Maybe it s time you hedged your interest rate and FX exposures

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Dinah Curtis
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1 Fall 2013 Are you overlooking key areas of financial risk? Maybe it s time you hedged your interest rate and FX exposures Donald Lloyd, Senior Vice President Interest Rate Derivatives and Foreign Exchange, Associated Bank You might say that economic history is the history of people learning to manage risk. James Surowiecki

Managing a company s finances is a risky business these days perhaps more so than any time in modern history. True, on the surface everything looks calm.

2 Managing a company s finances is a risky business these days perhaps more so than any time in modern history. True, on the surface everything looks calm. But there are at least some indications that we may merely be seeing the calm before the storm. Consider, for instance, that the world s leading economies are only slowly emerging from devastating recessionary pressures. The Eurozone is suffering through the second half of a double-dip recession, perhaps exacerbated by high interest rates. The U.S. is only beginning to recover from one of the deepest recessions in our history. And even China, the economic poster child of progressives everywhere just a year or two ago, seems to be positioned for a strong correction after what looked like a period of skyrocketing growth. For many American businesses, there are two particular areas of potential risk that are often overlooked, in spite of their high potential for wreaking havoc with the bottom line. The first of these involves interest rates. In the U.S., of course, we re enjoying historically low rates, at least for the moment. But the Federal Reserve seems poised to boost them at any time, and the economy s movers and shakers flinch every time anyone with any power brings the subject up. The second area of risk involves foreign exchange (FX) rates. They ve always been unpredictable. But we may be seeing even greater volatility in the months ahead. And the current synergy of the world s economies means that a change in one market can have a domino effect on the others. Fortunately, both interest rate and FX-rate risks can be largely mitigated by taking advantage of commonly available hedging tools.

3 WHAT EXACTLY IS YOUR EXPOSURE? If your organization has no debt and neither buys nor sells overseas, you have no direct exposure to the kinds of fiscal risks that are keeping some of your counterparts awake at night. But if you do carry debt, engage in any significant importing or exporting of products or services, or operate facilities overseas, you re definitely at risk. If you have floating-rate loans, for interest, climbing interest rates could be toxic to your cash flow, and to your profitability. And if you participate actively on either side of the foreign exchange fence, you might have significant sums at stake if you re on the wrong end of impending rate adjustments. In light of such risks, what are the wisest policies to pursue in today s economic environment? We re talking more than petty cash How much does your company stand to lose if interest or foreign exchange rates take a bad turn? That depends on many factors, of course, but just as an example, let s say that your business closes $3 million in sales a year, 33 percent of it with customers overseas and that the exchange rate between the U.S. and your primary customers nations fluctuate by a not-so-terribly-unusual average of 10 percent a year. That would put $1 million of your sales at stake and mean a potential risk of $100,000 that you could probably spend much more wisely than throwing it away on fluctuating exchange rates. 3

A HEDGE AGAINST CLIMBING INTEREST RATES There s nothing terribly complicated about the problems rising interest rates could pose for an organization with loans based on floating rates.

4 A HEDGE AGAINST CLIMBING INTEREST RATES There s nothing terribly complicated about the problems rising interest rates could pose for an organization with loans based on floating rates. Nor is there really anything complicated about a knowledgeable banker s solutions: interest rate hedging tools, or swaps. Here s how it works. When you buy a swap, your bank sells you a hedge that, in effect, transforms your floating-rate loan into a fixed-rate instrument. As interest rates climb, so does your floating rate; but at the same time, your swap functions as a hedge against those increases. Reductions in the monthly swap settlement amount offset higher floating rates, and if floating rates rise above the agreed-upon fixed rate, the swap will actually reimburse you for the difference between fixed and floating rates. The result? You have, in effect, fixed your interest rate at a palatable level. And you ve done so without the hassle and costs of re-doing your entire loan. In fact, swaps are much easier to execute, allowing you to amend your rate structure entirely apart from the loan agreement itself. And they re much cheaper to execute, with no upfront costs; all fees are built into the swap rate. A case in point What s the magnitude of the loss your company could avoid with a smart swap? Here s just one example of how the rates play out over several years with a swap payment calculated at a fixed swap rate of 1.25% minus one-month s LIBOR. FLOATING-RATE LOAN SWAPPED LOAN 1 mo. Loan All-in Swap Effective LIBOR Spread* Floating Payment** Fixed Rate 8/1/ % 3.00% 3.25% +/- 1.00% 4.25% 8/1/ % 3.00% 4.00% +/- 0.25% 4.25% 8/1/ % 3.00% 5.50% +/ % 4.25% 8/1/ % 3.00% 7.00% +/ % 4.25% * Documented in loan agreement ** Documented in swap confirmation 4

5 What s more, swaps are extremely flexible, offering you a range of structures from forward or partial hedges to caps; there s sure to be a solution that will meet your needs. They don t lock you in, since you can sell your fixed-rate back to your bank at any time at a make-whole value determined by market conditions. As long-term interest rates rise, your swap may actually become an asset for which you ll be reimbursed if you decide to terminate the contract early. (Of course, if interest rates fall, the opposite is true.) FLOATING-RATE LOAN SWAPPED LOAN BORROWER LIBOR % Pay: Floating Rate on Loan FLOATING RATE LOAN OR ASSOCIATED BANK AS SWAP PROVIDER LIBOR Receive: Floating Rate on Swap BORROWER Pay: Fixed Rate on Swap 1.25% A swap contract can create the ideal hedge against interest rate risk, effectively fixing your rate at an acceptable level. In this example, the borrower s net interest rate is 1.25% %, or 4.25%, rather than LIBOR %. 5

A HEDGE AGAINST FOREIGN EXCHANGE FLUCTUATIONS The subject of foreign exchange rates is somewhat more complex, because there are so many variables that can enter into the picture, and because the

6 A HEDGE AGAINST FOREIGN EXCHANGE FLUCTUATIONS The subject of foreign exchange rates is somewhat more complex, because there are so many variables that can enter into the picture, and because the world s economies are unpredictable, volatile, and increasingly interconnected. But if you regularly deal with vendors or buyers overseas, or operate facilities abroad, your company is exposed to foreign exchange risk every time you conduct a foreign-currency transaction a risk that can impact some companies profitability by as much as 25 percent. So it s well worth investigating the issue, because the sums at stake can be significant. US Dollars (USD) to 1 Euro (EUR) Source: This graph shows how dramatically exchange rates can fluctuate even in an apparently stable economic climate. Illustrated here are the FX rates between the U.S. Dollar (USD) and the Euro (EUR) over just six months, from 1/20/2013 to 7/17/

The three buckets of FX hedging FX FX FX FORWARD CONTRACTS essentially immunize you from any FX movements, good or bad, for the length of the contract.

7 The three buckets of FX hedging FX FX FX FORWARD CONTRACTS essentially immunize you from any FX movements, good or bad, for the length of the contract. VANILLA OPTIONS provide all the protection of a Forward Contract, but leave you free to reap all the rewards of favorable moves. STRUCTURED OPTIONS offer you full protection while limiting your ability to capitalize on favorable moves. Fortunately, there are a number of ways to protect your company against the foreign exchange risk. They fall into three general categories, each one using tools that are similar in many ways to insurance policies: Forward Contracts protect you fully against unfavorable changes in FX rates, but don t allow you to benefit from favorable changes. Vanilla Options Contracts protect you fully from unfavorable rate changes while allowing you to reap all the rewards of favorable changes. The downside? You have to pay a high premium for the privilege. Structured Options Contracts offer you full protection while reducing or eliminating the premium entirely and limiting your potential gain. The common denominator: All these instruments allow you to lock in today s exchange rates, as is or within a pre-set range, thereby providing you with the desired level of protection against adverse exchange-rate movements. The FX risk can be substantial Whatever currencies may be involved, if you re buying parts or selling product overseas, exchange rate fluctuations will impact your Cost of Goods Sold (CGS). And that can have a significant impact on your organization s bottom line, as this example demonstrates. Exchange rate: Sales (in USD): $10.0 mm $10.0 mm $10.0 mm CGS (converted to USD): ($3.3 mm) ($3.9 mm) ($4.5 mm) Net Income: $6.7 mm $6.1 mm $5.5 mm E250,000 X 12 months = E3.0 mm E3.0 mm X the exchange rate (1.1000) = $3.3 mm, or E3.0 mm X the exchange rate (1.3000) = $3.9 mm, or E3.0 mm X the exchange rate (1.5000) = $4.5 mm 7

FORWARD CONTRACTS Forward Contracts allow you to buy or sell a fixed amount of foreign currency at a specific price, for settlement on an agreed-upon future date or within a specified amount of time.

8 FORWARD CONTRACTS Forward Contracts allow you to buy or sell a fixed amount of foreign currency at a specific price, for settlement on an agreed-upon future date or within a specified amount of time. As we mentioned, they provide full protection from the bad news but don t allow you to capitalize on the good news. With Forward Contracts, your profit or loss on each transaction is entirely independent of the exchange rate. Instead, you know today what rate you will be using down the road, regardless of actual market movements, because you have locked in your exchange rate for the length of the contract. And that makes it easier for you to do accurate forecasting, budgeting and planning especially if you do business regularly with overseas vendors or customers. There are two types of Forward Contracts: Closed Forwards, which must be settled on a specific date Open Forwards, which allow you to settle any portion of the contract within a defined period of time Whichever you choose, you ll find a Forward Contract to be a flexible solution, for two reasons. First, it allows you to manage your exposure by either closing your Forward Contract or rolling it over to a later date. This flexibility makes it a popular tool for just about any type of enterprise, including importers, exporters and foreign investors. Second, it leaves room for tailoring the contract to meet your needs precisely for example, with what s known as a Non-Deliverable Forward (NDF), which is liquidated at maturity with the net profit or loss settled in U.S. dollars. For reasons such as these, a Forward Contract can be an attractive solution, indeed. That s especially true for businesses with expenses payable in local foreign currencies for example, for foreign-office operations or local loans. There are no upfront costs or fees for Forward Contracts. You pay the prevailing spot rate for the currency in question, adjusted by a discount or premium tied to the difference in interest rates between our currency and theirs. Is a Forward Contract right for you? Here s one example of how a Forward Contract would make our fictitious $10 million OEM immune from fluctuations in FX rates. Exchange rate: Sales (in US$): $10.0 mm $10.0 mm $10.0 mm CGS (converted to USD: ($3.3 mm) ($3.9 mm) ($4.5 mm) Gain/loss on FX forward hedge: $0.6 mm $0.00 $(0.6 mm) Net Income: $6.1 mm $6.1 mm $6.1 mm 8

9 VANILLA OPTIONS If you re looking to not only avoid risk but also to take advantage of favorable changes on the FX front, you might be interested in a Vanilla, or Currency, Options Contract. It gives you the right (but never the obligation) to buy or sell currency at a specific rate or within a specific timeframe. Say, for example that the current exchange rate between Euros and U.S. dollars is i.e., each Euro is selling for $1.31. With a Currency Option, we ll guarantee you the right to buy Euros for $1.31 each, no matter what the exchange rate does. But there s no obligation to do so. So if the market rate is better than say you can ignore the contract and purchase the Euros at the market rate of $1.20. On the other hand, if the market has moved to a worse position say you can elect to purchase your Euro at the contract price of $1.31. The advantage is obvious, but there is of course a cost involved, in the form of a premium payment at the time of the transaction. Exactly how much will this premium be? That depends on factors such as strike price, time and volatility. The Strike Price is one variable that can be used to determine your premium. It s essentially the rate that you set for exercising your hedge contract. For the sake of illustration, let s use the example we applied above, with the current exchange rate at one Euro for 1.31 in U.S. dollars. In this scenario, your alternatives look like this: At the money Option: This is your choice if you want to keep your FX rate exactly at the current exchange rate of $1.31. Your cost will be $1.31 no matter how high the rate goes for the rest of the world. Getting technical: A brief glossary of FX Option terminology Here are a few terms that are commonly tossed around in risk-management circles, along with their definitions. You shouldn t have to understand them to minimize your company s risk exposure. But if you re working with someone who prefers jargon to plain English, this little glossary may give you a start at interpreting the lingo. Call Option: The right to buy a specific amount of a currency at a specific rate and future date. For this right, you pay a premium. Derivative: Anything whose value is derived from an underlying asset. For instance, gold futures derive their value from the current price of gold; gold futures are therefore a derivative. Foreign Exchange Derivative: An instrument whose value is derived from an underlying currency or its exchange rate. Implied Volatility: A currency pair s rate of change over time. The more volatile the rate, the more you will pay for risk protection. Premium: The cost of an Option, paid up front by the buyer. Put Option: The right to sell a specific amount of a currency at a specific rate and future date. For this right, you pay a premium. Spot Market: An agreement between two parties to exchange one currency for another at a specific rate, with delivery typically two days from the trade date. Strike Price: The exchange rate at which you can exercise a Call or Put Option. 9

10 Out of the money Option: To reduce your premium somewhat, you could cap your maximum price a little higher $1.35, say. In the money Option: This alternative gives you the right to buy at an even more attractive price sticking with our example, let s say $1.20. The premium on this transaction would be relatively high, but in some circumstances, it might be worth it. Time is another variable impacting your premium. Quite logically, the longer your protection lasts, the more you ll pay for it. Volatility is a third variable affecting premium. Some currencies budge no more than 0.10 percent over time; others might move 2 percent or more over the same period. The greater a currency s current volatility, the higher your premium will be. Currency Indices Appreciation Depreciation Base Source: The world s currencies are both volatile and interdependent, as can be seen by this chart showing just a week s worth of fluctuations in late

11 STRUCTURED OPTIONS If Vanilla Options sound good, but you don t like what the premiums could do to your cash flow, Structured Options might be a better alternative. They reduce or eliminate your premium while limiting how much you can gain from favorable FX movements. There are many types of Structured Options. Here are three examples: Range Forward Contracts establish firm floor and ceiling FX levels. You won t gain on rates below the contracted floor, or lose on rates above the contracted ceiling. Forward Plus Contracts set a protective floor while allowing you to capitalize on favorable moves in the FX rate, up to an agreed-upon rate called a trigger event. Participation Forward Contracts also establish a protection rate for adverse market movements. But they limit your gains on favorable moves to an agreed-upon percentage. Structured Options are, in other words, variations on the theme of providing you with worst case protection while giving you varying levels of rewards in various best case scenarios. All require some level of premium payment, but less than is required for a Vanilla Options Contract. IT CAN GET MUCH MORE COMPLEX Although the foundational principles remain the same, individual situations can become quite complicated, especially if you are buying from, or selling to, companies in multiple nations. If that describes your situation, your bank should be able to put together a package to protect your cash flow and your profit margins in even the most complex scenarios and then manage the package for you, so you can attend to more pressing matters. THE BOTTOM LINE Whatever your particular situation may be, if you have floating-term loans or conduct business overseas, it is well worth discussing the details with your banker. At the very least, tools such as those described in this white paper could help you manage your company s risks in an increasingly volatile economic climate potentially saving substantial sums and having a significant impact on your organization s financial well-being. 11

Your Associated Bank Capital Markets Contact Donald J. Lloyd Senior Vice President Capital Markets Foreign Exchange and Derivatives 312-544-4575 Donald.Lloyd@ AssociatedBank.

12 Your Associated Bank Capital Markets Contact Donald J. Lloyd Senior Vice President Capital Markets Foreign Exchange and Derivatives AssociatedBank.com When Don joined the Associated Bank team in 2008, he brought to the table more than 30 years of banking experience. In his current position, he oversees international payments, foreign exchange and interest rate hedging, along with the sales strategy of trade services for commercial clients. Don earned his BBA in Banking and Finance at the University of Mississippi and his MBA at the University of North Carolina Charlotte. He is ACI-certified, and holds memberships in the US Regional Bank Forex, the Milwaukee World Trade Association (MWTA), and the Wisconsin Treasury Management Association (WTMA). He s a Past President of Forex USA, and a former member of the Federal Reserve Foreign Exchange Committee. He has also served on the Committee for Professionalism for the Financial Markets Association of Canada. A man whose love and talent for teaching becomes apparent in even a brief conversation, Don also serves as an Adjunct Professor at Aurora University in Illinois, teaching Money and Banking, Corporate Finance, and Economics. In his spare time, he volunteers with Open Arms Home for Children and BEDS Plus. 12

13 CHOOSING THE RIGHT BANK When it comes to selecting the right bank to help you hedge your interest rate and FX risks, you d be hard-pressed to find a team that s more qualified or experienced than Associated Bank s. We offer all the services you d expect from the nation s largest financial institutions, plus the personalized service and support available only from a community bank. Consider, for example, our international banking services. They include: Foreign exchange spot and the FX hedging complex International wire transfers Foreign checks and drafts Documentary collections Import, export and standby letters of credit Trade finance Travel services Associated Bank also offers you the financial strength you need. With $24 billion in total assets, for example, we exceed OCC requirements and regulatory standards for well capitalized banks, signifying a strong and stable organization. We re also among the top 50 financial services holding companies operating in the U.S., as well as being a member of the S&P Midcap 400 stock index. over the decades. We may be the largest bank headquartered in Wisconsin a bank with branches throughout not only our home state but also in Minnesota and Illinois, as well as commercial offices in Detroit, Indianapolis, Cincinnati, St. Louis and Houston. But we also have a 120-year history of providing sound advice and financial solutions to clients who are our families, friends and neighbors. We are determined to routinely exceed our customers expectations in order to win their loyalty, trust and respect and to maintain deep and lasting relationships with them all. What s more, we place great emphasis on our employees on helping them to apply their individual talents, to grow both personally and professionally, and to assume leadership positions in their communities. In a nutshell, it s our vision to be the most admired financial services company in the Midwest, distinguished by sound, valueadded financial solutions, personal service for our customers, a strong commitment to our colleagues and the communities we serve, and exceptional value for our shareholders. How may we be of service to you? We would be delighted to discuss your banking requirements at your earliest convenience. To schedule a meeting, please give us a call today. Perhaps even more important, however, are the local-bank vision and values we have held Associated Bank, N.A. ( AB ) is a Member FDIC and Associated Banc-Corp ( AB-C ). Equal Housing Lender. Equal Opportunity Lender. Loans are subject to credit approval and involve interest and fees as well as risk. Please ask for further details. Associated Commercial Finance, Inc., is an affiliate of AB-C. Loans are subject to credit approval and involve interest and fees. Equal Opportunity Lender. (9/13)

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