Corporate Mentality on Foreign Exchange Hedging

Karim Alidina
Rotman MBA 2007
karim.alidina07@rotman.utoronto.ca

The views and recommendations in this presentation do not represent the views of RBC Capital Markets and are solely of the author.
What is FX Risk?

ƒ Three types of FX Risk:

¾Transaction
¾Translation
¾Economic
ƒ Companies who conduct business across borders must deal in foreign
currencies
ƒ Exchange foreign currencies for home currencies when dealing with
receivables, and vice versa for payables
ƒ Foreign exchange risk is the risk that the exchange rate will change
unfavourably before the currency is exchanged
 Value at Risk

ƒ A Canadian Corporation buys USD 1mm out one year using a forward contract
ƒ A USD/CAD spot range of 0.8644 – 1.1507 represents the potential spot movements over
one year.

ƒ The Value-at-Risk (VaR) is USD 131,000.

95% Confidence Level

Forward Curve 1.1507
1.1700

1.1200

1.0700 Exposure USD 1.0 mm

1.0200 Achievable
CAD 0.87 mm
1.0000 Value
0.9700
95% Worst
CAD 1.15 mm
0.9200 Case
0.8700 VaR USD 131,000
0.8200 0.8644
13-May-11

29-Nov-11

16-Jun-12

02-Jan-13

21-Jul-13

06-Feb-14
Canadian Dollar Spot
Why do Corporations Manage FX Risk?

ƒ Minimize the effects of exchange rate volatility on earnings

ƒ Creation of shareholder value through:
¾Stabilizing revenues and expenses
¾Communicating clear expectations and risk profile
¾Facilitating the pricing of products sold in export markets
ƒ Typically not for speculation or gains
How do Corporations Manage FX Risk?

ƒ Identification of exposure:
¾Determine whether you need to hedge
ƒ Determine FX levels:
¾Budget rate
¾Target rate
ƒ Execute FX hedge when target reached
¾Use appropriate hedging instrument
Example

Assumptions:
ƒ Canadian Corporate needs to purchase USD
ƒ Exposure:
¾USD 1mm notional
¾Term: 1 year
ƒ Budget rate: 1.0000

Strategy:
ƒ Client enters into one year forward contract to buy USD 1mm at an all-in
rate of 1.0000.
What Can Prevent Best Practice?

ƒ Target rate vs. Budget rate

ƒ Hedging Strategy
ƒ Hedge Accounting
Target Rate

ƒ The rate at which to execute

Inherent human flaws:

ƒ Behave in an all or nothing manner
ƒ Asymmetry of risk appetite
¾Risk loving when out of the money
¾Risk averse when in the money

Result:
ƒ Execution rate is often at or below the target rate
Hedging Strategies

ƒ Forward contracts, option strategies, exotics

Limitations:
ƒ Corporations tend to only use certain products
¾Product knowledge
¾Board decision
ƒ Only some Corporations use FX options
ƒ Purchased options are useful if there is doubt whether a foreign exchange
transaction will be necessary

Result:
ƒ Corporations cannot participate in favourable currency moves
Hedge Accounting

ƒ Accounting standards enable hedge accounting for three different

designated FX hedges:
¾A cash flow hedge may be designated for a highly probable forecasted
transaction
¾A fair value hedge may be designated for a firm commitment of a
recognized asset or liability.
¾A net investment hedge may be designated for the net investment in a
foreign operation.

Limitations:
ƒ Reduced potential use of various option strategies

Result:
ƒ Corporations cannot fully participate in favourable currency moves
Example

Assumptions:
ƒ Canadian Corporate needs to purchase USD
ƒ Exposure:
¾USD 1mm notional
¾Term: 1 year
ƒ Budget rate: 1.0000

Strategies:
ƒ Client enters into one year Forward Contract to buy USD 1mm at an all-in
rate of 1.0000.
ƒ Client purchases a one year USD Call for CAD 41,000 (410 CAD pips)
ƒ Client enters into a one year Costless Collar to buy USD 1mm, with
protection level at 1.0500 and benefit level at 0.9700.
ƒ Client enters into a one year Cablecar Forward Contract to buy USD 1mm
at a rate of 1.0100 with a knock-in barrier at 0.9200.
Hedging Strategies

Forward USD Call Costless Collar Cablecar Forward

Outright Strike: Benefit: Protection:
CAD Notional Possible 1.0000 0.9700 1.0100
to Purchase Spot Rate Rate: Premium: Protection: Trigger:
USD 1mm at expiry 1.0000 0.041 1.0500 0.9200
CAD pips Not
Triggered Triggered
900,000.00 0.9000 1.0000 0.9410 0.9700 N/A 1.0100
910,000.00 0.9100 1.0000 0.9510 0.9700 N/A 1.0100
920,000.00 0.9200 1.0000 0.9610 0.9700 N/A 1.0100
930,000.00 0.9300 1.0000 0.9710 0.9700 0.9300 1.0100
940,000.00 0.9400 1.0000 0.9810 0.9700 0.9400 1.0100
950,000.00 0.9500 1.0000 0.9910 0.9700 0.9500 1.0100
960,000.00 0.9600 1.0000 1.0010 0.9700 0.9600 1.0100
970,000.00 0.9700 1.0000 1.0110 0.9700 0.9700 1.0100
980,000.00 0.9800 1.0000 1.0210 0.9800 0.9800 1.0100
990,000.00 0.9900 1.0000 1.0310 0.9900 0.9900 1.0100
1,000,000.00 1.0000 1.0000 1.0410 1.0000 1.0000 1.0100
1,010,000.00 1.0100 1.0000 1.0410 1.0100 1.0100 1.0100
1,020,000.00 1.0200 1.0000 1.0410 1.0200 1.0100 1.0100
1,030,000.00 1.0300 1.0000 1.0410 1.0300 1.0100 1.0100
1,040,000.00 1.0400 1.0000 1.0410 1.0400 1.0100 1.0100
1,050,000.00 1.0500 1.0000 1.0410 1.0500 1.0100 1.0100
1,060,000.00 1.0600 1.0000 1.0410 1.0500 1.0100 1.0100
1,070,000.00 1.0700 1.0000 1.0410 1.0500 1.0100 1.0100
1,080,000.00 1.0800 1.0000 1.0410 1.0500 1.0100 1.0100
1,090,000.00 1.0900 1.0000 1.0410 1.0500 1.0100 1.0100
1,100,000.00 1.1000 1.0000 1.0410 1.0500 1.0100 1.0100
BETTER THAN FORWARD OUTRIGHT

Conversion rates include premium cost.

Conclusions

ƒ A Corporation’s execution rate is often at or below the target rate

ƒ A Corporation cannot fully participate in favourable currency moves:
¾Limiting hedging products inhibits a corporation’s ability to optimize risk
management
¾Hedge accounting limits a corporation’s ability to optimize hedging
practice
Recommendations

ƒ Setting target rates can help a Corporation decide when to use forwards
versus other option strategies:
¾Take profit versus stop-loss level management
¾The Corporation can use forward contracts to buy USD when the CAD is
strong and it is beneficial to lock in gains
¾The Corporation can use other hedging strategies to buy USD when CAD
is weak which allows them to benefit from CAD appreciation
ƒ Use various hedging strategies to express views, manage forecast errors
and to avoid forward contract losses
¾Diversify a corporation’s hedging portfolio
ƒ MTM variations on income statements should be accounted for in the
valuation of a company by the analyst
¾The Corporation should not be limited in their hedging strategy
Questions