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Practice Pricing Foreign Exchange Option Contracts

Option contracts are financial contracts that give the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific exchange rate, called the strike rate, on or before a pre-arranged date. A call option is the right to buy a particular currency, and a put option is the right to sell a particular currency. An option is a right, not an obligation, so it will be exercised only when it is favorable to do so.

An option is comprised of two value drivers, (1) intrinsic value, which is the difference between the strike rate on the contract and the then prevailing spot rate in the market, and (2) time value, which is any excess value beyond intrinsic value related to time to maturity.

A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, typically purely time value, and will expire with a either a positive intrinsic value or zero fair value. When intrinsic value is positive, it is referred to as “in the money” since the strike rate is more favorable than the spot rate, and when intrinsic value is zero is referred to as “at the money” if the strike rate is equal to the spot rate or “out of the money” if the strike rate is less favorable than the spot rate.

Options, when hedging, secure the value of an underlying position, providing 100% protection against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves, which may justify the premium paid. Options tend to be used most frequently for longer dated exposures such as forecasted transactions, since the greater the timeframe, the greater the potential for the market to move materially, which creates greater potential to participate in favorable market movements.

Options are also attractive for scenarios where there is uncertainty the exposure will materialize, such as a bid to award contract or a forecasted acquisition, since an option is a right, not an obligation. Options provide a high degree of certainty and the greatest degree of flexibility, but are employed less frequently in practice when hedging due to the premium paid up front.

In order to price an option contract, a number of option pricing models can be used in the marketplace, but currency options are priced most often using the Garman-Kohlhagen option-pricing model. The Garman-Kohlhagen option-pricing model is a complex equation that takes into account the following six variables:

1. The spot foreign exchange rate
2. The interest rate on the base currency
3. The interest rate on the terms currency
4. The strike rate of the option
5. The time to expiration
6. The volatility of the currency pair.

To illustrate the concept of an option contract, this Foreign Exchange Derivative Speculator can model the economic and accounting aspects of both a put and a call option. The first step is to select a long position, which represents a call option to buy the currency, or a short position, which represents a put option to sell the currency. The next step is to enter the parameters of the trade, which includes specifying the currency pair, spot rate, trade date, expiration date, notional amount, and currency quoting convention.

In step 2, select an option contract as the foreign exchange derivative instrument, and enter the pricing variables outlined above, which include the domestic and foreign interest rates, the strike rate (which is the exchange rate that the option contract can be exercised at), and the volatility of the currency pair. You can change any of the option variables to instantly see the impact on the premium, or cost, of the option contract.

For example, adjusting the strike rate lower or higher will increase or decrease the premium of the option contract. Similarly, changing the level of implied volatility in the currency pair impacts the price of the option as well, whereby the more volatile the currency pair, the more expensive the option premium.

In step 3, the ending spot rate can be adjusted to see how changes in the spot rate on the expiration date impact the economic value of the option contract. This tool demonstrates how the option will only be exercised when the strike price is more favorable than the ending spot rate. If the ending spot rate is more favorable for buying or selling the currency than the strike rate, the option finishes "out of the money" such that the maximum loss on the contract is the premium paid. Conversely, if the ending spot rate is less favorable for buying or selling the currency than the strike rate, the option finishes "in the money" and equals a positive value.

You can practice pricing foreign exchange options using the Foreign Exchange Derivative Speculator to illustrate the economics and accounting of an option contract, both a put and a call, and to see how variables such as the option strike rate and implied volatility impact the premium or cost of the option at inception. Additionally, you can explore how options can finish "in the money" where a cash payment is received at maturity, or "out of the money" with a zero fair value where no further payment is required to settle the contract.

Take advantage of this unique learning resource to discover the three key distinguishing characteristics of vanilla option contracts, which include (1) the premium paid upfront, (2) the asymmetrical payoff profile relative to the spot foreign exchange rate, and (3) the lack of obligation to make a payment at maturity.

If you are interested in learning more about option contracts, sign up for FX Initiative's Currency Risk Management Training and benefit from our educational videos and interactive examples. Our course on Foreign Exchange Spot & Derivatives walks you through real-world examples of using derivative instruments, and leverages our Foreign Exchange Derivative Speculator to illustrate essential concepts. Foreign exchange options pricing can be complex, but our approach simplifies the academic theory and focuses on the practical application of using options to help your international organization achevei their foreign exchange risk management objectives.

Ready to practice pricing foreign exchange options? Click here to get started!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Identify the Top Two FX Hedge Objectives

Companies that hedge foreign exchange must establish clear objectives in order to gauge the efficacy of their FX risk management program. While the priority of hedge objectives can vary between public and private companies, the same two overarching goals apply: (1) minimizing earnings volatility and (2) preserving cash flows. Gaining a better understanding of these two objectives can help organizations better decide how to allocate resources to achieve their desired economic and accounting results.

First, minimizing earnings volatility means neutralizing to the greatest extent possible the Income Statement impact of fluctuating foreign exchange rates. At the highest level, this requires aligning the accounting treatment for the derivative with the accounting treatment for the underlying exposure to achieve equal and offsetting gains and losses at the same time and in the same geographic area of the financial statements.

When hedging forecasted transactions that do not impact the Income Statement on a current basis, minimizing earning volatility often involves the use of elective “cash flow” hedge accounting treatment, which provides the timing benefit of deferring derivative mark-to-market gains and losses in equity during the forecast period and the geography benefit of accounting for the derivative gain or loss in the same financial statement line item as the forecasted exposure.

When hedging booked transactions that do impact the Income Statement on a current basis, neutralizing earning volatility refers to using the "default" accounting treatment, whereby the highly visible foreign exchange gains and losses related to the underlying exposure and the derivative hedging instrument work in tandem to create a largely equal offset in earnings that mitigates Income Statement volatility automatically at the end of each reporting period.

When hedging net investments in foreign subsidiaries that are accounted for in equity, reducing earning volatility means using elective "net investment" hedge accounting treatment, which allows for derivative gains and losses to be recorded in other comprehensive income (OCI), which is a component of equity, as part of the cumulative translation adjustment (CTA) until the point in time that a sale or liquidation event of the net investment occurs.

Second, preserving cash flows means reducing the variability in functional currency equivalent cash flows resulting from foreign currency transactions. When hedging booked and forecasted transactions, this means hedging to stabilize the amount of cash received or paid upon conversion of the foreign currency at a later date. When hedging net investments in foreign subsidiaries, preserving cash flows can involve a variety of strategies depending on the short and long term goals of the organization. For example, 3 different cash flow strategies include, (1) hedging excess cash balances that are held by foreign subsidiaries and that may eventually be remitted back to the parent, (2) hedging the value of a net investment position to preserve cash flows related to an anticipated sale or liquidation event of the foreign operation in the short or medium term, or (3) not hedging the position in a long term foreign subsidiary that may require cash settlement upon expiration of the derivative instrument.

While these concepts can get quite technical in detail, the overarching theme is that both public and private companies are focusing on the same two foreign exchange risk management hedging objectives: (1) minimizing earning volatility and (2) preserving cash flows. Public companies are often most concerned with mitigating periodic earnings volatility, which suggests they prioritize goal number 1 of minimizing earnings volatility over preserving cash flows. In contrast, private companies are usually more concerned about the economics over the accounting implications, which implies they focus more on preserving cash flows first and foremost. The key highlight is that public and private companies usually have different priorities between the same two FX hedge objectives.

To learn how your organization can prioritize and achieve your company’s specific hedging objectives, sign up for FX Initiative's currency risk management training to start learning best practices. We offer a complete continuing professional education (CPE) curriculum for controlling currency risk consisting of on-demand educational videos, interactive real-world examples, and live webinar events that can be customized to your organization’s particular needs. Take the FX Initiative today to learn how we help both Fortune 500 companies and small and medium-sized enterprises (SMEs) understand, identify, assess and mitigate foreign exchange risk.

Ready to achieve your FX Risk Management objectives? Click here to get started >

The FX Initiative Team
support@fxinitiative.com

How to Price Cryptocurrency (Bitcoin) Derivatives?

Bitcoin (BTC) broke through to a record high of $11,831 over the weekend as volatility in the cryptocurrency continues to rise. Amidst these large and recent price fluctuations, the CME Group (Chicago Mercantile Exchange & Chicago Board of Trade) announced that its new bitcoin futures contract will be available for trading on December 18, 2017. While the valuation of traditional currency and equity derivatives is well established among professionals working in the financial industry, the introduction of the first cryptocurrency bitcoin derivative poses valuation questions as it relates to a new pricing model. Simply put, how are cryptocurrency derivatives priced?

Financial engineering is a continuously evolving discipline designed to introduce and test new products, pricing models and hypotheses. Currently, equity futures are typically priced using variables such and the risk free interest rate and dividends, and currency forwards are priced based on the foreign and domestic interest rate differential between the two currencies in the pair. Additionally, equity options are typically priced using the Black–Scholes option pricing model, and currency options are priced using the Garman–Kohlhagen option pricing model. All of these equations take into account variables such as dividends and/or interest rates.

However, bitcoin as an asset class does not pay dividends nor is it tied to a specific risk free, domestic or foreign interest rate. As a result, a new or modified version of a derivative pricing model for cryptocurrency that accounts for the unique nature of this new digital asset class will likely be used to value the first bitcoin futures contracts. Many academics and practitioners are sharing their thoughts on the best approach for pricing bitcoin derivatives. A couple of commonly raised questions include: (1) How are dividends removed from the traditional pricing models? and (2) What interest rate(s) should be used? As the financial industry navigates a new frontier with cryptocurrency and blockchain technology, how do you think bitcoin derivatives should be priced?

Ready to learn more about currency and derivatives? Click here to take the FX Initiative today!

The iPhone X Index: A FX Comparison Tool

The Economist magazine first published the Big Mac Index in 1986 as a novel way to compare currency prices. The premise of the Big Mac Index is based on the theory of purchasing power parity (PPP), which states that the exchange rate between two currencies is equal to the ratio of the currencies' respective purchasing power. While this can be a rather sophisticated academic theory, the Economist made the concept of “bugernomics” more relatable to a widespread audience.

In simplest terms, the “burgernomics” of the Big Mac Index implies that the same good, a Big Mac, should cost the same in any two countries based on current market exchange rates. To use an extreme example, if today’s euro (EUR) / U.S. dollar (USD) exchange rate is equal to 1.16 and a Big Mac in the U.S. costs USD 1.16, then a Big Mac in the Eurozone should cost EUR 1.00. When there is a price difference in Big Macs between two countries, one of the two currencies in the pair is considered under or overvalued.

More specifically, the Economist 2017 update to the Big Mac Index shows that “the average price of a Big Mac in America in July 2017 was $5.30; in China it was only $2.92 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 45% at that time.” While the Big Mac Index is not a precise approach for valuing currencies and identifying arbitrage opportunities, it is a fun and approachable way for the lay person to learn about foreign exchange valuations.

Click here to explore the Economist’s interactive Big Mac Index

To expand the analysis to other goods and services, FX Initiative has applied the same logic to create the iPhone X Index. For example, the recently released iPhone X is a high demand global product that Apple sells to consumers worldwide in several different currencies. In theory, the same iPhone X should cost the same in any two countries based on current market exchange rates. However, similar to the Big Mac Index, there is a significant variation in U.S. dollar equivalent costs as follows:

.

From this simple example, we can see that the best value is purchasing an iPhone X denominated in Japanese Yen, which saves approximately USD 1.00 or 0.10% compared to U.S. dollar pricing. In contrast, the worst deal appears to be purchasing an iPhone X denominated in euros, which would cost an additional USD 369 or 36.9% more. The FX economic misalignment is clear from a theoretical perspective, but practically speaking most consumers will still buy the iPhone X in their local currency.

This article underscores FX Initiative’s mission to make complex foreign currency matters simple and manageable. Our currency risk management training provides educational videos, interactive examples, and webinar events on best practices from leading companies such as Apple. We help global businesses and financial institutions optimize their foreign exchange risk profiles to efficiently and effectively mitigate earnings volatility and preservice cash flows. To get started, take the FX Initiative today!

Talking Tax Reform, Repatriation & $2.6 Trillion Overseas

Talk of tax repatriation holidays and foreign profits held overseas often accompany the conversation of corporate tax reform. Currently, congress is working with politicians and business leaders to make a plan by year-end. While there is widespread agreement that tax avoidance strategies employed by multinational corporations are a growing problem, there is considerable disagreement in congress over how to solve this problem. Therefore, this article will examine the vast sums of foreign profits currently held by American corporations overseas, the effect of the last U.S. tax repatriation holiday in 2004, and the conflicting objectives between businesses and government over the highest and best use of funds.

In March of 2017, the Institute on Taxation and Economic Policy (ITEP) reported that 322 of Fortune 500 companies collectively held a record $2.6 trillion offshore. It is well documented that the business decision to keep foreign profits overseas is driven by tax avoidance strategies, with the goal of minimizing a firm’s tax liability. As it stands today, companies that repatriate foreign profits do so at a 35 percent U.S. tax rate (minus a tax credit equal to taxes the company paid to foreign governments). Since many corporations strategically stash their cash in countries that are deemed tax havens with low corporate tax rates, the U.S. tax credit they would receive upon repatriation may be insignificant. Therefore, companies strategically keep foreign profits overseas, and they become taxable in the U.S. only if and when a company chooses to brings funds home at their discretion.

To put the enormity of these foreign currency denominated cash reserves in context, the top 3 companies alone held more than half a trillion dollars at the end of 2016. Specifically, Apple reported more than $230 billion, Pfizer reported more than $197 billion, and Microsoft reported roughly $124 billion based on the figures in their 2016 annual reports (10-K). The diversity of companies employing tax avoidance strategies is industry agnostic and includes the world’s largest technology, pharmaceutical, financial, and energy companies among other sectors. Overall, the information from SEC filings clearly proves that American companies are holding vast sums of money overseas largely to avoid taxes, and the tax rules and accounting standards as they are written today provide several loopholes and opportunities that help facilitate and exacerbate these strategies.

Apple clearly has the biggest stake on the corporate side of the debate, and CEO Tim Cook recently stated in an interview with Lester Holt of NBC News that “the biggest issue with corporations in this country is that if you earn money outside of the United States, which most companies increasingly will, and it’s taxed in those countries by the way, the only way that you can bring it into the U.S. and invest, is if you pay 40% - for us. This is kind of a crazy thing to do, so what do people do? They don’t bring it to the United States.” Apple is perhaps the most vocal and recognizable brand among many other technology giants that spent a record amount on lobbying for a lower corporate tax rate in the second quarter of 2017.

The proposed solution is a repatriation tax holiday, which would provide a temporary reduction in U.S. corporate tax rates to encourage bringing profits home to invest in the domestic economy and create jobs. The Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance recently released a Unified Framework for Fixing Our Broken Tax Code that claims it will end “the perverse incentive to keep foreign profits offshore by exempting them when they are repatriated to the United States.” It is reported that the most recent bill proposes a one-time tax of 12 percent on U.S. companies’ accumulated offshore earnings that are held as cash and 5 percent for non-cash holdings.

Historically, a tax repatriation holiday was enacted in 2004 as part of the American Jobs Creation Act of 2004 (AJCA). Specifically, section 965 allowed multinational corporations to repatriate foreign profits to the United States at a 5.25% tax rate, rather than the existing 35% corporate tax rate. The result was that corporations repatriated $362 billion back to the U.S., and the largest multinational companies only brought back approximately 9% of their overseas cash positions. In turn, companies used these funds to pay dividends, repurchase shares, and acquire other companies rather than invest in the economy and create jobs. The corporate actions fueled by the legislation set a poor precedent for encouraging politicians to support future proposals of a similar nature, and a second repatriation tax holiday was defeated in the United States Senate in 2009.

While most business leaders and politicians can agree on the problem, finding the right solution remains an ongoing challenge. As it relates to the highest and best use (HBU) of funds, government is most interested in using taxpayer resources to achieve steady economic growth and low unemployment whereas business is most interested in using capital to minimize risk and maximize short and long term profits for shareholders. As a result of these conflicting objectives, businesses that utilize repatriated funds to invest in jobs and innovation may be taking on additional risk and sacrificing profit maximization opportunities. On the other hand, governments that offer tax repatriation holidays may be sacrificing shorter term tax revenue opportunities in exchange for longer term economic growth and job creation that may never materialize.

It has been over 13 years since the last tax repatriation holiday, and businesses and politicians will continue to debate the costs and benefits of new legislation. With a new administration in the White House, newsmakers are reporting a renewed sense of optimism that a potential deal can be reached that benefits multinational corporations and taxpayers alike. Gary Cohn, the director of the National Economic Council and President Donald Trump's top economic adviser, states that he wants tax reform done this year. The 2017 calendar of the U.S. House of Representatives shows the last legislative session will be held on December 14th, 2017, which leaves them with 20 sessions to reach an agreement and get tax reform done this calendar year.

If you were involved in the corporate tax reform debate, how would you approach the topic of repatriating foreign profits held overseas? From a taxpayer perspective, how would you encourage businesses to use these funds to invest in the economy and create jobs? From a shareholder perspective, how would you expect a corporation to use repatriated funds responsibly? What incentives or penalties would you impose to promote the best possible outcome for all parties? These are tough questions to answer, and finding a mutually agreeable solution between taxpayers and shareholders is at the center of the debate. As congress continues the conversation, join the discussion and share your thoughts and comments.

FX Initiative is an independent informational platform focused on foreign exchange. We help multinational corporations assess and mitigate foreign currency risk. The strategic and unbiased advice we provide global companies helps them proactively plan for events such as tax repatriation holidays. Whether you are looking to preserve the U.S. dollar value of your foreign currency cash reserves, hedge the net investment position in your foreign subsidiaries, or analyze the cash flow and accounting implications of a proposed repatriation strategy, we have the expertise, tools, and resources to efficiently and effectively optimize your plan. To benefit from FX Initiative’s advisory services or to learn more about foreign exchange risk management and repatriating foreign profits, contact us today by emailing support@fxinitiative.com or visiting our website at https://fxcpe.com.

Comparing Cryptocurrency to Foreign Currency

Cryptocurrencies such as Bitcoin have captured headlines in 2017, and the question of how modern cryptocurrencies compare to traditional foreign currencies is often raised. FX Initiative helps global businesses manage foreign exchange (FX) risk, and this article will explore some of the key differences between cryptocurrency and foreign currency from a corporate foreign exchange risk management perspective.

It is clear that cryptocurrencies are still in their infancy, but the debate in the financial community over the future growth of this digital asset class remains open. While many articles have focused on areas such as monetary authorities, regulation, costs, timing, and transparency, this article will offer a unique focus specifically on the areas of acceptance, exchange, utilization, obsolescence, and risk management.

Acceptance
A small but growing number of brand name companies promote their acceptance of Bitcoin, such as Overstock.com, DISH Network, Expedia, Microsoft, and others. In fact, Coinbase claims that 47,000 businesses integrate Bitcoin with their service. However, companies such as Dell and Fiverr announced their acceptance of Bitcoin in 2014 but have since updated their policies to no longer accept Bitcoin. As it stands today, cryptocurrency, unlike foreign currency, is not a universally acceptable medium of exchange for procuring goods and services.

Exchange
It is important to note that most major corporations who accept cryptocurrency are partnered with digital asset intermediaries such as BitPay and Coinbase to instantly exchange Bitcoin for fiat money such as U.S. dollars or euros. By doing so, the companies minimize their holding period and financial exposure to the heightened volatility of a cryptocurrency. Unlike foreign currency, which is not always immediately exchanged, a company’s acceptance of cryptocurrency largely depends on their partnership with intermediaries to transfer the financial risk immediately.

Utilization
While Bitcoin is increasingly used by investors and consumers, businesses still lack widespread utility for the cryptocurrency. For example, when a company earns foreign currency denominated revenue, they may also have foreign currency denominated expenses (i.e. payroll, suppliers, vendors, cost of goods, etc.), which creates a natural utility for the foreign currency. In contrast, most corporations that earn Bitcoin denominated revenue lack Bitcoin denominated expenses, which reduces the utility of the cryptocurrency for funding ongoing business operations.

Obsolescence
Although Bitcoin is perhaps the most well known cryptocurrency, there were over 200 initial coin offerings (ICO) in 2017, which collectively raised more than $3.2 billion. The following white papers on Bitcoin, Ethereum, Zcash, Monero, Bancor, Tezos, and EOS explain the pros and cons of each project, and there remains a high degree of uncertainty as to which cryptocurrency will emerge as the long term market leader. Unlike foreign currency, specific cryptocurrencies have the potential to become obsolete as newer and better technology evolves over time.

Risk Management
The Consumer Financial Protection Bureau (CFPB) warned about the potential issues with virtual currencies such as unclear costs, volatile exchange rates, the threat of hacking and scams, and companies not offering help or refunds for lost or stolen funds. Additionally, the most viable current means of managing Bitcoin's financial risk is simply transferring ownership though intermediaries. If and when firms such as the Chicago Board Options Exchange launch bitcoin derivatives trading products, foreign currencies have superior risk management products & services.

Overall, foreign currencies are widely accepted, easily exchanged, naturally utilized, lack obsolescence, and offer a range of risk management tools to mitigate risk such as over the counter (OTC) and exchange traded derivatives including forwards, swaps, options and futures. As we approach the 10 year anniversary of Bitcoin’s introduction, the adaptation of cryptocurrency in the business world will continue to be notable and newsworthy. Join the ongoing discussion and share your comments and stories on cryptocurrency and its impact on business.

FX Initiative is collaborating with cryptocurrency experts to help educate the business community. We’re creating compelling content and interactive risk modeling tools for simulating Bitcoin denominated transactions, hypothetical hedging instruments, and policies and procedures to facilitate a wider understanding of the practical application and potential of cryptocurrency. To learn more about foreign exchange risk management or to participate in our cryptocurrency collaborations, contact us here, email support@fxinitiative.com or visit FX Initiative at https://fxcpe.com.

Morningstar's Missing FX Risk Management

FX Initiative is fascinated with how global companies manage foreign exchange (FX) risk. This analysis focuses on Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia. Founded by Joe Manseuto in Chicago in 1984, Morningstar’s timeline outlines their expansion into Japan in 1998, Australia, New Zealand and Canada in 1999, and the opening of Morningstar Europe, Morningstar Asia, and Morningstar Korea in 2000. Today, the company has operations in 27 countries as outlined in their 2016 annual report (10-K):

The company’s Securities and Exchange Commission (SEC) filings offer 3 interesting highlights from a FX perspective:

1. Morningstar has direct exposure to 23+ currencies through their wholly owned or majority-owned operating subsidiaries.
2. 26% of Morningstar’s 2016 consolidated revenue was generated from operations outside of the United States.
3. Their most recent 10-Q for the second quarter of 2017 states that "approximately 69% of their cash, cash equivalents, and investments balance as of June 30, 2017 was held by their operations outside the United States."

The two main goals of a FX risk management program are to (1) minimize earnings volatility on the Income Statement and (2) preserve cash flows on the Balance Sheet. Hedging involves taking an offsetting position in a specific currency in order to reduce the impact of unfavorable foreign exchange rate fluctuations, whereby when the underlying position incurs a loss, the hedge incurs a gain, and vice versa. The goal of hedging currency risk is not to gain or lose, it’s to make the financial outcome more certain and predictable. Let’s examine Morningstar’s FX risk profile with a simple year over year comparison between 2015 and 2016 by examining their revenue, operating expense, and other income highlights.

First, let’s explore the impact to the Income Statement from a gross margin perspective (i.e. revenue minus operating expenses). In 2016, “foreign currency translations reduced revenue by about $9.5 million” and their “operating expense by $11.5 million”, for a $2.0 million favorable variance. In 2015, “foreign currency translations reduced revenue by about $26.9 million” and “operating expense by $23.9 million”, for a $3.0 million unfavorable variance.

Second, the impact to “Other income, net primarily includes foreign currency exchange gains and losses arising from the ordinary course of our business operations.” In 2016, “Other income, net” was a positive $6.1 million compared to a positive $1.2 million in 2015. This volatility comes from the “mark-to-market” revaluation of booked receivables and payables each period that is reported in earnings on a current basis. These exposures are booked and known, and serve as the foundation of foreign exchange “balance sheet hedge” programs that are employed by many companies.

As it relates to Morningstar’s discussion of their FX risk management strategy, they state “Our operations outside of the United States involve additional challenges that we may not be able to meet. There are risks inherent in doing business outside the United States, including challenges in currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.” They also state they “do not expect to repatriate earnings from our international subsidiaries in the foreseeable future.”

While Morningstar clearly discloses their substantial currency risk, the company surprisingly states that "We don't engage in currency hedging or have any positions in derivative instruments to hedge our currency risk." Their 2016 annual report also goes on to state that “Foreign currency movements were a factor in our 2016 results, although to a lesser extent than in 2015, as continued strength in the U.S. dollar reduced revenue from our international operations when translated into U.S. dollars. This has been an ongoing trend for several years and reduced revenue by $9.5 million in 2016 and $26.9 million in 2015.”

Morningstar.com’s articles offer various investor perspectives on hedging FX risk. For example, the article “Hedge Your Currency Risk When Investing Abroad” mentions that “Investors should definitely invest globally and they should hedge out at least part of their foreign risk.” Another example from the article titled “The Impact of Foreign-Currency Movements on Equity Portfolios” is that “Betting on currency movements is generally a fool’s game and should be avoided by the average investor.” Applying this advice, it appears that Morningstar is invested globally but doesn’t hedge any part of their currency risk, and their decision not to hedge is a bet on FX.

Finding the right balance between risk and reward is a classic tradeoff for any investor or organization. Morningstar is a highly respected global thought leader when it comes to investing, and they have clearly analyzed their corporate exposure to FX risk as it relates to revenue, operating income and net investments (as shown in the screenshots below). Additionally, Morningstar has an array of publications on currency such as their Currency Category Handbook, and offers data services such as their Morningstar Foreign Exchange Feeds. The company seems to have the personnel, operations, and resources to manage FX risk.

From an enterprise risk management perspective, foreign exchange risk is a non-core business risk that often poses more of a threat than an opportunity, whereas core business risks are related the strengths that a company is rewarded for taking on, such as investing in new products and research and development. Therefore, hedging foreign exchange risk allows firms like Morningstar to budget more reliably when engaging in international business in order to focus on their core strategic initiatives more effectively.

What are your thoughts on Morningstar’s approach to FX risk management? Each market participant must define their own risk appetite, and there is no “standard" protocol. However, in closing this analysis, a quote from Gary Cohn, the Director of the National Economic Council and former president and chief operating officer of Goldman Sachs, comes to mind: “If you don't invest in risk management, it doesn't matter what business you're in, it's a risky business.” Join the conversation and share your thoughts on FX risk management in the comments section.

To learn more about FX risk management, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples, and webinar events help simplify complex currency risk management issues using real-world scenarios from leading organizations such as Apple. Our mission is to help banking and corporate treasury professionals deliver effective currency risk management results in a time efficient manner. Start learning best practices for mitigating FX risk by taking the FX Initiative today! Click here to for more information >

Image Sources: Morningstar Inc. 2016 Annual Report (10-K)

Identify the 5 Stages of the FX Trade Lifecycle

Foreign exchange trading is a critical element of currency risk management, and understanding the trade lifecycle can help organizations plan their hedging activities more efficiently and effectively. The foreign exchange trade lifecycle, as discussed in the FX Risk Management course, can be enhanced with automated resources and typically includes the following 5 stages:

1. The first stage involves identifying and evaluating exposures. To aid in the exposure identification and evaluation process, best practices relate to investment in quality automated resources such as an enterprise resource planning (ERP) system or treasury software application that can be set up to extract data across the enterprise to identify and evaluate foreign exchange exposures rather than manual analysis, which can be time consuming and limited in scope.
2. The second stage involves collecting and quantifying exposure details. These tasks can be automated through software modules such as a netting system for matching foreign currency inflows and outflows or a cash flow forecasting module for determining future exposures based on historical trends in comparison to manual collection and quantification processes through spreadsheets, which can be vulnerable to human errors and oversight.
3. The third stage involves developing and analyzing hedging strategies. This analysis process can be streamlined and structured with automated software that performs value at risk analyses and simulates hedge strategies such that scenarios can be modeled prior to trading in order to save significant time and costs down the road, whereas performing this analysis manually can limit the ability to compare economic and accounting strategies in a comparable format and in a time efficient manner.
4. The fourth stage involves the administration and execution of hedge strategies. This is increasingly facilitated through the integration of electronic trading platforms, where multi-provider execution platforms can be integrated for optimal rate bidding across numerous FX service providers in real time, coupled with automated straight though processing of trades with back office systems to handle transaction reporting, confirmation matching, and payments between counterparties rather than manually performing these critical tasks.
5. The fifth and final stage of the foreign exchange trade lifecycle is financial & managerial reporting. This communication and recordkeeping can be automated through the integration of accounting systems to enable seamless financial reporting for both internal and external audiences rather than manual reporting and compliance processes.

Overall, the 5 stages of the foreign exchange trade lifecycle include (1) identifying and evaluating exposures, (2) collecting and quantifying exposure details, (3) developing and analyzing hedging strategies, (4) administering and executing hedging strategies, and (5) financial accounting & managerial reporting. Each of these stages is essential when implementing foreign exchange trading best practices, and understanding the lifecylce can help organizations plan their hedging activities more efficiently and effectively.

To learn more about foreign exchange best practices and to observe how world class organizations such as Apple employ each stage of the FX trade lifecycle, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples and webinar events can help you and your team better mitigate FX risk and deliver measurable results to the bottom line, so get started today by taking the FX Initiative!

Ready to start FX Risk Management Training? Click here to choose your plan.

The FX Initiative Team
support@fxinitiative.com

How to Compare Currency Derivatives & Credit Considerations

Foreign exchange risk management involves the use of currency derivatives, which are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. In order to use currency derivatives to achieve foreign exchange risk management objectives, companies must be able to deal or trade with a credit worthy counterparty such as a bank or financial institution.

Counterparty credit risk is the risk that the counterparty to a contract does not perform, and is involved in any banking activity, including trading currency derivatives. Therefore, both parties in the transaction need to consider the financial condition of their counterparty by quantifying their creditworthiness. It can be helpful to compare key credit considerations between the three most common currency derivatives, which include forward contracts, vanilla options, and zero cost collars.

Forward contracts involve the exchange of two currencies at an agreed upon rate on the date of the contract for settlement on a date more than two business days in the future. A forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate. From a credit perspective, forward contracts usually do not require an upfront exchange of funds, but almost always requires a payment at maturity to settle the asset or liability position of the contract.

Option contracts are financial contracts that give the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific exchange rate, called the strike rate, on or before a pre-arranged date. A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, and will expire with either a positive value or zero fair value. In other words, options require an upfront payment, but do not require the option holder to make a payment at maturity.

A zero cost collar is a combination of two vanilla options, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. This structure enables the holder to buy or sell a quantity of a particular currency within a specified range of exchange rates between the two option strikes on or before a pre-arranged date. In turn, collars do not require an upfront exchange of funds, but may require payment at maturity if the structure finishes in an asset or liability position.

The two key credit variables to consider are (1) the upfront exchanges of funds and (2) the obligation to make a payment at maturity. Since a forward contract is a firm obligation for a future settlement to be made with no upfront exchange of funds, this derivative has a higher credit risk than a purchased option where upfront premium is paid and there is no obligation for the option holder to make a payment at maturity. Similarly, since a collar may require a payment at maturity to settle the contract, collars are more credit intensive than vanilla options.

Conterparty credit risk became a prominent headline during the financial crisis of 2007–2008, and remains an important factor to consider as credit limits may prohibit a firm or entity from entering into a derivative transaction, particularly in a tight credit economy. When credit constraints inhibit business decisions, firms may need to consider alternative means to transact such as posting collateral. When trading FX derivatives, the acronym KYC, which traditionally stands for Know Your Customer, can be modified to Know Your Counterparty.

If you are interested in learning more about foreign exchange derivatives, credit considerations, and how to hedge using financial instruments, sign up for FX Initiative’s Currency Risk Management Training today. Our educational videos, interactive examples, and webinar events use real world companies such as Apple, Inc. to illustrate aspects of their world class foreign exchange risk management policies and procedures. Mitigating currency risk is a top priority for global businesses, and you can benefit your firm’s bottom line by taking the FX Initiative!

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The FX Initiative Team
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