Case Study 1

Futures & Options 2018/2019

FX Risk Hedging at EADS

Abstract: The presented discussion and analysis is based on the case study “FX Risk Hedging at EADS”
elaborated by W. Carl Kester, Vincent Dessain and Karol Misztal from Harvard Business School. The
report contains a small description of the problem as well as of the background of the company and
why it should hedge its exposure to exchange rate risk. Along the report it is also analysed the
current hedging policy of EADS and the different options the company is considering to implement. At
the end, some examples were provided concerning other companies operating in different industries
that also hedge their exposure to outside factors.

Keywords: Forward Contracts, Hedging Policy, Exchange Rate

Table of Contents
1. The Problem………………………………………………………………………........................................3
2. Company Background…………………………………………………………….…………………………..…...3
3. Economic Motivation to Hedge………………………………………………….…………………………….4
4. Current Hedging Policy…………………………………………………………………………………………....4
5. New Hedging Strategies Being Considered by EADS
a. Reset the Speed Grid……………………………………………………...……………………………6
b. Enter into a Single Large Forward Contract………………………….……………………...6
c. Buy FX Options……………………………………………………………..………………………………6
6. The Example of Other Industries……………………………………………………………………………..7
7. Appendix………………………………………………………………………………………………………………….8

2
The Problem
As of May 2008, Jean-Baptiste Pons, the Head of Corporate Finance and Treasury at EADS
(European Aeronautic Defence and Space Company) had to present to the company’s senior
executives the following problem: since 2005, Airbus, EADS’ commercial jet division and primary
source of revenue, had reported record order intakes of 3 times the company’s revenue, however
net income during the same period had been decreasing (negative in 2007). This was because most
of its sales were billed in dollars, while costs were mostly reported in euros. Since 2006, the dollar
had depreciated substantially against the euro (from $1.20 per euro to $1.58 per euro), which means
that every dollar in sales was now yielding 25% fewer euros. To add to this, EADS tried to mitigate
the problem by hedging future revenues with FX forward contracts, these however were not hedging
the total of the currency exposure and were being traded at increasingly unfavourable rates. To
solve these problems, Pon’s team was considering 3 possible solutions: invest in FX options, changes
in the method to estimate the amount of hedge necessary to cover all currency exposure, and/or
reinforce “natural” hedges at EADS. These solutions are analysed in greater detail in the pages
bellow.

Company Background
In the year 2000, EADS was established as a joint company from other three companies from
Spain, France and Germany, to counterweight the U.S. aerospace and defence industry consolidation
of the late 90s. This company had dual headquarters in Paris and Munich. By 2007, the company was
already a major global player, with 116,500 employees in 19 countries (however 95% where in
Europe), €39.1 billion in revenues and €550 billion in booked orders, with a backlog of €339.5 billion
(Appendix 1). More than half of its revenues and two-thirds of its orders came outside of Europe, yet
76% of materials and components came from Europe.
Of the total revenues, €25.2 billion (2/3 of total revenue) came from Airbus. This division
was competing with Boeing in a global duopoly for commercial aircrafts of over 100 seats. It had the
majority (83%) of the backlog. EADS sought to achieve a 50/50 revenue balance between Airbus and
the remaining divisions, to counter the cyclicality and capital intensiveness of the commercial
aerospace business.
The commercial aircraft sector had been originally dominated by U.S. companies, however
Airbus had systematically caught-up to their competitors, achieving parity of 50% market share by
2007 (Appendix 2), expected to last for the years ahead. Airbus explained this due to the following
factors: launching new aircraft more frequently than their rival; catering to airlines' growing need for
lower operating costs by cutting their jets' fuel consumption; using common cockpit elements across
all aircraft families to decrease air carriers' training costs; tapping the low-cost airline segment and
luring air carriers from emerging markets.
Despite the globalization of the sector, the dollar was still the currency used for commercial
aircraft transactions. This was explained by 2 factors: the American origin of the industry and the
aircraft financing being quoted in dollars. To show how bad this was, in 2007, of the top ten airlines
by fleet size, nine were American, and four had never flown an Airbus aircraft. The dollar had every
condition to remain the main currency used in commercial aircraft transactions.
The industry’s long-term outlook was optimistic, since this was a market expected to
continue to grow, both in supply and demand. EADS strategic ambition for 2020 was to become the
worldwide leader in air and space platforms and systems. They targeted an €80 billion in revenue by
2020, half of which would come from Airbus, a 10% EBIT margin by 2015, and lifting non-European
sourcing from 23% to 40% by 2020 (to limit the FX exposure). This last point would be achieved by,
among other tactics, acquisitions in North America to balance the portfolio and justify production in
the U.S. (this would risk direct competition with Boeing), and opening an assembly line in China.

3
Economic Motivation to Hedge
The main reason corporations hedge their exposure to outside factors is to reduce the risk of
the business. Most non-financial businesses are not used to predict fluctuation in business risks
arising from fluctuation of interest rates, exchange rates, etc. By hedging, companies will not need to
worry much about these other factors since they have their position protected by the hedged
position and will then focus all their skills for what they do the best. With these procedures,
companies will avoid obnoxious change in prices of the factors for which the company is expose.
One argument against hedging is that shareholders of the company can hedge themselves
their positions, reducing their risk. Although it is true that shareholders can hedge their positions,
usually these procedures are cheaper per dollar when done by larger corporations. Moreover, due to
the size of some future contracts it is occasionally difficult for investors to hedge their positions.
Nonetheless, investors can also reduce the specific risk of an industry by holding a diversified
portfolio.
Another reason to hedge is to diminish a competitive advantage that competitors might
have. In this particular case, Boeing clearly has a competitive advantage concerning the currency
where they receive and spend their money. Since Boeing is an american company, most of its
revenues and costs are accounted in dollars whereas EADS’ revenues are accounted in dollars and its
costs accounted in euros. Therefore, EADS requires to hedge its exposure to the dollar fluctuations
to eliminate this competitive advantage of Airbus
It is important to note that the use of derivatives to hedge potential harmful exposure to
outside factors is not intended to lead to a profit but to abate the potential risks that this situation
might bring to the company. Generally, if a company makes a profit on the hedge position, this profit
is offset by a lost in the operating profit due whereas if it make a lost on its hedge position, this lost
if offset by a gain on the operating profit of the company. Theoretically, the outcome of an hedging
strategy is zero.

Current Hedging Strategy

Airbus’ operations have a high exposure to the exchange rate between the dollar and the
euro. Since its revenues are accounted in dollars whereas its costs are largely incurred in euros, a
devaluation of the dollar in relation to the euro would lead to severe losses. Moreover, Airbus’ main
competitor, Boeing, has most of its revenues and cost structure accounted in the same currency, the
dollar, which gives them a more stable operations cash flow. Therefore, it is crucial for the company
to impose a good risk management strategy in order to optimize its profits and the managers of the
company are aware of this. The CEO of the company at the time often stated that a 10-cent
movement in the dollar-to-exchange rate would affect EADS’ EBIT by 1 billion dollars. The company
currently has two approaches to hedge its dollar exposure. One is risk mitigation through operating
decisions (also called “natural hedge”). The other is risk transfer over the use of forex derivative
contracts.
Since the company has a lot of exposure to cash flows in dollar terms, the main goal of the
first strategy is to try to minimize the net dollar inflows. EADS basically tried to have a better balance
between dollar revenues and dollar costs. Since most of the revenues of the company arrived in
dollar terms whereas most costs were in incurred in euro terms, the company has tried in the last
years to increase the percentage of costs incurred in dollar. With the implementation of the “Power8
Program” in 2007, EADS targeted a restructuring of its cost structure towards a more dollar-based
cost structure and reducing the workforce. The company projected to save a cumulative of €5 billion
in the next few years and €2.1 billion from 2010 onwards. Although the project seems promising,

4
EADS’ managers had to be careful when attributing so much weight on dollar-based currency. For
example, the rise of emerging markets could create opportunities for the creation of new airline
companies in these countries. This could guide the company to obtain a greater part of its revenues
in currencies other than the dollar, creating a larger exposure of the company to fluctuation of these
other currencies against the dollar and leading to a completely waste of resources in implementing
the new program.
The other approach consists basically in using derivatives, mainly forward contracts to hedge
EADS’ forex exposure, where the company locks a certain future exchange rate where it would
exchange its receivables in dollars for euros. The purpose of hedging is to reduce risk. The company
implements this strategy almost since it started to operate, and it helps to maintain a stable stream
of euro-denominated cash flows every period. The Corporate Treasury is the responsible for this
derivative hedging of the company. This entity is responsible for setting EADS’ hedging policy such as
the hedge coverage ratio, the monthly amount of new derivatives purchases, etc.
To ease the process of execution of the hedge strategy of EADS, the Treasury Committee
created a mechanism called “Speed Grid”. This mechanism was used to determine the number of
derivatives that were necessary to be purchased, taking into consideration the year of hedging and
the forward rate of the EUR/USD exchange rate (Appendix 3). Although this strategy has the
advantage of the time diversification, it falls short in terms of the volatility of the forward rate. For
example, if the euro appreciation trend keeps on going, the mechanism will not be able to work with
higher levels of forward rate. Nonetheless, since the company already hedged its positions for the
next couple of years, they will have time to adjust its strategy. Additionally, it is interesting to
analyse how the company changes its weekly volume of hedging, adjusting them to the forward rate.
As the dollar depreciates, the forward rate $/€ increases which leads to a lower pace of weekly
hedging by the company. Although this procedure seems odd, it actually makes a lot of sense. The
company bases its decision on the forecasts made by leading investment banks for the next years. As
we can see in Appendix 4, the forecasts of banks range from 1.2$/€ up until 1.5$/€. Therefore, if the
forward rate is close to values as 1.5$/€, it is reasonable for the company to reduce its weekly
hedging since it is expected that the forward rates will decrease in subsequent periods. On the other
hand, if the values of the forward rate are close to 1.2$/€, the company should increase their level of
weekly hedging since the exchange rate the euro will most likely appreciate in the following periods.
Although the company speculates on which direction will the exchange rate move towards, the
ultimate goal of the company is to hedge its exposure to the exchange rate risk and not make a
profit out of this speculation. Consequently, one cannot argue that the company is not speculating
on the market but that the company is trying to forecast the possible direction of the exchange rate
to hedge its exposure to the exchange rate fluctuations.
An important entity in the hedging process of the company was the “Middle Office”. This
department was in charge of many tasks such as accounting the gains/losses of the hedging position
as well as controlling and selecting hedging counterparties. The accounting of hedge positions is not
easy. The financial assets have to be marked to its market value at the end of each reporting period
and the accounting of hedging positions is different from the accounting of speculative positions.
Since the company used derivatives to hedge its exposure to the forex markets and not to bet on
whether the forex market would go up or down, the “Middle Office” was in charge of making all
these accounting procedures to ensure it was all correct. It is crucial for such companies as EADS to
take special attention to the accounting of these financial assets because, for example, if the
financial asset was accounted as speculative, it would be recognized in the current income which
would lead to earning volatility. Another area monitored by the “Middle Office” was the
counterparty risk that consisted in the risk of default of any of the parts. This was particularly
important for the company at the time because the hedge portfolio of EADS was approaching the
limits of risk tolerance by banks which could create problems in future capital raises of EADS to
purchase new derivatives.

5
 Overall, the hedging policy followed by EADS was mainly implemented through natural
hedging and the use of forward contracts. The success of this policy is crucial to the profitability of
the company. It affects not only the cash flow the company receives but also the implementation of
future projects necessary for the company to keep its competitiveness with the main rival Boeing.

Hedging strategies Being Considered by EADS

Reset the Speed Grid
A clear advantage for the Speed Grid is that it enables the company to employ a layered
hedging strategy where they hedge in the shorter term and less in the longer term, thus this gives
some flexibility, which complements the usage of pre-determined forward rates. However, it is
unfortunate that a depreciation of the dollar reduces the allowable hedge ratio as a weaker dollar
increases the impact of unfavorable currency movements. The forward rate is naturally connected to
the spot rate, meaning it may be expensive locking in a depreciating dollar rate, but EADS utilizes
hedging derivatives to reduce risk, not to speculate on the direction of the exchange rate. Thus, they
should consider how much they want to hedge independent of the exchange rate movements.
Enter into a single large forward contract
Entering into a single large contract reduces and even closes the currency cap. The main
advantage with this method is that it is efficient and easily provides a solution to EADS’ risk problem,
giving management more time to focus on strategy and the business rather than currency risk.
However, it is often not financially sustainable to reduce 100% of risk, as EADS would benefit from
increased flexibility in its hedging policy, meaning they may not want to lock in future exchange rates
for all dollar revenue today, but perhaps hedge some of it at a later time. Conclusively, relying on
forward contracts is an efficient way of reducing currency risk as they lock in the future rate, gaining
time for the implementation of the Power8 Program that serves as a natural hedge. However,
entering such a large contract requires that EADS finds a counterparty that is willing to take the
other side of the trade, and significant amounts of time may be spent to find that counterparty and
to ensure that the counterparty has a low risk of credit default, as the remaining amount EADS
wants to hedge is considerable.
Buy FX options
The authors see this alternative as most suitable, as it introduces more flexibility in the
hedge portfolio. A combination of forwards and call options on euros from dollars, allows the
company to secure the currency rates while still benefiting from appreciations of the dollar. On the
other hand, this, of course, comes with a price, as options are quite expensive. Given that EADS has
suffered significant losses due to unfortunate currency movements, investing in options would
perhaps be worth the cost. The company should take into account that those significant costs could
be invested elsewhere, to some degree compensating for the currency losses from not hedging.
Nevertheless, optionality will result in a better view of the company’s financial risk from the outside,
as it minimizes the risk of default when they do not lock in future rates as they do with forwards. An
additional benefit is that banks get premiums from selling options to EADS, thus they may be more
willing to offer those instead of large forward contracts, resulting in less amount of time and effort
spent on finding a counterparty from EADS perspective. By implementing a so-called risk reversal
strategy, EADS can reduce the overall cost of option hedging. They can buy put options allowing
them to sell dollars for a given amount of euros and write similar call options at a higher rate,
meaning the exchange rate at which EADS will transact will be restricted to an interval. EADS would
have to pay for the put but receives a premium for writing the call, thus the net cost of the hedge
would be significantly lower than merely purchasing options. Nevertheless, buying options is
expensive as the currency pair dollar/euro is volatile and EADS has little experience in utilizing such
instruments. Thus, if they were to start with options, they are encouraged to only hedge a small

6
portion of their exposure with options and focus on forwards contracts for now, until the dollar/euro
exchange rate is less volatile, and they are more used to using options.
Lastly, utilizing swaps is also a relevant alternative that the management may consider. As a
European based company, EADS can leverage their bargaining power and perhaps achieve a lower
interest in euro denominated loans rather than dollar denominated ones. If they increase their share
of costs in dollars, as with the Power8 Program, they can use swaps to exchange euro loans to
dollars, matching debt principals with an increased share of dollar costs.

The Example of Other Industries

As mentioned above, the Airbus Group former called EADS is Europe’s largest aerospace
company. Due to their high exposure to exchange rate risks they applied several hedging strategies
to secure their position in the aerospace industry. In contrast to Airbus, their main competitor
Boeing must deal with lower levels of exchange rate risk due to their majority of revenue and cost
structure accruing at the same place. However, also Boeing uses foreign currency forward contracts
to manage currency risk associated with certain transactions made in foreign currencies.
While Airbus and Boeing both operate in the Aerospace industry, there are also companies
from other industries which rely on hedging strategies to secure their business against currency
fluctuations. One example representing the automotive industry, is the German automotive
company BMW. As an internationally operating enterprise, the BMW Group conducts business in a
variety of currencies, thus giving rise to currency risk and opportunities. The BMW group manages
currency risks at both strategic and operational level. Strategic measures include increasing
production volumes and purchase volumes in foreign currency regions (natural hedging). Therefore,
BMW steadily increases their international appearance by opening production facilities as for
example in China or Mexico. For operational purposes BMW also uses hedging instruments from
financial markets. To measure their exposure to exchange rate risk they use a Cashflow-at-risk model
for which the planned foreign currency transactions serve as a basis. Input parameters for the model
include the planned foreign currency transactions, which can be seen in Appendix 5 and the
potential negative impact resulting can be seen in Appendix 6. The applied derivative financial
instruments are mainly currency risk forwards but also option contracts are used in certain phases.
Another exemplary industry is the cork industry, where the Portuguese company Corticeira
Amorim is the world market leader for wine corks. They operate in various international markets and
are consequently exposed to exchange rate variations in the local currencies in which they conduct
their business. Around one third of its total sales are denominated in currencies other than its
reporting currency, with the majority in US Dollar. Corticeira Amorim established an exchange rate
risk management policy which points out to a total hedging of the assets deriving from sales in the
most important currencies. To hedge against currency fluctuations, Corticeira Amorim uses natural
hedges as well as financial instruments in the form of forward outrights and options. An overview of
the amounts being hedged can be seen in Appendix 7.

7
Appendix
Appendix 1: EADS’s Financial Statements (€ million)

Appendix 2: Airbus’ and Boeing’s Commercial Aircraft Deliveries

Appendix 3: Speed Grid

8
Appendix 4: EADS’ $/€ Market Forecasts, May 2008

Appendix 5: BMW Input parameters for cash-flow-at-risk model (source: BMW Annual Report
2017)

Appendix 6: BMW Potential negative impact caused by fx risk (source: BMW Annual Report 2017)

9
Appendix 7: Corticeira Amorim hedging overview (source: Corticeira Amorim Consolidated
Management Report 2017)

10