ARACRUZ

Brazilian company that lost over U$2 billion due to Click to edit Master subtitle style exchange rate movements resulting from the financial crisis of 2008

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Aracruz (1999-2009)
Aracruz was the major Brazilian manufacturer of pulp and paper with steady growth in revenue, output and profits throughout 1999-2007. the biggest world producer of bleached eucalyptus pulp net revenue : U$1.42B & 26% of world market market capitalization of U$7.1B (July 8th, 2008) & BBB flat rating by Moodys , S&P 2008 1999 2001 2003 2005 2007 2009

Aracruz used 6 types of derivatives during 1999-2008 to hedge its position : Standardized derivatives : 1) Standard future contracts 2) Currency coupons OTC derivatives : 1) Non deliverable forwards (NDF) 2) Conventional swaps 3) An exotic swap with monthly settlements 4) A structured derivative : sell target forward Losses of U$2.13B in derivatives posted ~ 3.7 times of 2007 EBIT ~ 30% of Aracruzs market capitalization Stock plunge > 90% in 3 months, Acquired by another 4/19/12 cellulose producer in 2009.

Share prices take a nose dive

80

Share Price

60 40 20

6M

Volum e
2007 2008 2009 2010

4M 2M

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2011

Optimal & Effective Hedge

Aracruz Foreign Currency Liabilities and Assets, and Derivatives Short position (US$ million) 1999-2008

Effective Exchange Rate US$/Real and S&P500 08/28/2008 to 10/02/2008

Aracruz Optimal and Real Hedge (US$ million) 1999-2008

Expectation (1,6,12 months) and Effective 4/19/12 Exchange Rate US$/R$ 2003-

Shifting Focus to Sell Target Forwards

Aracruz started to invest in Sell Target Forwards in 2008 Sell Target Forwards allowed Aracruz to double hedge the exchange rate risk:

1. Traditional dollar forward sale the standard hedging

for currency risk 2. Then sold the same dollar again via a call option where the speculation and the scandal starts
Sell the same dollar again Taking the same short position on the $ The problem is that the second position has a strike price where the bank will call the option which constitutes a ceiling. But there is no floor
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continued
The contract is valid for a year with monthly
settlements => is equivalent, for Aracruz, of selling 12 calls with successive monthly strike dates, and also 12 NDFs.

P/L = 2nt *( X S ) P/L % = 2*12 *( X- 1.5X ) *100/1.5X = 800% n: notional amount , t: time left in the contract, X:
strike price ; S: actual price.

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Scandal ???
Far greater exposure to the derivatives than was
necessary to hedge against the USD risk
rather than minimizing it

Molding its hedging activities towards creating risk

Severe violations of the companys hedging

policy

Strategy deviated from share-holder protection

towards making money from betting.

Agency problem poor corporate governance

because too much discretion given to CFO
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