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Date:29^th July 2010	Compiled by: M Sathya Kumar
FX Currency Hedging: Applying Cash Flow at Risk Cash flow at risk (CFaR) is a tool that corporates can use to show the impact of currency risk on profit and loss (P&L) and in turn earnings per share. This article looks at how to make best use of this tool. While globalisation has promoted increased trade and corporate expansion, it has also created new currency exposures, the volatility of which has made company profits more uncertain. The credit crisis has exacerbated this currency volatility. These facts of corporate life have made foreign exchange (FX) risk management an ever-growing feature of the corporate treasury landscape. Almost all companies sourcing, manufacturing, or selling overseas are exposed to some currency risk, and to protect profits, they need to assess what and how much to hedge. Applying systematic methods to make these assessments, such as using Cash flow at risk (CFaR) can be useful in making hedging decisions. To demonstrate, consider a US company that sells in US dollars and has expenses in US dollars, Canadian dollars and Mexican pesos (the latter two representing currencies used in the US company’s production and assembly facilities). The company expects the cash flows shown in Table 1 at the end of one year. Table 1: Anticipated Cash Flows On a spot basis, this represents a forecasted 22.83% operating margin. The company is subject to foreign currency risk via the Mexican peso and Canadian dollar expenses. Any unfavourable movement in either currency will impact operating margins, e.g. a 10% adverse movement in both exchange rates reduces profit to US$167,720 or 6.05% decrease in operating margin. The company would like to know how much of its margin is at risk and what the cost will be for locking in the margin at the start of the year. Assume that the company can only tolerate a 50% decrease in profit (US$114,154). The data in Table 2 is provided. Table 2: Spot Rates and Volatility A rough estimate of the cash flow risk can be calculated by multiplying the Mexican peso and Canadian dollar expenses by their respective daily volatilities adjusted for a level of confidence and converting into US dollar. About US$5,532 of the Mexican peso expenses and US$4,046 of the Canadian dollar expenses are at risk at the 95% confidence level. The daily FX risk is US$9,578. Annually, this represents US$152, 044, which is about 66.6% of the total forecast profit and more than the tolerated level. Approximate as it is, it is a useful upper bound of risk. A more accurate assessment of risk can be measured using CFaR,^2 which takes into account correlations between the currencies. This is shown in Table 3. Table 3: Assessment of Risk Using CFaR The CFaR results bear out the rough estimate, though it is less. The CFaR reflects the correlation between the different currencies - Mexican peso currency risk is still greater than Canadian dollar currency risk. The relatively high correlation between Mexican peso/US dollar and Canadian dollar/US dollar results in a lower contribution to CFaR than that of the rough estimate. The annualised CFaR is US$129,331.31, which represents about 57% of expected profit. Again, while lower than the rough estimate, this is greater than the tolerated amount. Given the assumption of the maximum bearable risk, the company must hedge to reduce the currency risk. Alternative Hedging Strategies The company could hedge with: · FX forwards for all or part of the Mexican peso and Canadian dollar exposures. · FX participating forward to hedge all of the downside FX risk and only half of the upside FX risk, leaving open the possibility of participating in favourable currency movements. · At the money FX option for both Mexican peso and Canadian dollar exposures. The impact on CFaR of each alternative is as follows: FX forwards (Mexican peso and Canadian dollar) Intuitively, this strategy should eliminate all currency risk, and therefore lower CFaR to zero. CFaR does fall to zero. The cost of this strategy is the foregoing of any favourable gains in FX rates and the forward point costs, which in this case is a gain of US$14,700 (for 100% cover). The gain reflects higher Mexican peso interest rates, though it comes with the loss of any upside potential. In this hedging example, the decrease in CFaR is linear with respect to the hedge percentage, so the company could choose a hedge percentage that results in a CFaR that is within accepted limits, e.g. an 87.5% hedge percentage results in a CFaR equal to 10% of annual expected profit. A company may find this approach useful as there may be uncertainty in the cash flow forecast and a gradually increasing hedging programme is more appropriate. Figure 1: Daily VaR by Hedge Ratio For example, a 50% hedging programme would result in an annualised CFaR of USD $64,750, representing 28.36% of annual profits and at a gain of US$7,350.^3 FX participating forward to hedge all of the downside FX risk and only half of the upside FX risk Under this strategy 50% of the exposure is hedged with an FX forward and the remaining 50% covered with a FX option. This leaves a 50% exposure to favourable currency movements. The cost of this option is US$6,050 and CFaR falls to zero. At the money FX options to buy both Mexican peso and Canadian dollar exposure amounts The strategy will lock in worst-case FX rates for buying Mexican peso and Canadian dollar and allow the corporate to benefit from favourable FX rate movements. CFaR falls to zero, though the cost of this strategy is US$27,800. Table 4: Summary of Each Strategy's Outcome It is very clear that each strategy eliminates all downside risk to profits. The cost varies from a gain of US$14,700 to a cost of US$27,800. So, for a maximum cost of less than 15% of profits, the company can eliminate all chance of lost profit due to currency movements, and in some cases take advantage of favourable currency movements to increase profits. The best option for the company is the one that reflects its appetite for risk and its hedging budget. A Final Word on CFaR Lesser known than its close relative, value at risk (VaR), CFaR is more suited to corporates because it deals with undiscounted cash flows excluding time value, reflecting the profit and loss statement rather than VaR’s asset/liability fair values (including time value), which are more reflective of the balance sheet. Ultimately, a corporate wants to know the impact of currency risk on profit and loss and in turn earnings per share. If a company can quantify how much risk (loss) it can bear, then it only needs the tools available to make the decision to hedge very easy. CFaR is one such tool that is particularly suited to the corporate world. Article was published in one of the reputed financial magazine.
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