Corporate hedging
Reducing long-term forex transaction
risk under volume uncertainty
Uncertain foreign cashflows bring along risks that cannot easily be hedged with common
forwards alone. Adding options to the hedge portfolio can help to manage these risks
effectively. By Huub van Capelleveen and Jan-Willem Wijckmans
L
arge companies increasingly experience the negative impact foreign exchange rates can have on their
financial results. Hedging these foreign exposures is therefore an important issue.
However, forex hedging is not usually carried out in an optimal way, especially when
the expected future cashflows within projects are uncertain and extend far into the
future. In this article, we will show that uncertain foreign cashflows can be hedged
effectively using a combination of forward
contracts on a foreign currency (forex forwards) and options. Provided the hedge is
adequate and monitored regularly, fluctuations in equity can be seriously reduced
and extreme risks can be more than halved,
against acceptable levels of costs.
In the past two years, many firms have
blamed the weakening dollar for a decline in profit or turnover. Large companies such as Volkswagen, Airbus and
Philips, among others, have experienced
a forex loss on profit arising from unhedged sales in dollar countries. More-
1. Hedged and unhedged net equity
distributions after 10 years
100
90
80
70
60
50
40
30
20
10
0
<
–
–2 2.5
to
–
–1 1.5
to
–0
.
0 5
to
0.
5
1
to
1.
5
2
to
2.
5
3
to
3.
4 5
to
4.
5
5
to
5.
5
Probability (%)
Unhedged
Hedged with forwards
× €m
Probability (%)
2. Hedged and unhedged net equity distribution
after one year
100
90
80
70
60
50
40
30
20
10
0
Unhedged
Hedged with forwards
2
1
.5
.5
0 .5
1 1.5 o 2
2
2.5 to – –1 to – –0 to
0
to
t
>=
< – 2.5 2 to 1.5 1 to –0.5 0 to 0.5 1 to 1.5
–
–
–
–
x €m
70
CREDIT RISK ● RISK JANUARY 2005 ● WWW.RISK.NET
over, some companies, such as Heineken,
Nokia and again Airbus (see also Rothman, 2004), have already announced that
the weakened dollar will keep affecting
returns, due to mere short-term hedges in
previous years1.
Companies with substantial revenues
in a foreign currency and whose production costs are mainly in the domestic currency, have several possibilities to reduce
their forex risk. The most common of these
solutions are conversion of contracts into
domestic currency or transferring the production abroad. In this article, another solution is considered: hedging the expected
foreign currency cashflows using forex
forwards in combination with options.
This solution is particularly relevant in
case future foreign currency sales prices
are fixed or when the forex risk is relatively large compared with net equity.
Accounting considerations
The forex risk for a company will increase
with the length of its foreign commitments.
If these are stretched out over multiple
years, the expected exposure to forex risk
may even exceed several times the annual turnover. Relative small changes in the
forex rates can have a huge impact on the
profit and solvency of those companies.
A well-known method for reducing the
forex risk with regard to future cashflows
is to enter into a series of forex forward
contracts that approximate the expected
cashflow. If all foreign cashflows are certain and hedged from the very outset with
forex forwards, the turnover in euro is perfectly stable and insensitive to forex fluctuations (see, for instance, Hull, 2003).
However, according to the new accounting rules of IFRS/IAS (see IASB, 2004), all
fluctuations in the market value of financial instruments need to be ‘on balance’.
Financial instruments for future cashflows
will therefore affect profit and loss and net
equity statements, since the future cashflows themselves will not yet be ‘on balance’. This introduces a serious threat to
1
See Volkswagen (2004), Airbus (2004), Philips
(2004), Heineken (2004) and Nokia (2004)
economically logic hedges (see also DeMarzo and Duffie, 1995). If cashflow hedge
accounting may be applied (see KPMG,
2004) the corresponding destabilising effect on the P&L can be mostly eliminated.
The effect on the net equity statement will,
however, remain. In the rest of this article,
we will assume that the company applies
cashflow hedge accounting.
Certain volume
We consider a Europe-based company
reporting in euro, which produces for the
US dollar industrial market. Contracts with
its customers typically have handling
times ranging between five and 15 years.
Production may take place during the entire length of the contract, and the endured costs are mainly in euro. Payments
occur every time a delivery is made,
against dollar prices that are contractually fixed at the beginning. Furthermore, we
assume for now that trade volumes are
also known at the beginning. This leaves
the company with known dollar cashflows during the length of the contract.
The company is, however, interested in
the net result of all projects in euro.
We simulate a simplified situation of
such a company with 10 identical projects.
Each project lasts for 10 years and generates a known cashflow of $100,000 a year.
The net margin at the outset of the projects is 15%. The investments take up
20–30% of total costs and are written down
linearly during the first five years of the
project. We assume the euro and dollar interest rates to be stochastic and to have
equal means in the long run, starting with
the actual levels of January 2004. Euro/dollar exchange rates are also stochastic.
With this model, we can show the difference between a strategy without hedging and one with hedging using forex
forwards. A good way to assess the return
on such a project at the outset is by looking at its expected contribution to net equity at the end of the project. All possible
net equity outcomes are summarised in figure 1. Without hedging, the profitability of
the total project portfolio is uncertain and
the probability of a loss is quite high. The
Corporate hedging
2 Throughout
Managing forex risk cannot be done without
simultaneously considering business risk. The
uncertainty of the expected future cashflows
should be incorporated in the hedge decision
Apart from the possibility of default of a
counterparty, most industrial sectors are
also subject to other volume uncertainty.
For long-lasting contracts, prices over the
entire production period are set at the beginning of the contract for every delivery. However, the exact amount of
products to be delivered in each year is
not agreed upon. This amount is determined by the counterparty and will depend on prevailing market conditions or
the specific delivery needs. The producing company is contractually bound to
the uncertain deliveries. These contracts
are quite common in, for example, the
aerospace, engineering, shipping and
petrochemical industries. When uncertainty about the actual demand increases, it becomes ineffective to hedge the
risks with forex forward contracts only
(see also Brown & Toft, 2002).
If all expected cashflows are 100%
hedged using forex forwards, there are two
factors that influence the result in euro: the
realised production and the future forex
forward rate.2 These two factors are de-
this article, by forex rate we actually mean the forex forward rate, which also contains the
risk of a change in spread between the dollar and euro interest rates. For long-term contracts, this
interest rate risk is as important as the forex spot risk if forex forward contracts are to be settled before
maturity.
3. Impact of hedging with forwards on the net
equity distribution after 10 years in case of a
possible default
Probability (%)
Other uncertainty in volumes
duction (whether by a default or
otherwise) and an appreciation of the dollar. Since production is less than expected, an overhedge in forex forward
contracts emerges, which need to be settled at a loss. This loss is added to already
lower profit due to lower production. In
case of a higher than expected production
and a depreciation of the dollar greater
than the profit margin of the project, the
unhedged production can generate a loss
that is greater than the profit of the hedged
production. This situation will occur more
often if profit margins are low.
Since the imperfect hedge consists of
linear products, it can also turn out to improve the final result. The imperfect part
of the forex hedge will have the same ef-
70% of scenarios without default
70
60
50
40
30
20
10
0
30% of scenarios
with default
Unhedged
Hedged with forwards
–5 < –
.2 5
–4 to .2
.4 –
–3 to 4.4
.6 –3
–2 to .6
.8 –2
–2 to .8
–1 to –2
.2 –1
–0 to .2
.4 –0
t .
0. o 0 4
4 .4
to
1. 1
2 .2
2 to 2
t
2. o 2
8 .8
3. to 3
6 .6
4. to
4 4.
to 4
>= 5.2
5.
2
viously, but with a 30% probability of default. In figure 3, the distribution of the
change in net equity over a period of 10
years is shown. If no default occurs, hedging will stabilise the total profit perfectly,
while not hedging will result in a highly
uncertain outcome. On the other hand, if
a default occurs, the loss in case of being
unhedged will be exactly the investment
costs, while being hedged will result, besides investment costs, in an extra risk on
the forex forwards. In this case the extreme risk is even enlarged due to hedging (see also Lidbark & Acar, 2003). Using
options instead of forex forwards can
truncate this risk quite well.
× €100,000
4. Possible consequences from deviating
production and forex rates, in case of a 100%
hedge with forex forwards
High
Until now, we assumed that the cashflows
to be received in the future were certain
cashflows. For relatively short contracts
(several months) this assumption can be
acceptable. For longer contracts, this assumption will increasingly be more questionable. Most cashflows are only certain
under the assumption that the customer
does not default or cancel the programme.
Often, a contract contains several clauses
that enable the customer to cancel the contract, for instance not meeting quality standards or the total project becoming
uneconomic for the customer. If a default
or cancellation occurs, projected ‘certain’
cashflows suddenly disappear. If all cashflows are 100% hedged using forex forwards, and one or more of these hedged
cashflows suddenly falls out, the forex for-
picted in figure 4. High and low production are relative to the expected production. An appreciated dollar refers to a
stronger dollar in comparison with the initial rate of the purchased forex forward contracts. Five distinctive situations have been
depicted inside, along with comments.
The worst situation stems from a combination of a lower than expected pro-
Production
expected
Default and cancellation risk
wards remain and need to be settled at the
then-prevailing appropriate forex forward
rate. The forex forward contracts can at that
time have negative market value for the
company. Instead of being fully hedged for
all forex risk, the company now suddenly
faces a loss on the forex forward contracts.
For explanatory purposes, we assume
only one single project, as discussed pre-
Low
hedged distribution shows the complete
certainty about the result, not dependent on
the levels of the euro/dollar rate over time.
The distribution of the net equity after
just one year (see figure 2) shows results
that stress the effect of the accounting
rules. Under the assumption of cashflow
hedge accounting, the annual profit and
loss distribution in our simulation is without risks. However, the net equity realisation after one year comprises not only
the one-year result of each hedged project, but also the value of the forex forward contracts for all subsequent years.
Through time, more forward contracts
are settled and thus are no longer subject to market risk. Therefore, the distribution of net equity in case of hedging
converges to the narrow distribution
shown in figure 1. The uncertainty about
the net equity in case of no hedging will
only get larger as time passes by.
Using forex forwards to hedge known
foreign cashflows is therefore very effective in order to reduce the uncertainty
about the project’s net equity contribution.
However, one should bear in mind that
this hedge increases the uncertainty about
reported figures on capital (see also DeMarzo & Duffie, 1995). If the possibility of
strong negative fluctuations in capital prevents the company from hedging, options
should be considered, even if there is no
uncertainty in volume. Replacing forex
forwards with options on forex forwards
will hedge the extreme risks in expected
return and profit and loss just as well, but
will limit the unfavourable slumps in capital. Later on, this will be shown for a case
with volume uncertainty.
Considerably higher production,
reinforced by positive result on
unhedged additional volume
Production higher than
expected, lower exchange rate
on unhedged additional volume
Lower production worsened
by overhedged forwards
Cancellation project strongly
worsened by extremely
overhedged forwards
Lower production, partly
compensated by currency result
on (overhedged) forwards
Dollar
Appreciation
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Depreciation
●
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Corporate hedging
fect as if the company had purchased
forex forwards as a speculation, ‘uncollateralised’ by some project result.
It is important to notice that managing
forex risks cannot be done without simultaneously considering business risk.
The uncertainty of the expected future
cashflows should be incorporated in the
currency hedge decision.
Options on forex forwards
To reduce the extreme risks associated
with a project, the strategic use of options together with forward contracts is a
good solution. The effect of replacing
forex forward contracts with options on
forex forward contracts, keeping the
hedge at 100% of expected exposure, is
30
25
20
15
10
5
0
Unhedged
Hedged with forwards
Hedged with options
–5
.6
<
–5
.
to 6
–5 –
.2 5.
2
–4 to –
.8 4.
to 8
–4 –4
.4 .4
–4 to –
to 4
–3 –
.6 3.6
–3 to –
.2 3.
t 2
–2 o –
.8 2.
to 8
–2 –2
.4 .4
t
–2 o –
to 2
–1 –
.6 1.6
to
–1
.2
Probability (%)
5. Left tail of the net equity distribution for a
hedge with options instead of forex forwards, in
case of a possible default
× €100,000
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
100% forwards - 0% options
0
.2
<
–0
<
–0
.4
.6
<
–0
8
<
<
–0
.
–1
<
.4
<
–1
<
<
–1
.2
70% forwards - 30% options
–1
.6
Probability (%)
6. Left tail of the cumulative probability
distributions of the NPV of the 30% option
strategy versus the 100% forward strategy
× €m
10
9
8
7
6
5
4
3
2
1
0
Unhedged
.7
5
–0
–1
<
.2
5
–1
Optimal hedge
To investigate the impact of volume uncertainty on the hedge strategy, stochas-
tic production scenarios are added to the
business case. The stochastic production
scenarios differ in both the number of
production units in each year, as in the
number of production years. Although in
every scenario future production volume
is uncertain, we assume the degree of uncertainty will decrease linearly as future
cashflows come nearer. For each project,
we assume a constant annual probability of default or cancellation of 3%.3 Production is set in such a manner that 90%
of the production scenarios is between
70% and 130% of expected production.
Based on expert judgement, the volumes of the different projects are expected to be 30% correlated. The volume
risk will be diversified for a portfolio, because low-volume performance of the
projects is not expected to occur for the
entire portfolio at the same time. The
forex risk, however, will not profit from
portfolio diversification because all projects are in the same currency. The diversification effect on the volume
uncertainty will therefore make the forex
risk more important. At the same time, the
optimal hedge strategy will require less
than 100% options, as it would have on
a single contract basis, making the hedge
strategy more effective.
We compare the strategies including
options with the 100% forex forward strategy by means of several value-at-risk measures4 of the net present value (NPV) of
the expected future cashflows. Since not
all projects in the portfolio have the same
duration, NPV seems a more approriate
measure than net equity after 10 or 15
years, although they give comparable results. The probability of a result less than
–€540.000 for the 100% forex forward
strategy is exactly 1%. The 2.5% and 5%
VAR levels are respectively –€185.000 and
€110,000. For several option strategies,
table A gives information about the probability of crossing these VAR levels.
From table A, we see that replacing part
A. Probabilities for different option strategies of making at least
an equal loss as under the 100% forex forward strategy,
including option costs
Forwards
Options
Prob (NPV <
–€540,000)
Prob (NPV <
–€185,000)
Prob (NPV <
€110,000)
Cost of
options
100%
0%
1%
2.5%
5%
-
90%
10%
0.70%
1.90%
4.10%
7.25bp
80%
20%
0.50%
1.80%
4.00%
14.50bp
70%
30%
0.40%
1.50%
4.20%
21.75bp
60%
40%
0.40%
1.20%
4.30%
29.00bp
50%
50%
0.30%
1.10%
5.70%
36.25bp
40%
60%
0.10%
1.50%
7.00%
43.50bp
<
× €m
<
<
–1
.5
.7
5
–1
<
–2
–2
<
–2
<
72
<
.2
5
100% forwards - 0% options
70% forwards - 30% options
.5
Probability (%)
7. Left tail of the cumulative probability
distribution of the equity capital, unhedged,
hedged with FX forwards only and hedged with
FX forwards and options, after five years
that the company can still find itself overhedged, but this overhedge can never
have negative market value. Therefore
the loss on the overhedge is limited to
the option premium.
To illustrate the impact of using options
for a situation with only default or cancellation risk, we focus on the realisations of
the default case. If the forex risk is hedged
with options instead of forwards, the possible loss on the hedge instruments is truncated to the premium of the options plus
the investment costs, as is shown in figure
5. Note that the case considered consists
of only a single contract, so the optimal
amount of options in this case is the entire 100% of expected exposure. In a portfolio context, as will be demonstrated later,
the optimal amount of options will typically be far less than 100%.
Replacing part of the forex forwards by
options on forex forwards also works quite
well in the other situations. In case of a
weakening dollar, the options are in-themoney and will act as forex forwards, giving the original 100% forward hedge. In
case of an appreciating dollar and a higher production the situation even improves,
because the loss on forex forwards is avoided and replaced by the option premium.
It is not necessary to hedge exactly
100% of the expected exposure. If the risks
of overproduction are considered too
great, for example due to extremely low
profit margins, a situation with a depreciated dollar and a higher than expected production can also impose a serious threat
on the profitability of the company. Besides replacing forwards with options it
could then be wise to also add options on
forex forwards, thus hedging more than
100% of the expected exposure. For simplicity, we will for now merely discuss
100% hedging strategies.
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Corporate hedging
of the forex forwards with options reduces
the risk significantly. Especially the extreme risks (1% VAR), where the strategies
with the highest option allocations show
the best reductions. It is difficult to point
out what the ‘optimal’ option strategy is.
This depends (among other things) on the
risk appetite of the company.
In the last column, the cost of the option strategy is shown, expressed as a number of basis points over the total turnover.
The costs of options are not equal to the
option premium paid upfront, but the difference between this option premium and
the expected payout of the option. In our
case, the cost of options is reflected by the
difference in expected NPV between a strategy with forex forwards and options, and
a strategy with an equal amount of forex
forwards but excluding the options. For a
strategy with 30% options, the costs amount
to roughly €2 per $1,000 turnover. Under
common risk-return considerations, these
costs seem relatively small for the achieved
reductions in risk.
In figure 6, the worst possible realisations of the NPV probability distribution
of both the 100% forex forward strategy
and the strategy with 70% forex forwards
and 30% options are shown. Adding options to the forex forwards reduces the
extreme forex risks quite well. The probability on a loss is substantially reduced.
More important is that the probabilities
on extreme losses are nearly vaporised.
The expected NPV of the projects is
€986,000 in case of a 100% forex forward
hedge and €973,789 in case of the forward and option strategy. The cost of the
tailor-made hedge with respect to the imperfect 100% forex forward hedge is the
difference in NPV. In profit terms, the
costs amount to approximately 1.25% of
expected profit.
Replacing forex forwards with options
on forex forwards also reduces the probability on a very negative value of all the
hedge instruments on any given moment.
Since this value is incorporated in the balance sheet (and the future dollar turnover
they are hedging is not), the risks of an extreme negative impact on the equity capital are also strongly reduced. Figure 7 shows
the undesired effect the hedge instruments
can have on the balance sheet for the strategy with only forex forwards. It also shows
the effect for the strategy with 30% of the
3 These
probabilities comprise default
probabilities that increase over time, for example,
based on credit ratings (see also Keenan,
Hamilton and Berthault, 2000), and often hard
to estimate probabilities of cancellation that
normally decrease over time, for example, based
on improving efficiency and experience
4 For more information about the advantages of
using the VAR measure, we refer to Jorion (1996)
forex forwards replaced by options. The expected equity after this period of five years
is approximately €770,000. Clearly, the options also substantially improve the extreme
negative impact on the equity capital.
We already mentioned the impact of
the profit margin for a hedged situation.
Low profit margins mean a strengthening
dollar can also become unfavourable.
When the initial profit margin is only
about 5%, instead of the 15% assumed
previously, the 100% hedging strategies
are no longer sufficient to effectively cope
with the risks of a strengthening dollar.
Optimal strategies now hedge between
110% and 120% of expected production.
The optimal amount of forex forwards remains fairly stable, so the extra hedging
volume comprises only options. Other
important project characteristics are
default risk and investments. Portfolios
consisting of projects with higher default
risks or larger investments will have more
options in their optimal hedging strategy.
Although, in practice, most companies
will decide not to hedge if default probabilities are 50% or more, a hedge of 100%
options can still reduce unacceptable
forex risks in case of no default.
ance statement) will exhibit risk reduction.
Strong profit and loss movements can be
eliminated by performing hedge accounting, strong movements in equity capital
cannot. To limit the unfavourable movements in equity capital, options can be
used even in a case without uncertainty.
Hedging forex risk becomes increasingly difficult with an uncertain foreign exposure. Simple solutions involving only linear
hedging products such as forex forwards
are no longer able to provide the desired
risk reduction. Hedging with only forex forwards can even increase the extreme risks.
Hedging by combining both forex forwards and options can seriously reduce
forex transaction risks for a company with
uncertain foreign exposure. Not only does
the economical hedge improve, but also
so do the short-term capital equity risks.
The strong risk reductions seem to outweigh the relative small costs.
The optimal strategic solution with
derivatives depends on the structure of
the underlying projects (profit margin,
default risk and/or fixed costs). Since, for
a given company, this structure is usually not very inconstant through time on a
portfolio level, the solution will turn out
to be quite stable. ■
Conclusions
Forex risk should be managed in combination with business risk. Hedging forex
risk based on deterministic expectations
of future cashflows can lead to ineffecient
and even risk-enlarging strategies.
Hedging forex risk is relatively straightforward when there is little or no uncertainty about the exposure. It is important,
however, to realise that not every measure
(such as one-year profit and loss or bal-
Huub van Capelleveen is research director and Jan-Willem Wijckmans is ALM
consultant at Cardano Risk Management
(www.cardano-riskmanagement.com).
Cardano is a Rotterdam-based company
that develops active tailor-made risk
management strategies. Its emphasis is
on reducing undesirable risks in a cost-efficient and transparent manner through
the strategic use of derivatives
References
Airbus, 2004
EADS annual report 2003
http://www.reports.eads.net/eads/ar_2003_en/pdf/book2.pdf
Brown G and K Toft, 2002
How firms should hedge
Review of Financial Studies 15, pages 1,283–1,324
DeMarzo P and D Duffie, 1995
Corporate incentives for hedging and hedge accounting
Review of Financial Studies 8, pages 743–771
Heineken, 2004
Annual report 2003
http://www.heinekeninternational.com/images/HHUK_annual%20report_tcm4-9998.pdf
Hull J, 2003
Options, futures and other derivatives
Prentice Hall, fifth edition
IASB
2004 international financial reporting standards (bound
volume)
ISBN 1-9042330-44-X
Jorion P, 1996
Value at risk: the new benchmark for controlling
market risks
Irwin Professionals
Keenan C, D Hamilton and A Berthault, 2000
Historical default rates of corporate bond issuers,
1920–1999
Moody’s Special Comment, January
KPMG, 2004
Financial instruments accounting
http://www.kpmg.co.uk/pubs/beforepdf.cfm?PubID=866#
Lidbark J and E Acar, 2003
Hedging stochastic cashflows: a driving issue
Risk October, pages 53–55
Nokia, 2004
Annual report 2003
http://www.nokia.com/agm/pdf/ann_acc_2003.pdf
Philips, 2004
Annual report 2003
http://jaarverslag.info/home/philips/$File/PHILIPS_Financial
Statements_2003_EN.pdf
Rothman, A, 2004
Airbus faces turbulent year as the dollar declines
International Herald Tribune, January 9, see also
http://www.iht.com/articles/124260.html
Volkswagen, 2004
Annual report 2003
http://www.volkswagen-ir.de/fileadmin/vwir2/dokumente/berichte/2003/20040309_gb2003_e.pdf
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