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Foreign Exchange Hedging Tutorial:Currency Impacts 101
Foreign Exchange Impacts on Corporate ValueMerrill Lynch Analyst & Investor Presentation
Presented by FiREappsOctober 31, 2008
This presentation is copyright 2008 Rim Tec Inc., all rights reserved. Any unauthorized reproduction or distribution is prohibited. Any authorized reproduction or distribution of this presentation must include this copyright notice and shall not remove or alter any references to Rim Tec or the FiREapps Service or other Rim Tec products or services contained herein.
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Speaker Introductions
Wolfgang Koester, CEO, FiREapps• Managed risk for a Fortune 500 companies &
governments, including G-10s, since 1986
• Monthly contributor to AFP Exchange magazine & member of AFP Risk editorial board
• One of Treasury and Risk magazine’s 2008 “100 Most Influential People in Finance”
• Member Global Exchange 2007 “Who’s Who in Foreign Exchange”
• Contributor to Treasury and Risk, Corporate Board Member, Business Finance, eForex and GT News
• CFO, Fortune, Wall Street Journal and the Economist
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Index: Currency Impacts on Corporations
Impact
Exposure
Net Risk
Actions
Risk
Solution
2.Income Statement, Balance Sheet
3.Operational & Financial (hedging)
4. What you should ask as an investor / analysts / board member
1.Introduction
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Discussion Overview
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• “There is No Free Pass for Foreign Exchange”– Treasurer, Microsoft
• Pharmaceutical Company FX Impacts10Q – Johnson & Johnson – Released 8/4/2008
• Located in ‘Item 2 – Management’s Discussion & Analysis• “For the first fiscal six months of 2008, worldwide sales were $32.6 billion, a total
increase of 8.2% including an operational increase of 2.8% over 2007 first fiscal six months sales of $30.2 billion. Currency had a positive impact of 5.4% for the period.”
10K – Bristol Myers Squibb – Released 2/22/2008• Located in ‘Results of Operations’• Net sales from continuing operations for 2007 increased 12% to $19.3 billion,
including a 3% favorable foreign exchange impact, compared to 2006. U.S. net sales in 2007 increased 18% to $10.8 billion compared to 2006. International net sales in 2007 increased 5% to $8.5 billion compared to 2006, including a 7% favorable foreign exchange impact.
• Solution– FA Client Quote: “We have no FX Surprises”
A Perfect Storm
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Business Units
Corporate Controllers
The Beginning of the Problem
Several days
Banks and Trading PlatformsComplex Exposure
Reporting Spreadsheets
Controller Treasurer
1. Accounting
2. Actions
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Translate Your Financial Statements into Reporting Currency
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Currency Definitions
• Local– The currency of the country of domicile
• Functional– The currency of the primary economic environment in
which the entity operates; normally the currency in which an entity generates and expends cash
– FAS 52 introduced the concept of functional currency
• Transaction– The currency in a business transaction has been
executed
• Reporting– The currency in which an enterprise prepares its financial
statementsCopyright 2008 Rim Tec Inc. Slide 9
FASB Statement No.52
• Foreign Currency Translation
• Affects the financial reporting of companies operating in foreign countries
• Provided information that is compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity – Adjustments for impacts that do not effect cash flow are
excluded from net income
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FASB Statement No.133
• Accounting for Derivative Instruments & Hedging Activities
• A hedge of a forecasted event is a ‘cash flow hedge’
• The results from cash flow hedges must be evaluated – The ineffective part goes to the Income Statement– The effective part is posted to Other Comprehensive
Income (OCI) in the Balance Sheet
• Amounts in OCI are reclassified to the Income Statement when the forecasted cash flow affects earnings
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R= E x v
Exposure x Volatility
Risk =
$100,000 =
$1,000,000
x 10%
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Exposurex Volatility
Risk =
September 2008 Exposure Volatility Risk (One Week)
G10 Currencies $70MM 10% = $7M
Non-G10 Currencies
$30MM 25% = $7.5M
$100,000 =
$,1000,000
x 10%
CompleteUnderstanding
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R= E x v
Exposure x Volatility
Risk =
September 2008 Exposure Volatility Risk (One Week)
G10 Currencies $70MM 10% = $7M
Non-G10 Currencies
$30MM 25% = $7.5M
$100,000 =
$1,000,000
x 10%
September 2008 Exposure Volatility Risk (One Day)
G10 Currencies $70MM 1% = $0.7M
Non-G10 Currencies
$30MM 3.2% = $0.96M
CompleteUnderstanding
Time
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R= E x v
Index: ExposureIncome Statement & Balance Sheet
Impact
Exposure Risk
2.Income Statement, Balance Sheet
1. Introduction
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FX Impacts to the Income Statement
Revenue
Costs (COGS + Opex)
Net Operating Income
Other Income/expenses
FX Gain/Loss
Net Income
Shares Outstanding
EPS
Income StatementForeign currency-denominated revenues & costs are translated to USD each reporting period
• Fluctuating exchange rates affects reported revenues and costs
FX gain/loss results from Balance Sheet transactions
• Realized from clearing foreign currency denominated monetary assets & liabilities
• Unrealized from FAS 52 remeasurement of monetary assets & liabilities at month end
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Companies doing business in foreign currencies risk NOI, Net Income & EPS impact
FX Impacts to the Balance Sheet
Assets
Liabilities
Stockholder’s Equity
Domestic Balance Sheet
• FX can significantly affect asset-liability balances when translated
• Some of translation does not flow through the income statement (i.e. equipment)
• Recorded as cumulative translation adjustment (CTA) in Other Comprehensive Income (OCI)
• CTA taken into account when a disposition occursCopyright 2008 Rim Tec Inc. Slide 17
International Balance SheetAssets
Liabilities
Stockholder’s Equity
OCI (CTA) “The Plug”
Accounting Impacts & FAS 52
Transaction Currency
Functional Currency
Reporting Currency
Result
Example 1 Revenue EUR EUR USD USD value of EUR revenue at risk
translation
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Example 2 Revenue EUR USD USD USD Value of EUR revenue at risk
translation
Example 3 A/R EUR EUR USD No income statement effect; only CTA adjustment in Balance Sheet
No fx gain/loss from remeasurement
Translation gain/loss (CTA)
Example 4 A/R EUR USD USD Income statement effect from FAS 52 remeasurement; no CTA adjustment
fx gain/loss from remeasurement
No translation gain/loss (CTA)
Impacts of a Rising Dollar
Q3 Guidance EUR USD Rate=1.55
Example: EUR Revenue Financial Statement RiskNotes
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August Sale120 day payment terms
Aug EUR Rate=1.50 Revenue EUR Revenue translated at August average rate
August Month-end
Balance Sheet Rate=1.45
FX gain/loss Account Receivable Remeasurement
SeptemberMonth-end
Balance Sheet Rate=1.40
FX gain/loss Account Receivable Remeasurement
December 27Month-end
Balance Sheet rate=1.28
FX gain/loss A/R Collected, Converted to USD
Result: $.27 (17%) difference between projected revenue & cash collection
Index: ActionsOperational & Financial
Impact
Exposure
Actions
Risk2.Income
Statement, Balance Sheet
3. Operational & Financial (hedging)
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How Do You Get Your House in Order?
a) Understand your exposureb) Take action - operational
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How Do You Get Your House in Order?
c) Take Action - Hedge
How Do You Get Your House in Order?
Income Statement Hedging• Protecting the USD value of non-USD
revenue & costs–Cash flow hedging; focused on top-line & NOI
• Typical time horizon: 6 months to 3 years
• FASS 133 for hedge accounting treatment–want to match hedge results to when the forecasted transactions occur
• Effective hedges are recorded & held in OCI (Balance Sheet) until the forecasted transactions occur; ineffectiveness flows immediately to the income statement
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Transaction Currency/Functional Currency and Impact on Cash Flow Hedging
Hedging Relationship
Risk Transaction Currency
Functional Currency
Reporting Currency
Cash Flow Hedge?
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Example 1 Revenue EUR USD USD Can hedge EUR-USD risk
Example 2 Revenue EUR EUR USD Cannot hedge EUR-USD risk
Example 3 Revenue EUR GBP USD Cannot hedge EUR-USD risk
How Do You Get Your House in Order?
Balance Sheet Hedging• Reducing the volatility of the FX
gain/loss line in the income statement – part of managing Net Income/EPS risk
• FX gain/loss results from:– Clearing recorded monetary assets/liabilities
on the balance sheet (realized)– Remeasurement of monetary assets/liabilities
at period end (unrealized)
• Hedge results are recognized currently in the income statement
• Overhedging typically occurs due to a lack of complete & timely understanding of exposures
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Assets
Liabilities
OE
OCI (CTA)
Impacts of a Rising Dollar
Q3 Guidance EUR USD Rate=1.55 Cash Flow Hedge – FAS133 Hedge accounting
Example: EUR Revenue Financial Statement RiskHedge Actions
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August Sale120 day payment terms
Aug EUR Rate=1.50 Revenue Cash Flow Hedge ExpiresBalance sheet hedge of A/R – 120+ days
August Month-end
Balance Sheet Rate=1.45
FX gain/loss Balance sheet hedgeContinues
SeptemberMonth-end
Balance Sheet Rate=1.40
FX gain/loss Balance Sheet HedgeContinues
December 27Collection
Balance Sheet rate=1.28
FX gain/loss Close Balance Sheet Hedge when Cash is Converted
Result: Reduced currency impacts on your corporation
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Index: Currency Impacts on Corporations
Impact
Exposure
Net Risk
Actions
Risk
Solution
2.Income Statement, Balance Sheet
3. Operational & Financial (hedging)
4. What you should ask as an investor / analysts / board member
1. Introduction
Recommendations
What Should You an Analyst / Investor / Constituent Do With All This?
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Recommendations
• Understand that FX exposure management is complex & difficult
• Drive for succinct answers to four questions• What are your exposures-past, present & forecasted?
– Income statement [impact on NOI, NI & EPS)– Balance sheet [impact on OCI (CTA)]
• What actions are you taking to protect corporate value?• What net risk are you managing towards (exposure x volatility)?• What was your actual risk?
• For historic purposes, examine earnings releases, 10K (incl. Item 7a) & 10Q (incl. Item 3)
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Example
Exposure
Net Risk
Actions
RiskBalance Sheet Exposure = $1.2B
Actions: <$800M>
$400M x 10% (Vol) =
$40M Net Risk
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FiREapps Solution
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Aggregate FX data for Balance Sheets & Cash Flows at the Push of a Button
• Creates transparency & understanding (completeness)• Can act within hours (not weeks, or months)
Result–No Surprises–Volatility ↓–Cost ↓–Less hedges
–Improve Communications–Enable Compliance –Improve Operational Efficiency
–Less time on aggregation–More value add
Thank You
For More Information
• View this presentation online at www.fireapps.com/news/presentation.html
• Contact FiREapps– Email: wstagl@fireapps.com– Phone: 480-443-7333 x157
• Visit our Web site at www.fireapps.com– Attend live and recorded Webinars– Download whitepapers– Read related trade and business articles
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