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Brendan McGrath, CFA - Director of Corporate Riskmoving money for better

Management
RISK MANAGEMENT | HEDGING SOLUTIONS
Agenda
• Basics of hedging

• Understanding FX risk

• 5 simple rules for FX risk management

This presentation is provided for informational purposes only and does not provide any financial, legal, accounting or tax advice.

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WHAT IS HEDGING?

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Hedging – an Introduction
• Hedging is a method of protecting your business against
changes in currency exchange rates
• Similar to an insurance policy, hedging can limit the impact of
foreign exchange movements on profitability
• Hedging can also eliminate risk resulting from transactions in
foreign currencies

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Why Hedge?
• Create certainty around gross margins
• Generate predictability of future cash flows
• Allow for concentration and focus on core business activities,
not market fluctuations

Hedging protects profits, reduces cash flow volatility, helps

long-term financial planning, and can aid competitiveness.

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UNDERSTANDING FX RISK

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Drivers of FX Risk
• Foreign payables – sourcing materials in a different
country/currency
• Foreign receivables – selling in a different country/currency
• Foreign assets or liabilities – balance sheet risk

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Types of FX risk
Changes in currency markets can impact a company’s earnings and cash flows in different ways. It’s
important to understand what these risks are, how to measure them, and how to manage them

Generally speaking there are two kinds of currency risk that a company must be aware of:
transactional risk and translational, or balance sheet risk.

Transactional risk involves sales or purchases that are denominated in a foreign currency

Translational risk involves the foreign assets or liabilities that sit on a company’s balance sheet

Both of these risks have different impacts on cash flows and earnings, so it’s important to understand
the difference between the two and how to manage each

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Transactional Risk
• The risk related to sales or purchases in a foreign currency
• Typically these are the easiest to measure and identify, and as a result are easier to manage
• Transactional risks are typically shorter term in nature (< 1year) but can be longer term if a
company has long term commitments
• Transactional risk is important to understand because it directly affects cash flows
• An appreciating foreign currency may mean the costs for an importer go up, directly affecting
gross profit margins
• A depreciating foreign currency may mean that the domestic revenue of an exporter will be
lower if they are receiving the foreign currency
• Any timing mismatch between when a company makes a commitment to buy or sell a foreign
currency and when they actually pay or receive that currency could give rise to foreign exchange
risk.

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Transactional risk
Example:
A U.S. based manufacturing company sources components for their products in Europe that are priced in Euros. The U.S.
company sells their products in USD. Once the company makes a commitment to purchase these components, they are
exposed to currency risk, even though they don’t have to pay for 90 days. Their risk is that the value of the Euro goes up
in 90 days, and as such, they will have to pay more US dollars to purchase the same component. There are a couple things
the company can do to manage this risk

2
1 The client can hedge this currency risk by locking in their future costs
using a forward contract. A forward contract simply allows the client to
They can do nothing and simply buy their Euros in
set the rate they will deliver upon in 90 days. Regardless of where the
the spot market in 90 days when the payment is
spot market is trading in 90 days time, the client will trade at the rate of
due. This completely exposes the company to
their forward contract, thereby eliminating FX risk. The trade-off is that
swings in the EUR, be they positive or negative,
the client won’t be able to participate in favorable market moves if the
and will have a direct impact on their cost of good
spot rate is advantageous in 90 days time. Regardless, by using a
sold.
forward the company will be able to lock in their profit margins ahead
of time and not worry about where currency rates go in the future.

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Transactional Risk
• Let’s look at how each alternative affects the profit margins of this company. We’ll assume that the company sells their
product for $100 and that the component they buy in Europe costs €60 EUR and represents all of their cost of goods sold.
• The current EURUSD spot rate is 1.1450 and the 90 day forward contract rate is 1.15. Here’s how things stack up in 90
days time:

Cash flows with Cash flows with no hedge

forward contract
EURUSD @1.15 EURUSD @1.20 (+4.4%) % Change EURUSD @1.10 (-4.6%) % Change

Revenues $100 $100 $100

COGS $69 (€60*1.15) $72 (€60*1.20) $66 (€60*1.10)

Gross Profit ($) $31 $28 $34

Gross Profit Margin 31% 28% -11% 34% +10%

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Translational Risk
• The risk related to holding assets or liabilities in a foreign currency
• These risks can be difficult to measure, as the level of assets or liabilities can
differ from day to day and can be difficult to quantify quickly.
• Translational risks are typically longer term in nature, such as factories in
foreign countries, long term debt, etc
• Translational risk directly affects the accounting earnings of a company,
although it doesn’t directly affect cash flow
• The impact to earnings is driven by the changes in the foreign currency rate
from the first day in the reporting period to the last day, although many
companies will re-measure their balance sheet on a quarterly or monthly basis.

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Translational Risk
Example:
A U.S. manufacturing company has purchased a factory in Canada to produce one of their product lines. On day 1 of year 1
this factory is worth $1M CAD and the USDCAD spot rate is 1.30. The company’s earnings are at risk if the value of the CAD
goes down, as their assets will be translated back to U.S. dollars for reporting purposes on an annual basis.
There are a couple things the company can do to manage this risk.

2
1 The client can hedge this currency risk by employing a rolling hedging
strategy using forwards. If they are reporting on a annual basis, the
They can do nothing and simply translate their CAD
company can manage this risk by selling $1M CAD for 1 year starting
denominated assets at the end of each quarter. This
on the first day of the reporting period. At the end of the reporting
completely exposes the company to swings in the
period, the CAD denominated asset will be translated back to U.S.
Canadian dollar, be they positive or negative, and will
dollars at the prevailing spot rate on that date. This creates a translation
have a direct impact on their net earnings, even if it
gain or loss on the company’s financial statements. At the same time, the
doesn’t impact their cashflow.
forward contract is closed out at the prevailing spot rate. The gain or loss
on the forward contract should offset the gain or loss on the asset itself,
thereby eliminating the currency risk of the foreign asset.

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Translational Risk
• Let’s look at how each alternative affects the earnings of this company. We’ll assume that the company’s net profit for
the year was $100,000 on revenue of $1,000,000.
• The USDCAD spot rate used at the beginning of the reporting period 1.30 and the 365 day forward contract rate is
also 1.30. Here’s how things stack up in a year’s time:

Outcome with Hedge Outcome without hedge

End of period spot rate USDCAD = 1.20 USDCAD = 1.40 USDCAD = 1.20 USDCAD = 1.40

Net Income $100,000 $100,000 $100,000 $100,000

Translation adjustment $64,102.56 = ($54,945.05) = $64,102.56 = ($54,945.05) =

($1MCAD/1.2 - $1M ($1MCAD/1.4 - $1M ($1MCAD/1.2 - $1M ($1MCAD/1.4 - $1M
CAD/1.3) CAD/1.30) CAD/1.3) CAD/1.30)
Forward Gain/Loss ($64,102.56) = $54,945.05 = N/A N/A
($1MCAD/1.3 - $1M ($1MCAD/1.3 - $1M
CAD/1.2) CAD/1.4)
Final Net Income $100,000 $100,000 $164,102.56 $45,054.95

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SIMPLE RULES FOR FX
RISK MANAGEMENT

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FOCUS ON WHAT YOU CAN CONTROL

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Focus on what you can control
• Process, not markets
• Business decisions, not trading decisions
• Drown out the noise
• Don’t try to time the market
• Psychology of decision making

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Decision Making and Risk
Example Gains Losses

95% chance to win $10,000 95% chance to lose $10,000

High probability (certainty
or or
effect)
100% chance to obtain $9,499? 100% chance to lose $9,499?

5% chance to win $10,000 5% chance to lose $10,000

Low probability (possibility
or or
effect)
100% chance to obtain $501? 100% chance to lose $501?

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% of trades closed out at gain vs loss

* Source FXCM

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Avg profit/loss per winning and losing trade

* Source FXCM

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Forecast (In)Accuracy

GBPUSD

* Thomson Reuters - April 2017

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KNOW THYSELF

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Know thyself
• Understand your risk profile
• Know your objectives
• Know your business
• Seek advice

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Top Hedging Objectives
Deloitte Global Treasury Advisory
recently conducted a survey to get a
deeper understanding of the challenges
corporations face when managing FX
risk, as well as the approaches they take
to manage said risks. In terms of
hedging objectives, the survey found
that reducing income statement
volatility and protecting cash flows
were of the highest importance to
corporations.

In times like these, FX volatility can

have a huge impact on cash flows and
profitability, so having a plan in place
and employing it consistently is your
best insurance against the unexpected.

*according to Well Fargo 2016 Risk Management Practices Survey

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Loss Aversion

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Risk Management Process
STEP
STEP1:1:Review
Review
Performance
Performanceand
andQuantify
Quantify
Risk
Risk

STEP
STEP4:4:Execute
ExecutePlan
Plan STEP
STEP2:2:Set
SetGoals
Goals

STEP
STEP3:3:Develop
DevelopStrategy
Strategy

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THINK LONG TERM

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Think Long Term
• Short term moves shouldn’t dictate long term decisions
• Strategy to protect for the long term
• Success measured over time, not per trade

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Hedging Strategies
In terms of hedging FX risk, the survey found that the
majority (59%) of corporations surveyed used some form
of a rolling hedge strategy. A rolling hedge strategy is one
that is employed on a regular basis with predetermined
hedge ratios for certain time periods in the future. These
ratios can be either static, where the same amount is
covered for the time period on a regular basis, or layered,
where an increasing amount is covered for various
periods as time moves forward.

The remainder of respondents used either an annual

hedge, or an ad-hoc approach to hedging. The ad-hoc
approach can be problematic, especially in volatile times,
as market psychology can have a big impact on business
decisions. It’s always important to ensure that hedging
decisions are made for your business and not made by the
market.

*according to Well Fargo 2016 Risk Management Practices Survey

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What Do Corporations Hedge?
Forecasting appears to be an important consideration for
corporations when it comes to hedging. A large majority
(68%) hedge forecasted transactions, while 54% hedge
committed transactions. Balance sheet exposures had a
lower response, but still appear to be of significance given
the 44% response rate.

Gaining visibility of future exposures is of great

importance to companies looking to hedge their FX risk.
Those that have a better ability to forecast will have a
better handle on their risk and as such will be able to
manage it better.

Even if forecasting is difficult, a layered rolling hedge

strategy to cover a small portion of forecasted exposures
is prudent, rather than leaving it to chance.

*according to Well Fargo 2016 Risk Management Practices Survey

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Layered Hedging Strategies

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*Simulated outcomes RISK MANAGEMENT | HEDGING SOLUTIONS
DISCIPLINE

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Risk Management Challenges
• Absence of formal hedging policy
– 64% of companies surveyed use one, but of these, 86% of public companies and
only 47% of private companies
• Lack of risk quantification
• Only 10% of private companies use a quantitative method to measure risk,
compared to 26% of public companies – both stats are worrying
• More than half of companies said that determining when to hedge and what
strategy to use was their biggest challenge

All of these challenges point to a lack of planning, oversight and discipline.

*according to Well Fargo 2016 Risk Management Practices Survey

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Discipline

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Layered hedging strategies

• Hedges in various amounts and time periods – diminishing

profile
• Hedges built up over time
• Decisions based on rules and time constraints
• Consistent approach smooths future cash flows

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Layered Hedging Strategies

1 – 3 mths 80% min 4 – 6 mths 60% min 7 – 9 mths 40% min 10 – 12 mths, 20% min

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Layered Hedging Strategies

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DIVERSIFY

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Diversify

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Recap –
Simple rules of fx risk management
• Focus on what you can control
• Know thyself
• Think long term
• Discipline
• Diversify

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Q&A

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THANK YOU

Brendan McGrath, CFA

Director of Corporate Risk Management
[email protected]
Mobile: 250-661-8894

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