Establishing and Maintaining an FX and Interest Rate Hedging Program: The Lifecycle of a Hedge presented by Thomas Armes, Managing Director Foreign Exchange, PNC Capital Markets Steve Goel, Assistant Treasurer, Freescale Semiconductor March 26, 2012 Agenda The Lifecycle of a hedge Why Hedge? How to Hedge? Trends and Strategies in Interest Rate and FX Risk Management 1 Why Hedge? Competing Interests 80% of transactions in the currency market are speculative Increasing Volatility 2 1
FX Volatility VAR Value At Risk Value-at-Risk (VAR) CURRENCY1 Currency:USD Industry Sector Historical 3Y 95% Time Horizon: 1 Day Distribution Name %Port MktVal(M) VaR VaR (%) Industry Sector - 100.00 100,000 931,483 0.93 CASH - 100.00 100,000 931,483 0.93 AUD Curncy AUSTRALIAN DOLLAR 10.00 10,000 161,562 1.62 NZD Curncy NEW ZEALAND DOLLAR 10.00 10,000 157,464 1.57 BRL Curncy BRAZILIAN REAL SPOT 10.00 10,000 150,952 1.51 MXN Curncy MEXICAN PESO SPOT 10.00 10,000 137,577 1.38 CAD Curncy CANADIAN DOLLAR 10.00 10,000 117,860 1.18 RUB Curncy RUSSIAN RUBLE SPOT 10.00 10,000 117,600 1.18 CHF Curncy SWISS FRANC SPOT 10.00 10,000 116,522 1.17 EUR Curncy EURO SPOT 10.00 10,000 112,120 1.12 JPY Curncy JAPANESE YEN SPOT 10.00 10,000 105,412 1.05 GBP Curncy BRITISH POUND SPOT 10.00 10,000 102,038 1.02 Data: Bloomberg 3 Why Hedge? Protect income statement Ensure company meets cost of goods sold forecast Reduce earnings volatility Market volatility Focus on core competency 4 Understanding Best Practices 10Q Excerpts WMT 10Q 9/1/2011 The Company uses derivative financial instruments for hedging and non-trading purposes to manage its exposure to changes in interest and currency exchange rates, as well as to maintain an appropriate mix of fixed- and floating-rate debt. AAPL 10Q 7/20/2011 The Company uses derivatives to partially offset its business exposure to foreign currency exchange risk. The Company may enter into foreign currency forward and option contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities. HD 10Q 9/1/2011 The Company uses derivative financial instruments from time to time in the management of its interest rate exposure on long-term debt and its exposure on foreign currency fluctuations. KO 10Q 8/1/2011 The Company uses various types of derivative instruments including, but not limited to, forward contracts, commodity futures contracts, option contracts, collars and swaps. 5 2
Currency Risk Mitigation - Why not to Hedge? Currency Hedging is Speculative In the long run, currency gains and losses average out We conduct all of our international business in US Dollars 6 How does the hedging process work? Develop hedge policy Internal communication / controls Ensure that all approvals are in place prior to hedging Setting budget rates Cash flow forecasting Determine exposures 7 Hedging before the hedge execution Documentation ISDA Corporate resolutions Tax documentation Credit Considerations Credit Equivalent Settlement Exposure Credit Valuation Adjustment 8 3
Documentation ISDA International Swaps and Derivatives Association Designed to protect both parties in an OTC (Over the Counter) transaction Most commonly used Most banks require this document for FX Options, Interest Rate Derivatives, and Long dated (>18 months) forward contracts Corporate Resolution Legal form which documents a corporate action From an FX perspective, the corporate resolution identifies the authorized parties that may enter into and approve transactions Tax form - W9 or W8 At maturity of a forward contract, the bank is required to submit a 1099 to the counterparty and to the IRS, unless a W9 or W8 is on file 9 Credit Considerations CE Credit Equivalent, also known as Pre-Settlement Risk Calculates the maximum loss that the bank would take in the event of a counter-party default AND a negative market movement Usually risk is calculated to 1 or 2 standard deviations, with heavier weighting on recent periods Not equal to the notional hedged (e.g. EUR/USD 6 Month Risk factor is 15% of notional) Not hard credit and does not impact availability of a credit line unless ABL SE Settlement Exposure The maximum amount that can settle on any given day; similar to ACH exposure Equal to notional amount Not hard credit CVA Credit Valuation Adjustment A reserve that the bank takes against potential future losses in long-dated structures 10 Executing the Hedge Selecting the counterparties that will bid Ancillary business goals Firms that provided advice / other work Credit position of each party that bids (e.g. participant in credit facility) Providing a term sheet Obtaining bids Phone call vs portal Opportunity for last look 11 4
Monitoring Effectiveness Evaluate importance of FAS 133 treatment Income statement volatility vs mark-to-market changes recorded in equity Calculate changes in the value of the hedge vs the forecasted change in the value of the underlying item being hedged 12 Strategies Buy and Hold Forward Contracts Non Deliverable Forwards Vanilla Options Participating Forwards Range Forwards 13 Strategy Comparison: Break Even Analysis Example: Customer has 1mm payment to make in 3 months. Current forward rate is 1.3675 Notional Worst-Case Best-Case Up-Front Break-Even Strategy Rate Rate Premium Amount to Forwards Forward Contract 1.3675 1.3675 N/A 1,000,000 N/A Vanilla Option 1.3675 unlimited $50,000 1,000,000 1.3175/1.4175* 50% Participating Forward 1.4000 unlimited $0 premium 1,000,000 1.3350 Range Forward 1.4100 1.3500 $0 premium 1,000,000 1.3675 * Break-evens inclusive of premium ** All options are priced with 3 mo Maturities 14 5
Strategy Comparison: Effective Rate Graph Example: Customer has 1mm payment to make in 3 months. Current forward rate is 1.3675 1.4400 1.4200 1.4000 Effective Rates 1.3800 1.3600 Forward Vanilla Range Forward Part. Forward 1.3400 1.3200 1.3000 Spot Rates at Expiry 1.2500 1.3000 1.3500 1.4000 1.5000 15 Interest rate hedging the fixed vs floating debt mix The optimal fixed-floating mix considers various factors, including the following: Cyclicality / seasonality of business Peer group Amount of leverage Interest expense in relation to total net income 16 Interest Rate Environment - changes over the past year 3m Libor Forward Curve 5.0% 4.5% 3/1/12 9/1/11 3/1/11 4.0% 3.5% Back end of curve shifted down 2.0% on concerns of prolonged sluggish economic conditions, European disruption 3.0% 2.5% 2.0% Front end of curve flattened as Fed announced rate hikes on hold until mid-2013 (Aug 2011) 1.5% 1.0% 0.5% Back end of curve flattened further as Fed announced rate hikes on hold until mid-2014 (Jan 2012) 0.0% Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Sep 2014 Mar 2015 Sep 2015 Mar 2016 Sep 2016 17 6
Fed Tightening - Historical Observations The current forward curve is flat relative to how rates have increased in previous tightening cycles The market tends to underpredict the pace and magnitude of rate hikes immediately prior to a tightening cycle 4.5% 4.0% 3.5% 3.0% 2.5% Fed Funds Target Rate 1994 Cycle 1999 Cycle 2004 Cycle 2.0% 1.5% 1.0% 0.5% 0.0% Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-1 18 Impact of Volatility Benefit of lower rates has a floor at zero % Swapping to fixed has an asymmetrical risk profile in a low interest rate environment 19 Hedging Strategy - Rate Locks Locking in interest rates prior to a debt issuance Treasury lock vs swap lock Disclosure requirements Impact of hedging and then not executing the debt issuance Fixing a debt issuance where there is a LIBOR floor 20 7
Hedging Strategy - Forward Starting Swaps Forward starting pay fixed swaps provide the opportunity to maintain low interest rates when variable rates are low, but to lock in a fixed rate at a future date Indicative Swap Rates (as of 3/2/12): Starting Term (Yrs) Current 1/1/13 2 0.52% 0.68% 3 0.65% 0.91% 4 0.86% 1.17% 5 1.10% 1.43% 21 Hedging Strategy LIBOR basis swap Interest rate basis swaps 3 month vs 1 month LIBOR Can take advantage of receiving 3mL through a swap and electing 1mL under a loan 22 LIBOR basis swap Hedge Strategy Floating to Fixed Interest Rate Swap with a Basis Swap Objective To lock in a fixed rate Notional Balance: $100,000,000 (for discussion purposes) Amortization: None Effective Date: March 1, 2012 Maturity Date: March 1, 2015 Floating Rate: 1m LIBOR, monthly, Actual/360 Fixed Rate Payer: ABC Company Floating Rate Payer: Bank Fixed Swap Rate 1.00%, monthly, Actual/360 1.00% Bank ABC Company Bank Loan 3m LIBOR 1m LIBOR + Spread 23 8
Hedging Strategy Libor vs Fed Funds 60 bp 50 bp 40 bp 30 bp 20 bp 10 bp Fed Funds vs. LIBOR The potential for a severe Fed Funds / LIBOR dislocation is rising as reduced inter-bank term lending keeps LIBOR elevated Spread Fed Funds Effective 3-Month LIBOR 3-Month Fed Funds Moving Average vs. LIBOR In a Fed Funds / LIBOR basis swap, the Fed Funds setting for a period is the daily average of the Fed Funds rate over that period. 60 bp 3-Month LIBOR 50 bp Fed Funds Effective 3m Moving Average 40 bp This basis swap 30 bp convention for Fed Funds further smoothes and 20 bp removes potential movement 10 bp 0 bp Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 0 bp Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Indicative Pricing (as of 3/2/12): Tenor 3mL vs. 1 Year FF + 35 bp 2 Years FF + 37 bp 3 Years FF + 38 bp 24 Trends in FX Risk Management - VOL Skew 25 Implied Probabilities Currency Spot Scenario Level 1 End Prob EURUSD 1.3081 Above 1.3000 6M 56.70% EURUSD 1.3081 Below 1.3000 6M 43.30% USDCAD 1.0023 Above 1.0000 6M 47.90% USDCAD 1.0023 Below 1.0000 6M 52.10% GBPUSD 1.5755 Above 1.6000 6M 41.30% GBPUSD 1.5755 Below 1.6000 6M 58.70% 26 9
Forward Points - Dislocation Spot Rate 1.3000 EUR USD 769,230.77 $1,000,000.00 1 Year Libor Rates 1.73% 1.10% Total at 1 Year 782,527.46 $1,010,957.00 Implied Rate 1.2919 Implied Forward Points -0.0081 Actual Forward Points 0.0033 Difference (Per Million USD) $8,759.62 27 Cross Currency Basis Swap 1) PNC Bank delivers USD Principal to ABC Company through revolving credit facility PNC Bank 2) ABC company enters into a cross currency swap with PNC to synthetically create a EUR loan. 1 USD Principal 3 EUR P+I (-69bps) Cross Currency Swap PNC Bank 4 USD P+I ABC Company 3) ABC Co. delivers EUR P and I (EURIBOR - 69bps). Equates to a $346k savings (PV ed) on a 10mm USD non-amortizing, 5 2 USD P+I plus Credit Spread year loan. 4) PNC Bank delivers USD Principal and Interest to ABC PNC Bank Company (At Fixed Rate of Exchange) 28 Basis Swap Spreads The breakdown of the basis swap spread in the wake of the financial crisis is attributable to: Liquidity concerns (the so-called dollar-shortage episode of 2008 or pressure on dollar funding market). Health of the banking system (similar to that of Japan in the late 1990s). The higher the banking credit default concerns, the more negative the basis swap spread. Supply and demand for long term funding (the more issuers of EUR swapping in USD, the wider the negative margin). 29 10
Libor vs. Basis Swaps LIBOR is an approximate average of lending rates from different banking institutions LIBOR rates do not include credit and liquidity risks USD Libor rate may have a better credit and liquidity quality than the EUR Libor fixing, so the spread represents the additional amount required by USD investors to receive a less credit-worthy currency Basis swap markets are very much driven by supply and demand for issuance A spread of -50 basis points means that there is little demand to receive EUR Libor, hence one has to receive a discount to convince investors to swap 30 Cross Currency Swap 10K/Q Excerpts NKE Nike Incorporated Derivatives used by the Company to hedge foreign currency exchange risks are forward exchange contracts, options and cross-currency swaps. The cross-currency swaps are used to hedge foreign currency denominated payments related to intercompany loan agreements. CYT Cytec Industries We used cross currency swaps to hedge the changes in the cash flows of certain Euro denominated intercompany loans receivable ( Euro loans ) held by U.S. entities and to hedge a portion of our net investment in Cytec Surface Specialties SA/NV (our largest Euro functional currency subsidiary). MKS Marks and Spencer The Group holds a number of cross currency swaps to redesignate its fixed rate US dollar debt to fixed rate sterling debt. The attributes of these derivatives match the characteristics of the underlying debt. CPB Campbell Soup Campbell Soup entered into three pay variable Australian dollar/receive variable dollar cross-currency swaps to hedge exposures related to inter-company financing transactions denominated in Australian dollars. 31 Standard Disclosure PNC, PINACLE, Working Cash, ActivePay, Global Trade Excellence, XPACK and Vested Interest are registered marks of The PNC Financial Services Group, Inc.( PNC ) Midland Loan Services, Enterprise!, CMBS Investor Insight, Portfolio Investor Insight, Borrower Insight, Deal Flow and Shared Servicing are registered marks of PNC Bank, National Association. Banking and lending products and services and bank deposit products and investment and wealth management and fiduciary services are provided by PNC Bank, National Association, a wholly-owned subsidiary of PNC and Member FDIC. Certain fiduciary and agency services are provided by PNC Delaware Trust Company. Equipment financing and leasing products are provided by PNC Equipment Finance, LLC, a wholly-owned subsidiary of PNC Bank, National Association. Aircraft financing is provided by PNC Aviation Finance, a division of PNC Equipment Finance, LLC. Merchant services are provided by PNC Merchant Services Company. Private equity financing is provided by affiliates of PNC Equity Management Corp. Mezzanine financing is provided by PNC Mezzanine Capital Corp. Investment banking and capital markets activities are conducted by PNC through its subsidiaries PNC Bank, National Association, PNC Capital Markets LLC, and Harris Williams LLC. Services such as public finance advisory services, securities underwriting, and securities sales and trading are provided by PNC Capital Markets LLC. Merger and acquisition advisory and related services are provided by Harris Williams LLC. PNC Capital Markets LLC and Harris Williams LLC are registered broker-dealers and members of FINRA and SIPC. Harris Williams & Co. is the trade name under which Harris Williams LLC conducts its business. Foreign exchange and derivative products are obligations of PNC Bank, National Association. Securities products and brokerage services are offered through PNC Investments LLC, a registered broker-dealer and member of FINRA and SIPC. Insurance products and advice may be provided by PNC Insurance Services, LLC. Important Investor Information: Brokerage and insurance products are: Not FDIC Insured. Not Bank Guaranteed. May Lose Value. PNC does not provide legal, tax or accounting advice. PNC does not provide investment advice to Vested Interest plan sponsors or participants. Lending and leasing products and services, including card services, trade finance and merchant services, as well as certain other banking products and services, require credit approval. 2011 The PNC Financial Services Group, Inc. All rights reserved. 3-23-2011 32 11
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