erspective P Insights for America s Business Leaders Best Practices for Foreign Exchange Risk Management in Volatile and Uncertain Times
Framing the Challenge The appeal of international trade among U.S. CEOs is on the rise. Companies continue to expand their businesses through import/export trade opportunities, outsource their production overseas, and pursue M&A activity in favorable foreign markets. According to the May 2010 U.S. International Trade in Goods and Services Report issued by the Department of Commerce s U.S. Census Bureau and the Bureau of Economic Analysis, exports of U.S. goods and services were up 17.7 percent to $739.5 billion in the first five months of 2010 from the $628.3 billion in the first five months of 2009. The report also indicates that U.S. exports of goods and services increased by 2.4 percent in May 2010 to $152.3 billion from April 2010, while imports increased 2.9 percent to $194.5 billion over the same period. The growth of foreign trade, combined with the volatile markets, has heightened the importance of prudent foreign exchange (FX) risk management. A clear framework is needed to better understand and manage the financial implications of international operations and expansion. Getting started requires a realistic game plan to manage these risks in an orderly manner. This paper will provide you with recommendations and fundamental best practices to help your organization manage the FX risk associated with emerging global trade opportunities. Why Hedge? The 2010 Financial Risk Survey conducted by the Association for Financial Professionals identified that 51 percent of participating organizations had exposure to FX risk and 72 percent of those used risk management strategies to hedge their exposure. A J.P. Morgan survey conducted among large corporations in Japan, Europe and the U.S. revealed that U.S. customers had hedged approximately 74 percent of their 2010 FX exposure and 34 percent of their 2011 exposure. You ll find that hedging is not about making money. The goal of savvy decision makers is to reduce volatility in earnings and cash flow not to make money on the hedge. A successful program will mute the volatility in earnings. For public companies, academic research posits that the hedging premium defined as higher firm value is on average 5 percent (Allayannis and Weston, 2001). These initiatives also allow managers to focus on maximizing the operating value of the firm and minimizing financial disruption risk caused by market fluctuations. FX Risk Management Framework The road map for successful FX risk reduction begins with a clearly written and board-approved policy and ends with consistent execution of the policy. Some of the key items that should be included in the policy are as follows: Defining the hedging objectives Establishing risk management procedures Defining the term and percentage exposure to be hedged Listing the permitted hedge instruments Delegating authority for hedging decisions and execution In general, implementation of the policy will involve a number of best practices, including the following: Identify the FX risks Centrally measure, collect and manage the global FX exposures Utilize all the prudent hedging tools, including forwards and options Determine the success of the hedging program The goal of savvy decision makers is to reduce volatility in earnings and cash flow not to make money on the hedge. 2
Identify Risks FX risk can be organized into four categories, as outlined in the diagram below. The first two exposures, forecast risk and transaction risk, cover the cash and earnings cycle from budgeting to final cash collections/payments. Budgets are exposed to assumptions on exchange rates as revenues are expected to be generated in one currency and costs are expected to be incurred in another currency. As budgets are realized, receivables and payables in different currencies will create remeasurement risks that impact current earnings. The translation of a subsidiary s balance sheet is generally not a key risk unless there is substantial foreign currency cash held at the subsidiary or if there are plans to sell overseas assets. The translation of a subsidiary s income statement is difficult to hedge but may be achieved by proper application of the forecast risk hedging program. Transaction Risk/ Balance Sheet Hedging Most companies begin by hedging transaction exposure as it impacts current earnings and near-term cash generation. Transaction exposure is defined as a receivable, payable, cash or repayable inter-company loan denominated in non-functional currency that will have to be revalued with gains or losses reported in earnings. Since changes to these booked exposures are reported in current earnings, cash flow hedge accounting the reporting of derivative gains/ losses in equity is not required or desirable. A short-dated forward contract is the typical hedge. Forwards are simple to execute and flexible enough to be rolled over into a new hedge at the end of the period (for a different amount as the exposure changes). Longer dated exposures such as inter-company loans may be hedged using forward contracts that have a longer maturity or with cross-currency swaps. Forecast Risk This risk type a future transaction where revenues will be denominated in one currency and costs in another impacts future margins (variances to budgets) and is the first exposure shown in the diagram below. A good illustration is the U.S. manufacturer that exports product to Germany and will be paid in euros (EUR) at some point in the future. The forecast risk impacts earnings projected profit margins change as the EUR value to the U.S. dollar (USD) changes and eventually cash once the receivables are collected and converted to USD. Qualifying for hedge accounting is important since the exposure (the future export sale) will not be recorded until a later date. In the absence of hedge accounting, the hedge instrument will have to be revalued in earnings prior to the time the sale is recognized, creating earnings volatility. Cash flow hedge accounting enables the earnings impact of the hedge instrument to be matched up with the timing of the exposure recognition in the income statement. The practice of pricing a forecasted transaction with a foreign customer or supplier in USD should be considered carefully. A common misconception is that these transactions do not entail risk since they are denominated in USD. However, a better way to view this is that the risk has simply been transferred to the customer or vendor. For example, a vendor who accepts USD payment will have to sell the USD received and purchase local currency to cover costs. If FX rates have shifted, the vendor may attempt to get a price adjustment for a shortfall (i.e., raise prices) or may be unable to supply the product. The transfer of risk to the vendor in this example is real and may lead to the conclusion that paying the vendor in local currency and managing the risk leaves the importer in control of the exposure. The Four Types of FX Risk Transactional Risk Translational Risk Forecast Risk Cash Flow Hedging Transaction Risk Balance Sheet Hedging Foreign Denominated Cash Risk Balance Sheet Translation Earnings Translation Risk Income Statement Translation Considerations for implementation Sale/Expense Cash Flow Use of Cash/ Repatriation Strategic/long term Automatic rolling program Immediately identifiable exposure Minimized via forecast program Earnings and cash risk Earnings and cash risk Cash risk Earnings risk Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October 2010. 3
Translation Risk The next two risk categories shown in the diagram on page 3 cover balance sheet translation and earnings translation, and apply to U.S.-based parent companies with a foreign subsidiary that uses the local currency as its functional currency. When the parent company consolidates its financial results, it will have to translate that foreign subsidiary s balance sheet and income statement into USD. When translating a foreign subsidiary s balance sheet, there will be a gain or loss to report in the parent company s financial statements due to FX rate movements. Importantly, the translation of that balance sheet (net investment exposure) does not impact earnings; rather, the gain or loss is reported in equity. While it is less common to hedge net investment translation risk, since it does not create earnings volatility, cash held on a subsidiary s balance sheet, the anticipation of a future dividend from a foreign subsidiary, or a potential future divestiture of an overseas operation are all great examples of where net investment hedges are used regularly. Remember that one of the core objectives of hedging is to protect the USD value of cash. A net investment hedge accounting model exists that will allow the mark to market of the hedge to be reported in equity thus avoiding any P&L volatility when hedging this exposure. Finally, earnings translation exposure relates to the translation of a subsidiary s income statement, which, while impacting earnings, does not impact cash. Since hedge accounting is not available for hedging this risk type, it is particularly challenging. As previously noted, this type of risk can often be managed by hedging the cross-border cash flows through the forecast risk program. Measuring, Collecting and Managing the Risk Measure Risk at the Parent Company Centralizing the risk management function at the parent company means decisions are USD centric, which should translate into a strategy to manage risk to a USD result a clear advantage. While a U.S. parent may own foreign interests and subsidiaries that use their local foreign currency for reporting, it is important to analyze all risk on a consolidated basis at the parent level in order to: Maximize the use of natural offsets that arise across the enterprise Increase the control of offshore hedge activity Minimize transaction costs Sub-optimal risk management can occur if risk management is decentralized. Let s assume a U.S. parent has a subsidiary in Germany with EUR sales and expenses generating EUR earnings and free cash flow. From the parent s USD perspective, this is a long EUR exposure, but how does the subsidiary view the risk? If the subsidiary s operating management is measured in terms of EUR results, they won t be inclined to hedge risk, but the parent is exposed to earnings volatility. This example gets more complicated if we assume the subsidiary also has USD sales (in addition to the EUR sales and expenses). Recognizing that the parent is already long on EUR, should the parent allow the subsidiary to hedge forecasted USD revenue by selling USD/buying EUR via an FX forward contract? Such a trade would actually add to the overall consolidated risk of the firm. Collect the Risk Data Data gathering for forecasted transactions should be done in a format where ALL subsidiaries with the same functional currency for accounting purposes are grouped together. Similarly, balance sheet risks need to be aggregated on a global basis. Companies with highly developed risk management practices: Integrate the gathering of the transaction risk data into their monthly accounting process in order to hedge effectively Integrate the gathering of the forecast risk data into their quarterly or annual budgeting process In general, the booked transaction risk data is fairly easy to identify as the underlying exposures themselves impact earnings and unexpected gains and losses are thoroughly investigated. Forecast risk can be more problematic, especially if a series of foreign acquisitions have left a company with numerous reporting systems around the world. Before implementing a full forecast hedge program, the sales and expense data listed by the currency in which those transactions will take place must be gathered. While these new processes may take a budget cycle or two to fully implement, gathering forecasted data will highlight the real FX exposures faced by a company. 4
One-Year Back to Budget EUR Hedging Program 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 Spot Managing the Risk Effective Hedge Rate 0.80 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October 2010. As noted previously, the approved policy will provide the guidelines that should be followed when managing the FX risk. Beyond the control items, such as who can hedge and how large a trade is allowed before additional approvals are necessary, the three common questions often asked are: When should a company hedge? How far into the future should the program be structured? And what hedging tools should be utilized against various risks? Rolling and Layering: To smooth results, a rolling and layering strategy otherwise known as dollar cost averaging is recommended to reduce volatility to earnings and cash from forecasted transactions. The rolling and layering process involves choosing a hedge horizon (typically 12-24 months, depending on accuracy of forecast, ability to change prices/ competitive environment, among other factors) and, in a disciplined manner, adding a percentage of the desired monthly hedge ratio each quarter. between 50 and 80 percent for each month and the next quarter may be hedged between 40 and 70 percent for each month, etc.). At the end of each quarter, each month s exposure is topped up to the predefined hedge percent. Over time, there is a dollar cost averaging impact to the program. Once the program is up and running and each month s hedges mature, the result will be an average of four rates: one from four quarters ago, one from three quarters ago, etc. This eliminates the need to answer the question, Is this a good time to hedge? which of course is impossible to answer accurately on a consistent basis. Having said this, some discretion in between the ranges makes perfect sense as long as a minimum/ maximum threshold is set. Companies that execute hedges monthly would follow the same rolling and layering plan but would have more hedges building the eventual average rate. When Should a Company Hedge? Two to six months before the end of a fiscal year, a company may set a plan for the following year and then hedge each of the next twelve months worth of forecasted transactions. At the next year s planning process, the cycle is repeated as the following twelve months worth of risk would be covered with a strip of twelve monthly hedges, effectively locking in the plan for a year and creating a level of certainty. There is some downside, since this creates what is referred to as a cliff effect. Locking the rate on an entire year s cash flow executed on a single date results in a rate that may end up being a great rate or a negative rate when compared to the hedge rate for the following year. Notice the performance of the hedged outcome in the graph at the top of the page. For example, at inception of a typical rolling and layering hedge program, each quarter s exposure will be hedged within a predefined range (the nearest quarter may be hedged One-Year Rolling EUR Hedging Program With Rolling and Layering 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 Spot Effective Hedge Rate 0.80 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October 2010. 5
Discipline with some amount of discretion can be seen in the following diagram. How Much Discretion Should Your FX Policy Permit? J.P. Morgan recommends a policy that mandates discipline in hedging forecasted cash flows. The policy could also allow for a measure of discretion within that discipline. Discretion on whether the company hedges to the minimum required by its policy or up to the maximum allowed in any given quarter. Discretion on layering trades intra-quarter: when does the company add a layer? 100% 90% 80% 70% 60% Minimum mandated by policy Discretion between minimum mandated and maximum allowed by policy 50% 40% 30% 20% 10% 0% Mandatory % Hedged Layer E Layer D Layer C Layer B Layer A Q1 (current quarter) Layer E Layer D Layer C Layer B Layer E Layer D Layer C Layer E Layer D Q2 Q3 Q4 Q5 Q6 50% 40% 30% 20% Assumptions: sliding scale minimum base level, decreasing discretionary maximum level, 15-month hedging tenor Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October, 2010. Layer E 10% How Far Out Into the Future Should a Company Hedge? Each company s ability to forecast is different. By utilizing the rolling and layering approach, adjustments to the percentages hedged can be made as new information becomes available. Most companies have sufficient visibility to hedge out 12 to 24 months. Companies with long-term projects may need to hedge out five years or longer. What Hedging Tools Should Be Utilized? The transaction risk program should generally only rely on forward contracts. The tenor is generally short before cash is collected or paid and the amounts are known. The forecast program is naturally more uncertain and therefore adding option products will provide flexibility. The flexibility that options provide can be framed in the context of the best of all worlds: protection when the FX rate is moving in an unfavorable direction and no protection when FX rates move favorably. This flexibility becomes more important as the hedge horizon is extended. In other words, when forward contracts are used and FX rates move in a favorable direction, forward contracts don t allow a company to take advantage of this benefit, which leads to longer-term strategic competitive issues. Options, on the other hand, allow the hedger to enjoy the benefits of favorable movements (and can lead to an increase of market share or improvement in margins or both). So, if the benefits of options are easy to understand, the natural question to ask is whether options are expensive. This is particularly important when comparing a simple purchased option with a forward contract. 6
Options typically require a premium at inception. As a discussion point, would options be less expensive than forward contracts if the premium had to be paid at maturity? The comparison becomes: Forward contracts where there is no cash paid upfront, but an unknown amount of cash required to settle, versus Options where there is no cash upfront and a known and limited amount of cash is required at maturity In this context it becomes easier to make a comparison. In fact, the illustration to the right reflects historical analysis recently conducted to quantify this. Companies that used simple purchased options to hedge forecasted EUR sales over the past four years would have had a much cheaper hedge than they would have experienced with forward contracts. The bar chart on the right shows that forward contract cumulative settlement value was a loss compared to the cumulative gain recorded by using options. Forwards (Selling EUR) vs. Options (Buying EUR Puts): How Did the Hedges Perform Over the Period From a Cumulative Perspective? 6,000 4,000 2,000 0 (2,000) (4,000) (6,000) (8,000) (10,000) (12,000) Forwards ATM Options OTM Options 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October 2010. Forwards vs. Options: What Was the Result of the Hedge Plus the Exposure? Forwards were successful in eliminating currency impact Options perform better over this time period by capturing upside The highlighted bars demonstrate the protection offered by purchased options. While forwards experienced a significant cash loss in 6 consecutive quarters, the loss on at-the-money and out-of-the-money options were limited to their premiums. Note: Each quarterly outcome is the result of 4 trades per month (200,000 EUR each) executed over the previous 12 months. In fact, if you include in this analysis the earnings impact of the exposure plus the hedge, you get an even more interesting cumulative result. The point here is not that options should always be used versus forwards, but rather to suggest that options have the ability to provide a much better outcome than forward contracts, and the longer the hedge horizon, the more valuable this flexibility can become. 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Forwards ATM Options OTM Options When the outcome of a hedge is netted with the gain/(loss) of the underlying, forwards will equally offset the underlying position +/- a forward point residual. Options allow for participation. Stated another way, a 3 or 4 percent option premium may seem like quite a significant outlay for a hedge until it is compared to how much it can cost to settle a forward contract at maturity. 0 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 Note: Each quarterly outcome is the result of 4 trades per month (200,000 EUR each) executed over the previous 12 months. Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, October 2010. 7
Exhibit 1: Standard Hedging Tools Forwards No matter where the currency is trading at maturity, the company will execute the FX transaction at the Forward Rate Allows a company to lock in a fixed exchange rate for a specific future date Provides 100 percent protection against negative currency moves, but does not allow for the opportunity to benefit from favorable moves No outright transaction cost or upfront USD payment required Credit or cash collateral required Plain Vanilla Purchased Options The company pays a premium for full protection from the downside, with the ability to participate in 100% of upside Purchased options provide the company with the right, but NOT the obligation, to exchange a specified amount of currency on a specific date at a predetermined rate known as the strike price In exchange for this right, the company pays an upfront premium Purchased plain vanilla options differ from forward contracts in that the company is NOT locked into an exchange rate and can thus participate in 100 percent of all favorable market movements Because the company must pay an upfront premium for this right, purchased options do not require credit or cash collateral Zero-Premium Collars The company is fully protected from the downside, and can participate in upside to a predetermined level Protection Level Participation Level Zero-premium option based strategy Provides protection against adverse currency fluctuations, while allowing for participation in favorable moves up to a predetermined participation level Ability to execute better than the current forward rate Flexibility in setting range for protection and participation Best- and worst-case scenarios are known upfront Credit or cash collateral required Zero-Premium Participating Forward The company is fully protected from the downside, and can fully participate in upside on 50% of the exposure Protection Level Zero-premium option based strategy Like a plain vanilla forward, provides protection against adverse currency moves at a given rate, yet allows for flexibility to participate in favorable moves on a portion of the exposure The company gives up some participation in profit for the benefit of being fully hedged The company has flexibility in setting the level of protection and/or the percentage of participation Worst-case scenario known upfront Credit or cash collateral required 8
Exhibit 2: Glossary of Terms Base currency: Foreign exchange is quoted as the number of units of one currency needed to buy or sell one unit of another currency. The currency whose value is set at 1.00 is the base currency. Call option: The right but not the obligation to buy a fixed amount of a particular currency at a predetermined strike rate. The purchaser (holder) of a call option has the right to buy currency at the predetermined strike rate. The seller (writer) of a call option has the obligation to sell currency at the predetermined strike rate if the option is exercised. Confirmation: A communication with the counterparty of a trade that details the relevant data for settlement of the trade. Common types of confirmation include: verbal (phone), mail (letter, memo), fax and/or electronic (e-mail). Currency appreciation: A rise in the value of one currency in relation to another. Deal date: The date on which two or more parties enter into a contract. The deal date is also referred to as the contract date or trade date. Expiry (date): The last date or only date on which an option can be exercised. Forward: Actual exchange of currencies where settlement takes place more than two days after the trade at a fixed rate. The forward price is comprised of the spot rate plus the forward points. Forward points: Points calculated from the interest rate differential between two currencies, which is added to or subtracted from the spot rate. Forward points compensate the buyer of a higher-yielding currency so that there is no economic difference between buying the foreign currency forward vs. buying the foreign currency spot and putting it on deposit. FX swap: Spot foreign exchange transaction simultaneously reversed by a forward contract. The difference in rates reflects interest rate differentials between the two currencies. Hedge: The forward sale or purchase of a foreign currency (or the execution of an option strategy) to reduce the exchange risk exposure connected with the assets or liabilities (or forecasted transactions) denominated in a foreign currency. Mark to market: To mark to market is to calculate the fair value of a derivative instrument based on the current market rates or prices of the underlying exposure. Maturity date: The settlement date or delivery date agreed upon for a forward contract. Non-deliverable forwards (NDFs): Synthetic forwards that entail no exchange of emerging markets currencies at maturity. NDFs exist due to tight currency controls from government regulations. The settlement occurs in U.S. dollars and is based on the difference between the agreed contract rate and the market reference rate at maturity. Put option: The right but not the obligation to sell a fixed amount of a particular currency at a predetermined strike rate. The purchaser (holder) of a put option has the right to sell currency at the predetermined strike rate. The seller (writer) of a put option has the obligation to buy currency at the predetermined strike rate if the option is exercised. Settlement date: The date on which currency is exchanged, delivered, or on which a contract settles (also called value date). Spot trade: Actual exchange of currencies where settlement takes place two days after the trade date. (In Canada, spot trades settle one day after the trade date.) Volatility: The volatility is a measure of uncertainty. The higher the uncertainty, the higher the price of an option. 9
The Final Step: Determining the Success of the Hedging Program There s a common misconception that the only good hedge is the one that pays off but don t fall into that trap. It is not unusual to learn of treasury teams who were challenged by their management for losing money on a specific hedge. This reactive behavior could potentially lead to canceling a hedging program at the bottom of a market or doubling down on risk. Any gain or loss on a hedge should be analyzed against the loss or gain on the underlying exposure. While it is desirable to have sophisticated benchmarking against an ideal hedge program, most companies do not have the time or resources to complete this analysis. Common sense suggests a successful hedge program when: Balanced Sheet Hedging Program There are no longer review meetings to discuss outsized, unexpected results in the Other FX Gain/Losses line item of the Income Statement. Forecast Risk Program CEOs and CFOs can read about a weaker USD in The Wall Street Journal and know that their company s overall budget has been positively (an exporter) or negatively (an importer) impacted by less than the overall market volatility. This reduction in volatility (goal achieved!) assumes implementation of a policy that requires hedging of the budget. Net Investment Program The consolidated USD value of cash (many of the balances trapped in foreign subsidiaries) has remained stable despite a much stronger USD. Conclusion The approved FX policy should clearly define the risk management program for a company, including the approved traders, allowable hedge products, expected frequency of trading, and amount of discretion permitted the finance group. A disciplined hedge program that is executed with the intent to reduce volatility leads to a process that eliminates the need to determine whether now is a good time to hedge. This issue of Perspective is part of a series of publications for executive business leaders compliments of Chase Commercial Banking. Each in-depth report is designed to present you with relevant news you can use on emerging business issues. For more information, please visit us online at www.chase.com/newsyoucanuse. This material is provided by JPMorgan Chase & Co. for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or other financial instrument or to adopt any investment strategy. JPMorgan Chase & Co. makes no representations as to the legal, tax, credit, or accounting treatment of any transactions mentioned herein, or any other effects such transactions may have on you and your affiliates or any other parties to such transactions. You should consult with your own advisors as to such matters. Copyright 2010 JPMorgan Chase & Co. All rights reserved. Chase is a marketing name for certain businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters included herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone not affiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.