Foreign Exchange Currency Risk

Financial Management Foreign Exchange Risk Analysis Assignment submitted by: CURRENCY EXPOSURE A currency exposure is any business operation whose profitability can be impacted by a currency exchange rate fluctuation. Currency exposures assume many forms: they can be assets or liabilities; current or committed; contracted or merely forecast; they can be for trade, investment or balance sheet purposes. Cases of currency exposure can emerge at any point along the value chain, with various repercussions. Each requires a transfer of funds, and for each the rate of exchange is uncertain.

Examples of different types of currency exposures are presented below. FIGURE 1: CURRENCY EXPOSURES ACROSS THE VALUE CHAIN Project planners calculate profitability based upon competitiveness in the target market. Thereafter, a competitor in a third country benefits from favorable exchange rates between its currency and the currency of the target market. The exchange gap makes the competitor’s product more competitive. The product loses market share and ceases to be profitable. Product manufacture relies on components or machinery purchased in foreign-denominated currency.

A shift in exchange rates renders these purchases more expensive—in terms of home-country currency—and the product loses profitability. |Development |Manufacture |Marketing |Sale |Accounting & | | | | | | |Reporting | | | | | | | | | An unfavorable exchange rate movement renders products relatively more expensive in terms of the foreign currency.

The vendor must either maintain the nominal price level— at the risk of losing market share—or lower prices and erode the profit margin. Any adverse exchange rate movement that takes place between the times of price quote, bid offer, sale confirmation, invoice receipt or payment deposit may render the sale undesirable, unprofitable or void. A foreign subsidiary may post a satisfactory profit in terms of its base currency, however a negative exchange rate movement makes these figures less impressive upon profit repatriation.

While this is a superficial incident, it may strongly impact stakeholder opinion or debt repayment schedules. TYPES OF CURRENCY EXPOSURE The currency exposures presented on the previously can be classified into three categories, according to the type of activity they impact. The three types of currency exposure are as follows: • Transaction Exposure—Vulnerability to exchange rate movements between the base currency and a foreign currency in the course of trading • Translation Exposure—Vulnerability to exchange rate movements between the base currency and a foreign currency in the course of accounting Economic Exposure—Vulnerability to exchange rate movements between two foreign currencies, or vulnerability resulting from indirect effects on product competitiveness Transaction Exposure A transaction exposure is an exchange of goods between two currencies. Such an exchange presents the risk that, during the delay between planning the necessary currency exchange and executing it, the rate of exchange might change. The source of vulnerability of a transaction exposure is the time lapse between the point of pricing and the actual point of currency transaction (i. . , settling of the account). This lapse allows for a change in exchange rates, altering the premises on which pricing was determined. Such situations arise when a company anticipates or commits to a trade of goods denominated in a foreign currency. Every company determines its profit margin based upon anticipations of input costs and product revenues. When an input (machinery, components, capital, labor, etc. ) is denominated in a foreign currency, the risk exists that an unfavorable exchange rate movement will increase the cost of doing business.

When the products are priced and sold in a foreign currency, an adverse exchange rate movement will make the product appear more expensive to consumers, decreasing demand or forcing the company to reduce its own profit margin to maintain lower price levels. For companies with integrated international business systems, an exchange rate shock can literally force them out of business, with their operations experiencing pressures from both cost and profit centers. The following example illustrate this situation. Company A, based in the United Kingdom, has purchased equipment from a supplier in Germany. Company A has entered a contract to pay its supplier in annual installments of 100,000 DM. The first year, with an exchange rate of 1. 50 ? /DM, Company A must pay ? 66,667. The next year the exchange rate has depreciated to 1. 40 ? /DM. Thus Company A must now exchange ? 71,429 in order to have the DM 100,000 necessary to repay its debt, a 7. 14 percent increase from the previous year. As the exchange rate continues to depreciate, it becomes increasingly expensive for the British company to repay its debt. |COMPANY A’S TRANSACTION EXPOSURE | | | | | |Year One |Year Two |Year Three |Total | | |Contracted | |DM 100,000 |DM 100,000 |DM 100,000 |DM 300,000 | | |Payments | | | | | | | | | | | | | | | |Anticipated | | | | | | | |payments, | |? 66,667 |? 66,667 |? 66,667 |? 00,000 | | |Year One | | | | | | | |Rate of | |1. 50? /DM |1. 40? /DM |1. 30? /DM | | | |Exchange | | | | | | | | | | | | | | | |Actual | |? 66,667 |? 71,429 |? 76,923 |? 15,019 | | |payments | | | | | | | | | | | | | | | | | | |Cost of currency exposure: |? 15,019 | | Translation Exposure A translation exposure is an exchange of funds from one currency to another on the balance sheet (the exchange is never actually executed) for accounting purposes. Such an exchange presents the risk that business activities in the foreign currency will be misunderstood by the parent organization. Translation exposure results from the nominal conversion of foreign subsidiaries’ account balances into the home country currency for accounting purposes.

This does not represent a ‘real’ exposure, in the sense that the subsidiaries’ costs and revenues are unaffected. Rather, it is merely the perception of those figures that might change. For example, a Japanese subsidiary of an American company might post a 10 percent growth rate in one year, in yen. Should the yen depreciate by 10 percent in that same year, the net change—when examined in terms of American dollars—would appear to be zero. Although this does not reflect a real risk for the subsidiary, the potential risk to the parent company is real, however indirect. A negative perception by stakeholders—such as stockholders or industry analysts—might adversely affect cash flows.

Furthermore, should the parent company require American dollars for the repayment of debt, the subsidiary’s revenues will not be able to contribute added funds. The following table describes this translation risk. Economic Exposure: An economic exposure is the risk that a competitor’s currency exposure might impact the competitor favorably, making its products more attractive than one’s own. Economic currency exposures are indirect exposures, resulting when exchange rate movements do not impact business operations directly, but do impact the competitiveness of that business’s operations relative to its competitors. Since the effects of economic currency exposure are indirect, it is very difficult to manage them, and in fact very few companies attempt to do so.

The following is an example of economic currency exposure. DETERMINANTS OF EXCHANGE RATE VOLATILITY Fundamentally, the rate of exchange is determined by the demand for a given currency. Several factors, however, influence the demand for currencies. The rate of exchange between free-floating currencies is determined by two factors: economic factors and political factors. The economic factors—the relationship between the economies of the corresponding currencies—form the foundation of the exchange rate, and dictate its long-term trends. The political factors—the impact of individuals or non-financial events—affect the short-term movements of exchange rates. INFLUENCES ON DEMAND FOR CURRENCY* › Economic factors: | |› Political factors: | |Inflation | |Elections | |Balance of payments | |Political Turmoil | |Growth rates | |Influence of analysts | |Capital flows | |Investor perceptions | | | | | *This list is not exhaustive. ECONOMIC FACTORS The four economic factors outlined below are each related. Since none is mutually exclusive, the most effective assessment includes considerations of all four factors. Inflation

Inflation is a decrease in the purchasing power of a currency. Inflation manifests itself in higher consumer prices and lower exchange values relative to other currencies. The argument that relative rates of inflation determine exchange rates is put forth in the theory of Purchasing Power Parity (PPP). The concept behind PPP is that tradable goods compete on a world market and that exchange rates compensate for price differentials in different economies. Consider an American consumer searching for a pair of blue jeans. A pair may cost $20 in the United States, and a comparable pair may cost 15,000 lira in Italy. At an exchange rate of 1,500 lira/$, the Italian jeans cost the equivalent of $10.

If this is the case, then it is a better economic decision for the consumer to buy a pair of jeans imported from Italy. In order to do so, the consumer would have to exchange his dollars for lira. As more American consumers exchange their dollars for lira, in order to buy their blue jeans, the demand for lira increases. As in any market subject to the influences of supply and demand, items of high demand extract increasingly higher prices until demand and supply equilibrate. In this case, the supply and demand factors will equilibrate when the exchange rate has increased to such a level that the Italian jeans cost exactly as much as the American jeans. In this way, the rate of inflation—the rate at which prices change—influences the rate of exchange.

PPP equations, which factor the rates of inflation of the respective economies, provide figures for anticipated exchange rates. While there is considerable evidence to support this theory, there are weaknesses. One of the primary shortcomings of PPP is that it assumes all goods are tradable: many services (such as dry-cleaning, haircuts and rent) cannot be exported, and so their effect on the economy will not influence exchange rates. In advanced industrial economies, where services comprise as much as two thirds of the economy, this effect can be substantial. A second shortcoming of PPP is that is does not account for the fact that some goods are more competitive than others are.

American blue jeans, for example, may be more desirable than Italian ones because of vendor service, better quality or high fashion. Thus, consumers will be willing to absorb the higher price of the American good, and the demand for the Italian currency will not change. The Current Account Balance The national current account is the nation’s balance sheet. The current account balance describes the net flow of goods into or out of the country. Exporting and importing requires exchanges of funds, so a current account balance also indicates the relative demand of currencies—and therefore their relative prices—on the world market.

The national current account balance provides a similar perspective on currency demand, and has been shown to be more accurate than PPP theory in predicting exchange rate movements within a short time horizon. The national current account balance is the net cash flows into and out of a country: it is the national balance sheet. When the country possesses its own currency, the currency account balance accounts for the bulk of the currency transactions. The current account balance between France and England, for example, represents the net flow of goods between the countries and thus the net exchange of currencies. Should France possess a current account surplus in relation to England, this would indicate a net flow of goods from France to England.

This would require a net exchange of funds from the British pound to the French franc, representing an increasing demand that would result in an appreciation of the franc relative to the pound. Growth Rates The rate of growth of a country’s gross domestic product indicates an increased demand for goods, as producers require more inputs for production and consumers have more disposable income. When demand outpaces production, countries look abroad to satisfy demand. This increases demand for foreign currencies and results in local currency depreciation. One financial indicator that determines both current account balances and inflation rates is the growth rate of the economy.

Simply put, if an economy is growing rapidly, it can experience inflation and may look abroad to satisfy the internal demand for goods. Inflation, as the PPP theory suggests, will lead to currency devaluation. By purchasing goods from overseas, the current account balance will shift in favor of foreign economies, resulting in a depreciation of the currency. As such, relative growth rates will likely influence the exchange rate between two economies. Capital Flows Like foreign trade, foreign investment requires currency exchange. Capital inflows will increase the demand for that country’s currency, causing a relative depreciation of its currency.

Capital flows—the exchange of currency for the purposes of investment, not trade—affect exchange rates through the same mechanisms as trade in goods. Investors will be attracted to countries whose economies maintain high interest rates. The investors require the local currency in order to invest, however, and so demand for the currency increases. As demand increases, so will the price, until the interest rate, adjusted for the rate of exchange, is comparable with other global rates. Capital flows represent the major economic activity not accounted for by the PPP theory and, more importantly, they represent an increasingly significant proportion of global monetary flows.

Higher interest rates have encouraged increased savings in many economies—providing a greater capital base— and the internationalization of financial systems has allowed for extensive overseas investment. Capital flows can be more important than trade in goods when determining the exchange rate both because of the volume of capital flows and because of the ease with which investors can shift capital investments from one country to another. One factor that lessens the attractiveness of a currency for investment is the potential for exchange rate volatility. The highest interest rates are found in emerging markets; however, these emerging markets are also the most vulnerable to short-term, non-economic shocks.

The risk of exchange rate volatility imposes a high discount rate on these investments, making them appear less attractive. This type of non-economic shock, which can impact capital flows dramatically, is described in the following section. POLITICAL FACTORS The individual actors, through actions not directly related to the national economies, can often influence the exchange rate between currencies in the short term. These influences are called “political factors” in exchange rate movement. Rates of exchange reflect the relationship between two economies; however, they also respond to certain actions of individuals outside the economic mechanism.

The demand for a currency has concrete determinants—such as the purchasing power of the currency, as described in the previous section. These factors are influenced by the collective action of an entire economy. Additionally, the demand for a currency may be affected by expectations of exchange rate activity, as perceived by individuals within those economies. While the actions of these individuals do not necessarily reflect the actual state of the economy, they may nevertheless impact strongly that economy’s currency exchange rate. Examples of political influences fall into one of two categories: • Events that erode confidence in the government • Shifting opinions of economic analysts

Confidence in the Government— This category includes such events as elections, coups and periods of no confidence in the government. An election may introduce a new administration with different policies, such as expansionary policies that increase inflation and devalue the currency. Coups raise the specter of direct government control of the currency, which renders financial and commercial activity unpredictable. Finally, periods of no confidence in the government lead domestic investors to hold their money in foreign monies, producing a depreciative effect on the currency. In such cases, demand for the currency falls, precipitating a devaluation of the currency on the international market.

Analyst Speculation— This latter category is among the most influential in determining short-term exchange rate movements. While methods of analysis are not always as rigorous as more academic approaches, they probably have greater influence: these methods have become so widespread, and those who accept these methods control such a large share of the currency being traded, that their conclusions may bring about the very events they predict. Analysts and speculators examine historical exchange rate data to identify trends. For example, they may conclude that, very often, a certain economic shock is followed by a brief appreciation of the currency, then a long-term depreciation.

Based on this pattern, speculators will purchase currencies immediately after such a shock, then sell quickly. Similarly, a downgrade of the credit rating of a country’s bonds by an investor’s service can have major repercussions for exchange rates. While the bond may in fact be reliable enough, a reassessment of credit will lead investors to move their assets to other investment vehicles, causing a depreciation of the country’s currency. Company Profile: Company profile: Australia New Zealand Banking Corporation Ltd Headquaters: Australia TACTICS FOR MITIGATING FOREIGN EXCHANGE RISKS There are two approaches to minimizing foreign exchange risk.

The first is called internal or natural hedging, and the other external hedging. These two approaches correspond to the two components of foreign exchange risk, currency exposure and currency volatility. › Internal hedging—Operational or financial measures implemented within the company designed to minimize the currency exposures of its business activities › External hedging—Financial arrangements concluded between a company and external parties that minimize the exchange rate volatility experienced by the company as it conducts business INTERNAL HEDGING In conducting internal hedging, a company seeks to make itself less vulnerable to exchange rate movements by minimizing cross-border trading activity.

An example of an operational internal hedge might be the construction of a production center within the country to which its products are to be sold. This tactic eliminates the transactional exposure that results from selling goods across borders. It does not eliminate exposure: translational exposure remains when the activities of the production center are entered into the parent company’s account records in the home currency. This exposure is, however, more manageable and less damaging than the original transactional risk. Examples of financial tactics used in internal hedging include pricing, leading/lagging and netting. Pricing—Conducting all transactions in a single currency eliminates the transactional risks of commerce.

By selling goods in the home currency, the exchange risks are passed on to the counterparties. Similarly, certain industries maintain a standard currency in order to minimize the currency risks. For example, the oil industry conducts business in American dollars. While there are other peripheral activities in other currencies, maintaining a standard currency eliminates many of the multi-currency transactions that would take place. Pricing tactics do have certain shortcomings. Pricing in the home currency is undesirable when such a move would impair business activity; in the case of consumer goods, for example, it would be unattractive if not impossible to require that the consumers purchase in a foreign currency.

Moreover, while such pricing strategies avoid exchange risks, they do not eliminate them: an unfavorable exchange rate movement would influence business activity even if priced in the home currency in the case that a competitor’s currency experiences a favorable exchange rate movement. Netting—Combining complementary risks reduces the total real risk to the company. For example, an equal volume of sales to that country can offset the transaction exposure of purchasing components from a foreign country. An exchange rate movement might decrease the value of accounts receivable, but it would also decrease the costs of component purchases. This particular situation might be unlikely—and indeed it would probably be best addressed by moving the production facilities to the target country.

However, when companies conduct netting across the organization, pairing costs from one business unit with revenues from another, there are many more opportunities to reduce real currency exposures. Netting can also be used to pair different but closely tied currencies. Currencies of the European Union, for example, are so closely linked that some treasurers will balance one against the other in netting currency risks. Leading and lagging—Delaying or advancing payment of invoices avoids certain risks of currency exchange. Leading describes payments made in advance of the contract date; lagging describes a payment paid after the contract date. These instruments are used almost exclusively for intra-company settlements.

Strategic Business Unit A (SBU A) might owe DM 1,000,000 to SBU B on February 1. SBU B might owe DM 1,000,000 to SBU C on January 1. Rather than require that SBU B exchange funds so as to pay SBU C, then reconvert funds once they are received from SBU A, the three might arrange for SBU A to pay SBU C directly on a mutually convenient date. It is favorable to lag with strong currencies—so as to profit from their appreciation—and lead with weak ones, so as to avoid the effects of their depreciation. EXTERNAL HEDGING External hedging involves the use of financial instruments to minimize or eliminate exchange rate volatility experienced by the company.

This is necessary when, as in most cases, internal hedging does not cover all currency exposures. The instruments used to hedge against foreign exchange risks take the form of financial derivatives. FINANCIAL DERIVATIVES: A financial instrument whose value is tied to the value of an underlying asset. Derivatives are based on contracts designed to execute sophisticated financial transactions. They are similar to commodity options. These transactions are initially priced so that they are equally attractive to both parties involved. However, the value of the underlying asset—the asset being exchanged— may change over time, while the terms of the contract do not.

If a change occurs, the contract could become more or less profitable for one of the parties involved. Derivative contracts differ from some other contracts in that the actual obligation represented by the contract can be bought and sold. The actual contract has a monetary value, based on the expected profitability of the agreement it describes. For the purposes of exchange risk management, these derivatives can be considered simple contracts between parties. However, sophisticated risk management operations will take into account the face value of the contracts they enter, and the resulting opportunity to recover some of the costs of hedging their risks.

Some risk management operations manage to manipulate their hedging contracts so effectively that they generate a profit for their companies. This requires a very advanced understanding of financial derivative instruments, however, and there exists a well-publicized risk of loss when trading in derivatives. The most basic financial derivative used in foreign exchange risk management is the futures contract. Other derivative products used to hedge against foreign exchange volatility are as follows: • Forward contracts • Swap contracts • Option forward contracts • Foreign exchange futures • Currency options • Option-based derivative contracts Forward Contracts

A forward contract is an arrangement between two parties, obligating them to exchange a specified amount of currency at a specified rate on a specified date. Forward contracts are used to hedge actual or forecasted currency exposures that will materialize at a future date. For example, on page 3, Company A, a British company, is described as having obligated payments to make to a German supplier. In that scenario, Company A had to pay increasing sums in order to purchase the deutsche marks needed to repay its debts, as the ? /DM rate fell. Company A could alleviate this risk by entering into forward contracts for the necessary sums on the specified dates. In this way, it would guarantee its exchange rate and know in advance its costs in home currency terms.

The price of a forward contract—the premium that the company would have to pay its counterparty in order to guarantee the exchange rate—is determined by the forecasted exchange rate on the date of exchange, the maturity date. An initial purchase of a forward contract will guarantee the forecasted rate, and it usually costs between one percent and four percent of the volume on the transaction. As the maturity date approaches, the value of the contract may change. Should the home currency depreciate more than expected, the forward becomes more valuable: upon maturity, the holder is able to acquire the necessary foreign funds for less than the market rate provides.

Conversely, a currency appreciation would force the holder to transfer funds at rates worse than the market rate, representing a net loss. In such a case the value of the contract would fall. For companies trying to hedge their risks, however, the guaranteed exchange rate is valuable in itself, and many multinational firms willingly pay the premium for such peace of mind. Swap Contracts A swap contract is a pair of forward currency contracts arranged with the same two parties. These forward contracts usually deal with the same amount of currency, but each matures on a different date. A swap contract allows a company to acquire a certain amount of a foreign currency for a certain period of time.

Swaps are most often used as an alternative to taking a loan: essentially, companies “swap,” or trade debts/payments. The cost of arranging these contracts may be a less expensive means of acquiring foreign currency than taking a loan from a foreign bank. As a foreign risk hedging tool, it allows the holder to extend an existing currency hedge. The following diagram illustrates the use of a swap contract. |EXC| |HAN| |GE | |RAT| |E | Entered forward contract based on initial assessment of necessary exchange date. Learned that currency exchange would need to take place on a later date; enters swap contract consisting of two forward contracts.

The forward contract and the first half of the swap mature on the same date; the funds exchanged in the forward are exchanged back with the swap. The second half of the swap matures on the necessary date, allowing the funds to be transferred at the predetermined rate. Potential cost covered through swap instrument TIME Option Forward Contracts Option forward contracts are forward contracts with a range of maturity dates. They provide for the exchange of a specific sum of currency at a specified rate. Unlike option contracts— described below—option forward contracts require that the currency be exchanged; the ‘option’ referred to is the choice of maturity dates.

The two parties that engage in option forward contracts are obliged to exchange funds at the specified rate, however one party has the right to determine the date of exchange, within a specified window. The purchasing party must give two days notice, and the exchange must be completed before the final day of maturity. |Contract dealing date: |Forward contract maturity period: | |January 1 |February 1 – February 15 | Purchasing party may exercise contract at any point within this period Foreign Exchange Futures Foreign exchange futures are standardized forward contracts traded on market exchanges.

Each futures market exchange determines the tradable volume of its futures contracts and the months that the contracts can use as exercise windows. For example, a given market exchange allows trade of futures options with volumes of $10,000 and with maturity months of March, June, September or December. A company that needs to hedge a larger amount would buy a number of the futures. These contracts are useful in financial markets, but they accomplish little in terms of foreign exchange risk hedging that can not be accomplished with other instruments. For this reason, very few companies allow the use of foreign exchange futures for exchange risk management. Option Contracts

Currency options are a type of forward contracts in which one of the parties has the option not to exercise the contract. This allows that party to decline participation in a contracted exchange in the event that it is not profitable at that time. A currency option gives the buyer the right, but not the obligation, to exchange a specified amount of currency on a specified date. A forward contract is binding: while it allows the holder a more favorable exchange rate in the event of a depreciation, the buyer is also obliged to trade at a worse rate in the case of an appreciation. A currency option gives one party the right to exercise the contract or to let it expire unexercised. The counterparty must respond as the purchaser of the option dictates.

This instrument covers the purchaser in the event of an unfavorable exchange rate movement, but allows it to benefit from a favorable exchange rate movement. Options are used as foreign exchange hedging instruments in order to cover a potentially damaging exposure. For example, on page four Company C is described as pursuing a bid for a large contract. Company C will need to conduct extensive currency exchanges should it win the contract, but it will not want to conduct any exchanges should it lose. A currency option would allow Company C to guarantee its exchange rates, without binding it to exercising them. Should Company C lose the contract, it can let the contract expire, losing only the premium it initially paid.

Additionally, there is a growing interest in “financial engineering,” in which financial instruments such as option contracts are combined and customized to provide specific results for the parties involved. While the subject of financial engineering is beyond the scope of this study, individuals dealing in derivatives should be able to recognize certain varieties of options. The following lists include the names of common option products. Composite options, in which several basic option contracts—differing only in the volume of exchange, the rate of exchange or whether it is a “put” or “call” option—are combined to provide multiple hedging benefits: • Spreads • Straddles Strangles • Conversions Option-based derivative products, in which various provisions of the option contract—such as the rate of exchange, the time of payment, the amount of the principal or the volume to be exchanged—are changed or are variable •Boston options •TTC options •Compound options •SCOUT options •Cylinder options •Participating forwards •Knock-out options •Average rate options •Lookback options • Cylinder options • Participating forwards • Knock-out options • Average rate options • Lookback options ORGANIZATIONAL FRAMEWORKS The policy of the company will determine how these foreign exchange risk management instruments are used.

The organization of the foreign exchange risk management mechanism is characterized by three qualities. CENTRALIZED The organization consists of only one entity or, if there are several business units, the corporate center holds responsibility for currency risk management and accounting. DECENTRALIZED The organization consists of several business units and each is responsible for its own currency risk management. COST CENTER The treasury is responsible for hedging all risks entirely. It does not have the authority to engage in hedging activities selectively. PROFIT CENTER The treasury is responsible for ensuring that the company suffers no loss due to exchange movements.

It is entitled to speculate so as to recover the costs of covering corporate risks through profitable hedging. COMMON RESPONSIBILITY The corporation considers its net risk exposure as a common liability and addresses it collectively. INDIVIDUAL RESPONSIBILITY Each business unit is responsible for managing its own foreign exchange risks. The corporate treasury may still execute the contracts (see page 17), but individual units are ultimately responsible for the hedging. Four models of foreign exchange risk management organization structures are outlined on the following pages. MODEL 1: UNIFIED ORGANIZATION, CENTRALIZED RISK MANAGEMENT • Centralized organization • Treasury as cost center • Risk considered a common liability

A company with limited business activities overseas does not possess extensive currency exposures, so it does not likely to maintain a large exchange risk management staff. Nor does it likely possess the expertise necessary to maintain the treasury as a profit center. The treasury brokers individual hedging contracts with its bank on behalf of the entire organization. Business Line A Business Line B Central Treasury Foreign exchange contracts MODEL 2: DECENTRALIZED RISK MANAGEMENT • Decentralized organization • Central treasury not involved • Risk considered an individual liability Companies with disparate business lines, managed by business units with great autonomy, allow individual business units to manage their own risk through individual arrangements with banks. Business Unit A

Foreign exchange contracts Business Unit B Foreign exchange contracts Business Unit C Foreign exchange contracts MODEL 3: DECENTRALIZED RISK PLANNING, CENTRALIZED TRANSACTION EXECUTION • Decentralized organization • Treasury as cost center, but invested with some expertise • Risk considered an individual responsibility but a collective liability Subsidiary business units manage their own foreign exchange risks, and request contracts through the treasury. The treasury reviews the deals, looking to identify inadequate hedges or opportunities to net hedges. The treasury negotiates deals with the bank(s) and returns to the subsidiaries the details of the contract. | |Contract A request | | | | | | | | | |Business Unit A | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |Contract A details |Corporate | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |Treasury | | | | | | | | | | | | | | | | | | | | | | | |Contract A | | | | | | |Contract B request | | | | | | | | |Business Unit B | | | | | | | | | | | | | |Operational center | | | | | | | | | |Contract B details | | |Contract B | | | | | | | | | | | | | | | | | |for foreign exchange | | | | | | | | | | | | | | | | | | | |Contract C request |contract execution | |Contract C | | | | | | |service | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Business Unit C Contract C details MODEL 4: DECENTRALIZED ORGANIZATION, CENTRALIZED RISK MANAGEMENT • Decentralized organization • Treasury as profit center with extensive expertise • Risk management considered a collective responsibility Subsidiary business units report their exposure forecasts to the treasury, where exposures are analyzed and compared. The treasury makes net hedges with banks as it sees fit. It reports the gross hedges back to the business units. Business Unit A Business Unit B |Exposure forecast | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |Gross contracts |Corporate | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |Treasury | | | | | | | | | | | | | | | | | | | | | | | |Contract | | | |Exposure forecast | | | | | | | | | | | |Operational center | | | | | | | | |Gross contracts | | |Contract | | | | |for foreign exchange | | | | | | | | | | | | | | | | | | | | |Exposure forecast risk management | |Contract | | | | |service | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Business Unit C Gross contracts PROFILES OF CORPORATE FX MANAGEMENT The relatively young field of financial derivatives hedging, the rapidly expanding role of international trade in the development of businesses in every industry, and certain recent developments in derivatives reporting have left many corporations uncertain as to the best method to approach this issue. While most financial executives, including the treasury executives at non-financial corporations, are comfortable with the application of FX-hedging derivatives, many companies appear uncertain about the structure and procedures that best use these tools.

While little consensus exists between FX management heads, executives that express satisfaction with their FX management structure often share variations of a two-tiered FX accounting structure, similar to Model Four on the preceding page ANZ provides the most elaborate development of this model, and the profile of ANZ provides further discussion of this model and its benefits. CORPORATE OVERVIEW ANZ engages in primarily one line of business; its operations, however, are diverse, including all upstream and downstream processes. Moreover, it possesses extensive international capital investments and conducts banking activities across the globe that include Retail and wealth, institutional and Private banking. The company faces diverse exposure risks that can increase the cost of investing, financing and operating its business. As with all types of risk, foreign exchange risk is highly particular: how one perceives risk depends entirely on the type of ANZeing run and the type of business involved.

ANZ operates in a competitive environment that accentuates certain risks, while downplaying others. The company and its competitors maintain extremely diverse business lines in dozens of countries with dozens of currencies. ANZ and its competitors source their products in dollars, however, limiting the complexity of the exchange risks involved to some degree. Moreover, the market in which ANZ deals is highly liquid: retail and wholesale prices change frequently, and any nominal costs—such as the cost of an adverse exchange rate movement—are passed on to the consumer. The following example illustrates this process: DOWNSTREAM RISKS AT ANZ: ANZ and a competitor, operating in Australia , both source in dollars and sell in AUD marks.

If the US$/AUD exchange rate shifts, both ANZ and its competitor adjust their prices accordingly such that each preserves its profit margin. The cost of the exchange rate movement is passed on to the consumer. In such a case, which ANZ labels its “downstream risk,” the competitive risk is minimized, rendering the actual currency risk immaterial. Thus, ANZ’s particular market situation allows it to ignore the transaction exposures of buying and selling its products and services. This is a luxury not shared by most other companies. ANZ focuses instead on three other categories of exposure, as described on the following page. ANZ recognizes four categories of FX exposures.

The first of these, the “downstream risks” receive little attention from the FX function due to the unusual competitive environment faced by ANZ. The other three, however, demand sufficient attention so as to warrant a rather robust FX management mechanism. FX CONCERNS AT ANZ Downstream Risk—The risk associated with the sale of goods in local currencies Capital Expenditures—The risk associated with financing major capital projects abroad, ensuring the net present value and the rate of return for the project is guaranteed Earnings Remittance—The risk that foreign subsidiaries’ earnings, needed to support dollar dividends, will be adversely affected by exchange rate movements (ANZ does not hedge earnings that are reinvested)

Host Country Taxes—For subsidiaries whose earnings are in dollars and costs are in foreign currency, ANZ will hedge the tax payments required based on earnings translation The aspect of currency risk that ANZ does focus on—the exposures relating to financial and capital flows—is shared by other companies. The mechanism by which ANZ addresses these risks is transportable to other businesses in other markets. Indeed, corporate finance analysts have characterized ANZ’s currency risk management system as “best-in-class” ORGANIZATIONAL STRUCTURE Corporate Organization ANZ manages its business operations through integral business units, wholly owned subsidiaries and majority-owned subsidiaries.

The various business units and affiliates are organized along functional and regional lines; however, ANZ does not maintain a matrix reporting structure. Each business unit and affiliate—with a regional and/or functional focus—reports directly to the corporate center. Coordination between regional business units or functional business units occurs secondarily, through informal, if structured, means. Due to the devolution of authority in ANZ “proper,” the subsidiaries (“affiliates”) appear to hold approximately equivalent positions as the business units in respect to the corporate center. The corporate center delegates the same responsibilities to both its internal business units and to its subsidiaries.

Each business unit operates as an autonomous unit, responsible for all operational and financial activities. Centralized functions maintain primary responsibility for coordinating external relations and for balancing the needs of the diverse business units. Treasury Organization The corporate center, however, does not operate as a skeleton holding company. Centralized functions exist, although their scope of activities is limited. The central functions coordinate intra-company activities, execute coordination of external affairs and—above all—provide integral support to the business units’ activities. The functions of the treasury are bifurcated along these lines, as described below. BIFURCATION OF TREASURY RESPONSIBILITIES AT ANZ Central Treasurer | |Business Unit / Affiliate | | | | |Treasurer | | | | | | | |v Capital investment projects | |v Handling working capital | | |v Dividend payments | |v Regional cash management | | |v Cash disbursements | |v Revenue payments to | | |v Intra-company loans | |upstream and downstream | | |v Debt issuance | |partners | | | | |v Planning and financing | | | | |individual projects | | | | | | | The treasury function therefore exists at both the centralized and the decentralized levels.

The decentralized treasurers handle operational activities, although they report directly to the central treasurer. INTERACTION BETWEEN BUSINESS UNITS AND THE CENTRAL TREASURY Each business unit and affiliate maintains its own treasury and, with its treasury, its own FX function. The task of managing foreign exchange is usually executed on a case-by-case basis, without dedicated personnel. The individuals assigned to handle FX management work with the business unit to analyze and develop operational plans. With primary reporting responsibilities to the central treasurer, the central treasury maintains a good deal of control over business-unit activities.

In terms of FX management, the affiliate treasurer handles all risks within its jurisdiction, reports all exposures to the central office and consults the central office for advice in implementing appropriate hedge instruments for declared risks. The central FX office is “profit-and-loss neutral. ” This indicates that, in the parlance of cost-centers and profit-centers, it is probably a conservative semi-profit center: on a scale of one to ten, with one representing a purely cost center and ten representing an aggressive profit center, ANZ occupies a rating of two or three. |Cost Center |Profit Center | |12345 67891 0 | Conservative Semi-Profit Center:

FX function seeks to cover the company from all potential losses; however, it does so intelligently, avoiding obvious superfluous hedges. The costs of covering nearly all exposures—and covering most exposures twice—is offset by the value of providing extra oversight and close accountability for all hedging activities. Finally, being “above” profit allows the central treasurer to provide objective advice to the consulting treasurers. The central treasury supports affiliates’ and business units’ FX hedging activities by providing the following services: O Transaction services O Foreign exchange market intelligence O Advice on hedging techniques O Coordination of the resolution of financial accounting and tax issues ROLES OF CENTRAL TREASURY

The devolved FX team interacts with a central FX team of three to four full-time equivalents through the following four mechanisms: ROLES OF ANZ’ S CENTRAL TREASURY IN BUSINESS UNITS’ FX M ANAGEMENT |Mechanisms of Interaction |Role of Central Treasury | | | | | | FX hedge instruments, to which the central treasurer is the counterparty Monthly risk and exposure statements Daily automatic downloads of financial activity Voluntary referrals concerning major exposures CENTRAL TREASURY AS COUNTERPARTY CENTRAL TREASURY AS OVERSIGHT CENTRAL TREASURY AS CONSULTANT

These mechanisms of interaction between the corporate center and the regional treasuries are described in greater detail on the following pages. Central Treasury as Counterparty The central treasury serves as the counterparty to nearly all hedge contracts of the business units and affiliates. The devolved treasury enters into financial arrangements with the corporate center exactly as it would with an external bank. The corporate treasurer then enters into contracts of equal size and value with third parties. The central treasurer does not hedge overall corporate exposure; the central bank enters into the same volume of contracts as those it issues to its subsidiaries except in cases where two exposures cancel each other out (netting). Business Unit A Contract request Treasurer

Contract details |Business Unit B |Contract request | | | | | | Treasurer Contract details Contract request Business Unit C |Treasurer |Contract details | | | | | | | | | | Corporate Treasury Corporate Foreign Exchange Bank Contract Contract Contract FX REDUNDANCY AT ANZ : “In some companies, such as ANZ, exposures are defined at two levels: the exposure of the company overall and the exposure of individual business units within the company.

These companies believe that foreign exchange exposure is an important competitive aspect of every business and that individual business managers must be judged partly on how they manage that exposure. They also want to have the centralized expertise in treasury overlooking the exposure of the corporate as a whole. ” Source: Financial Executives Research Foundation In this way nearly all hedging transactions appear on ANZ’s books twice: once on the business unit or subsidiary’s account, and once on the corporation’s account. The redundancy that this causes also provides certain benefits; namely, it allows an optimal combination of autonomy and oversight.

The benefits of this system are presented in greater detail on the following pages. Corporate Treasury as Oversight Monthly reports Each business unit is required to deliver a monthly statement of risk to the central treasurer. This statement describes ongoing currency exposures and exposures anticipated for the following period, categorized by currency and type of transaction (e. g. , area of operations). This is a concise form, serving not as a planning statement but merely as a report of known activities. It allows the corporate treasurer to monitor FX activities in the medium-term, and it guarantees an open line of communication between the various components of the treasury function. Daily reports

In addition, data on the financial activities of all business units and affiliates are automatically downloaded each night from the computer systems of decentralized treasurers to the computer system of the corporate treasurer. Each night the system records any hedging transactions of the business units— including any arranged with third-party banks—and calculates the corporate value-at-risk. Between monthly and daily risk statements, the central treasurer is able to maintain close supervision over the activities of subordinate business units, without regulating them directly. The process of each of these roles is described below. OBJECTIVES OF CENTRAL TREASURY’ S OVERSIGHT MECHANISM Regulate corporate risk and exposure The central treasury will cover its net exposure even when the business units fail to cover all their hedges.

In the event that a business-unit head chooses to leave a risk unexposed, it is free to do so; however, the central treasurer is notified of all exposures and thus it can cover its risks as it requires. In fact, it has become increasingly rare for the central treasurer to intervene proactively to cover unhedged exposures, due to the fact that most regional treasurers share the risk posture of the central treasury. Evaluate business-unit managers Business units are ultimately responsible for profit and loss, and so executives seek to account for all business activities at the lowest level. Related to this is the corporate policy to hold business leaders accountable—if only nominally—for all their business activities. The monthly and daily reporting systems allow executives maintain records of all hedges transacted and not transacted.

Executives can thereby evaluate the performance of the business-unit heads independently of the larger corporation. Corporate Treasury as Consultant The most important role played by the corporate treasurers is as an advisory resource. While the central FX office enters into numerous large financial hedges, the source contacted at ANZ claims that its most valuable function is that of a consultant to, not an executor of, financial policy. While the central office exercises its initiative through more direct instruments—such as the oversight mechanisms described on the previous page—its greatest influence is exerted through voluntary interaction with devolved treasurers.

The central FX office organizes formal functions with the various treasury departments to facilitate understanding of policy and best practices. Recently, for example, the central treasury hosted FX staff from global business units to discuss the changing face of FX management. The seminar covered broad topics, namely the need to reconsider risks in light of the changing political and economic landscape. The real value of the seminar, however, appears to be as a vehicle of communication between disparate treasury employees. In addition, regional treasurers will approach the central office proactively to seek assistance with large or complex exposures.

While there is no regulation regarding interaction with the central office—such as an exposure level over which subordinate treasurers must confer with the central office—subordinate treasurers recognize that such interaction is in their best interest. The central office possesses specific skills from which the other treasuries can benefit. Moreover, it is the central treasury that evaluates the performance of the business unit treasuries. While this sounds rather heavy-handed, the interviewee states that in fact there is little need for coercion, and that the system of dual accounting operates effectively. Strategy and solutions for foreign exchange risks

ANZ provides solutions to mitigate those exposed to foreign exchange risks through Forward Exchange Contracts A Forward Exchange Contract is a contract between two parties (the Bank and the customer). One party contracts to sell and the other party contracts to buy, one currency for another, at an agreed future date, at a rate of exchange which is fixed at the time the contract is entered into. Features/benefits •Contracts can be arranged to either buy or sell a foreign currency against your domestic currency, or against another foreign currency. •Available in all major currencies •Available for any purpose such as trade, investment or other current commitments.

Forward exchange contracts must be completed by the customer. A customer requiring more flexibility may wish to consider Foreign Currency Options. Foreign Currency Options Foreign Currency Options can provide a fixed exchange rate for a future date if rates move adversely, but also provide the added flexibility of being able to use the prevailing spot rate if rates have moved favourably. If you buy a foreign currency option, you get the right to choose, on an agreed future date, whether you want to exercise the option and transact at the option’s exchange rate or not. If the spot rate is more favourable than the option’s exchange rate, then you will choose to transact at the spot rate.

However, if the spot rate is less favourable you will use the option. For this right to choose, you will pay a premium at the outset (as you would for insurance). Options give you more flexibility in selecting the exchange rate you want to cover at. However, the more favourable the exchange rate you select, the higher the premium cost will be. Options can also be used to hedge uncertain exposures. The maximum cost will be the premium amount paid for the option. Options can be structured in many ways to assist you in the management of your foreign exchange exposures. How are Premium and Strike Rate determined Premium In exchange for entering into a foreign currency option, you will pay ANZ a premium.

ANZ determines the premium on a transaction by transaction basis with reference to a number of factors, including: >> transaction type (call option or put option); >> the nominated strike rate; >> currency pair; >> expiry date; >> delivery date; >> current spot exchange rate; >> current forward exchange rate; >> the contract amount; >> market volatility of the underlying currency pair; >> current interest rates; >> ANZ’s internal fixed and variable costs; and >> ANZ’s risk/ profit margin. The premium must be paid in cleared funds on the premium payment date (generally two business days after the trade date).

If the premium is not paid on the premium payment date, the foreign currency option will automatically terminate and you will be liable for any costs arising as a result of the termination of the foreign currency option. How are foreign currency options settled on the delivery date? If you exercise the foreign currency option by the expiry time on the expiry date, the foreign currency option will be settled on the delivery date, which is usually two business days after the expiry date. This means that on the delivery date you will make a physical delivery of one currency to us and we will make a physical delivery of another currency to you at the agreed strike rate. Can a foreign currency option be extended? After entering into a foreign currency option, you may not vary the agreed term or expiry date. Can a foreign currency option be terminated early?

You may find that you have no further use for an existing foreign currency option. A foreign currency option may be terminated at any time before the expiry time on the expiry date, either: >> by agreement between you and ANZ; or >> in accordance with the master dealing agreement. Where the foreign currency option is terminated by agreement between you and ANZ, the amount payable on termination is as agreed. Where the foreign currency option is terminated in accordance with the master dealing agreement, the amount payable is determined in accordance with those terms. Termination of a foreign currency option involves ANZ notionally buying back the foreign currency option from you.

ANZ will notionally buy back the foreign currency option at a price it determines using the same methodology it uses for determining the premium and any costs applicable to the termination . ANZ will give you a quote for terminating the foreign currency option. Depending on the current market conditions, the foreign currency option could be worth more or less than the original premium. You may lose money by terminating the foreign currency option. If early termination results in you having to pay an amount to ANZ, you must ensure that you have sufficient cleared funds in your nominated account to meet the payment, or as otherwise agreed. What are the benefits of a foreign currency option? The benefits of a foreign currency option include: gt;> ability to lock in a ‘worst case’ exchange rate (the strike rate) on a future date; >> flexibility to tailor the product to suit your needs such as the contract amount, the currency pair, and the term to protect against adverse exchange rate movements; >> the premium is a known cost for entering into the foreign currency option; >> you can take advantage of favourable movements in the exchange rate; and >> you can choose whether to exercise the foreign currency option or to let the optionexpire (not exercised). Unless you exercise the foreign currency option there is no commitment or obligation to exchange currencies.

What are the disadvantages of a foreign currency option? The disadvantages of a foreign currency option include: >> you must pay the premium on the premium payment date >> if the foreign currency option expires and is not exercised, it is worthless and results in the premium you paid being an additional cost to you and the total transaction cost being higher than if you had not purchased a foreign currency option as the premium is not refundable; >> the expiry date or term cannot be extended; >> you may not recoup the full premium paid if the foreign currency option is terminated prior to the expiry date. Flexible Forwards

ANZ provides a range of foreign exchange management products offering customers diverse and flexible hedging solutions to known exposures. These products are known collectively as flexible forwards and include: •Collar •Converting Forward •Smart Forward •Smart Forward Plus •Deferred Premium Option •Knock-Out Forward •Others eg Bonus Forwards, Layered Forwards, Binary Options (Digital) Flexible forwards contain in-built strategies for hedging foreign exchange risk and each have particular advantages and disadvantages associated with their use. The products chosen by the customer would be expected to reflect a combination of the customer’s attitude to risk, overall exposure management objectives and broad view on the future movements of the foreign exchange market.

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