Find Out the 4 Ways Firms Manage FX Risk

Operationally, foreign exchange risk can be managed in four ways: (1) Avoided, (2) Transferred, (3) Retained and (4) Reduced. Each of these four methods can be applied individually or collectively, and there is no standard protocol on which approach to use when conducting international business. Therefore, companies can benefit from defining and exploring examples of how each approach works in practice as follows:

First, avoiding foreign exchange risk refers to engaging only in domestic business opportunities where both parties to every transaction use the same functional currency. For example, a company based in the United States that uses the U.S. dollar (USD) as their functional currency would only conduct business with counterparties that also use the U.S. dollar as their functional currency. As a result, neither party to the transaction is exposed to foreign exchange risk, but this approach severly limits business opportunities internationally.

Second, transferring foreign exchange risk refers to pricing transactions in the company’s functional currency rather than the customer’s local currency or through risk sharing agreements where a portion of the risk is shared. For example, a company based in the United Kingdom that sells to American consumers could price their goods and services in British pound sterling (GBP). In turn, the foreign exchange risk is transferred to the consumer, but this approach creates a barrier to closing sales in the United States since customers must first acquire GBP to make a purchase.

Third, retaining foreign exchange risk refers to accepting the risk associated with foreign exchange transactions and bearing the potential volatility that accompanies market fluctuations. For example, a Canadian company that does business in the United States where transactions are denominated in U.S. dollars is exposed to exchange rate fluctuations. Consequently, the amount of Canadian dollars (CAD) required for the company to settle a transaction varies, which can create uncertainty and volatility in earnings and cash flows.

Fourth, reducing foreign exchange risk refers to structuring deals strategically through deliberately denominating transactions in a particular currency and hedging the associated foreign exchange risk. For example, a Japanese company that sells automobiles to the United States that are denominated in U.S. dollars can enter into a currency derivative to hedge the U.S. dollar (USD) / Japanese yen (JPY) exchange rate. Accordingly, this approach ensures that the amount of JPY required to settle a future transaction is predictable and certain.

Overall, world-class foreign exchange risk management involves a combination of risk retention and reduction. Risk retention involves controlling the risk and accepting the gain or loss, and risk reduction involves mitigating the risk to an acceptable level by understanding when and how to hedge using financial instruments. FX Initiative’s currency risk management training outlines best practices related to risk retention and risk reduction techniques, including easy to follow guidelines for pricing and booking transactions.

Which approaches to managing foreign exchange risk does your global business employ? Our foreign exchange risk management training can help you optimize several important aspects of your program such as accounting booking rate conventions, exchange rate sources, and currency denomination parameters. Start the new quarter with an actionable plan for managing foreign exchange risk by taking the FX Initiative today!

Ready to retain and reduce your FX risk exposures? Click here to get started!

Cheers,

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.

Commemorating Forty-One (41) Years of Fiat Currency

This week marks 41 years since the definition of the U.S. dollar was officially changed through Public Law 94-564 on October 19, 1976. The result was a shift in U.S. monetary policy where the gold standard, which pegged all currencies to the U.S. dollar (USD) and fixed value in terms of gold, was replaced by our current system of freely floating fiat currencies, where currency no longer holds intrinsic value and is established as money by government regulation or law. This was the most notable event during the Nixon Shock, which was a series of economic measures undertaken by United States President Richard Nixon beginning in 1971, and shaped the nature of the foreign exchange market as it exists today.

Source: http://uscode.house.gov/statutes/pl/94/564.pdf

The free floating system of fiat currencies is best illustrated by the U.S. dollar Index (DXY) that was introduced in March of 1973. The DXY is a measure of the value of the United States dollar (USD) relative to a basket of foreign currencies, which include the euro (EUR), Japanese yen (JPY), Pound Sterling (GBP), Canadian dollar (CAD), Swedish Krona (SEK) and Swiss franc (CHF). At its start, the value of the U.S. Dollar Index was 100.000, and it has since traded as high as 164.7200 in February 1985, and as low as 70.698 on March 16, 2008. The DXY goes up when the U.S. dollar gains value when compared to other currencies, and goes down when the U.S. dollar loses value. The following graph shows the volatility in the value of the U.S. dollar over the last 50 years in relation to various political, economic and other major global events.

Source: US Dollar Index from Stooq.com

Free floating exchange rates are determined by the balance between supply and demand factors that influence a particular currency, and the intersection point where supply meets demand establishes what is known as the price equilibrium or exchange rate. The graph below of supply and demand shows that when there is an increase in demand and a corresponding shift of the demand curve to the right, a new intersection point where supply meets demand is established, and a new price equilibrium or exchange rate is set. In this case, as demand increases, the value or price of the currency also increases from Exchange Rate 1 to Exchange Rate 2. These fluctuations in currency values underscore the concept of exchange rate risk, or currency risk, which arises from the change in price of one currency against another.

Source: FX Initiative FX Market Overview Course

Supply and demand with respect to foreign currency valuations is a simple idea in theory. If at a particular exchange rate, demand exceeds supply, the price will rise, and if supply exceeds demand, the price will fall. Supply is influenced by a central bank’s monetary authority through monetary policy, and depending on the specific circumstances and economic goals of a country or region, a monetary authority will influence the money supply through interest rates and other market mechanisms. Demand, on the other hand, comes from a multitude of market forces including, but not limited to, (1) economic business cycles and economic data releases (2) international investment patterns and foreign direct investment (3) the balance of payments as it relates to tradable goods and services (4) government fiscal, monetary, or other policies and political developments and (5) speculation based on any or all of these factors.

Source: FX Initiative FX Market Overview Course

Over the last 40 years, governments have played a significant role in defining and driving the value of free floating fiat currencies. Since the financial crisis of 2007–2008, exchange rates have been impacted by several major foreign exchange interventions as follows:

• Venezuela’s introduction of a two-tier official exchange rate system for the Venezuelan bolívar in January 2010
• The Bank of Japan’s devaluation of the Japanese yen though quantitative easing and “Abenomics” in April of 2013
• The Central Bank of Russia allowing the Russian ruble to float freely in an attempt to stabilize value in November of 2014
• The Swiss National Bank (SNB) no longer holding the Swiss franc at a fixed exchange rate with the euro in January 2015
• Brexit’s impact on the British pound following the United Kingdom’s referendum to withdraw from the European Union in June 2016

In commemoration of the week that changed the foreign exchange market as we know it, we can look at free floating exchange rates through the lens of history and see how the events of the 1970’s are still impacting the value of more than 180 currencies recognized as legal tender in circulation throughout the world.

To learn more about the foreign exchange market and how to manage currency risk, explore FX Initiative’s educational videos, interactive examples, and webinar events. Our currency risk management training illustrates best practices from leading organizations such as Apple to help you efficiently and effectively mitigate foreign exchange risk for your international business. Learn how to assess and optimize your firm's foreign exchange risk profile by taking the FX Initiative today!

Ready to conquer currency risk? Click here to get started!

Cheers,

The FX Initiative Team
support@fxinitiative.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)

Due Diligence & Distinguishing FX Derivatives

Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions.

At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives.

The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows:

1) Forward Contracts

• Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges.
• Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate.

2) Option Contracts

• Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures.
• Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity.

3) Zero Cost Collars

• Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium.
• Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate.

Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives.

To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative!

Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples!

Cheers,

The FX Initiative Team
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Balancing Brexit & FX Balance Sheet Hedging

As Brexit continues to capture news headlines, FX Initiative is increasingly helping North American companies manage the currency risk associated with doing business in the United Kingdom (UK). Brexit refers to the prospective withdrawal of the United Kingdom from the European Union (EU), which was voted on in June of 2016. Since the referendum, the value of the British pound (GBP) versus the US dollar (USD) has fluctuated from highs near 1.4500 levels in June of 2016 to lows near 1.2000 levels in January of 2017. This approximate 15% decline in value has prompted many international companies to adapt their foreign exchange (FX) hedging programs to better stabilize earnings and preserve cash flows.

American companies exporting to the United Kingdom have seen significant fluctuations in their GBP denominated revenues and accounts receivables (A/R), which are translated into USD in their financial statements for accounting purposes. To state the obvious, the 15% fluctuation in GBP/USD exchange rates over a 15 month period has created sizable swings in earnings and cash flows for firms that operate with a non-GBP functional currency. To mitigate this volatility, one major US pharmaceutical company needed to reconsider their FX balance sheet hedge program to better respond to the changing political landscape and unpredictable currency market prices.

Balance sheet hedging is by far the most common approach among multinational corporations when hedging foreign exchange risk, and in the context of Brexit, refers to hedging GBP denominated receivables and payables on the balance sheet as part of a systematic hedge program at each period or month end, or upon booking a material foreign currency denominated transaction. This US pharmaceutical company was previously hedging at each month end to adjust and match the amount of the their underlying GBP receivables with the amount of their GBP forward contract hedges. However, the majority of their monthly receivable bookings occurred on the 15th of each month, and their mid-month A/R bookings were largely unhedged from the middle of the month through month end.

To address this problem, FX Initiative helped assess the mechanics of their balance sheet hedge program by looking at their financial reporting process and specifically at their accounting booking convention. An accounting booking convention refers to the foreign exchange rate used to record a transaction on the financial statements. In this case, they were using the daily spot rate, which meant they were exposed to changes in exchange rates for each mid-month booking of a material GBP receivable transaction. By probing all the way down to the accounting booking convention, this US company was able to quickly and effectively enhance their balance sheet hedge program by adding one additional “true-up” hedge mid-month.

Their revised approach meant that rather than only hedging at the end of each month, the company was now adjusting the amounts on their forward contract hedge both mid-month and at month end. The result of this fundamental fix was that the company is now hedging over 90% of their GBP exposure for the entire month, and the FX swings in their monthly and quarterly earnings have declined by over 50%. Regardless of whether you are a FX risk management expert or novice, knowing where to diagnose a FX exposure is critical and having the ability to drill down to a technical level of detail such as an accounting booking convention can help companies conquer currency market challenges more efficiently and effectively.

FX Initiative’s training and consulting services can help your global organization establish and improve your foreign exchange balance sheet hedge program. We use real-world examples from Apple to demonstrate how a balance sheet hedge works in practice, and our risk modeling tools enable you to practice your approach prior to implementation to get comfortable with the economics and accounting. While events like Brexit are hard to predict, a consistent and ongoing foreign exchange risk management program can proactively protect against changing political, regulatory, and economic environments. FX hedging is about making the outcome more certain, so give your company the FX certainty and predictably it needs to succeed abroad by taking the FX Initiative!

Ready to build a better FX balance sheet hedge program? Click here to start your Currency Risk Management training!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Grasping Groupon’s Passive FX Risk Management

FX Initiative analyzes how publicly traded companies manage foreign exchange risk. This analysis will focus on Groupon, a Chicago based worldwide e-commerce marketplace, and their passive approach to FX risk management. Using their 10-Q for the quarterly period ended June 30, 2017, let’s explore Groupon’s International segment and its FX impact on their Income Statement.

The Income Statement shows a company’s revenues and expenses during a particular period. The Income Statement in simplest terms totals revenues and subtracts expenses to find the bottom line or net income for the period. Using Groupon’s reported numbers from their Securities and Exchange filing, their International segment’s Income Statement is as follows:

^{_{Source: http://investor.groupon.com/secfiling.cfm?filingID=1490281-17-111}}

The words "foreign exchange", "foreign currency", and "FX" are mentioned 12 times in their earnings announcement, yet Groupon (unlike leading technology companies such as Apple and Google) is not managing their foreign exchange risk at all. Let’s examine Groupon’s FX risk profile by digging into their revenue, expense, and gross profit figures.

• Revenues - Groupon’s revenue increased $27 million in their International segment, but declined $13.8 million due to changes in foreign exchange rates. In other words, Groupon intentionally grew their International revenue by increasing transactions in their Goods category, but unintentionally lost over 50% of that growth due to unhedged foreign exchange risk.
• Expenses - Groupon’s International segment expenses (cost of revenue) increased $29.9 million, but declined $6.9 million due to changes in foreign exchange rates. This increase in expenses was attributable to increases in direct revenue transactions in their Goods category, and unhedged FX risk reduced those expenses favorably but unintentionally by roughly 23%.
• Gross Profit - Groupon’s International segment’s gross profit declined by over $19 million or nearly 10%, and $6.9 million was lost due to unhedged foreign exchange risk. Not only did Groupon’s International segment report lower gross profit across all three of their Local, Goods and Travel categories, they lost even more money as a result of not managing their FX risk exposures.

Groupon’s International segment accounts for approximately 30% of their total revenue, which is a material amount. In comparison, Apple’s International sales accounted for 61% of their third quarter 2017 revenue, and they were awarded the Best Corporation in the World for FX Management by Global Finance Magazine in their 2017 Corporate FX Awards.

Whether you are a shareholder, vendor, creditor, employee or layperson, do you think Groupon should be managing their foreign exchange risk? FX Initiative’s training uses real world examples from Apple to demonstrate how multinational corporations like Groupon can significantly improve their international performance by employing currency risk management best practices.

If you are interested in learning how your organization can improve their foreign exchange risk management program, sign up for FX Initiative’s currency risk management training today. Our educational videos, interactive examples, and webinar events simplify complex FX risk management issues and equip you with actionable intelligence to effectively mitigate FX risk.

Ready to learn FX Risk Management Best Practices? Click here to get started!

The FX Initiative Team
support@fxinitiative.com