Corporate Mentality on Foreign Exchange Hedging Karim Alidina Rotman MBA 2007

Transcription

1 Corporate Mentality on Foreign Exchange Hedging Karim Alidina Rotman MBA 2007 The views and recommendations in this presentation do not represent the views of RBC Capital Markets and are solely of the author.

2 What is FX Risk? Three types of FX Risk: Transaction Translation Economic Companies who conduct business across borders must deal in foreign currencies Exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables Foreign exchange risk is the risk that the exchange rate will change unfavourably before the currency is exchanged

3 Value at Risk A Canadian Corporation buys USD 1mm out one year using a forward contract A USD/CAD spot range of represents the potential spot movements over one year. The Value-at-Risk (VaR) is USD 131, % Confidence Level Forward Curve Exposure USD 1.0 mm Achievable Value 95% Worst Case CAD 0.87 mm CAD 1.15 mm VaR USD 131, Feb Jul Jan Jun Nov May-11

4 Canadian Dollar Spot

5 Why do Corporations Manage FX Risk? Minimize the effects of exchange rate volatility on earnings Creation of shareholder value through: Stabilizing revenues and expenses Communicating clear expectations and risk profile Facilitating the pricing of products sold in export markets Typically not for speculation or gains

6 How do Corporations Manage FX Risk? Identification of exposure: Determine whether you need to hedge Determine FX levels: Budget rate Target rate Execute FX hedge when target reached Use appropriate hedging instrument

7 Example Assumptions: Canadian Corporate needs to purchase USD Exposure: USD 1mm notional Term: 1 year Budget rate: Strategy: Client enters into one year forward contract to buy USD 1mm at an all-in rate of

8 What Can Prevent Best Practice? Target rate vs. Budget rate Hedging Strategy Hedge Accounting

9 Target Rate The rate at which to execute Inherent human flaws: Behave in an all or nothing manner Asymmetry of risk appetite Risk loving when out of the money Risk averse when in the money Result: Execution rate is often at or below the target rate

10 Hedging Strategies Forward contracts, option strategies, exotics Limitations: Corporations tend to only use certain products Product knowledge Board decision Only some Corporations use FX options Purchased options are useful if there is doubt whether a foreign exchange transaction will be necessary Result: Corporations cannot participate in favourable currency moves

11 Hedge Accounting Accounting standards enable hedge accounting for three different designated FX hedges: A cash flow hedge may be designated for a highly probable forecasted transaction A fair value hedge may be designated for a firm commitment of a recognized asset or liability. A net investment hedge may be designated for the net investment in a foreign operation. Limitations: Reduced potential use of various option strategies Result: Corporations cannot fully participate in favourable currency moves

12 Example Assumptions: Canadian Corporate needs to purchase USD Exposure: USD 1mm notional Term: 1 year Budget rate: Strategies: Client enters into one year Forward Contract to buy USD 1mm at an all-in rate of Client purchases a one year USD Call for CAD 41,000 (410 CAD pips) Client enters into a one year Costless Collar to buy USD 1mm, with protection level at and benefit level at Client enters into a one year Cablecar Forward Contract to buy USD 1mm at a rate of with a knock-in barrier at

13 Hedging Strategies Forward USD Call Costless Collar Cablecar Forward Outright Strike: Benefit: Protection: CAD Notional Possible to Purchase Spot Rate Rate: Premium: Protection: Trigger: USD 1mm at expiry CAD pips Not Triggered Triggered 900, N/A , N/A , N/A , , , , , , , ,000, ,010, ,020, ,030, ,040, ,050, ,060, ,070, ,080, ,090, ,100, Conversion rates include premium cost. BETTER THAN FORWARD OUTRIGHT

14 Conclusions A Corporation s execution rate is often at or below the target rate A Corporation cannot fully participate in favourable currency moves: Limiting hedging products inhibits a corporation s ability to optimize risk management Hedge accounting limits a corporation s ability to optimize hedging practice

15 Recommendations Setting target rates can help a Corporation decide when to use forwards versus other option strategies: Take profit versus stop-loss level management The Corporation can use forward contracts to buy USD when the CAD is strong and it is beneficial to lock in gains The Corporation can use other hedging strategies to buy USD when CAD is weak which allows them to benefit from CAD appreciation Use various hedging strategies to express views, manage forecast errors and to avoid forward contract losses Diversify a corporation s hedging portfolio MTM variations on income statements should be accounted for in the valuation of a company by the analyst The Corporation should not be limited in their hedging strategy

16 Questions