Earnings and Foreign Exchange (F/X) - A Material but Easily-Manageable Risk
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1 Earnings and Foreign Exchange (F/X) - A Material but Easily-Manageable Risk Quantifying and minimizing F/X risk will Protect Profits Decrease Earnings Volatility Increase Firm Valuation Decrease Weighted Average Cost of Capital (WACC)
2 F/X Risk and Profits Currency Exchange Rates : Volatile (3 month G-7 volatilities vary from 10% to 14%) Unpredictable, with sudden, swift changes (event risk, devaluation, sovereign default) 25% change in 30 days USD/CAD US Fortune 100 companies lost between $15B and $20B due to unhedged currency moves in 2009 (GTNews, 2009). Some examples: Oracle lost 5 /share in Q4 09, the latest in 3 quarters of negative currency impacts SAP saw a 15% constant-currency growth reduced to zero by F/X in In 08, they saw a YoY negative revenue impact of 4% from F/X
3 Earnings Volatility From F/X is Real Actual monthly variation of $-denominated earnings on a nominal 370,000 ($500,000) EUR/USD monthly cash flow, over a 20 month period. Earnings Variation $60,000 $40,000 $20,000 Variation $0 -$20, Unhedged Hedged -$40,000 -$60,000 Months
4 Earnings Volatility Hurts Firm Value Volatility in earnings, ratios and cash flow are perceived negatively by lenders and investors Increasing borrowing costs (see next slide) Decreasing debt service capacity Reduced institutional investment (who seek a maximum Sharpe Ratio 1 ) Volatility results in unstable cash flows, impeding long-term capital planning Many studies show firms with higher earnings volatility trade at lower values 2 1. Sharpe Ratio = (Return Risk Free Rate)/(Standard Deviation of Return) 2. Allayannis and Weston (2001), Nain (2004) and Kim et al. (2006)
5 Earnings Volatility Increases WACC Rd is the cost of debt (interest rate). It is equal to the risk-free rate plus a company-specific risk premium or spread The higher the earnings volatility, the higher the risk premium, higher Rd, and therefore higher WACC Higher WACC increases project costs and product pricing Higher WACC = lower shareholder value D = Corporate debt E = Corporate equity Rd = Cost of debt Re = Cost of equity ω = Corporate tax rate
6 Common Misconceptions About Exchange Rates Assuming Purchasing Price Parity (PPP) will drive exchange-rate equilibrium Assuming F/X rates will even out over time Neglecting tail risk - Black Swans (9/11, Lehman Bros, Greece) Assuming that hedging is too expensive or complicated Note how the USD TWI (Trade-Weighted Index, a proxy for all F/X) varies +/- 20% around the PPP over many years. Mean reversion is evident only over decade-long time frames
7 F/X Exposures Pre-Transaction Exposure Price List/ Tender Order Receipt from Foreign buyer Transaction Exposure Production Ship Invoice Receipt of Foreign Currency Accounting Exposure
8 F/X Risk Management is Good Practice F/X Risk Management is widely practiced among larger firms, not as common amongst smaller firms 83% of large firms hedge (sales>$1.2bn) 12% of small firms hedge (sales <$150m) 1 A recent Business Outlook worldwide survey 2 of CFOs show currency volatility is # 3 (Asia) or #4 (US & EZ) out of top 10 concerns Tracking F/X Exposure is required by FAS 52 F/X Hedge accounting covered by FAS 133, IAS 39 Hedged Profit No Hedge Not hedging F/X exposure is unnecessarily risky! 1.Wharton study,
9 F/X Risk Management Increases Competitiveness Accommodating customers: Invoice in customer s home currency (or currency of choice) without risk Competitors may already do so (or are local to customer) Competitive pricing You don t have to pad your bid to cover potential F/X risk Customers won t push as hard on price if its invoiced in home currency Accelerate Payments Inbound wires are not subject to delay by intermediary banks Dynamic product development (lower WACC means more investment capacity) Profits not at risk
10 Hedging Theory + Change in PO Value Based on F/X Rate Impact on deal Net Deal Change Exchange Rate - Change in Hedge Value
11 Nuts and Bolts of Hedging Example: a US company will receive 1M (GBP) in 6 months Options (1 Month to 1 Year) Create synthetic GBP/USD short by buying 100 Puts and selling 100 Calls with 6 month expiry (using Put-Call Forward Parity) Forwards/Futures (1 Month to 1 Year) Sell 6 month GBP forward, lock in current rate, close out when 1M received Money Market (6 Months to 2 Years) Borrow the Present Value of 1M, convert to $, invest that in US Treasuries (or AAA corporate bonds) for 6 months. At the end of 6 months, collect the 1M receivable and repay the loan with it Currency Swaps (2 to 10 Years) Agreement with counterparty to exchange cash flows (interest payments) during the hedge period, and principle (at agreed upon rate) at some point in the future
12 Example Hedge: Assumptions Deal Points: Swiss Firm exporting to the US Aggregated Purchase Orders for the current month total $300,000 Due in 90 days net (July 22) PO signed today, April 22. USD/CHF Financial Market Data USD/CHF 3 month volatility 10.45% Current USD/CHF exchange rate is1.0780
13 Hedged Using Option Spread Deal impact with and without Hedge Exchange Rate Change in P&L $25,000 $20,000 $15,000 $10,000 $5,000 $0 -$5,000 -$10,000 -$15,000 -$20,000 -$25, With Without Contract spot Hedge is 30 long (-6,690 CHF), 30 short (+6,360 CHF), expiry July 24. Net -330 CHF
14 Challenges of Currency Risk Management Lacking internal resources who can dedicate their time Lacking internal knowledge on how to manage F/X Risk Difficulty calculating exposure Transaction, translation Finding and Using Natural hedges (offsetting transactions) Designing Financial Hedges (options, futures, money market) Developing policies and measures Outsourcing Currency Risk Management is the perfect solution for small to mid-sized companies
15 F/X Risk Management Best Practices Use standard tools Eschew exotic options, complex models, directional trades, or anything you don t understand No speculation The point is to reduce risk Start off small Assess impact of hedging on key financial metrics Lets you prepare operationally- accounting (e.g. SFAS 161), tax processes Establish metrics Cash flow at risk (VaR), return on capital (RAROC), FAS 133 (mark-to-future) Risk Governance Oversight, execution, communication to all stakeholders
16 What will it cost? How do I get started? 0.5 to 1.0% = Hedge cost, depending on variables 0.5% = Consulting fee (USD $500 minimum) 1.5% = Total fees and costs To learn more or get started: Or contact Paul Stafford, Director, Currency Risk Management pstafford@hedgeforeignexchange.com
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