Foreign Exchange Risk Managem ent: Perspectives From Financial - - PowerPoint PPT Presentation

April 2013

Foreign Exchange Risk Managem ent:

Perspectives From Financial Executives

Defining and Understanding FX Risk

Defining and Understanding FX Risk – Survey results Overview of Survey Results:

 What is clear according to this study* by the Canadian Financial Executives Research Foundation (CFERF) is that foreign exchange risk is a major issue  In fact, 90% of organizations surveyed rated foreign exchange management as an important consideration in their business  Canadian businesses continue to adapt to an increasingly complex currency universe  For most organizations, foreign exchange risk – and its management are challenges for which there exists an emerging and ever-more sophisticated set

• f policies, procedures and tools

* The Foreign exchange risk management: Perspectives from financial executives report is based on the results of an online survey that took place between November 26, 2012 and January 3, 2013, during which time 109 respondents completed the survey.

Defining and Understanding FX risk: Survey Results Overview of Survey Results:

 Three out of four respondents reported some percentage of their revenue is denominated in foreign currency  17% reported that 76% to 100% of revenue is denominated in a foreign currency  Export credit agency Export Development Canada noted in a recent foreign exchange white paper that Canadian companies that are active in international markets view volatility in the Canadian dollar as the number one constraint to growing exports  The CFERF foreign exchange risk management study similarly found that

• rganizations consider the management of

FX risk to be a critical task  More than two-thirds of respondents (68% ) rated foreign exchange management ‘extremely important’ or ‘important.’ Just 10% rated FX management ‘not at all important.’  However, only about half actually had a policy or procedure in place to manage risk

W hat Percentage of Revenue Com es From Foreign-Denom inated Currency?

25% 18% 13% 10% 9% 8% 17% 0% 5% 10% 15% 20% 25% 30% None 1-5% 6-15% 16-25% 26-50% 51-75% 76-100%

Defining and Understanding FX Risk W hat is currency risk?

 It is financial risk posed by exposures to movements in the exchange rates between two currencies. Multinational Businesses, Importers, Exporters and Investors are all faced with currency risk  These risks can have a material financial impact if they are not identified and managed appropriately

W hat is Risk Managem ent ( Hedging) ?

 The process of analyzing risks and determining how to prioritize and handle exposures “To take risk is the essence of econom ic activity….the m ain goal m ust be to enable com panies to take the right risk…by providing know ledge and understanding of the alternatives”

Peter Drucker, 1 9 7 4

Defining and Understanding FX Risk Types of risk

 There are essentially three types of risks:

• Transactional
• Economic
• Translation

Any or all of these exposures can pose fluctuations in value, cash- flow and financial reporting w hich can m aterially affect a firm ’s perform ance and com petitiveness

Defining and Understanding FX Risk Before m arket risk can be m anaged it m ust be understood

 Identify:

• What market risks is the company exposed to, directly and

indirectly?

• Where do the market risks impact the business?
• What impacts the amount of exposure the company has?

 Quantify:

• What is the impact of unfavorable market moves on the company?

 Expectations of the market risk impact depends upon:

• The forecasted exposure
• The expected/ potential market rates

Defining and Understanding FX Risk: USD/ CAD Market Conditions

 The chart below shows the maximum swing each year as measured from Jan 1st  The average annual move in USD/ CAD is + 6.1% , and –6.2% from start to end

• f year

 The average suggests a 2013 range of 1.0527 to 0.9302 using a starting point

• f 0.9920

Percentage Yearly High/ Low Sw ing in USD/ CAD Exchange Rate ( Sw ing measured from Jan. 1 of each year)

1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3

• 30.00%
• 20.00%
• 10.00%

0.00% 10.00% 20.00% 30.00% 40.00%

Stronger USD Stronger CAD Stronger USD Average Stronger CAD Average

Percentage Yearly High/ Low Sw ing in USD/ CAD Exchange Rate ( Sw ing m easured from Jan.1 of each year)

Note: Data updated as of March 25, 2013

Defining and Understanding FX Risk: USD/ CAD Market Conditions Has the Canadian Dollar stabilized?

 The “Risk on – Risk off” pattern is expected to continue with uncertainty in Europe and escalating risks of a global slowdown  Financial markets volatility is expected to continue

0.90 1.00 1.10 1.20 1.30 1.40 1.50 1.60 1.70 Mar-75 Mar-77 Mar-79 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 9 years 6 years 10.5 years 5.1 years 1 year 1.4 years 2.0 years

CAD per USD Historical Exchange Rate

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

historic volatility FX option market volatility

Quebec Referendum US Sub-Prime US Twin Deficits Euro Introduced BoC changes Intervention Policy Russian Default / LTCM Euro-Zone crisis

Defining and Understanding FX Risk: USD/ CAD Market Conditions

1 YR USD/ CAD Volatility

Defining and Understanding FX Risk Com m on w ays to m easure risk:

 Notional ( dollar) am ount

• Forecasted exposure necessary for any risk measure
• Simple
• Doesn’t tell you about implications to financial results

 Sensitivity to a static m ove (e.g. 10% or 1 cent move)

• Gives you a gauge
• Doesn’t tell you what is likely

 Market forecast/ view (e.g. future expectations of economists)

• Directional prediction of what will happen
• Someone’s opinion based on information currently available

 Volatility m easures (e.g. EBITDA at risk)

• Provides you with a probability based on market price of risk – view neutral
• A little more complex to model and calculate

0.9500 0.9700 0.9900 1.0100 1.0300 1.0500 1.0700 3/4/2013 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q4 2013 Q4 2013

CIBC TD BNS Royal BMO AVG

Canadian Multi-Bank Econom ist Forecasts

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q4 2013 Q4 2013 CIBC 1.0300 1.0500 1.0400 1.0300 1.0100 0.9800 0.9600 0.9800 TD 1.0000 1.0000 0.9900 0.9800 0.9800 0.9800 0.9700 0.9700 BNS 1.0400 1.0400 1.0200 1.0100 1.0100 1.0000 1.0000 0.9900 Royal 1.0200 1.0400 1.0500 1.0400 1.0300 1.0200 1.0200 1.0200 BMO 1.0090 1.0440 1.0290 1.0070 0.9970 0.9920 0.9870 0.9820 AVG 1.0198 1.0348 1.0258 1.0134 1.0054 0.9944 0.9874 0.9884

Defining and Understanding FX Risk Som e key questions to address

 What is the company’s appetite for uncertainty?  What outcomes/ aspects of the business are we trying to protect?  What potential impact can the business withstand?  For how long does the business need to be protected? How long to adjust the business?  What are competitors doing?

Defining and Understanding FX Risk How has your com pany’s focus on FX risk changed in the last five years? Panel Discussion

Doing Business I n Em erging Markets

Doing Business I n Em erging Markets Em erging Markets

 Global FX market turnover grew 20% in 2010 vs 2007, with average daily volume of US$4.0 trillion. The increase was driven by a 48% jump in spot transactions, which represent 37% of total FX turnover. (Source: BIS)  USD (85% ), EUR (39% ), and JPY (19% ) hold the dominant market share of daily turnover, although significant increases have been seen in the Chinese Renminbi, Turkish Lira, Brazilian Real, and Korean Won. Each hold around a 1% share (CAD accounts for 5.3% )  FX markets have become more global, with cross-border dealer transactions accounting for 65% of trading activity, while local dealer transactions represent 35% , it’s lowest share ever  The Canadian government and industry groups have encouraged Canadian companies to lessen their dependence on the US market to expand their trade

• pportunities into emerging markets. These countries continue to seek new

sources of natural resources and goods to further their industrial and infrastructure development FEI survey show s 4 2 % of respondents are doing business in an em erging m arket country

Doing Business I n Em erging Markets Grow th in Sw ift Paym ents

 While the Euro has seen its share slip, it remains the dominant currency in international SWIFT payments  The US dollar has increased, partly due to its role in payments to emerging market countries  While still very small, the Chinese Yuan has risen to 13th place, with a 171% increase from Jan 2012 to Jan

• 2013. The growth is due to falling

government trade restrictions and businesses growing in size where they are no longer reliant on the US dollar

Sw ift Paym ents

0.1 0.2 0.3 0.4 0.5 NZD – New Zealand Dollar ZAR – South African Rand RUB – Russian Rouble DKK – Danish Krone CNY – Chinese Yuan NOK – Norwegian Krone THB – Thai Baht SEK – Swedish Krone HKD – Hong Kong Dollar SGD – Singapore Dollar CAD – Canadian Dollar CHF – Swiss Franc AUD – Australian Dollar JPY – Japanese Yen GBP – British Pound USD – US Dollar EUR – Euro 0.6% 33.5% 39.9% Jan 2013 Jan 2012

Doing Business I n Em erging Markets Chinese Renm inbi ( CNY vs. CNH)

 CNY (onshore) is restricted to trading by entities registered in

• China. It is convertible under

certain conditions and trades within a set trading range  CNH (offshore) is the same as CNY, but free floating and deliverable. CNH has gained in popularity as markets are more transparent, have less restrictive delivery and trading hours, and there are a greater number of investment products and growing bond market “Dim Sum Bonds”  As trading in CNH has grown and market acceptance increased, the spread between CNY and CNH has converged, moving spot spread close to zero

1 2 m onth Onshore vs Offshore Fw d vs NDF

6.25 6.30 6.35 6.40 6.45 6.50 6.55 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 NDF Onshore Offshore

Source: BIS, Bloomberg. and CIBC World Markets

20 40 60 80 100 120 140 160 180 200 Dec-05 Dec-06 Dec-07 Dec-08 Jan-10 Jan-11 Jan-12 Feb-13 Real Exchange Rate I ndex Dec 2002 = 100 Argentina Brazil Mexico Colombia Peru Chile Venezuela

LATAM Currencies: Brazil Strongest, Mexico W eakest

Source: BIS, Bloomberg. and CIBC World Markets

50 70 90 110 130 150 170 190 210 Dec-05 Jul-06 Mar-07 Oct-07 Jun-08 Jan-09 Sep-09 May-10 Dec-10 Aug-11 Mar-12 Real Exchange Rate I ndex 2010= 100 Argentina Brazil Mexico Turkey Hungary Phillipines

EM Currency perform ance has been m ixed

Doing Business in Em erging Markets Managing EM FX Risk

 Widely accepted practice of using a proxy currency which is more predictable and has no restrictions  Often use foreign currency accounts to manage flows in local currencies

How Do You Manage Exposure To Em erging Markets Currencies?

9% 15% 17% 22% 37% 0% 20% 40% Other Combination of dealing in currency and using proxy Deal directly in the currency Products such as forward contracts, non-deliverable forward contracts, options Use proxy e.g. USD, EURO, AUD

Doing Business I n Em erging Markets How does your FX Policy differ for G1 0 vs. EM currencies? I s there pressure to deal in local currency vs. a proxy? Panel Discussion

FX Risk in Action

FX Risk in Action: W ho’s in Charge? W ho’s responsible for FX Risk Managem ent?

 Survey clearly shows that the Finance Dept. has the responsibility for recommending and implementing policies and procedures  In the majority of companies surveyed (54% ) said the CFO was accountable; followed by the VP Finance/ Director of Finance (24% ) and Treasurer (19% ) depending on the size and structure of the company  Most companies have multiple levels of monitoring and compliance within their

• rganization

 Risk Committee is responsible for evaluating the transactional elements of risk management in the firm  Senior Management is responsible for evaluating the performance of their policy, deciding when or when not to hedge and ensuring their policy is in line with the needs of the business  Ultimately the Board of Directors approves the overall direction of the policy and ensures management is in compliance

FX Risk in Action: Policies and Procedures Just over half ( 5 1 % ) of survey respondents have a policy or form al process in place to m anage FX risk

80% 88% 41% 55% 72% 43% 0% 20% 40% 60% 80% 100% Rated FX as important or extremely important Track FX by currently unit Conduct business transactions in ermerging markets Respondent with formal FX risk management process or policy Respondent with no policy in place

Com parison Betw een Survey Respondents W ith And W ithout Form al Fx Risk Managem ent Policies

FX Risk in Action: W hy Establish a FX Hedging Policy? W hy do m ore than 5 0 % of firm s develop and im plem ent an FX Hedging Policy?

 We note that as international

• perations have expanded, the

focus on foreign currencies and their impact on business metrics have taken on a higher profile in many companies  They want to reduce cash flow volatility that hits key business metrics like margins and EDITDA and need to ensure consistent funding costs

19% 13% 30% 38%

Purpose Of FX Hedging Policy

Mitigate short-term exchange rate impact (6, 12 or 18 months) from sales or purchases in foreign currencies or from the repatriation of foreign income Give certainty to exchange rate impact

• n cash flows in home

currency Neutralize balance sheet impact on working capital and long-term capital, including debt Other

FX Risk in Action: I nstrum ents to Mitigate Risk As confirm ed by the study, the m ajority of firm s hedge their exposures w ith the use

• f financial instrum ents

 Companies recognize that any exposure not naturally hedged may need to be managed by way

• f a derivative instrument

Financial I nstrum ents Used To Mitigate Risk

15% 8% 13% 23% 41% 0% 20% 40% 60% Other Foreign Exchange Swaps Currency options (vanilla

• ptions or structures)

Futures contracts (exchange traded contracts that allow you to buy or sell a currency at a set exchange rate in a given m onth) Forwards (OTC agreem ents to buy or sell a given am ount of a currency at a set exchange rate on a specific future date)

FX Risk in Actions: Risk and Rew ard Derivative Products change a com pany’s risk profile and have differing risk/ rew ard characteristics

 Let it float

• Exchange in the spot market

 Lock it in

• Fixed price forward contract

 Insure it

• Purchased option

 Combination of lock it in and insure – Option based strategies with different risk/ reward scenarios

• Collar
• Expandable Forward
• Ratio Collar
• Variable Rate Forward

 Structured Hedging Solutions

• Structured solutions can be designed to provide either perfect or partial protection

while allowing for participation in a potentially favourable spot movement

• Certain strategies are designed to “boost” the forward rate available and can be

tailored to take into account the client’s risk appetite and/ or market views.

• e.g. At-Maturity Variable Rate Forward, Conditional Forward, Fade-In Forward

FX Risk I n Action: To Manage Risk or Not…and How

Deciding Factors W hether Or Not To Manage FX Exposure

13% 15% 17% 20% 23% 28% 42% 43% 0% 20% 40% 60% Creditworthiness

• f financial

institution/ counterparty Role of Audit and/ or Finance Committees FX as a profit centre Access to credit to suppor a hedging program Industry specific practices Accounting Guidelines Sufficient resources to manage a hedging program Level of knowledge and access to advice

FX Risk I n Action: To Manage Risk or Not…and How Observations:

 Public companies are more concerned with accounting treatment/ Income Statement volatility and therefore favour simple strategies like Forward

• Contracts. The FEI survey has 64% of companies using either OTC Forwards or

Exchange traded futures contracts  Private companies are more open to alternative hedging strategies. Focus is more on economic performance than reducing Income Statement volatility  Lack of knowledge has kept some companies from using option based strategies  An increase in market volatility often attracts more companies to structured

• ption hedges because of their relative attractiveness to simple forward

contracts and futures  In the Emerging Markets space, companies with formal FX policies typically hedge more of their exposures but also shy away from the more volatile local currency in favour of proxy currencies such as the USD, EUR and AUD  Those without a formal policy are typically more risk accepting. This is demonstrated by the reduced use of hedging products (9% vs. 35% for those with a policy) and the likeliness of trading in the local currency (22% vs. 13% )

PERSPECTI VE Canadian Dollar Parity, Boon or Hindrance? Benjam in Tal Deputy Chief Econom ist, CI BC

Central Banks Diversify into Broader FX Reserves 100 200 300 400 500 600 2000 2002 2004 2006 2008 2010 Reserves of Reporting Central Banks* Esim ate: Global Reserves Official FX Reserves excl. US$, sterling, Swiss franc, euro & yen (in bns of USD) * covers roughly 60% of world official FX

Source: IMF, CIBC

Rising C$ Correlation w ith Rates

Source: Bloomberg, Statistics Canada, CIBC

• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 0.6 0.8 1.0 1.2 Cdn - US 2 yr spread (L) CADUSD (R) Start of current account deficit

Estim ated Currency Over/ Undervaluation*

• 15%
• 10%
• 5%

0% 5% 10% 15% Indonesia Japan Germ any China India Thailand S Africa Korea Mexico Euro Area Brazil USA Switzerl. UK Canada Australia Spain Overvaluation/undervaluation (% )

* relat ive t o each count ry's t rading part ners; m idpoint of est im at ed range

Source: IMF, BIS, CIBC

The Lost Decade

Source: Statistics Canada, CIBC

Ca na dia n Ex por t Vol. I nde x ( 2 0 0 7 = 1 0 0 ) 60 65 70 75 80 85 90 95 100 105 110 97 99 01 03 05 07 09 11 US$/ C$ 11% US$/ C$ 35% US$/ C$ 5%

Exchange Rate Vulnerability I ndex

I NDUSTRY Export I mport Combined Ranked By Vulnerability Vulnerability Export- I mport Total

(% of shpts. Exported (% of shpts. to Can. Mkt) x

Vulnerability Vulnerability

less I m ported inputs) (im port penetration of Can. Mkts.)

H Furniture 46.2 35.8 8 2 .0 1 I Machinery 60.4 12.2 7 2 .6 2 G Wood Products 62.1 5.9 6 8 .0 3 H Electrical Equipment 32.3 35.7 6 8 .0 4 Paper Manufacturing 57.9 5.7 6 3 .6 5 M Computer & Electronics 45.5 11.1 5 6 .6 6 E Primary Metals 35.1 10.6 4 5 .7 7 D Transportation Equipment 36.6 6.5 4 3 .1 8 I Fabricated Metals 13.7 27.9 4 1 .6 9 U Printing & Allied

• 0.9

34.1 3 3 .2 1 0 M Clothing 13.5 18.6 3 2 .1 1 1 Chemical Manufacturing 25.4 6.3 3 1 .7 1 2 L Food Manufacturing 11.8 15.3 2 7 .1 1 3 O Textiles 2.9 21.9 2 4 .8 1 4 W Beverages/Tobacco 4.0 11.9 1 5 .9 1 5 Petroleum Refining & Coal Prod

• 12.1

5.3

• 6 .8

1 6

No Clear Correlation Betw een Dollar Sensitivity and GDP Perform ance

High vulnerability Low vulnerability

Source: Statistics Canada, CIBC

• 7
• 6
• 5
• 4
• 3
• 2
• 1

1 2 3

• 20

20 40 60 80 100 I ndex of $ vulnerability furniture m achinery wood products electrical equip. paper m fg chem ical m fg textiles beverages/ tobacco food m fg petroleum / coal Avg annual GDP % growth (07-12) transp. equip.

China: “Dem ographic Dividend” Poised to Fade

Source: NBS, UN Population Division

62 64 66 68 70 72 74 90 95 00 05 10 15 20 25 age 15-65, % of total population Projected

Source: US Department of Energy

Shale Oil Revolution Shifts the US Supply Curve ( L) ; I m port Share of US Market % ( R)

1 2 3 4 5 6 7 8 1990 1995 2000 2005 2010 2015 Shale/ Other Tight Other Lower 48 onshore Lower 48 offshore Alaska production, m n bbl/ day 30 35 40 45 50 55 60 65 95 99 03 07 11 15 19 23 imports/ US oil consumption (% )

Conclusion

Conclusion In conclusion, the research study shows that Canadian companies are embracing the need to expand their businesses beyond our borders and deal with the currency risks that come with that strategy. Therefore, Foreign Exchange risk management needs to be part of a Canadian company's international growth strategy. Because only half of the organizations surveyed have a policy or formal process in place to manage FX risk, it appears there's a need for Canadian businesses to take a more comprehensive, pro-active approach to managing these material risks.