Presented by: The Northern Trust Company Fran Wawrzyniak, CTP June 7, 2012

1. Windy City Summit CTP Review Chapter 9 Service Expertise Integrity Presented by: The Northern Trust Company Fran Wawrzyniak, CTP June 7, 2012

2. Chapter 9 Financial Risk Management Fran Wawrzyniak, CTP

3. There are 8-10 questions from this chapter on the exam Know Overview of Financial Risk Management Know Derivatives Instruments Know Different Exposure Interest Rate FX Commodity Accounting and Tax Issues Studying this Chapter

4. Overview of Risk Management in Treasury • Financial risk is the risk of direct or indirect losses resulting from the uncertainty of the future level of interest rates, FX rates, commodity prices, or from adverse impacts on a company with highly leveraged capital structure

5. Overview of Risk Management in Treasury • Techniques to evaluate the impact of risk-reducing events • Value-At-Risk (VaR) • Developed by traders to estimate the possible loss for the entire trading operation • Volatility of an expected average value (such as cash flow) and a standard deviation of the distribution of future outcomes • Sensitivity Analysis • What-If exercise to determine how sensitive cash flow is to changes in variables • Scenario Analysis • Similar to Sensitivity Analysis but multiple variables are altered • High and low variables are used to find the overall best and worst possible outcomes • Monte Carlo Simulation • An extension of Sensitivity Analysis, but includes a series of probability distributions to produce an overall probability distribution of some final measure or outcome

6. Overview of Risk Management in Treasury • Measuring the exposure of changes of prices of assets which can alter the company’s risk profile. • Hedging – Use of financial instruments to reduce or eliminate risk of future cash flows • Speculation – Betting on the direction of the market - Will the price of an asset will go up (long) or down (short)? • Arbitrage – Buying an asset in one market while simultaneously selling in another. Transaction assumes no risk but attempts to profit from market inefficiencies • The Benefits of Risk Management • Reduced financial stress on company • Greater predictability of future cash flows • Enhanced borrowing advantage

7. Derivative Instruments Used As Financial Risk Management Tools • A derivative instrument is a financial product that acquires it value by inference through a formulaic connection to another asset. • Companies usually need to sign an International Swap and Derivative Association (ISDA) Agreement • Standard industry contract • Defines terms and conditions of the derivative contract • Types of Derivative Instruments • Forwards • Futures • Swaps • Options

8. Derivative Instruments • Forwards • Contracts between two parties that require specific action at a later date at a price agreed upon today • Future Date = Maturity Date • Contract Price = Delivery price • Not traded on an organized exchange • The buyer is in a long position, the seller is in a short position • Long position gains value when the price rises and loses when the price falls

9. Derivative Instruments • Forwards - Contracts between two parties that require specific action at a later date at a price agreed upon today • Future Date = Maturity Date • Contract Price = Delivery price • Not traded on an organized exchange • The buyer is in a long position, the seller is in a short position • Long position gains value when the price rises and loses when the price falls

10. Derivative Instruments • Futures - Same as Forward, but have standardized contracts and are traded on organized exchanges • Contract size and its maturity date set by exchange • Requires a margin account • Daily mark-to-market and margin calls if necessary

11. Derivative Instruments • Swaps- Agreement to exchange (or swap) a set of cash flows at a future point in time • Interest rate swap most common type of swap. One party swaps its floating interest rate for a fixed rate and vice versa • Allows Companies with weaker credit ratings to get better rates • Other types include currency, commodity and basis swaps • Primary risk is counterparty risk

12. Derivative Instruments • Options - Contract between two parties where the buyer has the right (not obligation)to buy or sell a fixed amount of underlying asset at a fixed price on or before a specified date • Counterparty is the Writer of the option and received the price paid • May be exchange-traded or negotiated between two parties • Call Option: the contract allows the owner to buy the asset at a fixed price • Put Option: the owner has the right to sell the asset at a fixed price • Fixed price is the strike/exercise price of contract • Possible relationships between premium and strike price: • At-the-money→ asset price = strike price • Call Out-of-the-Money →asset price less than strike price • Put Out-of –the-Money → asset price greater than strike price • Call In-the-Money → asset price greater than strike price • Put In-the-Money → asset price less than strike price

13. Derivative Instruments • Options (continued) • Strike/exercise price—The fixed or contracted price of the underlying asset • Maturity date (or exercise date)—Specified date after which the option expires • Seller of option receives a premium from the buyer • American Style – you can settle at any time during the option period • European style – you can only settle on the option expiration date • Bermuda style – you can settle at predetermined date or at expiration

14. Foreign Exchange (FX) Risk Management in Treasury • FX rates are quoted in several ways, depending on the currency and the markets involved • One U.S. Dollar equivalent to foreign currency • One foreign currency equivalent to U.S. Dollar

15. Foreign Exchange (FX) Exposure • Rates are obtained by real-time rate reporting services (Bloomberg, Reuters), through a dealer or free on the internet • FX Markets • Spot Market • Current exchange rates • Settled in one or two days – such as Canadian dollars or Mexican pesos in the US • Forward Market • Settled in more than two days – such as European and Asian currencies in the US • Current spot rate plus or minus interest rate differential (interest rate parity) • Forward points • Par – interest rates are the same • Discount – currency with higher rate will trade • Premium – currency with lower rate will trade

16. Foreign Exchange (FX) Exposure • Change in Foreign Exchange Rates • Types of FX exposure • Economic Exposure • Global markets and related currencies causes the price of goods to change • Even if a company does not have a global business perhaps their competitors do • Transaction Exposure • Physically converting one currency for another currency • Translation Exposure • Consolidating foreign subsidiary's financial statements into the parent company's currency • Accounting exposure • Large amount to hedge, loans in the foreign currency can hedge this exposure

17. Currency Derivatives Used to Hedge FX Exposure • FX Derivatives • Currency or FX Forwards – Commitment to buy foreign currency at a future date. • Currency Futures – Similar to forwards but traded on the exchange and standard contract. • Currency Swaps – Exchange of floating rate cash flow in one currency for fixed in another currency. • Currency Options – Right to buy or sell fixed amount of foreign currency at a fixed exchange rate, on or before specified date.

18. Currency Derivatives Used to Hedge FX Exposure • Forward • U.S. company agrees to pay an invoice for 125,000 GBP in 90 days • Buy GBP and sell USD • Forward FX exchange rate = 1.6365 (current spot rate plus or minus forward points) • 90 days the company must deliver $204,563 (125,000*1.6365) to counterparty • Counterparty will deliver 125,000 GBP wherever the company needs it to

19. Currency Derivatives Used to Hedge FX Exposure • Futures • U.S. company agrees to pay an invoice for 125,000 GBP in 90 days • Buys future contract at an exchange rate of 1.6365 and puts up cash margin • In 90 days company buys GBP in spot market to deliver to supplier and sells USD • If futures contract has a gain then the company can sell the futures contract for a profit • If futures contract has a loss then cash margin is lost

20. Currency Derivatives Used to Hedge FX Exposure • Swaps • U.S. company borrows in the U.S. markets to fund an investment in Japan • Interest expense in USD and interest income in Yen • To reduce FX exposure company swaps Yen interest income for USD at a fixed rate over the term of the debt • Company still owes money to the U.S markets but instead of receiving Yen it will receive USD

21. Currency Derivatives Used to Hedge FX Exposure • Options • U.S. company agrees to pay an invoice for 125,000 GBP in 90 days • Buy GBP and sell USD • Buys option contract at an exchange rate of 1.6365 and pays an upfront premium • Caps, floors, collars • In 90 days company has the OPTION to buy GBP in spot market or at the option price depending on what the then current FX rates are trading at

22. Interest Rate Exposure and Risk Management • Companies with variable interest rate investments face lower earnings (interest income) when rates fall • Companies with variable interest rate debt face higher borrowing costs (interest expense) in rising rate environment

23. Interest Rate Exposure and Risk Management • Forwards • Buyer can lock in a rate (price) today to be used in the future • Forward Rate Agreement (FRA) • Futures • Traded on the Chicago Mercantile Exchange • Swaps • Exchange cash flows of two different securities • Fixed-floating swap most common

24. Interest Rate Exposure and Risk Management • Options • Interest Rate Cap - ensures a floating rate loan receives a ceiling if interest rates rise • Interest Rate Floor - a hedge against rates dropping below a certain level • Interest Rate Collar - combo of Cap and Floor that effectively locks in a range for its borrowing costs

25. Commodity Price Exposure • Price Exposure- potential for changes in price of commodity (agriculture and meat products, oil and gas, minerals, and metals) • Two types of exposure • Price – mitigate with derivatives • Delivery – mitigate with long-term contracts • Exposure hedged by Forwards, futures, swaps, and options

26. Other Issues Related to Financial Risk Management • Accounting Issues • Addressed by International Accounting Standards Board (IASB) and Financial Accounting Standard Board (FASB) • Valuation and Disclosure of Derivative Instruments • Primary problem is determining accurate value when mark-to-market is applied • Updates made to accounting rules • Topic 820-10 (Fair Value Measurement) • Topic 815 (Derivatives and Hedging)

27. Other Issues Related to Financial Risk Management • Impact on Derivatives from Dodd-Frank Act • Brings more transparency and accountability to derivative markets • Closes regulatory gaps • Requires central clearing and exchange trading • Requires market transparency • Adds financial safeguards • Sets higher standards of conduct

28. Other Issues Related to Financial Risk Management • Tax Issues Related to Hedging • Very complex tax issues when using hedges • Errors in the accounting treatment can be very costly especially if restatement of earnings is involved • More complex for global companies • Wrongs methods could impact gains and losses • Obtain legal, tax, and accounting experts who specialize in this area

29. Other Issues Related to Financial Risk Management • Hedging Policy Statement • Should come from the highest level in an organization as possible (board of directors) • Policy statements for FX risks, interest rate risks, and commodity pricing risk

30. Other Issues Related to Financial Risk Management • Emerging Markets – Special challenges companies face: • Tightly managed currencies (F/X and availability) • Not all hedging instruments are available • Emerging Market Currencies • Fall into one of three baskets • Free floating • Capital controls • Non-readily tradable in global F/X marketplace

31. Issues with Exotic Currencies Liquidity Volatility Transparency Capital controls Carrying risk Pricing distortions Risk-sharing options Internal hedging alternatives Transfer risks Other Issues Related to Financial Risk Management

32. Issues with Exotic Currencies Low level of transaction activity Dramatic fluctuations Central bank restrictions Less developed financial markets Other Issues Related to Financial Risk Management

33. Hedging Tools Available for Emerging/Exotic Currencies • Non-Deliverable Forward (NDF) • Cash settled in a major base currency and used when exotic currency is not actively traded in the forward market • On settlement, there is no exchange of currencies, only the difference between the NDF rate and the spot rate. • Non-Deliverable Option (NDO) • Same as NDF but buyer has the right (an option) to buy or sell