October 2008 l US Version

Foreign Exchange Risk Management: Protect Your Profits

and Prosper in an Uncertain Economy

Over the past few decades the growth and complexity of international business, multinational operations and import and export
has increased at a staggering rate. As the economies of many different countries become more entwined, the economic stability
and prosperity of the countries that you do business with becomes more important. This, coupled with the dramatic currency
fluctuations that have taken place in developed and emerging economies, demonstrates the need to be aware of the factors
influencing your business operations and the need to take an active role in protecting, stabilizing and potentially increasing your
currency assets.

Dealing with multiple currencies, foreign suppliers, imported goods or overseas operations exposes you to foreign currency risk.
The key to surviving and thriving amidst ever-changing market conditions and currency fluctuations is to hedge these foreign
currency risks that affect your business.

A 2006 survey conducted by a large North American foreign exchange provider found that 80% of the corporations surveyed
acknowledged that their businesses were exposed to significant foreign exchange risk. However, only 42% of these corporations
indicated that they currently employ currency hedging techniques to manage their risk.

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 Top Three Myths About Currency Hedging
Currency hedging is a common practice and essential to protect your business if you
are involved in foreign economies or indirectly affected by the domestic economic
performance within foreign nations. Yet there are still many misconceptions surrounding
hedging.

Myth #1: Currency hedging is speculative and risky.

Currency hedging is a defined market that both dedicated foreign exchange companies
and banks routinely deal in via specific over-the-counter products. Choosing which of
those products to use and how to best employ them is determined solely by the party
executing the hedge – your company. These decisions are carried out by a bank or
dedicated foreign exchange provider under the explicit instruction of the client and
according to previously defined parameters.

The objective of currency hedging is not to maximize profits through currency speculation

The purpose of but rather to minimize the risk that your company is exposed to. A hedging strategy is
currency hedging essentially an insurance policy against the adverse effects of currency fluctuations and
isn’t to generate economic conditions that are out of your control. In the same way you would insure
trading gains. your business from fire or theft, hedging insures your company’s currency assets from
The purpose unforeseen changes in the global foreign exchange market.
should be to
Currency hedging is an important component to your business planning to ensure that
mitigate risk, not
increase it or the success of your business is determined by its operations and not unpredictable
swap one form of economic factors and volatile currency rates. It acts as a stabilizing mechanism to
risk for another. ensure that a company can project future cash flows - the valuation and reporting
requirement for most businesses - with better certainty. Currency hedging involves
pro-actively taking measures to off-set uncertainty in international markets, exchange
rates or a respective country’s economic strength.

Also keep in mind that a currency hedging strategy is not the same as the various
strategies employed by hedge funds, which are vehicles designed to take on market
risk as opposed to mitigating it; you maintain control over the activities and degree of
leverage and protection used. A strategy can involve making an informed decision to
do nothing. It can also consist of partial or full protection, offering companies the ability
to benefit from positive market changes while protecting them from negative ones.

Myth #2: Currency hedging is only for the short term; in the long run exchange
rates always average out.
Some people believe that over the long term the gains and losses associated with
exchange rates will average out and there is no need to protect your company against
foreign currency fluctuations. This entirely depends on which currencies you are
exposed to and what you consider long term to be. Such mean reversion theories
have lead to the downfall of many hedge funds and financial institutions in the current

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 market environment. As the saying goes, markets can remain irrational longer than
most speculators can remain solvent. Betting on long-term trends or reversion to
historical averages can become very damaging when the markets shift dramatically in
the short term, as they have in recent months.

A long-term investor may take the viewpoint that a firm with revenues generated by
foreign subsidiaries shouldn’t be hedged for translation purposes back to the parent
company. Such an investor is primarily concerned with the operational profitability of
each of the individual entities in their home currency, irrespective of what those net
earnings are when translated back to the home currency. In such an environment there
will be ups and downs: some years you will win and realize a windfall gain, while other
years will result in a decline in earnings. In the long run however, the law of averages
will hold and earnings will be smoothed over time. To an investor or manager with just
such a view, a currency hedging system produces little or no value.

That being said, a decision-maker with a long-term investment horizon will often lean
towards implementing a hedge for one-time, non-recurring business expenses or
projects with specific currency exposures. If the net present value or benefit of a
particular project is put at risk through an unlikely but still probable adverse movement
in currency values, the application of a currency hedge is certainly prudent. Even
recurring business expenses that are core to the operational and financial performance
of a firm should be hedged if the margin for profit and error are slim. If the viability
of your entire business is put at risk should currency markets move unfavorably by a
narrow margin for an entire business cycle or less, the implementation of a currency
hedge should probably be a one-sided debate.

Myth #3: I don’t need to hedge currency risk if I operate in US Dollars and
conduct foreign business in US Dollars—I’m not exposed to other currencies.
Even if you decide to pay suppliers in your domestic currency (i.e. US Dollars) you
are still exposed to currency risk through the ever-fluctuating currency rates and your
international partner’s fluctuating economic strength.

Currency risk affects companies that operate in multiple countries, companies that
invest in operations abroad and companies that import or export their goods to other
countries directly or indirectly through their suppliers.

Even if you believe that you are not directly exposed to currencies outside of your
domestic currency it’s likely that you are. Companies that don’t directly deal in
foreign currency may be inadvertently impacted via suppliers if they deal in any foreign
markets. For example, when you purchase from a supplier that imports from China,
you are exposed to economic conditions in China, as your supplier will pass changes
in Chinese currency on to you. The Chinese economy has seen dramatic growth over
the past decade, thereby forcing the Yuan to continually appreciate against the US
Dollar. As such, when US Dollars are used to import goods, their purchasing power is

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 continually diminished.

How To Manage Your Risks

There are three things that a company can do when faced with the task of managing
their foreign exchange risks.

The first is to do nothing. If your international business relationships are strong and you
think that any currency fluctuations will even out over time, doing nothing is an option.
More often than not, however, it is a recipe for disaster. It is similar to purchasing a
house and then failing to purchase house insurance to protect your investment. In the
vast majority of cases, the acceptance of at least a moderate level of protection from
currency risk is prudent.

The second option is to alter your business practices and operations to manage the
risk internally. This can be a very costly and time consuming task and it doesn’t always
lead to better business efficiencies.

The third and most effective technique is to partner with a provider that can help you
manage risk through a currency hedging strategy.

Hedging can be accomplished using financial derivatives to realize different goals based
The best ways to on the level of risk protection you’re seeking. Keep in mind that the types of tools and
manage currency the extent to which you use them is entirely up to your company. What worked for
risk is to identify your company last year or last month may no longer be in line with changing market
your company’s conditions and shareholder objectives. The strategies employed can be repeated,
FX risks and changed or abandoned as your company sees fit. You are not obligated to continue
formulate a with a certain strategy if it no longer works for your company.
hedging strategy
to help mitigate This is where an expert in foreign currency hedging can be invaluable. They can
those risks. recommend a strategy and course of action based on your company’s specific goals
and level of risk you are seeking protection for. As your business grows, and as
operations and market conditions change, an expert is there to constantly re-evaluate
your position, level of protection and whether it is still in line with your corporate
objectives.

The Three Key Components Of Any Hedging Program

Understand what you’re getting into and ensure that your hedging regime is
aligned with your company’s overall goals. Ensuring that your hedge is appropriately
positioned to manage risk and the expectations of organizational stakeholders is key. It
is important to understand the downside risks to a financial transaction and the possible
ramifications created by the use of leverage. A hedging program should reduce risk
as opposed to generate risk; only moderate uses of leverage with derivative products
should be employed.

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 Although there have been many widely publicized instances of large corporate failures
involving derivatives, it is usually the excessive use of leverage that jeopardizes
companies, not the derivative products themselves. As my grandfather used to tell
me, a drink or two a day won’t kill you, but 10 a day will. The same theory goes for
leverage.

Regardless of the motivation for implementing a hedging regime, the core principles

A hedging of a successful program will be the same across any organization. The purpose of a
strategy should currency hedging program shouldn’t be to generate trading gains. The purpose should
minimize the be to mitigate risk and not increase it or swap one form of risk for another.
risks your
Many times over in my career I’ve seen companies lock in to what they believe is a
company is
favorable exchange rate with the expectation that the market will soon move in the
exposed to while
opposite direction. They think that a hedge placed at a level they feel will be in-the-
ensuring that
the success of money will afford them a competitive cost advantage over their competitors. If the
your business market moves in the other direction, however, they could very well find themselves with
is dependent on an obligation that acts as an anchor on the competiveness of their business. If you find
core business yourself in the situation where you think such a strategy may be prudent you should
operations ensure, at the very least, you enter into an optional hedge as opposed to a forward-
rather than the based obligation.
fluctuations in
the currency Ensure your hedge is placed at a level that provides breakeven cost certainty
market. with room for a normal profit. Placing a hedge or worst-case exchange rate at a
level that doesn’t allow your company to earn a normal profit is not a sustainable long-
term strategy. The central motivation of a hedging strategy should be to reduce the risk
that an adverse exchange rate movement poses. If you set your hedges such that they
don’t truly protect the value of your enterprise, you’ve failed to mitigate this risk.

Companies can choose to devise a strategy to deal with these risks. This involves
identifying where a company is exposed to currency risks, forming a policy to deal with
those risks, defining the goals and strategies for mitigating those risks and how and
when to act on or execute those strategies.

Each company’s business operations and international exposure is unique. As such, it

is important to create a strategy that is designed to accomplish different goals based
on your company’s appetite for risk.

If you already have a corporate hedging strategy and employ hedging mechanisms to
protect your company it is important to re-evaluate your status and objectives on an
ongoing basis. This will ensure that the reasons you are hedging are still in line with
corporate objectives, overall shareholder objectives and the company’s appetite for risk.

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 1 Identify
Exposures
6 Evaluate
Results & 2 Formulate
Adjust Currency Risk
Management
The Foreign Exchange Policy

5 Execute
Hedging Process
Hedging
Strategy 3 Determine
Budget Rates
4 Formulate & Goals
Hedging
Strategy

Finding The Right Products And Services For Your Needs

The available vehicles and strategies in the marketplace for hedging range from simple
to very complex and it is important to have at least a general understanding of what
these products are. This allows you to more accurately instruct and communicate any
necessary changes to your hedging provider.

Forward Contract
The forward contract is the most straightforward currency hedging tool available. It
effectively allows you to buy or sell a foreign currency at today’s market price, while
delaying the settlement of the contract to some future point in time. An adjustment,
called the forward points, is applied to the spot price to compensate for the interest
rate differential between the two currencies in question and the passage of time.

Futures Contracts
Similar to currency forward contracts, a currency future allows for the simultaneous
purchase and sale of opposing currencies on a forward-dated basis. Currency futures
are exchange traded and regulated products that trade in standardized amounts
with four set expiry dates per calendar year. In addition, futures contracts trade in
standardized amounts depending on the currency in question and are typically offset
prior to, or at, expiry, with the most liquid contracts only being offered against the
USD.

Currency Overlay Strategy

Money managers often deploy capital outside of their domestic economy as part of
a sound investment diversification strategy. However, the decision to engage in an
equity investment outside of one’s home currency inherently comes with the added
risk related to the translation of currencies into the foreign unit and back out again. A
currency overlay strategy involves managing the currency exposure separately from

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 the underlying asset. In addition to hedging the currency risk embedded within the
decision to hold an existing asset, a currency overlay can also work if you’re expecting
to make a future purchase in a foreign currency but are concerned that a short-term
appreciation of the foreign currency will erode your purchasing power.

FX Swaps
An FX swap is the simultaneous purchase and resale of a foreign currency for different
value dates. In most cases, the near leg of the transaction is dated for either same
day, tomorrow or spot while the far leg of the trade is booked for a value date out
into the future. Effectively, the difference between the rates for the two trades only
amounts to the forward points between the two dates in question. Swaps can also
be invaluable tools when it comes to smoothing short-term cash flow requirements in
foreign currencies as well.

Non-Deliverable Forward (NDF)

A non-deliverable forward (NDF) contract is typically available in currencies that are
restricted or controlled by their central governments, such as the Chinese Yuan (CNY)
or Indian Rupee (INR). In these markets, the actual exchange of the local currency is
restricted to local, resident banking institutions, while off-shore entities are typically
prohibited from actually affecting local currency payments.

In controlled economies such as China or India, they pay less tax

when their customers outside of their borders pay them in USD or
another hard currency. As such, many foreign customers unknowingly
expose themselves to local currency risk even if they aren’t sending
the local currency to their Chinese or Indian beneficiaries. A nearly
constant rate of appreciation of the local currencies against the US
Dollar (especially the case with CNY) force the local suppliers to
increase prices for their exported products over time and the USD
they receive are converted in gradually less INR or CNY.

An NDF is a forward contract that provides a forward hedge but cannot be delivered
upon. Instead, the contract is closed out or “fixed” at expiry, resulting in a marked-
to-market gain or loss, which offsets the paper gain or loss that is achieved when the
purchaser actually purchases the local currency from an onshore bank. Exotic currency
forwards are relatively new products, available from select foreign exchange specialists,
which combine the hedging characteristics of an NDF with the ability to deliver the
local currency in restricted markets. Such contracts are not materially different from a
standard major currency forward and provide corporate entities with both the means to
hedge their currency risk and affect local currency payments to their suppliers.

Many companies are aware of hedging and employ hedging mechanisms. For the
most part, evaluating and managing these risks is an ongoing and complicated task.

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 As the foreign exchange market continues to evolve with economic changes, and as
new products and services are offered daily, it is important that every company make
risk management an ongoing and important task.

What To Look For In A Currency Hedging Provider

When looking for a provider to assist your company in minimizing currency risk there
are many factors to consider. The first being which type of provider would best fit your
needs: a bank, investment company or dedicated foreign exchange provider. Each
type of provider has their own advantages and disadvantages.

While your banking partner, financial institution or investment company may be able to
execute a hedging position for you, they may not be the best option. These institutions
are constrained by traditional banking hours, diverse operations and leveraged
positions mean that they cannot dedicate their time solely to all the intricacies of foreign
exchange and hedging for risk management. In addition, they will rarely possess the
ability to both execute a hedge and affect a local currency payment in many developing
markets.

Ensure that any provider in turn also deals with large commercial banks as opposed to
brokers and investment banks. The leveraged positions and high risk investments held
by many investment banks have been the cause of market turmoil as of late. Hedging
your currency risk is very different for hedge funds that are highly leveraged with the
goal of producing returns. These types of operations also expose your company to
counterparty risk – the risk that companies or individuals will be unable to pay the
contractual interest or principal on their obligations.

Hedging against your currency risks protects your assets much like an insurance policy
– it should not swap one form of risk for another.

With this extremely complicated and time sensitive industry it is best to employ an
expert that is knowledgeable and easily accessible when needed. Choose a provider
that fits your needs who can provide specialized advice specific to the functions of your
business as well as maintaining a stable market position, staying away from any type
of market speculation.

Quick Checklist When Sourcing A Provider

• Be sure to use a provider that offers a range of products – this doesn’t mean
you need to find the FX provider that offers the most products - make sure it works for
your needs and has the flexibility to change as the needs of your business change.

• Ensure that the provider you choose employs experts in hedging – being aware
of hedging products and being able to book one is much different than knowing the
intricacies of how, when and in what combination these products should be employed

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 to achieve your company’s objectives.

• Employ a provider that has exceptional customer service – after all, what good
is a company if you aren’t able to call them up when you have a question and receive
an informed answer?

• As with any business, ensure that they are financially stable – make sure that
the provider has sufficient size and stability to ensure that your company is well taken
care of.

• Ensure that they can help you when you need it – if you want to execute a
transaction at 3am to take advantage of a key event or maintain international business
hours, make sure that you can.

• Online platforms are essential – make sure that the provider can provide you with
an online account that is accessible at any time to execute a transaction as well as a
system that can provide management reporting with respect to transaction status and
can export information into your company’s financial software.

• Security/compliance – Ensure that any provider you choose to work with meets
and exceeds compliance and security regulations and is proactive to ensure the safety,
accuracy and timeliness of all transactions.

About the Author

As Vice President of Foreign Exchange Trading at Custom House, Mark Frey is
responsible for the company’s foreign exchange position, risk and cash management,
as well as the implementation of Custom House’s corporate hedging policy and the
management of inter-bank trading relationships. He is also responsible for relationship
development with present and prospective clients, as well as their advisors.

A graduate from the University of Calgary Economics Program, Mark is a candidate

in both the Chartered Financial Analysts and Canadian Derivative Markets Specialists
programs.

Mark is a regular contributor for many leading financial newswires and publications,
both online and off. He regularly authors the World Market Update newsletter writing on
topics related to risk management, hedging and emerging market currency trading.

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 About Custom House
Custom House is a global company that provides outstanding security and quality service
through a worldwide network of trading offices and strategic banking relationships.

Whether you’re a business wanting to manage foreign exchange risk or an individual

with international payment needs, Custom House offers fast, flexible and competitive
solutions to make foreign exchange efficient and secure.

Learn more about Custom House, visit www.customhouse.com

To learn more about Custom House,

visit www.customhouse.com

**Please note that not all services and/or products are available in all regions. Available products and services depend on regional financial
requirements and licensing. Some products and services discussed in this paper may not be available, please check with a Custom House office in
your region for specifics.

Regional Offices
United States Canada Australia UK
Custom House (USA) Ltd. Custom House Ltd. Custom House Currency Exchange Custom House Financial (UK)
Tel. 1.866.344.4583 Global Headquarters (Australia) Pty. Limited Limited
Fax. 1.877.255.0669 517 Fort St. Level 6, 34 Hunter Street Company Number 04380026
www.customhouse.com Victoria, BC V8W 1E7 Sydney, NSW 2000 Registered Office Address:
Canada Telephone: 61.2.8001.2100 2nd Floor, 12 Appold Street
Tel. 1.250.220.1015 Toll Free: 1.800.887.773 London, EC2A 2AW
Fax. 1.250.412.0775 Fax: 61.2.8001.2122 Registered in England
www.customhouse.ca www.customhouse.com.au Tel. 0845.882.4790
Australian Financial Services Fax. 0800.389.9432
Licence No: 238290 www.customhouseuk.co.uk
ABN: 95 086 278 659

Custom House (USA) Ltd. is owned by the Canadian registered company Custom House Ltd.
Custom House Currency Exchange (Australia) Pty. Limited is owned by the Canadian registered company Custom House Ltd.
Custom House Financial (UK) Limited is owned by the Canadian registered company Custom House Ltd.

This report in whole or in part may not be duplicated, reproduced, stored in a retrieval system or retransmitted without prior written permission of Custom House Ltd. Custom House has based the opinions
expressed herein on information generally available to the public. Custom House makes no warranty concerning the accuracy of this information and specifically disclaims any liability whatsoever for any loss arising
from trading decisions based on the opinions expressed and information contained herein. Such information and opinions are for general information only and are not intended to present advice with respect to
matters reviewed and commented upon.

This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution,
publication, availability or use would be contrary to law or regulation or which would subject Custom House Ltd. or its affiliates to any registration or licensing requirement within such jurisdiction. All material
presented herein, unless specifically indicated otherwise, is under copyright to Custom House Ltd.

©2009 Custom House Ltd. All Rights Reserved.