Interest Rate Risk Corporate End User Interest rate risk management activities typically are high profile, low volume of trading activity Hedging may be required as a condition of borrowing Larger corporates may manage interest rate risk on bond issues, investment securities Financial Entity/Institution Interest rate risk management more of core activity of enterprise More developed controls structure, more frequent trading, greater transaction volume 14

15 Risk Management/Derivatives Policy Typically board approved, and defines the parameters under which company can enter into derivative transactions Objective Risk Definitions, Tolerances, Limits Roles, Responsibilities, Controls Approved Counterparties Permitted Instruments & Applications Reporting & Performance Measurement Exception Procedures Includes FX or separate policy 15

16 Interest Expense Impact ($) Risk Management/Derivatives Policy may target approximately 50% of outstanding variable rate debt to be hedged depending on the amount of exposure generated by outstanding balances. This percentage will provide adequate protection in the event of a sustained increase in rates, while allowing the Company to participate in the benefit of falling rates on a percentage of its debt portfolio Interest Rate Sensitivity on $500MM Variable Rate Debt 6,000,000 4,000,000 2,000,000 0 (2,000,000) (4,000,000) % Variable Rate debt swapped 0% 25% 50% 75% 100% (6,000,000) -1.00% -0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00% LIBOR Movement 16

17 Key Controls on Hedging Activity Pre- trade review and approval Segregation of Duties Independent trade confirmation Limit structure Counterparty/Credit Concentration Coverage ratios Competitive Pricing Particular attention paid to derivative amendments and liquidations Independent valuation, or testing of counterparty marks Collateral management Reference: COSO Internal Controls Issues in Derivative Usage 17

18 Interest Rate Transaction Preparation Ideally treasury and accounting work side-by-side in preparing for trade execution Tax and Legal may be involved Hedge for tax purposes, ISDA negotiations Generally hedge accounting is preferred for interest rate hedging activities vs. mark-to-market through earnings Typically longer term contracts than FX trades How will treasury, or those responsible for setting rates on underlying variable rate borrowings, manage the rate setting on the underlying debt? Highly beneficial from a hedge accounting perspective to commit to rate and leave intact over life of hedging relationship For swaps on construction loans, operations may be involved in determining drawdown schedules Uncertainty around the draw downs on a credit facility may impact derivative accounting treatment 18

19 Interest Rate Transaction Preparation Certain interest rate strategies may require more due diligence in order to obtain hedge accounting treatment Conversion of fixed-rate debt to floating via receiver swaps (fair value hedge) Unless shortcut method of accounting is applied (out of favor and likely being phased out), ineffectiveness will be generated by coupon differential and bond and swap rate Accounting is simplified if bonds are not callable; bond prospectus should be reviewed to confirm no embedded derivatives or accounting complications Callable bond hedge needs to pass written option test Hedging coupon/yield on forecasted bond issue (cash flow hedge) Usually difficult to pinpoint exact issuance date; consider broad window in which debt is most likely to be issued Measure ineffectiveness based on actual issuance vs. terms of hedging derivative T-locks and Forward starting swaps typically used; T-locks pose additional valuation and accounting challenges due to pricing methodology (DV01-based) and accounting guidance (cash-flow based) 19

20 Commodity Hedging Considerations Purchasing/ procurement must be communicating with Treasury with respect exposures generated by nonfinancial/commodity contracts, and potential hedging solutions Procurement not as likely to naturally interact with Treasury Fixed price purchase/sale contracts for physical commodities may themselves qualify as derivatives under accounting guidance Possible exemption from derivative accounting under Normal Purchase/Sale exemption May consider MTM of both physical and financial contracts as a way of minimizing P&L volatility without application of hedge accounting Valuation of commodity derivatives typically more difficult than FX/IR derivatives Data requirements, basis/differentials Current hedge accounting rules require hedging all-in cost of commodity, as opposed to only commodity-based component of cost e.g. likely can t hedge fuel-price surcharge in transportation contract and apply hedge accounting 20

21 Current Topics OIS Based Valuation Use of Overnight-Index-Swap (OIS rate) for present-valuing derivative cash flows becoming conventional Post credit crisis, derivative valuations are no longer based on a single swap curve used to calculate forward rates and discount factors Acknowledgement in the dealer community that collateralized derivative trades should be subject to different discounting than non-collateralized trades Dealers are adopting discounting based on an overnight index swap rate (OIS), which reflects rates on collateralized deposits, as opposed to LIBOR which is based on unsecured deposits Dodd-Frank also playing a role in the increased used of OIS for discounting cash flows of collateralized derivatives Impacts on hedge accounting and derivative valuation processes should be considered Recent guidance suggests OIS will be an approved benchmark interest rate in near future for hedge accounting purposes 21

22 Current Topics Dodd-Frank Impacts Dodd-Frank Regulatory rule with impacts to trading process, derivative pricing and accounting Central Clearing model is key feature which is designed to ensure single counterparty defaulting does not have serious ripple effects Image Source: BusinessWeek.com 22

23 Current Topics Dodd-Frank Impacts Considerations for Derivative Users Participation in Dodd Frank protocol or other bilateral agreement necessary to trade swaps after May 1, 2013 Mandatory clearing dates for interest rate swaps established; trade on cleared basis or utilize end-user clearing exemption September 9, 2013: interest rate swaps traded by nonfinancial enduser subject to mandatory clearing Exemption requirements: Nonfinancial entity with board approval (if public) for trading non-cleared swaps which hedge/mitigate a commercial risk; must also notify CFTC no how it meets financial obligations associated with non-cleared swaps Deliverable FX Forwards exempt from clearing requirement Swap data reporting to repositories (SDR s) underway. Internal trades have certain reporting requirements as well. 23

24 Current Topics Dodd-Frank Impacts Clearing Considerations for Derivative Users Decision to clear or not may not be straightforward Infrastructure and relationships required to clear swaps Margin rules on non-cleared swaps not finalized Will there be any benefits in terms of margin in trading non-cleared swaps Pricing on non-cleared swaps vs. cleared Will cleared swaps be less effective as designated accounting hedges than non-cleared 24

25 THANK YOU 25