MAKE MONEY BY HEDGING CURRENCY RISK: IMPOSSIBLE?

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1 MAKE MONEY BY HEDGING CURRENCY RISK: IMPOSSIBLE? Todd Yoder, Fluor Francesco Tonin, Bloomberg APRIL // 10 // 2018

2 AGENDA 2 What is the goal of hedging? [lower earnings YoY vol? Protect budget?...} In the long run FX is a zero-sum game Impact of the dollar on corporate earnings, the case of 2014 Examples from Apple Inc. Chart of GBPUSD going back 100 years (not a mean reverting chart) The backtesting illusion [don t think that backtesting will reveal market secrets to you] Advantages of mechanistic approaches over emotional approaches The example of the CFO overriding the model Hedging errors Air Products Aracruz Processes versus judgement [why you should not trust your guts]

3 DISCLAIMER / TERMS AND CONDITIONS ANY VIEWS EXPRESSED IN THIS PRESENTATION ARE THOSE OF THE INDIVIDUAL PRESENTERS AND MAY NOT NECESSARILY REFLECT THE VIEWS OF THE COMPANIES THEY ARE EMPLOYED BY. THE PRESENTATION IS NOT MEANT TO PROVIDE LEGAL, COMPLIANCE, TAX OR ACCOUNTING ADVICE. ACCORDINGLY, ANY STATEMENTS CONTAINED HEREIN AS TO SUCH MATTERS WERE NEITHER WRITTEN NOR INTENDED BY US TO BE USED AND CANNOT BE USED FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED ON SUCH TAXPAYER BY TAX AUTHORITIES WHICH GOVERN THE COUNTRIES OPERATED IN OR ON BEHALF OF. PARTICIPANTS SHOULD SEEK LEGAL, COMPLIANCE, TAX AND ACCOUNTING ADVICE BASED ON THEIR PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT ADVISOR ACCEPTING SUCH LIABILITY. IF YOU ARE NOT IN AGREEMENT WITH THE TERMS AND CONDITIONS CONTAINED HEREIN, PLEASE EXIT THE VENUE AND DO NOT PARTICIPATE IN THIS PRESENTATION DISCUSSION.

4 RISK AWARENESS

5 INFORMED DECISION MAKING

6 XCCY BASIS SWAP MECHANICS A cross-currency basis swap agreement is a contract in which one party borrows one currency from another party and simultaneously lends the same value, at current spot rates, of a second currency to that party. The chart below* illustrates the flow of funds involved in a EUR/USD cross currency swap. At the start of the contract, A borrows X S USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor+ α from, and pays USD 3M Libor to, B every three months, where α is the price of the basis swap, agreed upon by the counterparties at the start of the contract. When the contract expires, A returns X S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the start of the contract or the FX spot Fixing rate struck at the last quarterly reset. (XCCY market convention is to have quarterly resets in FX spot). *BIS Quarterly Review, March 2008 Todd W. Yoder

7 HOW MARKETS TRADE

8 OCTOBER 7 TH, 2016 GBP SELL OFF

9 Which particle triggered the avalanche

10 5 YEARS OF HISTORICAL PRICES ( ) Copper HRC Nickel Oil like a financial advisor in a bull market, has been easy to be a good risk manager, Era of WRONG WAY RISK could have huge impacts.

11 FAST FORWARD // Copper HRC Nickel Oil

12 FAMOUS ANECDOTES 2015 Apple earnings call: first question was impact of USD and answer was 4% of earnings Treasurer of company decides single-handedly to override the rule-based hedging system in belief euro will rise FX managers ask at a meeting how you make money in FX, as if we could tell them in five minutes, as if there was a recipe that all FX on the Street know FX managers decide to build pricing system for exotic options by hiring parttime Ph.D. student A few tricks when bidding out hedges and trading with banks (for example, it is tricky to give a spot reference to the banks and then compete option premium) Large notionals to trade: ask many banks for full amount The case of Cairn Energy Plc 12

13 HEDGE ACCOUNTING CRASH COURSE 13

14 HEDGE ACCOUNTING CRASH COURSE 14

15 HEDGE ACCOUNTING CRASH COURSE 15

16 HEDGE ACCOUNTING CRASH COURSE 16

17 IMPACT OF USD VALUE ON US CORPS 17 Sample placeholder page

18 IMPACT OF USD VALUE ON US CORPS 18 Sample placeholder page

19 IMPACT OF USD VALUE ON US CORPS 19

20 STATIC HEDGING 20

21 ROLLING HEDGING 21

22 UNINTENDED RESULTS 22 G 794

23 LAYERED HEDGING 23

24 VOLATILITY REDUCTION 24

25 COMMUNICATION TO THE MARKETS Coca-Cola 10-Q filing, 27Jun14: During the three months ended June 27, 2014, foreign currency exchange rates unfavorably impacted consolidated operating income by 5 percent due to a stronger U.S. dollar. General Electric, 10-Q filing, 30Jun14 The total pre-tax amount in AOCI related to cash flow hedges of forecasted transactions was a $121 million loss at June 30, Apple, 10-Q filing, 23Jul14: the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. Google, 25Jul14: The notional principal of these [foreign exchange cash flow hedges] was approximately $10.0 billion and $9.4 billion as of December 31, 2013 and June 30,

26 COMMUNICATION TO THE MARKETS 26 Google, 25Jul14: We have a foreign exchange risk management program that is designed to reduce our exposure to fluctuations in foreign currency exchange rates. However, this program will not fully offset the effect of fluctuations on our revenues and earnings. Microsoft, 10-Q 31Jul14: Net losses on derivatives increased [to USD328mio] due to higher losses on foreign exchange contracts, losses on equity derivatives as compared to gains in the prior period Berkshire Hathaway 10-Q 1Aug14: BHRG s underwriting results included pre-tax foreign currency exchange rate losses of $139 million in the first six months of Ranbaxy Laboratories Ltd may post a foreign exchange loss of as much as $200 million in the September 2013 quarter because of wrong-way bets on currency hedges, analysts say. That loss may take its cumulative loss on account of derivatives to over $1 billion. March 2009 (Reuters) - Brazilian food company Sadia SDIA4.SASDA.N posted a large loss because of steep losses on currency derivatives. For the full year of 2008, the company posted a loss of 2.48 billion reais, the first annual loss in its 64-year history.

27 WHAT ARE YOU TRYING TO HEDGE? 27 Example 1 (all amounts in USD-equivalent) US parent has EUR-functional sub: Sub has 80 USD expenses, third party. Sub has 100 EUR expenses, third party. Scenario 1: unhedged. Cash flow at risk is 80 USD. Earnings at risk is 100 EUR. Scenario 2: If subsidiary hedges the 80 USD cash flow: Cash flow at risk decreases to zero: Then Earnings at risk increases by 80 USD because now the subsidiary has a forward contract where they sell EUR buy USD which will create PNL in translation, whereas the original USD liability does not create any PNL in translation.6

28 WHAT ARE YOU TRYING TO HEDGE? 28 Example 2: Intercompany exposures. Eur sub has 100 JPY expenses to the JPY sub. JPY sub has 100 JPY revenues from EUR sub. Scenario 1: no hedge. JPY sub CFaR is zero. EUR sub CFaR is 100 JPY. Total CFaR is 100 JPY. EaR is total zero as the EUR and JPY sub net out their translation risk. Scenario 2: EUR sub hedges the 100 JPY. JPY sub CFaR is zero. EUR sub CFaR is zero. Total CFaR is zero. EaR is 100 EUR plus 100 JPY (remember all numbers are expressed as USD equivalent).

29 IT IS UP TO YOU 29

30 TALES FROM THE TRENCHES 30 Air Products Votorantim Citigroup

31 ARACRUZ CELLULOSE Aracruz Cellulose Losses of USD 2.1bio in Q (global corporate FX hedging losses in about USD 500bio) I think about currencies 24 hours a day Losses were 3.7 times 2007 EBIT, and equal to 30% of market capitalization Stock price dropped 30% in three months and company was acquired in

32 ARACRUZ CELLULOSE Biggest world producer of bleached eucapyptus pulp, 26% global marke share, market cap of USD 7.1bio and net revenue of USD 1.42bio Private terminal shipped 85% of production, single product company Only company in cellulose sector part of the Dow Jones Sustainability Index 95% of revenue came from exports First Brazilian company to list at NYSE via ADR s in 1992 Won Instituto Brasileiro de Governanca Corporativa award in

33 ARACRUZ CELLULOSE Sell Target Forward: not reported in any financials as unwound before Company sells USD buys BRL monthly for a year plus sells USD call BRL puts as well, with unlimited losses possible Here is the calculation of the loss, with x being USDBRL. This is in terms of one of the monthly flows: Percentage Loss= 2 12 x 1.5 x x 33 This comes up to a loss of about 800% of the monthly notional Company first disclosed losses on October 3 rd, 2008 In early 2009 the company was acquired for USD 3bio by Votorantim

34 ARACRUZ CELLULOSE The treasury department was reporting to the CFO, including the team that evaluated the risk management But the point remains that all the company s deficiencies were only revealed by the arrival of the Great Financial Crisis, otherwise the company was looked at as an example to be emulated 34

35 THE ZERO-SUM-GAME THEORY 35

36 LIES, DAMNED LIES, AND BACKTESTING 36

37 ADVANTAGES OF MECHANISTIC APPROACHES 37

38 EPISTEMOLOGY 38

39 &A >>>>>>>>>>>>>