Currency Risk Management, LLC
Foreign Exchange
Risk Management
A primer on protecting and increasing profits
In international transactions and investments
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Currency Risk Management, LLC
The Problem:
FX Risk
Currency Volatility
The Solution:
Hedging concepts and tools
Success stories
Range of hedging solutions
Implementing the Solution
Banking
Getting Started
Conclusions
Currency Risk Management, LLC
FX Risk
Theres always FX risk in an international transaction
Payment spot
Contracted Spot
EUR/USD
Volatility = 13%
Contracted Spot
Payment spot
Case1:
If Exporter bills in EUR, you get a 11% windfall profit.
If Exporter bills in USD, EU importer pays 11% less
Case2:
If Exporter bills in EUR, you see a 8% loss.
If Exporter bills in USD, EU importer pays 8% more
Currency Risk Management, LLC
FX Risk
Transactional risk
When a foreign customer or distributor is invoiced in their home currency, and
there is any delay between contract and payment (e.g. net 60 terms).
Present in all common forms of payment: Letters of Credit, Documentary
Collection or Open Accounts (except cash in advance)
FX exchange rate changes will increase or decrease the price paid or received.
Operational risk (hidden)
Occurs when companies invoice foreign customers (or distributors) in their home
currency (e.g. a US company invoicing in USD)
Customers forced to manage FX risk will negotiate less-favorable terms to you.
Studies have shown the negative impact ranges from 3-8%1
Clients will seek out more trade-friendly partners.
Foreign transmittals of USD take longer
The best option is to assume the FX risk, and then actively manage it.
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Currency Risk Management, LLC
Currency Volatility
EUR/USD
3 month volatility: 13%
The risk even in normal times is
significant
Once every 100 years events dramatically affected exchange rates
1998 Asian Tiger meltdown
1998 Russian devaluation and default, LTCM bailout
2001 September 11
2008 Icesave bank failure
2008 Lehman Bros/AIG
2010 Greek bailout #1
2010 Ireland bailout (and subsequent rejection)
2011 Japan tsunami/nuclear reactor disaster, PIIGS debt , US credit de-rating
2012 Greek Euro exit? (and waiting on War: Iran/Israel, Syria; Debt crisis: Portugal/Spain
Currency Risk Management, LLC
Responses to FX risk
Ignore it
Assume Purchasing Price Parity (PPP)
drives exchange-rate equilibrium,
Assume F/X rates will even out over
time
Force the other party to take direct
FX risk
Add a reserve or buffer
hope it is sufficient
hope it doesnt kill the deal
Actively manage FX risk
72% of companies hedge FX risk1
1.0 AFP 2010 survey of CFOs
Currency Risk Management, LLC
Natural Hedging
Seek out opportunities to create offsetting exposures
Internal Parties
Subsidiaries
JVs
Foreign
Currency
Dividends
Royalties
Service Fees
(inbound)
External Parties
Clients Vendors Banks
Foreign
Currency
Receivables
Foreign
Currency
Payables
Foreign currency
interest and
principle payments
Export Sales
Purchase
Foreign Currency
Commitments Interest Income
Offsetting needs to be within same relevant time
and within each foreign currency.
But there will always be a net exposure remaining
Currency Risk Management, LLC
Active Hedging
Hedge (hj)
A security transaction that reduces the risk on an already existing transaction.
A/R Value vs. Exchange Rate
Exchange Rate (foreign/home)
Impact on A/R
Hedge Value vs. Exchange Rate
A perfect hedge moves exactly opposite to the A/R value,
offsetting any changes in A/R value.
Hedging does NOT require future spot prediction or trend
analysis
Currency Risk Management, LLC
Hedging with forwards
A Forward is a contract to buy or sell an asset (such as a currency) at a certain price (the
forward rate), on a certain date. It is made between the hedger and a counterparty,
typically a large bank (and thus is over-the-counter, OTC).
The forward rate cannot be at todays spot, but is offset by forward points (see appendix).
Forwards are settled at the end of the contract period
Payoff
Payoff
Spot
Spot
Forward Rate
Buy Position
Sell Position
Currency Risk Management, LLC
Directional hedges with options
Optimally, a hedge allows participation in upside if the spot moves in your favor,
and still protects you on the downside. Options can do that.
Options are the right to buy (Call) or sell (Put) an asset at a certain price (strike),
for a certain duration. The cost (premium) depends on those factors.
Payoff
Payoff
Short Call
Long Call
Spot
Spot
Short Put
Long Put
Spot
Spot
Currency Risk Management, LLC
Hedging with One Option
Long
Underlying
Exposure
Long Put
Spot
Spot
premium
Advantages
Strike
No collateral or FX LoC required
Combinations (Puts, Calls, long/short)
allow upside or neutral position with
spot
Best for hedging forecast cash flows
(uncertainty of exposure)
Spot
Break even
Disadvantages
Premium more expensive than
forwards, paid upfront
Long durations are expensive
If volatility of underlying is high,
premiums are expensive
Currency Risk Management, LLC
Success story
NGT secured a sales contract in March 2011 with an EU customer for
$469,708, or 343,028 (EUR/USD 1.369)
A series of four performance payments were scheduled from April
through Nov: design approval, major components, factory acceptance,
and site acceptance.
EUR/USD
The first two payments were hedged with Puts at 1.42
The second two hedged with forwards (due to long
duration)
As the EUR fell throughout 2011, NGTs hedges
saved over $47,000
Currency Risk Management, LLC
Success story
SM sells sporting goods into Canada, collecting monthly payments
from their distributors.
SM wanted to not only preserve their margin, but use hedging to add
to the bottom line. SM and CRM jointly decide to hedge 80% of
monthly receivables with forwards, and use a profit-generating multioption strategy for the remaining 20%
CRMs option-based hedge
structure added 3% nonoperating revenue at
inception, and retained that
profit throughout the term of
the hedge.
USD/CAD
(P&L in red)
Currency Risk Management, LLC
Success story
US-based FE (a Connecticut-based hedge fund) invests in Brazil.
Their exposure is $2M every quarter, with a Value-at-Risk of $358k.
Hedging USD/BRL is challenging for two reasons:
Brazilian interest rates are very high, making forwards very expensive
(160 bps/qtr)
USD/BRL volatility is very high, increasing the cost of options. In
addition, the skew between Calls and Puts is very high.
CRMs multiple option-based
hedge created a synthetic
forward, but cost only 84 bps
As the USD/BRL rose from 1.8
to 1.93, the synthetic forward
saved FE $144,000
USD/BRL
Currency Risk Management, LLC
Flexibility and ease of hedging solutions
Almost any exposure
From just one contract to a series of monthly payments
Certain (contract) or uncertain (forecast) cash flows
From very short (one week) to very long (5 years) duration
Almost any currency
Hedges can be designed to simply eliminate risk
or designed to allow some participation in currency upside
Fire and forget: once your hedge is in place (5 min phone call to
bank), you can focus on your core business and not worry about
exchange rates
Currency Risk Management, LLC
Working with Banks
Banks are essential partners in international trade.
They provide multi-currency accounts, ACH, EFT, Lockboxes, foreign wires
They provide the hedging instruments we needhowever-
However - pricing of forwards, options, swaps etc. is opaque
Forward points - a 20 bps misquote of interbank rates could double your hedge cost.
Option premiums - a 5% difference in implied volatility could increase premiums 50%
Spot rate quotes from the bank may be delayed or skewed
Setting expectations
Bank bid-ask spread is 20-50 bps over interbank/market pricing. Shop carefully
They expect you to know what youre doing, what you want, and how to accurately specify
products based on your exposure
What they may suggest optimizes their profit and risk, not yours
Best to have expert third-party assistance
Selection of optimum hedge components and specification (notional, strike, tenor, expiry)
Access to interbank data for price verification
Assistance with hedge inception documentation and accounting
Currency Risk Management, LLC
Working with CRM
We eliminate your FX risk, taking the worry out of international transactions.
All we need from you is cash flow information (amount, dates), and we take
care of the complexities. Your sales & finance staff remain focused on their job
We can match specific or forecast exposures, almost any currency, any
duration.
CRMs inside access to inter-bank pricing helps us negotiate the lowest
premiums and tightest spreads for you. Our own fees are very small (0.25% to
0.5%)
This is our specialty. The CRM team has over 25 years of FX experience. We
are happy to share anonymized deal histories and client referrals
No Conflict of Interest - we are consultants only - we do not access your
brokerage account, and we do not earn any fees from banks or market-makers
Currency Risk Management, LLC
Getting Started
Establish relationships
A banking relationship which provides the FX instruments (forwards,
options). Its best if this is an existing account, as business deposits can
count towards any margin required. If a new account is needed, be
advised banking Know Your Customer (KYC), and Anti Money
Laundering (AML) processes can take several weeks
Execute the Currency Risk Management consulting agreement. This 3page agreement doesnt carry any obligation or expense, it only
establishes our business relationship
Operational Phase
Client confirms cash flows and timing to CRM, and orders hedge
CRM designs a hedge structure for each unique cash flow/transaction
Joint Client/bank calls to initiate hedges
CRM reports interim results, assists in any necessary changes
Currency Risk Management, LLC
Conclusions
Any exporter or importer will have unavoidable and significant FX risk in its
international transactions
FX risk is easily mitigated (with the right expertise)
As a guideline, the all-in cost1 is approximately 1% of contract value for G-7
currencies (easily built in to your contracts). This much, much less than the
average Value-at-Risk of 12-15%.
It costs nothing, but takes time to get ready to hedge your international
transactions. Start now!
1. FX derivatives, bank spread and CRM fees
Currency Risk Management, LLC
Appendix
Currency Risk Management, LLC
Using forwards
Forwards are best suited to:
Certain exposures i.e. contractual exposures, not forecast cash flows.
Long duration hedges
Currencies with low interest rate differentials
The expiry date can be easily (and inexpensively) extended if a
customer payment is delayed
Forwards sometimes require margin or collateral, and in general do
not allow upside.
Forwards are available in more complex flavors (e.g. participating
forwards, accumulator forwards, knock-in forwards)
Currency Risk Management, LLC
Determining the forward rate
Fwd
contract
Near date
FX Bank
Exporter
767
Far date
(6 months)
EUR/USD Spot rate
USD 6 mo interest rate
EUR 6 mo interest rate
1.3140
0.955%,
0.714%
Today, $1,000 = 769
In 6 months,
769 invested at 0.714% = 774.50
$1,000 invested at 0.955% = $1,009.5
Gives a Forward rate of 1009.5/774.5 = 1.3034
$1,000
If the forward rate was the same as todays spot, an arbitrageur could make a riskless profit
For EUR, GBP, CAD, JPY, the rate is very similar to the spot.
For currencies with high interest rate differentials (BRL, AUD), the rate will vary more
Currency Risk Management, LLC
Value at Risk (VaR)
A standard measure of potential loss, VaR assumes that spot prices vary
randomly about a mean, with a normal distribution. That is, smaller price
changes are more common than larger ones.
Mean
Value at Risk then is the potential loss, with a certain level of
confidence, e.g. 90%, 95%, 99%.
Lets calculate VaR for a $1M contract with volatility of 13%,
to a 90% confidence. 90% is 1.28 standard deviations (the
z-value, in statistical terms)
Spot
1 Std Dev = 68.3%
2 Std Dev = 95.4%
3 Std Dev = 99.7%
90% VaR = 1.28*Std Dev*contract value
90% VaR = 1.28*13%*$1M = $166,400
This is not a maximum loss. We used a 90% confidence
level. 10% of the time, it could be more...
Currency Risk Management, LLC
Case Study #1 $1M USD hedged with forward
EUR/USD spot 1.3140
$1M = 769,000 at inception
3 month volatility 11%
Value-at-Risk = $140,800 (14%)
Hedge
Forward Contract to
sell 769,000 in 3
months
Forward points
.00069 (.07%)
Resulting forward
rate 1.31469
End result P&L indifferent to spot changes
Currency Risk Management, LLC
Case Study #2 $1M EU sale hedged with long
option
Spot 1.314, volatility 11%
3 month EUR Put option, strike 1.3,
Premium 1.7%, break-even spot 1.278
Currency Risk Management, LLC
Case Study #3 Hybrid hedges
Two options, one bought, one sold, different strikes and notionals
Net 4% premium to hedger, break-even spot 1.23
Currency Risk Management, LLC
CRM Fee
The first transactional consulting fee is 0.5% of the notional or face amount of
each individual exposure hedged, with a minimum notional of $50,000
The consulting fee is discounted as the aggregated sum of all previous hedge
notionals exceeds levels according to the following schedule:
Aggregated notional
Above $1,000,000
Above $5,000,000
Above $10,000,000
Fee
0.45% (45 bps)
0.40% (40 bps)
0.35% (35 bps)
Considering random FX movement of 50-100 bps/day,
mitigation of 10-15% Value-at-Risk,
and potential savings in bank bid-ask spreads, CRM easily pays for itself.
