FX risk hedging at EADS 1 2 Reasons for EADS FX risk management - - PowerPoint PPT Presentation

FX risk hedging at EADS

1

Reasons for EADS FX risk management policy

2

Mismatch between dollar denominated revenues and euro, pounds denominated cost base (50 % of aircraft’s order) Significant time lapse between payment commitment and cash receipt ( about 8 years)

Loss of competitiveness (Prime rival is a US- based manufacturer)

Loss of competitiveness as prime rival (Boeing) is a US-based manufacturer Large amount of eligible exposure with highly instable exchange rates have a dramatic impact on company’s EBIT

1 2 3 4

Reasons for EADS FX risk management policy

Double - pronged approach

3

Double- pronged approach Risk transfer Risk mitigation (natural hedge) Using off- shores Restructuring Programs (e.g. Power8) Hedging with forward contracts Hedging with

• ptions

Double – pronged approach

4

What is the Speed Grid ?

Speed grid is a mechanical hedging approach that is aimed to determine the weekly amounts of FX forward contracts to purchase in order to execute EADS’ hedging policy. What is the Speed Grid ?

5

Factors affecting speed of hedging

5

Year to hedge

the further ahead, the less is hedged per week

Dollar to euro forward exchange rate,

the stronger the forward exchange rate for the dollar against the euro, the higher weekly amounts of forward contracts that traders had to purchase and vice versa.

Hedging Speed

The weekly amounts of FX forward contracts to purchase

Result

Execution EADS’ hedging policy

Factors affecting speed of hedging

6

The pros and cons of Speed Grid

In extreme cases the Speed Grid’s functioning is not appropriate to EADS’ FX hedging policy.

The pros and cons of Speed Grid

7

At a crossroads

Resetting Speed Grid: Increasing the amount hedged per week Hedging with a large single forward contract: All the eligible exposure will be hedged within a month by using forward contracts Using FX options: EADS Front Office can decide is it worth to be exercised or not At a crossroads

Current Business Environment

Current Business Environment

8

Current Business Environment

2 1 1 2

Increase in Number of Aircrafts Orders Drop in Exchange Rate from $1.20/€ to $1.47/€ two years later Growth of Euro denominated cost base Growth of delivery years ahead up to 8 years Surge in Overall dollar exposure up to $94.2 billion Decrease in earnings Growth of credit spread volatility risk Decline in the share price from € 21.8 to €15 per share

9

FX Options

Flexibility Risk mitigation in volatile market Elimination of default risk Gaining counterparty’s loyalty Option for reselling Requirement of mark-to-market through P&L Rumors on the market

Forward Contracts

Relatively cheap instrument Strict obligation

Comparison of options and forward contracts

Huge expenses on option premium, especially in volatile market (2-8% of the contract) Comparison of options and forward contracts

Data

10

weekly spot and forward EURO/USD exchange rates weekly central strike prices of EURO/USD options weekly premiums of EURO/USD options

The aim of the analysis:

to find out which alternative’s exchange rate could be the most beneficial

Source: Bloomberg

Time period

2000 March of 2008 From To

Alternatives Evaluation

Alternatives Evaluation

11

Period FX exposure,

• bln. $

Share in total FX exposure Current year 0,0% In 1 year 326 0,7% In 2 years 661 1,3% In 3 years 2 531 5,1% In 4 years 3 264 6,6% In 5 years 3 930 8,0% In 6 years 10 445 21,2% In 7 years 12 050 24,5% In 8 years 15 960 32,5% Cumulative 49 167 100%

Alternatives Evaluation

Alternatives Evaluation

Source: Company data

Time FX exposure distribution

1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years

32,5% 24,5% 21,2% 8,0% 6,6% 5,1% 1,3% 0,7%

12

Time period Period of hedging Strike price Spot price at expiration date FX rate of conversion (minimum of spot and strike prices) Option Premium Final FX rate (sum

• f price of FX deal

and option premium)

1 week 1 year 1,065 0,887 0,887 0,0160 0,903 2 years 1,079 0,895 0,895 0,0162 0,911 3 years 1,098 0,985 0,985 0,0165 1,002 4 years 1,115 1,120 1,115 0,0167 1,132 5 years 1,133 1,227 1,133 0,0170 1,150 6 years 1,151 1,211 1,151 0,0173 1,168 7 years 1,168 1,260 1,168 0,0175 1,186 8 years 1,186 1,353 1,186 0,0178 1,204 The aggregate FX rate (at which all the FX gap was closed, if we start hedging on the 1st week) = 0,903 * 0,7% + 0,911 * 1,3% + 1,002 * 5,1% + 1,132 * 6,6% + 1,150 * 8% + 1,168 * 21,2% + 1,186 * 24,5% + 1,204 * 32,5% = 1,165 Source: Bloomberg, Team Estimates

Alternatives Evaluation

Alternatives Evaluation

13

Solution

Strategy Speed Grid Single forward FX

• ptions

No hedging Exchange rate $/€ 1.149 1.008 1.023 1.355

0,2 0,4 0,6 0,8 1 1,2 1,4 1,6 1,8 1 20 39 58 77 96 115 134 153 172 191 210 229 248 267 286 305 324 343 362 381 400 419

Spot rates

spot $/€ ratio

Source: Bloomberg Source: Bloomberg, Team Estimates

weeks

Solution

14

Alternative approaches

Alternative approaches Continuous futures “Double hedge” “SPOT-swap combo” It allows to mitigate significant negative movements of FX rate and to be close to current FX rate. Although, this contract requires cautious approach to rolling position. This approach includes two levels of hedging. The first level is a typical hedge contracts (forwards or options). The second level allows mitigating risk of volatility. This approach gives the opportunity to operate in the market for all hedging time. The technique is to buy foreign currency by SPOT FX rate.

Counter-party default risk

Counter-party default risk

15

Monitoring hedge counterparty risk arising from changes in the market value of EADS’ derivatives. To mitigate the credit default risk we need to carefully estimate creditworthiness of the banks we deal with.

Synthetic credit rating model

Synthetic credit rating model

16

Data

334 banks, which had long- term credit ratings of S&P, Moody’s or Fitch and whose financial statements were disclosed banks credit ratings financial statements

The aim of the analysis:

Possibility to determine banks’ credit ratings in every period of time; Possibility to determine banks’ credit ratings of those banks, which do not have in order to minimize option premium

Source: Bloomberg

sovereign credit ratings of the countries, in which banks operated

Sample

17

Credit rating Score AAA 6 AA 5 A 4 BBB 3 BB 2 B 1 CCC / C

Where w(i) – weight of financial factor i (sum of all the weights is equal to 1) Factor score(i) –score of financial factor i (varies from 0 to 1)

Synthetic credit rating model

Synthetic credit rating model

18

Tier 1 capital ratio, % ROA, % Cash / Demand deposits Total assets,

• bln. $

Factor score <12.51 <0.32 <0.07 <4.7 12.51 - 13.87 0.32 - 0.60 0.07 - 0.21 4.7 - 10.3 0.2 13.87 - 14.86 0.60 - 0.87 0.21 - 0.39 10.3 - 22.7 0.4 14.86 - 16.10 0.87 - 1.13 0.39 - 0.61 22.7 - 42.4 0.6 16.10 - 18.0 1.13 - 1.62 0.61 - 0.98 42.4 - 121.7 0.8 >18.0 >1.62 >0.98 >121.7 1 Factor Weight Tier 1 capital ratio 6,2% ROA 26,3% Cash / Demand deposits 25,7% Total assets, bln. $ 41,8%

Synthetic credit rating model

Synthetic credit rating model

Credit risk mitigation: default probabilities

Credit risk mitigation: default probabilities

19

Credit risk mitigation: limits

Credit risk mitigation: limits

20

Criteria: PD > 2% -> Lim=0% PD < 0.5% -> Lim=100% Lim = 0.5% / PD

Credit risk mitigation: limits

Credit risk mitigation: limits

21

Criteria: PD > 1% -> Lim=0% PD < 0.1% -> Lim=100% Lim = 0.1% / PD

Risk mitigating with downgrade trigger approach

22

Stating Downgrade Trigger Covenant in the Forward Contract Bank has an option to close out the contract at current market price EADS has an option to close out the contract at current market price EADS’s credit rating falls Bank’s credit rating falls Risk mitigating with downgrade trigger approach

Risk mitigating with collateralization approach

23

Specifying Forward Exchange Rate and Calculating Threshold Subjecting to mark-to-market Exchange Rate moves in Bank’s favor Exchange Rate moves in EADS’s favor EADS posts collateral to equalize a threshold EADS refuses to post collateral Bank refuses to post collateral Bank posts collateral to equalize threshold Bank has an option to close out the contract at current market price EADS has an option to close out the contract at current market price Risk mitigating with collateralization approach

Thanks for your attention

24