sals.a Educational Research

sals.a Educational Research - April 2009

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bApril 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're not yet a sals.a customer, you can register for a free 4- week test subscription. It pays to know!

This issue focuses on the topics And the Nobel Prize goes to ... Karl Marx? Currency management with financial instruments during the crisis

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

And the Nobel Prize goes to ... Karl Marx? www.kfpsalsa.com/news

The media world recently celebrated its stars at the Oscars. Is there a comparable event in the business community? Did the Nobel Prize for Economics go to the wrong person last year? Today, the main tenets of Paul Krugman’s economic theories seem completely alien: International everyone

trade

longer a taboo subject. And the discussion about protectionism kindles old memories of the era before European integration. In the midst of all these headlines, some facts are ignored: for instance that Paul Krugman has correctly explained the reasons behind currency risks over the past several years and that he was one of the first to warn of a real estate bubble in the USA.

benefits

“Economies of scale” generate advantages (example auto industry) Implementation of government industrial policies is misguided; globalisation should be left to happen without intervention Would Karl Marx and John Maynard Keynes be more deserving of a posthumous Prize this year? A fair argument could be made. The world has never seen fiscal measures to the extent currently being proclaimed throughout the globe. Even in the motherland of free markets, bank nationalisation is no

There is an exception to every rule. We are currently suffering from the most extreme example of this – several markets are no longer able to function without government intervention. But, this does not justify a call to shift the paradigm towards a permanent “more government” solution. “Some people call for change and secretly hope that others will stop it from happening.” [Pavel Kosorin] L.K.

Currency management with financial instruments during the crisis http://www.kfpsalsa.com/login -> Market data -> „FX“ & „Templates“ -> „Sample portfolios“

Figure 1: Reuters-FX forecast EUR/USD 1.6500 1.5500 1.4500 EUR/USD

Since 2008, the currencies of the world have been on a veritable rollercoaster ride. A look at the forecasts being used by the professional players in the market shows the current lack of consensus and that anything is possible. For the next 12 months, the highest projections put the EUR/USD exchange rate at 1.6000, while the lowest come in at 1.0750. Consistent with this, the medium-term forecast lies precisely in the middle, although there are certainly no expectations that exchange rate developments will be smooth!

1.3500 1.2500 1.1500 1.0500

Historical EUR/USD Minimum forecast Maximum forecast Forecast median Market

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 - April 2009 Since interest rates are at similar levels in the US and the euro area, the spread cannot be used as a significant indicator for future rate movements (current rule of thumb: spot = forward)1. It is often said nowadays that exchange rates increase arithmetically, but fall geometrically2 (figure 2). This asymmetry in exchange rate developments is among the most difficult factors to predict. Figure 2: Plot – arithmetically rising and geometrically falling exchange rates (USD/CHF).

there as well. Waiting and hoping for “better conditions”, however, is more than just prudent caution – it’s speculation. Companies are not only faced with the erratic swings of the forex markets, there are real economic factors at play as well, like: Bankruptcies of suppliers or clients; to be found, e.g. in the automobile and mechanical engineering industries Forecastability of sales; fall-off in exports by 2040% in some regions & sectors; elimination of production capacities

1.2500

1.2000

Relative competitiveness; The currencies of countries on all sides of the euro area are on a downward slide

1.1500

1.1000

The idea that “crises call for new approaches” is certainly valid in this context. A return to conventional home currency invoicing or simply hoping for better conditions (i.e. doing nothing) is no alternative.

1.0500

1.0000

So, what are the “new approaches” in light of the current situation? With all of the uncertainty out there, however, the markets may not permit the common approach that says “we have to take our time with this,” or “in a few days, I’ll talk over some ideas with the bank”. Figure 3 clearly shows that the EUR/USD exchange rate in 2008 statistically underwent changes of +/- 200 points in a matter of days (e.g. 1.3000 → 1.3200). One year previous (blue), the probability of this was substantially lower. Figure 3: How many days did it take for a statistical change of 200 points? (Probability of EUR/USD +/- 200 pip change 2007 vs. 2008) 100.0%

97.3%

100.0%

100.0% 94.3%

Hedging is a virtue! Not only concrete solutions in the form of currency forwards should be taken into account, but also incorporation of participation (= return potential) Longer maturities (in excess of 9 months), for strategic reasons, beginning on 1 January if possible. Below is an example that will hopefully make the process more clear:

Hedged transaction Transaction name

Exports to the US Ongoing transaction

Volume

USD 1 million / month

Timing

23rd of each month

Term

1 year

90.0%

2007

80.0%

2008

70.0% Probability

68.6% 59.2%

60.0% 50.0%

The monthly volume of USD 1 million is the continuous base amount. Any so-called “peaks” that exceed the base amount are either left open, in the case of minimal volumes, or hedged short-term via forwards or options.

41.0% 35.1%

40.0% 30.0% 20.0% 10.0%

6.5% 0.8%

0.0% Intraday

More than intraday

More than 1 week

More than 2 weeks

More than 1 month

Consequently, anyone putting off hedging transactions can end up being penalized with an unfavourable rate. Of course, the volatility also represents an opportunity, and not everyone is an exporter, there are importers out 1 Some experts consider fundamentals (GDP, stimulus programmes, bank recapitalisation etc.) to be more significant indicators. 2 The Economist 22 January 2009: “In 2007 Dick Fuld, the former head of Lehman Brothers, observed that whereas credit grows arithmetically, it shrinks geometrically. Much to his cost, he was later proved right.”

In the case of order-specific transactions, a longer-term hedge overlay may also be taken into consideration. Often, an aggregated base amount can be calculated on the basis of several orders (e.g. in the steel, mechanical engineering industries). Derivatives can be used as a supplement to bring forward or postpone a hedging transaction, which also serves to increase flexibility in this context.

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sals.a Educational Research - April 2009 What about an example using actual figures?

In sals.a, the hedged transaction (Exports to the US) is captured using the menu item “FX Free-Cash-Flow”: Without hedging, the current (as per 23.3.2009) monthly receipt of USD 1 million equates to the EUR sum in the column “Amount Currency2”.

This strategy comprising transactions 1 & 2 is not cost neutral: As can be seen in the “NPV 1” fields, the net present value of the two transactions results in a premium of [EUR -167,549 + 430,476 =] approx. EUR 263,000. The premium is payable by the customer up front for this hedging solution. In order to flexibly hedge this transaction, two financial instruments are now used: 1) A forward currency transaction (hedge): sale of USD 1 million/month at a fixed rate of 1.3000

Hedging transaction Transaction name Starting (purchase) date Maturity Price Volume Frequency

Forward currency sale USD 23 March 2009 23 February 2010 1.3000 USD 1.0 million Monthly

The key to calculating the premium is the option volatility, which increases in line with quoted volatility (implicit volatility) on the market. In summary: Without hedging, the exporter has no planning reliability, since the EUR/USD exchange rate (based on the forecasts) can move within a range of 1.6000 to 1.0750. Figure 4A shows the potential risks and rewards of exchange rate movements without hedging. The brown line indicates the maximum and minimum forecast values from the latest Reuters poll. Figure 4: Situation prior to (A) and after (B) hedging 1.6500 1.6000 1.5500 1.5000 1.4500 1.4000 1.3500 1.3000 1.2500 1.2000 1.1500 1.1000 1.0500

A Historical EUR/USD Minimum forecast Maximum forecast Median forecast Market

Figure 4B: Situation after hedging

2) Purchase of a EUR/USD put option (participation in the falling EUR/USD exchange rate): the option to buy USD 1 million monthly at a rate of 1.2600

1.6500 1.6000 1.5500 1.5000 1.4500 1.4000 1.3500 1.3000 1.2500 1.2000 1.1500 1.1000 1.0500

Option contract Transaction name Start date Maturity Price Volume Payment dates

EUR Put Option 23 March 2009 23 Febrary 2010 1.2600 USD 1.0 million Monthly

Figure 4B illustrates the maximum exchange rate risk spread after flexible hedging with integrated participation. The exporter has reduced the maximum risk from foreign currency payments to a corridor between the option price (1,2600) and 1,3000 (red area).

sals.a Educational Research - April 2009 Various exchange rate development scenarios: 1)

The exporter is protected in the EUR/USD rate P/L 1.6500 -2,239,758 case of market rates above 1.3000: If the exchange rate for 1.6000 -2,012,485 EUR/USD is, e.g. at 1.3800 on the 1.5500 -1,770,550 payment date, the effective Maximum -1,567,410 exchange for the customer is 1.5000 -1,512,485 1.3000. 1.4500 -1,236,623 As long as the EUR/USD rate is 1.4000 -941,057 within the corridor on the 1.3500 -623,596 payment date, the forward rate 1.3000 -281,716 of 1.3000 applies for the 1.2615 0 exchange – which is roughly 240 Median 22,980 points higher than the current 1.2500 87,515 market rate. 1.2000 487,515 If the rate is below 1.2600 on the 1.1500 922,297 payment date, the participation Minimum 947,991 takes over. The participation was 1.1000 1,396,606 acquired (= purchase of EUR put 1.0500 1,916,086 option@1.2600) through 1.0000 2,487,515 forfeiture of the forward market rate starting at 1.3000 and payment of an upfront premium. The buyer, however, does not benefit 100% from a lower market rate. If the rate is, e.g. 1.2200, the following final rate applies for the customer: [1.3000] minus [option proceeds (1.2600 – 1.2200) = 400 points] = 1.2600

In practice, the parameters for the hedging solution can be approached as set out below: The exporter should ask the question, “What is the maximum amount in EUR that am I willing to lose from currency translation in one year?” This figure (usually relatively small) is equated to an exchange rate. For the planned hedging transactions, this serves as a worst case or reference level. The exchange can be calculated as follows: On the basis of the forecast rates (minimum, maximum, median forecasts and rates in between) we determine the monthly upward/downward movements in comparison to the initial rate (spot price). The monthly sub-totals are added together, in order to generate an isolated scenario for the impact on profit and loss for one year. The scenario results (12-month observation) can thus be assigned to the correct exchange rate level (see adjacent table) If the exporter is willing to accept, e.g. a maximum loss of approx. EUR 280k, this equates to a hedging level of EUR/USD 1.3000.

Based on the above example, practical alternatives can be structured with lower premium payments or without additional payments. The table below shows three possible alternatives: Possible alternatives for currency hedging with participation Alternative I

Alternative II

Alternative III

Full participation (against payment of a premium, above example, here beginning at 1.2600)

Neutral premium, partial participation (here starting at 1.2600)

Neutral premium, gradual building of participation

Participation in “rate improvements” below the corridor for the entire forex sum

e.g. purchase of EUR put option for 50% of the forex sum, instead of full participation in above example

e.g. participation in 10% of the sum during the first three months and an additional 10% per month up to 100% in the final month

Ultimately, a consultation between the customer and a bank is required to determine the optimum solution. This should include a clarification of the changes in market value under the various structures. In the second two alternatives, the customer comes very close to the postulated premium-neutral hedging with participation. These long-term flexible hedging strategies can be summarized under the heading “hedging volatility peaks without forfeiting market rate opportunities”. Figure 6: Long-term flexible hedging

Time

The red line depicts the worst case hedge. The green areas indicate the participation range. The right selection of currency scenarios enables a meaningful simulation of potential risks and rewards from currency positions. A reasonable question in this context however, is: What does such a scenario entail? This is the topic of our next issue in May.

Currency hedging with flexible forwards (forward hedging with exchange rate participation) Simulation of exchange rate scenarios IAS/IFRS hedge accounting

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Forward contract with hedge effect at 1.3000 and participation

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