sals.a Educational Research June 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 trial subscription. It pays to know!
This issue focuses on the topics: Risk management in times of crisis Public-sector interest rate management – exclusive report Currency hedging – to option, or not to option? Half-time Report: Educational Research put to the test
KFPD GmbH An der Welle 4 60322 Frankfurt Germany Managing Director: Mr. Lauri Karp Telephone: +49-(0)69-7593 7732 E-mail: service@kfpsalsa.com Frankfurt Local Court HRB 81098 USt-ID: DE 256618623
Risk management in times of crisis www.kfpsalsa.com/news
The financial crisis has propelled the topic of risk management into the spotlight. Spectacular examples of poor risk management in the financial sector have created doubt among many companies as to the effectiveness of modern financial instruments. At owner-operated companies, the focus of conservative financial management is not on short-term share prices, but on the achievement of stable cash flows. Such stability has become increasingly important and challenging in the wake of the global economic crisis, giving rise to the fundamental question: Do companies need to focus even more on risk management or does a wait-and-see approach make more sense given the lack of sales visibility? Everyone is at risk, risk is simply an unavoidable part of every business. At its most basic, risk management refers either to operational measures or hedging transactions using financial instruments (or a combination of the two). The former includes elements such as passing on price risks, price escalation clauses, relocation of operations or substitution of raw materials in order to protect cash flow profits from undesirable changes. On the other side of the risk management coin are non-securitised transactions such as forward contracts or options. Such derivatives have established themselves as standard instruments for financial risk management over the past 25+ years. The decline in minimum volumes for such products to EUR 250,000 highlights their suitability for broad and direct application for hedging of exchange rates, interest rates or commodity prices. The view often expressed in the media that the use of financial instruments is a speculative practice fails to look at the entire picture. Hedging means that a “speculative” underlying
transaction (e.g. the purchase of diesel fuel) is matched with a “speculative” financial instrument, providing a mutual offsetting effect which results in something “non-speculative”. Only in the absence of the corresponding underlying transaction can isolated use of financial instruments be deemed speculation. In the vast majority of cases however, companies are using such instruments for hedging of an underlying transaction. Operational measures alone do not suffice. The financial crisis has clearly shown that a purely operational approach to risk management does not provide absolute planning reliability in cash flows. Companies that invoice exclusively in their domestic currency can observe that even domestically manufactured products are being offered within their own countries at a lower price after taking a detour through countries with depreciated currencies. For their part, companies in these other countries are increasingly demanding price reductions or pushing for price renegotiations, as domestic currency invoicing means increased costs for the customer as a result of the exchange rate difference. Furthermore, the traditional fixed-price contract in raw materials procurement is no longer "risk-free" either. The more fluctuation there is in sales and the more customers are lost in the process, the greater is the risk represented by contractually agreed purchase commitments. A separation of ongoing procurement from price risk management is often the solution of choice in this case. Adaptability and a long-term planning horizon for the business activities of owner-operated companies should also apply to risk management. When it comes to practical application, the flexibility of financial instruments offers valuable benefits, especially in volatile times.
Disclaimer The information contained in this document by KFPD GmbH does 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 contents. 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 contents should be construed as advice relating to financial or any other matters. It should also not be considered a substitute for professional advice. None of the contents should be construed as a recommendation to conclude or refrain from concluding specific transactions without prior professional consultation that takes into account the requirements of the customer.
sals.a Educational Research - June 2009
Public-sector interest rate management – exclusive report The largest-ever survey of German municipalities on the topic of modern debt and interest rate management is now complete. More than 220 municipal bodies took part in this important study, the results of which are currently being analysed by the Institute of PublicSector Finances and Public Management at the University of Leipzig (under the supervision of Prof. Thomas Lenk and Oliver Rottmann (Dipl.-Vw.)). The final study report will be published in June. As part of its support for this project, sals.a posed the following two questions from the survey to the th participants at the 6 Salzgitter-Congress for Municipal Finance:
Which statements do you associate with the topic of active debt management? 0.0%
mehr Kalkulationssicherheit Greater planning reliability
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
24.8%
2.3% 3.1%
40.4% 43.2% 43.8%
Zinslast senken Reduction of interest rate burden 5.0%
Spekulation Speculation
13.6%
21.9% 24.2%
Attractive borrowing conditions attraktive Kreditkonditionen
28.1%
31.8%
2.2% 0.0% 3.1%
unnötiger Unnecessary administrative burden Verwaltungsaufwand
3.4%
Other Sonstiges
9.1%
0.0%
Salzgitter Congress 1stWS workshop Kongress 1.
Umfrage UniversityUni of Leipzig survey
Salzgitter Kongress Congress 2. 2ndWS workshop
Which implementation-related topics are most relevant in your experience with interest rate management? 0.0%
5.0%
10.0%
15.0%
20.0%
30.0% 26.2%
Intransparenz der Non-transparence of the financial Finanzinstrumente instruments
21.1% 5.9%
keine ausführliche Beratung No comprehensive consultation Gesetzgebung und Unclear unklare legislation and regulation Vorschriften Human resource availability/capacity personelle Ausstattung und and training Weiterbildung
2.1%
23.3%
4.3%
Software support and portfolio Softwareunterstützung für analysis die Abbildung, Analyse und…
25.5%
31.6%
6.4% 7.9% 10.6% 10.5%
0.0% 0.0%
29.8%
15.4% 15.8%
10.6%
Accounting Bilanzierung
35.0%
17.0%
7.9% 6.6% 5.3%
neutrale bankenunabhängige Neutral, bank-specific monitoring Kontrolle/Überwachung
Other Sonstiges
25.0%
13.2%
2.9%
Umfrage Uni University of Leipzig Leipzig survey
Salzgitter Kongress Congress 1. 1stWS workshop
Salzgitter Salzgitter Kongress Congress 2. 2ndWS workshop
In this comprehensive studyyou can also expect sample solutions and practical tips for some of the problems cited by the study participants.
Are you interested in receiving the study report from the University along with further information? Please register here (in German only) and we will send you the study as soon as it is published, as well as the sals.a sample solutions and practical tips, free-of-charge and with no obligation.
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sals.a Educational Research - June 2009
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Currency hedging – to option, or not to option? www.kfpsalsa.com/try -> “Educational Research” -> Sample portfolio “Cross currency swap”.
Since September 2008, importers and exporters have been experiencing a roller coaster ride on global currency markets. In past issues of Educational Research, we have discussed the role of direct and indirect currency risks. Indirect risks are those difficult-to-identify and unpredictable risk components that arise when shifts in currency relationships impact the amount represented by orders and sales.
3.
The job of the sals.a team is to describe the baseline situation. The Department of Mathematical Finance at our partner university will then carry out the methodological and statistical analysis. This includes both back testing and simulation methods. The results will be published jointly here in Educational Research, with practical examples made available by sals.a.
This occurs, for instance, when a German producer issues invoices in euro, while the customer in Poland experiences an increase in import prices as a result of weakness in his domestic currency, the zloty, and therefore pushes for renegotiation of the delivery terms. In May 2009, we began a multimonth study, with the support of university researchers, to answer the following three questions: 1. 2.
In the case of more than 6 currencies within a company – what is the role of correlation in setting hedging policy?
Description of the status quo: The high volatility of forex markets makes option premiums relatively expensive. Does the higher premium compensate for the observed fluctuations in currency exchange rates? Two alternatives will be examined:
When does it make economic sense to hedge using currency options?
1.
Ongoing, order-specific hedging (monthly) – green line
2.
General price hedging – one price for monthly exchange transactions over a one-year term (01 Jan – 31 Dec) – red line
Which hedging approach is most suitable for small to medium-sized companies?
Order-specific vs. general price hedging with forwards
Order-specific vs. general price hedging with options 1.5500
EUR/USD rate
1.5000 1.4500
1.6000
Spot Kasse Order-specific hedging Auftragsbezogen
1.5500 1.5000
Bodensatz General price hedging
EUR/USD FX rate
1.6000
1.4500
Spot Kasse Auftragsbezogen Order-specific hedging Bodensatz General price hedging
1.4000
1.4000
1.3500
1.3500
1.3000
1.3000 1.2500
1.2500
1.2000
1.2000
1.1500
1.1500
Average exchange rates under the different hedging strategies 2006 - 2008
2006
2007
2008
No action
1.2512
1.3651
Strategy 1 Option – order-specific
1.2475
Strategy 2 Option – general price hedge
1.2323
Strategy 1 Forward – order-specific
1.2426
1.3546
1.4689
Strategy 2 Forward – general price hedge
1.2090
1.3344
1.4718
Nominal
1 000 000
Position
Receive USD
1.4543
Trading day
10 Dec 2007
1.3602
1.4619
Initial Exchange
10 Jan 2008
Final Exchange
10 Dec 2008
1.3508
1.4598
Exchange Frequency
monthly
Date
Volume
Analysis shows that a general price hedging strategy based on forward contacts is the better solution in years of limited volatility. In more volatile times, longer option strategies do better relative to conventional forwards.
Call for participants! Companies or banks that are interested in this project are welcome to submit their suggestions, practical experiences or current challenges to us until 30 June 2009 at service@kfpsalsa.com.
sals.a Educational Research - June 2009
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Halftime Report: Educational Research put to the test sals.a Educational Research was launched in the fall of 2008. Since then, we have gathered and published a wealth of information on interest rates, currencies and commodities. Our readers have been asking whether our solutions are proving effective in practice. And we are more than happy to illustrate the following answers to this question:
Start date Description
Current trend Comments
Interest rates
Interest rates
Commodities
Currencies
Investment + Swap
Financing + CCS
Diesel + Swap
Export + Forward + Option
07 Nov 2008
Dec 2008
22 Feb 2009
23 Mar 2009
Enhancement of a fixed-term deposit investment with a receiver swap at 3.8%; 5-year term
Optimisation of EUR fixed-rate financing with a EUR/CHF cross currency swap at 1.5713 (receive EUR 4.5%; pay CHF 3.5%)
Hedging of monthly diesel purchases with a gasoil swap at 507 USD/mt; 2-year term
Hedging of monthly exports with a combination of a EUR/USD forward transaction at 1.3000 and purchase of a EUR put option at 1.2600
Rapid ECB interest rate cuts pushed the overall yield curve lower
Strengthening of CHF against EUR results in a negative mark-tomarket for the CC swap of approx. -4%
An uptrend in the oil price towards USD 60/bbl pushing diesel prices higher
No visible trend. Keep reading the “Weekend” section of the paper; the “Business” section still has no answers on this
Next check
August 2009
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Disclaimer The information contained in this document by KFPD GmbH does 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 contents. 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 contents should be construed as advice relating to financial or any other matters. It should also not be considered a substitute for professional advice. None of the contents should be construed as a recommendation to conclude or refrain from concluding specific transactions without prior professional consultation that takes into account the requirements of the customer. All issues of our Educational Research are available at http://www.kfpsalsa.com/research