CFO Studio Magazine, 3rd Quarter 2012
By Charlie Stough, CFO of Atalanta Corporation
REDUCING COSTS ON INTERNATIONAL TRANSACTIONS
We live and work in a very uncertain world. Any company in the United States that buys or sells products to or from companies in other countries faces currency risk, even if the transaction is denominated in U.S. dollars (USD). Either the buyer or the seller has to manage the risk, and that action has an impact on the agreed-upon price.
Foreign currency exposures are generally categorized into the following three distinct types: transaction exposure, economic exposure, and translation exposure. These exposures pose risks to firms’ cash flows, competitiveness, market value, and financial reporting.
A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. Such outcomes could be troublesome, as export profits could be negated entirely or import costs could rise substantially.
A firm has economic exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid, the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.
A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm’s cash flows, it could have a significant impact on a firm’s reported earnings and therefore its stock price.
Given the current situation in Europe, many financial teams are spending more time monitoring their euro exposures. Corporations are taking a sharper look at what their hedging strategies need to be in 2012. My company, multinational food importer Atalanta Corporation, certainly is doing so.
Steps to Follow
The first step in preparing to hedge foreign currency transactions needs to be measuring how much of a particular foreign currency your company bought or sold in the last 12 months on a global basis.
The second step is calculating how much of that currency you will buy or sell in the next 12 months, by month, for all divisions on a global basis. Many banks offer “treasury management software systems” which facilitate the gathering of information, the administration and control of outstanding foreign exchange (FX) contracts, etc. When there is significant hedge activity, the cost of such systems can be a good investment for larger companies.
The third step is to formulate both short-term and long-term plans with management, and the audit committee if the company has one, and agree on the range of months forward that you feel comfortable hedging. it could be three, six, or 12 months, depending on recent volatility. This analysis can also include whether there are any “natural hedges” such as the situation where you are selling a product to a company in Canada in Canadian dollars (Cad) and also buying a product from another company in Canada in Cad. In this scenario there would be an opportunity to open a bank account in
Canada and net the two transactions to better manage Cad risk over time. Other examples of “natural hedges” would be building a plant or opening a purchase/sales office in a foreign country where sales and purchases are made.
The fourth step is to determine what proportion of your exposure you feel comfortable hedging. Perhaps it could be 30, 40, or 50 percent depending on recent volatility. If you are hedging for a fixed supply contract it could be for 100 percent of the contract to ensure that your costs and margins are fully protected.
The fifth step is to make a decision on what types of hedging tools your company is comfortable using.
The most basic product is the plain fixed forward. This is a contract to exchange currency on a specific date at the difference between today’s spot exchange rate and the interest rate differential for the time period (for example, lock into buying euros at 1.30 in six months and selling USD on that date).
A variation is a forward window contract, which gives a company the ability to hedge a period of time—30 days, for example—as an alternative to the basic forward contract (hedging to one date in the future). A plain fixed forward is a good tool for a 12-month supply contract, but it does not give you an opportunity to participate in any positive movement of the currency in question.
Alternatives to Consider
As with most things in life, a variety of approaches may deliver the best result. Other alternatives include options such as calls, collars, and puts.
A call option, oft en simply labeled a “call,” is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument (the “underlying”) from the seller of the option at a certain time (the “expiration date”) for a certain price (the “strike price”). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a cash fee (called a “premium”) for this right.
A “put” or “put option” is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined expiry or maturity. The buyer of the put has the right, but not an obligation, to sell the asset at the strike price by the future date, while the seller has the obligation to buy the asset at the strike price if the buyer exercises the option. The buyer pays a premium for this right.
This is a type of insurance but some companies do not want to spend cash for the product. Approximately 50 percent of all corporations use options to hedge FX exposures. Forty-six percent of those prefer to use zero-cost structures, rather than the cash premium put and call examples above, to buy a “range of values” without paying cash up front.
One option product with zero cost is a “collar,” which provides protection from adverse exchange rate movements and participation in beneficial movements within a “specified range.” Worst-case and best-case scenarios are known up front. For example, buy euro call protection at 1.30 and sell euro put upside at 1.20 for zero cost. In this case your transactions can be no better or worse than the range of 1.20 to 1.30.
A second option product with zero cost is a participating forward, which provides protection at a given level and partial participation in favorable market moves. Worst case is known up front (for example, buy euro call at 1.30 with 50 percent downside participation below 1.30 for zero cost).
A third option product with zero cost is a forward extra, which provides 100-percent protection at a given level, with the ability to participate on a one-to-one basis in favorable market moves down to a barrier. Should the barrier be triggered, your company will be locked into a penalty protection level. So you get the good news up to a certain point, and then the bank moves you back to a rate where you have an unfavorable rate.
A sophisticated bank can offer 20-plus option products, but the best advice is to stick to the basics until you have a good track record.
Choose Your Partners
You are much better off working with a major money center bank if you are buying or selling millions of Canadian dollars, euros, and so on, because they can offer internet-based systems that are more convenient and that can usually provide you with better rates.
Some of the smaller foreign currency shops may offer competitive rates, but you need to test the rates that you are getting periodically, whether using a large institution or a small firm, to make sure that you are receiving market rates.
The sixth step is to start reading the news every day on the currencies that you plan to hedge so you can gain a better understanding of what the trading range is and why the currency is moving up and down.
In the case of the Canadian dollar, it may be primarily interest rate differentials, economic data, the price of oil, etc.
In the case of the euro it is much more complicated and may depend on interest rate differentials, economic data in the U.S. and individual countries in Europe, the price of oil, decisions by countries’ central banks to amend their basket of “reserve currencies” that they hold, world events, and the perceived risk related to currencies other than the USD, which is a safe harbor for many people, etc.
At Atalanta Corporation, we actively hedge the euro and the Cad. Our euro purchases are approximately 25 percent of our total cost of products sold. Of the 25 percent, we have hedged on average 30 or 40 percent. Our five year track record as measured at the end of each year has been an important level of savings.
We have a five-year syndicated loan for approximately $200 million and at various times we have used all of the lending banks for some portion of our currency hedging. The banks are Wells Fargo (agent), TD Bank, Israel Discount Bank, Citibank, Chase, and Banco Santander. The benefits of using banks in the syndication network are that they already have a collateral base, and hopefully can be convinced to offer more favorable rates than financial institutions not already doing business with the company. Each bank in the syndication network that is interested in the business provides a separate line of credit for hedging activity, based on existing collateral and the perceived risk of entering into foreign exchange transactions.
The euro was launched at parity with the U.S. dollar in May 1998. The lowest level was 0.82 USD in October 2000. The strongest level was 1.59 in April 2008 and the mathematical mean has been around 1.20. The volatility of the currency has meant that there were very important opportunities for Atalanta to save money on purchases of cheese, olives, olive oil, and other products from Europe.
The strongest level of the Cad the last five years was 0.92 to the USD in 2007. The weakest level was 1.30 to the USD in 2008 and the mathematical mean has been 1.06. The volatility of the currency has meant that there were very important opportunities for Atalanta to save money on purchases of meat from Canada.
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