sals.a Educational Research bFebruary 2009 sals.a Educational Research is a regular publication offering practical information about risk management using derivatives. The numerical examples in this document can be viewed on the website www.kfpsalsa.com and field-tested using your own actual figures. If you are not yet a sals.a customer, you can register for a free 4- week test subscription. It pays to know!
This issue focuses on: Risk-free financial management: fact or fantasy? Primer: The fundamentals of diesel hedging, Part 2 Primer: Cross currency swaps, Part 2
KFPD GmbH An der Welle 4 60322 Frankfurt Germany Managing Director: Mr. Lauri Karp Telephone: +49-(0)69-7593 7732 E-mail: service@kfpsalsa.de Frankfurt Local Court HRB 81098 USt-ID: DE 256618623
Risk-free financial management: fact or fantasy? www.kfpsalsa.com/news
“A person who is not willing to take risk is living in a fantasy world ” (Gudrun Kropp) Is there a new approach available in financial management - a risk-free approach without derivatives? In the current environment, real rays of hope have become few and far between – not a day goes by without more bad news about the economy or the banking sector. And many customers are becoming overly cautious when it comes to addressing the subject of “active financial management”. The rebirth of “traditional” and “conservative” financial management approaches gives rise to the impression that there is a way to structure financial management so as to eliminate risk. In practice, such an approach would look something like this: Only long-term, fixed-rate loans for financing Payment for exports / imports exclusively euro-based Procurement of raw materials via 12-month fixed-price contracts Unfortunately, this is an illusory goal. Any attempt to create the image of a volatility-free world in financial
management ignores reality. We all see how realistic, for instance, the “abnormally smooth returns” of Mr. Madoff turned out to be. Operational decisions require flexibility. When investment plans are halted or restructured, financing must also be readily adaptable. A money market rate near zero not only gets investors’ attention, but also serves as a last wakeup call to those fixed-interest fans who were recently happy to have secured “low” rates: a fixed rate stays fixed and is secure, but also precludes participation in falling money market rates. When foreign currencies experience extreme devaluation, traditional home-currency invoicing results in an “economic Waterloo” when it comes to sales turnover. And, it should not be overlooked that the greatest volatility in commodity markets has recently been for contracts up to 12 months. Financial management is only risk-free when operations and financing are synchronised. And the only way to accomplish this is by using financial instruments. L.K.
Primer: The fundamentals of diesel hedging, Part 2 http://www.kfpsalsa.com/login -> Market data -> „Commodities“ and „Templates“ -> „Sample-Portfolios“
In Part 1 of this article, we gave you a short overview of the functioning and dynamics of commodity markets. Prices on the commodity markets never “sleep”. Changes in the spot market price for oil, in particular, can be triggered by a variety of factors: Supply and demand. In Q3 – Q4 2008, the oil price fell from USD 149 to USD 32/barrel due to a pronounced weakening of demand. Political risks. The Middle East conflict is often cited as an example here.
Weather. Hurricanes in the Gulf of Mexico push prices higher due to short-term stoppages in oil production. Inventories. Inventory build-ups in Cushing, Oklahoma (site of one of the largest oil depots in the US) led to sharp declines in the price for West Texas Intermediate (WTI) grade oil in Q1 2009. Economic output. Expectations of weaker or stronger demand have an effect on the oil price over the medium term. Other factors. Freight, production costs, substitution, technological advancement, investment in new sources.
Disclaimer The information contained in this document by KFPD GmbH dies not constitute an offer for the purchase of securities, and is intended solely for informational purposes. In particular, the information contained herein contains no guarantees or other representations. KFPD GmbH makes no assurance and assumes no liability for the accuracy or completeness of the content. Information and data on interest rate swaps, interest rates, derivatives, currencies and markets, general or future market developments or any other statements about future possibilities reflect only the subjective views and/or assumptions of the author, based on the information available at the time. Any actions carried out on the basis of the methods depicted in this discussion paper are the sole responsibility of the customer. Neither this document nor any of its should be construed as advice relating to financial or any other matters. It should also not be used a substitute for professional advice. None of the contents may be construed as a recommendation to conclude or avoid certain transactions without obtaining prior advice that takes into account the individual situation of the customer.
sals.a Educational Research - February 2009
The arguments in favour of this method for increased planning reliability are strengthened further when looking at the prevailing price forecasts. The graphic below illustrates the oil price forecasts by various research firms published in January 2009 (source: Reuters poll). A gap between the forecasts of USD 60/barrel on average proves that even the professionals have no crystal ball with which to foresee the future. The median forecast indicates an oil price correction to the level of marginal production costs (see Part 1 of this article in the last issue of sals.a Research) in the medium term.
Fig. 2: Brent crude vs. diesel (gasoil) prices
1400
120
1200
100
1000
80
800
60
600
40 20
400
Brent
Gasoil
0
Keeping in mind these forecasts and price correlations, we will now look at the details of the hedging process. The underlying parameters are given in the table below: The transaction to be hedged is a regular diesel purchase order for 100 metric tonnes occurring on the 27th of each month.
Hedged transaction Transaction name
Purchase diesel 100mt/month = approx. 1.4m litres/year Wholesaler 27th each month
Fig. 1: Reuters oil price forecasts
Term
2 years
160.0000
Transaction details in sals.a
110
USD / barrel
100.0000
90 76.7
80.0000
70
60.0000
56.75 36
40.0000
38.1
83.65
43.9
20.0000 0.0000
Historical Brent spot Maximum forecast IPE Futures
Minimum forecast Median forecast
Changes in the price of diesel are closely linked to the oil price, meaning that a forecast of the oil price trend can be transposed upon the trend for diesel. For our analysis we use ICE Gasoil Futures 1 data (gasoil = No. 2 distillate).
1
Distillates are oil products obtained through the refining of crude oil. No. 2 distillates include heating oil, kerosene and diesel fuel.
200 0
Frequency
120.0000
USD/T
1600
140
Counterparty
140.0000
3
160
USD / bbl
Whether SMEs and municipal enterprises must necessarily formulate their own firm opinions about price movements is a question that must be critically examined. Having an opinion is certainly not a disadvantage. But the sheer volume of different factors that affect the spot price overwhelm even some commodity experts. Oftentimes, price expectations relate to the coming few months. But those seeking mediumterm planning reliability cannot afford to juggle with short-term price forecasts. A look at the long end of the commodity price curve can make more sense in such cases, as many of the abovementioned short-term price factors have less of an effect here, giving way instead to fundamental factors such as production costs.
Buy/Sell
Buy
Price curve
Gasoil (Diesel)
Volume
100 mt
Delivery frequency
Monthly
2
The screenshot below depicts the hedged transaction in sals.a (USD/mt) as well as the approximate future pump prices (EUR/litre including tax at a constant rate).
sals.a Educational Research - February 2009
The approximate future pump prices fluctuate when the market prices and/or exchange rate for EUR/USD change. Moreover, rates of fuel tax,
The nominal amount is expressed in units of volume (metric tonnes) and forms the basis of calculation for settlement
VAT and the contribution margin do not remain stable over time (see www.mwv.de).
A symmetrical transaction with respect to its risk/return profile
Thus, the gross price only remains constant if unchanging fuel tax rates, VAT and contribution margins are entered.
Monthly settlement of the fixed-price is based on the market price applicable at the time of payment (generally the closing price). The market price is calculated as the average daily price in the relevant month (monthly average settlement price – MASP)
Fuel tax (incl. eco-tax)
Contribution margin
€ 0.4704
€ 0.15
Source: www.mwv.de, www.ebv-oil.de *includes e.g. costs for transport, storage, statutory reserves, administration, sales/gross margin as well as, since January 2007, costs for addition of biofuel components.
Oil, however, is not a single product, but rather a family of products with numerous types and grades. The same can be said for distillates such as diesel or light heating oil. There is no instrument available for precise hedging of pump prices. In order to hedge an underlying transaction (e.g. diesel purchase), a reference price index must first be calculated, which tracks as closely as possible the price fluctuations of the underlying transaction. Reference prices for diesel are 10 ppm ULSD (source: Platts) and/or ICE Gasoil (source: Intercontinental Exchange - ICE). In our example, we use ICE Gasoil, as it exhibits a closer correlation to pump prices, and because the prices, unlike Platts, are transparently available to the public on the market’s website. Fig. 3: Correlation Brent crude vs. ICE Gasoil 1400
Correlation = 98,7%
1200
Gasoil (USD/T)
1000 800 600 400 200 0 0
20
40
60 80 100 Brent (USD/bbl)
120
140
160
On the world market, diesel (= gasoil) is traded in USD per metric tonne (mt). 1 metric tonne = 1183 litres (a density of 0.850 kg/litre is generally assumed - so that 1mt = 1176 litres). In order to calculate an approximate EUR pump price, the EUR/USD exchange rate must also be taken into account. A commodity swap can be described as follows: A purely monetary transaction in which the amount paid is set off against the amount payable in the contract currency (“netting”)
The swap may have either a positive or a negative market value between the settlement date and maturity, depending on the movement of the reference price on the world market. The example does not take into account any markups by the banks.
Hedging transaction Transaction name Counterparty Settlement date Starting (payment) date Maturity Transaction details Price Volume Delivery frequency
Commodity-Swap 2Y BANK ABC 22 February 2009 27 February 2009 27 February 2011 507 USD/mt 100 Monthly
3 3
sals.a Educational Research - February 2009
After conclusion of the commodity swap, no significant changes take place in the financial management process. The purchasing department continues to take care of physical procurement under the best terms from different wholesalers (generally based on daily prices). The finance department concludes a (monetary) commodity swap with the bank upon consultation with the purchasing department. The swap volume is based
on the volume prescribed by the purchasing department. Thus, planning reliability is achieved with a high degree of flexibility in the underlying transaction. As a rule, banks are willing to enter into a swap starting with a minimum volume of 60mt/month. For smaller monthly volumes, pooling is an option. More information on such a solution is best obtained directly from the bank. .
4 3
Primer: Cross currency swaps, Part 2 http://www.kfpsalsa.com/login -> „Templates“ -> „Sample-Portfolios“
Cross currency swaps (CCS) offer a broad range of applications: A combination of newly concluded foreign currency financing transaction with a CCS allows hedging of payments in the home currency Companies that prepare their financial statements in accordance with IFRS can hedge income and/or expenditures in connection, e.g. with subsidiaries abroad, against exchange rate volatility using a CCS
The transaction parameters for the CCS are also available under sals.a-Templates -> Sample Portfolios
In the overview 1+2, the aim is to achieve a reduction in the effective interest rate. Bankers often refer to this structure as a "synthetic CHF loan”. Fig. 2: Graphical representation of CCS and loan
In currency management, the CCS is often used in lieu of long-term currency forwards
Final Exchange:
@ EUR/CHF=1.5713
2
A subsequent reduction (not risk-free!) of financing interest payments in the home currency through conversion to the lower foreign currency rate.
As the basis for an application-oriented risk/return analysis, we will use the CCS already introduced in the December issue of sals.a Educational Research: 1. 2.
Transaction parameters Loan in EUR
The hedged transaction is a fixed interest loan in EUR (4.5% p.a.) plus a CCS, under which the customer receives 4.5% (EUR) and pays 3.5% (CHF)
Fig. 1: Cross currency swap in sals.a
EUR/CHF cross currency swap Receive (EUR)
Pay (CHF)
1 000 000
1 000 000
1 571 300
Payment date
17 Dec 2008
17 Dec 2008
17 Dec 2008
Maturity
17 Dec 2018
17 Dec 2018
17 Dec 2018
Annually
Annually
Annually
4.50%
4.50%
3.50%
Nominal
Frequency Interest rate
Overview: EUR loan plus EUR/CHF CCS 2. EUR/CHF (fixed/fixed) CCS Receive (EUR) Pay (CHF) 45 000 -54 996 45 000 -54 996 45 000 -54 996 45 000 -54 996
1+2 converted to CHF -54 996 -54 996 -54 996 -54 996
1+2 converted to EUR* -36 269 -36 777 -37 278 -37 772
2013 -45 000 45 000 -54 996 2014 -45 000 45 000 -54 996 2015 -45 000 45 000 -54 996 2016 -45 000 45 000 -54 996 2017 -45 000 45 000 -54 996 2018 -1 045 000 1 045 000 -1 626 296
-54 996 -54 996 -54 996 -54 996 -54 996 -1 626 296
-38 187 -38 658 -39 141 -39 681 -40 236 -1 206 701
Period 2009 2010 2011 2012
2
The idea of interest-reduction can be misleading. In the overview below, this term is not meant to denote “risk-free reduction of interest payments”. In order to reduce interest payments in the overview, derivatives are used, which entails a separate risk. Thus, the initial temporary reduction in interest payments can lead to a significant increase in certain cases. It is absolutely necessary that this possibility be addressed in the consultation between the bank and the customer.
1. Loan in EUR -45 000 -45 000 -45 000 -45 000
*based on forward prices as at 17 December 2008
Four weeks after our initial article on cross currency swaps, a look at the derivative structure
sals.a Educational Research - February 2009
reveals a negative market value of EUR -75K. The EUR/CHF exchange rate (currently 1.5402 EUR/CHF) has its greatest impact on the final exchange amount, as a result of the nominal volume. Market value is calculated based on the currency forward rate applicable on the payment date (see figure 3). The average forward rates on 27 January are above the break-even threshold, and thus imply a negative market value. A cash flow-oriented break even analysis can be used as a simple means to demonstrate the currency risk. On 17 December, the swap was concluded at the exchange rate 1.5713 EUR/CHF. Based on the payments to be made in CHF at a fixed amount of CHF 55K p.a., it is obvious that more EUR per CHF must be paid in the event of a falling EUR/CHF exchange rate to service the agreed CHF coupon. In this case, a CHF interest rate advantage is overturned as soon as the EUR/CHF spot price falls below 1.4630 EUR/CHF (figure 3).
5
Fig. 4: Risk component analysis
Period
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Current payments in EUR
3
EUR scenarios Interest Interest +100 -100 bps bps
-36 269 -36 777 -37 278 -37 772 -38 187 -38 658 -39 141 -39 681 -40 236 -1 206 701
0 0 0 0 0 0 0 0 0 0
CHF scenarios Interest Interest +100 -100 bps bps
0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0
EUR/CHF scenarios Exchange Exchange rate rate +10% -10%
3 297 3 343 3 389 3 434 3 472 3 514 3 558 3 607 3 658 109 700
-4 030 -4 086 -4 142 -4 197 -4 243 -4 295 -4 349 -4 409 -4 471 -134 078
A risk component analysis makes clear the effect of the exchange rate on the payment advantage or disadvantage under the CCS (figure 4). During the term, both the interest payments in CHF and the exchange at the end of the term are subject to – virtually unlimited – currency risk. A 10% movement up or down in EUR/CHF results in the above changes in interest payments and the final exchange.
Fig. 3: Simplified currency analysis of the cross currency swap Historical EUR/CHF
EUR/CHF
EUR/CHF spot history from Jan 1997
Break even
1.7500 1.7000 1.6500 1.6000 1.5500 1.5000 1.4500 1.4000 1.3500 1.3000
EUR/CHF forward (17.12.2008) EUR/CHF forward (27.01.2009) EUR/CHF spot (27.01.2009)
Break-Even 1.4630
In the coming issue of sals.a Educational Research: Currency hedging with flexible forwards (forward hedging with exchange rate participation) Simplified generation of sample portfolios and reports Risk reports
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Disclaimer The information contained in this document by KFPD GmbH dies not constitute an offer for the purchase of securities, and is intended solely for informational purposes. In particular, the information contained herein contains no guarantees or other representations. KFPD GmbH makes no assurance and assumes no liability for the accuracy or completeness of the content. Information and data on interest rate swaps, interest rates, derivatives, currencies and markets, general or future market developments or any other statements about future possibilities reflect only the subjective views and/or assumptions of the author, based on the information available at the time. Any actions carried out on the basis of the methods depicted in this discussion paper are the sole responsibility of the customer. Neither this document nor any of its should be construed as advice relating to financial or any other matters. It should also not be used a substitute for professional advice. None of the contents may be construed as a recommendation to conclude or avoid certain transactions without obtaining prior advice that takes into account the individual situation of the customer. All current and back issues of sals.a Educational Research are available at http://www.kfpsalsa.com/research