Enterprise Ireland Finance for Growth Strategies to better understand and manage foreign exchange risks Orla Meagher May 2018
Orla Meagher Treasury Products and Distribution Investec Bank Email: Orla.Meagher@investec.ie Phone: (01) 4210220
Finance for Growth Investec 3
Useful Definitions Treasury Risk Management: The process of administering to the financial assets and holdings of a business. The goal of most treasury management departments is to optimize their company's liquidity, make sound financial investments for the future with any excess cash, and reduce or enter into hedges against its financial risks Spot Rate: A spot exchange rate is the price to exchange one currency for another for delivery on the earliest possible value date. Although the spot exchange rate is for delivery on the earliest value date, the standard settlement date for most spot transactions is two business days after the transaction date Forward Contract: An agreement entered into to buy/sell currency at the prevailing market rate for delivery on a future date Mark to Market: The Fair Value of an Asset or Liability based on the current market price. Current market price in Foreign Exchange basically refers to the price at which the asset, if entered into today, is trading at. Currency Forecast: A Currency forecast is a prediction of where the Spot Rate will be trading in the future Derivative: Product whose value is derived from an underlying variable asset. In the case of foreign currency the variable is the FX rate. A forward contract or FX option are examples of currency derivatives. A Hedge: A risk management technique used to offset the risk of adverse movements in an asset Finance for Growth Investec 4
Foreign Exchange Drivers Finance for Growth Investec 5
Define, Define, Define.
Identify key risks Determine type and size of FX exposure Forecasted cash flows Tenor of contracts Competitive Landscape Regular review and controls Finance for Growth Investec 7
What type of FX Exposure do you have? There are three main types of foreign currency exposure: Transaction, Translation and Economic Exposure. Transaction This exposure arises when a company enters transactions in a currency other than its domestic currency e.g. Irish Retailer purchases stock in USD from China. Other forms of transactional exposure can include a requirement to purchase or sell currency following an acquisition or disposal. Translation Often referred to as accounting exposure, this is the risk of adverse movements in a firm s reported financial statements, resulting from consolidation of overseas businesses/ interests into the firm s reporting currency Translation exposure does not reflect actual movements of cash between currencies Economic Also known as operating exposure, this is the impact currency movements can have on competitiveness, barriers to entry etc. This is different to transactional exposure in that it is the impact on a firm at a macro rather than transactional level e.g. due to the appreciation of EURGBP, UK supermarkets substitute Irish producers with UK suppliers. Finance for Growth Investec 8
Building Blocks Define Risk Measure Risk Materiality Mitigants Peers Cashflows Finance for Growth Investec 9
Metrics Budget rate? How is it determined? Sales and finance interactions Budget rate relevant to what time periods Finance for Growth Investec 10
Risk Management Solutions Hedging objectives Protection v participation Appropriate hedging tenor Prevailing market Accounting considerations Finance for Growth Investec 11
Types of Foreign Exchange Transactions Spot Transactions Purchase or sale of currency today at today s market rates, with settlement in two business days Forward Contracts An agreement to purchase or sell currency at the agreed forward rate, for delivery on a date in the future. The forward rate is determined by today s spot rate, adjusted for the interest rate differential between two currency pairs. Premium Purchased Options A purchased option is a right but not an obligation to purchase one currency and sell another, at an agreed strike rate, on a date in the future. A premium is payable for a purchased option and it is determined by amongst other factors, the amount hedged, conversion rate, time to maturity and prevailing implied volatility Zero Premium Options Solutions Zero premium option solutions are a combination of purchased and sold options, structured for zero upfront premium. These provide clients with a hedged rate but also ability to participate in favourable market movements, within certain parameters. One such example is an FX Collar Finance for Growth Investec 12
Other Considerations Company A Significant currency exposures in the income statement are managed through the use of currency forward contracts, in line with the Board approved policy. The policy states that X Plc hedges between 65% and 85% of the next 12 months forecast surplus cash flows on a rolling basis, and between 45% and 65% of the following 12 months forecast surplus cash flows on a rolling basis Significant currency exposures relating to the acquisition cost or sale proceeds of aircraft is also managed through the use of currency forward contracts where up to 90% of the next 24 months committed forecast requirement is hedged Company B Derivative financial instruments The Group enters into forward foreign currency contracts to mitigate the exchange rate risk for certain foreign currency debtors. At 30 December 2017 the contracts outstanding have an average maturity of 5 months (2016: 6 months). Company C The Group s principal foreign currency exposures arise from the purchase of overseas sourced products. Group policy allows for these exposures to be hedged for up to 24 months ahead in order to fix the cost in Sterling. This hedging activity involves, the use of spot, forward and option contracts. The market value of outstanding foreign exchange contracts is reported regularly at Board level, and reviewed in conjunction with percentage cover taken by season and current market conditions in order to assess and manage the Group s ongoing exposure Company D Trading transactional currency risk is hedged up to five years in advance Finance for Growth Investec 13
Facilities Available Availability of banking facilities Terms of banking facilities Cash considerations Mark to market limits Execution Process and Procedure Finance for Growth Investec 14
Why do I require a credit facility to enter into FX transactions and what is the risk to the Counterparty? Finance for Growth Investec 15
Section 2 Case Studies and Discussion
Fixed Forward Contract A forward contract is an agreement to buy/sell currency at an agreed rate on a future date. The rate is agreed at inception, and delivered at a date in the future Todays spot rate, adjusted for the interest rate differential between the two currency pairs. Spot Rate +/- Interest Rate Differential = Fixed Forward Rate The holder of the higher yielding currency for the duration of the hedge must compensate the buyer for the hedging period. Not to be confused with a forecast Finance for Growth Investec 17
Fixed Forward Contract Example An Irish Software Company has just won a contract to supply a US customer. USD price agreed today but will be paid in 3 months. Seller wants to protect the euro value of his USD revenues Eurozone interest rates still in negative territory for this time period, USD Rates are positive. The Software Company are technically borrowing USD for 3 months. Spot EURUSD: 1.1750 EURUSD 3 Month Forward Points: +.0085 EURUSD 3m Forward Rate: 1.1835 All pricing levels are indicative and subject to change Finance for Growth Investec 18
Purchased Option Contract A purchased option is a right but not an obligation to purchase one currency and sell another on a specific date in the future at an agreed strike rate. The price of an option is determined by a number of variables including: The strike rate and prevailing spot rate The time to maturity The implied volatility of the underlying asset Interest rates Write an Option v Purchase an Option Put or a Call Option Finance for Growth Investec 19
Purchased Option Example Client is purchasing a business in the UK before the end of the year, and wants to protect the euro cost of the purchase. The business will cost 1m. The client is purchasing a put option the right but not the obligation to sell and buy. The client is considering a number of strike rates and also either a 3 month or a 6 month option. Current Spot: 0.8760 Current 3m Forward: 0.8780 Current 6m Forward : 0.8800 The right but not the obligation to sell and purchase GBP at 0.8760, in 3 months time costs a premium of 1.50% ( 15,000/ 17,123) The right but not the obligation to sell and purchase GBP at 0.8600 in 3 months time costs a premium of 0.75%( 7,500/ 8,560) The right but not the obligation to sell and purchase GBP at 0.8760, in 6 months time, costs a premium of 1.98% ( 19,800/ 22,600) All pricing levels are indicative and subject to change Finance for Growth Investec 20
Zero Premium Solution Example: An FX Collar A zero premium option structure is a combination of a bought and sold option, such that the premium of each offset each other to create a zero premium structure. Solve for the strike on each such that the cost of the bought and sold option net. Client is purchasing a business in the UK before the end of the year, and wants to protect the euro cost of the purchase. The business will cost 1m. Enter into a zero premium FX Collar: Client purchases a Put Option with a strike of 0.8650, maturity 6 months, cost 1.20% Client sells a Call Option with a strike of 0.8950, maturity 6 months, receives premium of 1.20% Finance for Growth Investec 21
Case Study 1 The Client is in the Food Sector, selling their product into UK Supermarkets. Given the nature of their product and the competitiveness of the market contracts tend to be reasonably short term and it is often difficult to pass on price increases to large retailers. Margins are single digit and they have priced their current sales on the assumption of a EURGBP rate of 0.8800. Client s objective is to protect margin on existing contracts and focus on further sales growth Finance for Growth Investec 22
Finance for Growth Investec 23 What risk management solutions should this client consider and why?
Case Study 1: Potential Solutions A Fixed Forward to sell GBP and purchase EUR in 3 months time at 0.8780 Is this a suitable approach? Protects Margin Aligned to cash flow reliability Provides certainty No further exposure to sterling depreciation Outperforms current budget rate ₓ Fixed commitment ₓ No ability to benefit from sterling strengthening over the period of the contract ₓ Requirement for credit lines are they available? Finance for Growth Investec 24
What other solutions could I consider that counter the challenges? Finance for Growth Investec 25
The market is currently better than my budget rate, I think I could consider hedging this for 6 or 9 months to lock in my budget rate Discuss Finance for Growth Investec 26
Case Study 2 The Client is in the Manufacturing Industry. The client has a number of long term contracts with large US customers. Lead times in terms of development and manufacture are long and contract length tends to be for a minimum of 24 months. Profit margins are good as it is very specialised, but timings of cashflows can change. Client would like to have certainty over the majority of their cashflows. Contracts are bespoke to each client and therefore tenor on each can be different. Payments tend to be staged. Client is keen to manage the risk and have a minimum hedged rate, but given profit margins is open to considering other options They have a 12 month credit line with their current providers Finance for Growth Investec 27
Event Risk Management Case Study The Challenge? Acquisitive Company, with plans for further acquisitions Overseas target? Acquisition price non euro denominated? Lack of certainty in terms of timing and probability of close Desire to risk manage the purchase price Mark to market risks The Solutions FX solution without a future commitment Forward contracts not necessarily appropriate Disaster protection In the money and out of the money options Key price determinants Shareholder communication Finance for Growth Investec 28
This presentation provides a number of examples of risk management solutions. This is not an exhaustive list and is just an illustration of some of the key components. Finance for Growth Investec 29
Key Messages FX Risk Management approach will be Company Specific FX Risk Management will be often contract and exposure specific Consider the competitive landscape and some peer analysis Consider your availability of credit Be clear on FX Risk Management Objectives at Board Level Start with the Building Blocks and Cash flow Analysis Finance for Growth Investec 30
Orla Meagher Treasury Products and Distribution Investec Bank Email: Orla.Meagher@investec.ie Phone: (01) 4210220 / 086 4649385
Disclaimer Investec Bank plc. (Irish Branch) ( Investec ) has issued and is responsible for production of this publication. Investec Bank plc (Irish Branch) is authorised by the Prudential Regulation Authority in the United Kingdom and is regulated by the Central Bank of Ireland for conduct of business rules. Investec Bank plc is a member of the London Stock Exchange and the Irish Stock Exchange. This publication should be regarded as being for information only and should not be considered as an offer or solicitation to sell, buy or subscribe to any financial instruments, securities or any derivative instrument, or any other rights pertaining thereto (together, investments ). Investec does not express any opinion as to the present or future value or price of any investments referred to in this publication. This publication may not be reproduced without the consent of Investec. The information contained in this publication has been compiled from sources believed to be reliable, but, neither Investec, nor any of its directors, officers, or employees accepts liability for any loss arising from the use hereof or makes any representations as to its accuracy and completeness. The information contained in this publication is valid as at the date of this publication. This information is subject to change without notice, its accuracy is not guaranteed, it may be incomplete or condensed and it may not contain all material information concerning the matters discussed herein. This publication does not constitute investment advice and has been prepared without regard to individual financial circumstances, objectives or particular needs of recipients. Readers should seek their own financial, tax, legal, regulatory and other advice regarding the appropriateness or otherwise of investing in any investments or pursuing any investment strategies. Investec operates exclusively on an execution only basis. An investment in any of the investments discussed in this publication may result in some or all of the money invested being lost. Past performance is not a reliable guide to future performance. To the extent that this publication is deemed to contain any forecasts as to the performance of any investments, the reader is warned that forecasts are not a reliable indicator of future performance. The value of any investments can fall as well as rise. Foreign currency denominated investments are subject to fluctuations in exchange rates that may have a positive or adverse effect on the value, price or income of such investments. Certain transactions, including those involving futures, options and other derivative instruments, can give rise to substantial risk and are not suitable for all investors. Investec (or its directors, officers or employees) may to the extent permitted by law, own or have a position in the investments (including derivative instruments or any other rights pertaining thereto) of any issuer or related company referred to herein, and may add to or dispose of any such position or may make a market or act as a principal in any transaction in such investments or financial transactions. Investec s conflicts of interest policy is available at http://www.investec.ie/legal/uk/conflicts-of-interest.html. Finance for Growth Investec 32