FX risk hedging at EADS 1
Reasons for EADS FX risk management policy Reasons for EADS FX risk management policy 2 1 Mismatch between dollar denominated revenues and euro, pounds denominated cost base (50 % of aircraft s order) 2 Significant time lapse between payment commitment and cash receipt ( about 8 years) 3 4 Loss of competitiveness as prime rival (Boeing) is a US-based manufacturer Loss of competitiveness (Prime rival is a USbased manufacturer) Large amount of eligible exposure with highly instable exchange rates have a dramatic impact on company s EBIT
Double - pronged approach 3 Double pronged approach Doublepronged approach Risk mitigation (natural hedge) Risk transfer Restructuring Programs (e.g. Power8) Using offshores Hedging with forward contracts Hedging with options
What is the Speed Grid? What is the Speed Grid? 4 Speed grid is a mechanical hedging approach that is aimed to determine the weekly amounts of FX forward contracts to purchase in order to execute EADS hedging policy.
Factors affecting speed of hedging Factors affecting speed of hedging 5 Year to hedge the further ahead, the less is hedged per week Dollar to euro forward exchange rate, the stronger the forward exchange rate for the dollar against the euro, the higher weekly amounts of forward contracts that traders had to purchase and vice versa. Hedging Speed The weekly amounts of FX forward contracts to purchase Result Execution EADS hedging policy
The pros and cons of Speed Grid The pros and cons of Speed Grid 6 In extreme cases the Speed Grid s functioning is not appropriate to EADS FX hedging policy.
At a crossroads At a crossroads 7 Resetting Speed Grid: Increasing the amount hedged per week Hedging with a large single forward contract: All the eligible exposure will be hedged within a month by using forward contracts Using FX options: EADS Front Office can decide is it worth to be exercised or not
Current Business Environment Current Business Environment 8 Increase in Number of Aircrafts Orders Growth of Euro denominated cost base Growth of delivery years ahead up to 8 years Current Business Environment 1 1 Drop in Exchange Rate from $1.20/ to $1.47/ two years later Decrease in earnings Growth of credit spread volatility risk Surge in Overall dollar exposure up to $94.2 billion 2 2 Decline in the share price from 21.8 to 15 per share
Comparison of options and forward contracts Comparison of options and forward contracts 9 FX Options Flexibility Risk mitigation in volatile market Elimination of default risk Option for reselling Requirement of mark-to-market through P&L Huge expenses on option premium, especially in volatile market (2-8% of the contract) Rumors on the market Gaining counterparty s loyalty Forward Contracts Relatively cheap instrument Strict obligation
Alternatives Evaluation Alternatives Evaluation 10 The aim of the analysis: to find out which alternative s exchange rate could be the most beneficial Data Source: Bloomberg weekly spot and forward EURO/USD exchange rates weekly central strike prices of EURO/USD options weekly premiums of EURO/USD options Time period From To 2000 March of 2008
Alternatives Evaluation Alternatives Evaluation 11 Period FX exposure, bln. $ Share in total FX exposure Time FX exposure distribution 0,7% 1,3% Current year 0 0,0% In 1 year 326 0,7% In 2 years 661 1,3% In 3 years 2 531 5,1% In 4 years 3 264 6,6% In 5 years 3 930 8,0% In 6 years 10 445 21,2% In 7 years 12 050 24,5% In 8 years 15 960 32,5% 32,5% 24,5% 5,1% 6,6% 8,0% 21,2% 1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years Cumulative 49 167 100% Source: Company data
Alternatives Evaluation Alternatives Evaluation 12 Time period 1 week FX rate of Final FX rate (sum conversion Period of Strike Spot price at of price of FX deal (minimum of Option Premium hedging price expiration date and option spot and strike premium) prices) 1 year 1,065 0,887 0,887 0,0160 0,903 2 years 1,079 0,895 0,895 0,0162 0,911 3 years 1,098 0,985 0,985 0,0165 1,002 4 years 1,115 1,120 1,115 0,0167 1,132 5 years 1,133 1,227 1,133 0,0170 1,150 6 years 1,151 1,211 1,151 0,0173 1,168 7 years 1,168 1,260 1,168 0,0175 1,186 8 years 1,186 1,353 1,186 0,0178 1,204 Source: Bloomberg, Team Estimates The aggregate FX rate (at which all the FX gap was closed, if we start hedging on the 1 st week) = 0,903 * 0,7% + 0,911 * 1,3% + 1,002 * 5,1% + 1,132 * 6,6% + 1,150 * 8% + 1,168 * 21,2% + 1,186 * 24,5% + 1,204 * 32,5% = 1,165
1 20 39 58 77 96 115 134 153 172 191 210 229 248 267 286 305 324 343 362 381 400 419 $/ ratio Solution Solution 13 Strategy Exchange rate $/ Speed Grid Single forward FX options No hedging 1.149 1.008 1.023 1.355 Source: Bloomberg, Team Estimates 1,8 1,6 1,4 1,2 1 0,8 0,6 0,4 0,2 0 Spot rates spot Source: Bloomberg weeks
Alternative approaches Alternative approaches 14 Continuous futures It allows to mitigate significant negative movements of FX rate and to be close to current FX rate. Although, this contract requires cautious approach to rolling position. Double hedge This approach includes two levels of hedging. The first level is a typical hedge contracts (forwards or options). The second level allows mitigating risk of volatility. SPOT-swap combo This approach gives the opportunity to operate in the market for all hedging time. The technique is to buy foreign currency by SPOT FX rate.
Counter-party default risk Counter-party default risk 15 Monitoring hedge counterparty risk arising from changes in the market value of EADS derivatives. To mitigate the credit default risk we need to carefully estimate creditworthiness of the banks we deal with.
Synthetic credit rating model Synthetic credit rating model 16 The aim of the analysis: Possibility to determine banks credit ratings in every period of time; Possibility to determine banks credit ratings of those banks, which do not have in order to minimize option premium Sample 334 banks, which had longterm credit ratings of S&P, Moody s or Fitch and whose financial statements were disclosed Data banks credit ratings financial statements sovereign credit ratings of the countries, in which banks operated Source: Bloomberg
Synthetic credit rating model Synthetic credit rating model 17 Credit rating Score AAA 6 AA 5 A 4 BBB 3 BB 2 B 1 CCC / C 0 Where w(i) weight of financial factor i (sum of all the weights is equal to 1) Factor score(i) score of financial factor i (varies from 0 to 1)
Synthetic credit rating model Synthetic credit rating model 18 Tier 1 capital Cash / Demand Total assets, Factor ROA, % ratio, % deposits bln. $ score <12.51 <0.32 <0.07 <4.7 0 12.51-13.87 0.32-0.60 0.07-0.21 4.7-10.3 0.2 13.87-14.86 0.60-0.87 0.21-0.39 10.3-22.7 0.4 14.86-16.10 0.87-1.13 0.39-0.61 22.7-42.4 0.6 16.10-18.0 1.13-1.62 0.61-0.98 42.4-121.7 0.8 >18.0 >1.62 >0.98 >121.7 1 Factor Weight Tier 1 capital ratio 6,2% ROA 26,3% Cash / Demand deposits 25,7% Total assets, bln. $ 41,8%
Credit risk mitigation: default probabilities Credit risk mitigation: default probabilities 19
Credit risk mitigation: limits Credit risk mitigation: limits 20 Criteria: PD > 2% -> Lim=0% PD < 0.5% -> Lim=100% Lim = 0.5% / PD
Credit risk mitigation: limits Credit risk mitigation: limits 21 Criteria: PD > 1% -> Lim=0% PD < 0.1% -> Lim=100% Lim = 0.1% / PD
Risk mitigating with downgrade trigger approach 22 Risk mitigating with downgrade trigger approach Stating Downgrade Trigger Covenant in the Forward Contract Bank s credit rating falls EADS s credit rating falls Bank has an option to close out the contract at current market price EADS has an option to close out the contract at current market price
Risk mitigating with collateralization approach 23 Risk mitigating with collateralization approach Specifying Forward Exchange Rate and Calculating Threshold Subjecting to mark-to-market Exchange Rate moves in Bank s favor Exchange Rate moves in EADS s favor EADS posts collateral to equalize a threshold EADS refuses to post collateral Bank refuses to post collateral Bank posts collateral to equalize threshold Bank has an option to close out the contract at current market price EADS has an option to close out the contract at current market price
Thanks for your attention 24