Assessing and Mitigating Financial Risks in Global Business

1. International Banking Assessing and Mitigating Financial Risks in Global Business February 7, 2007 Jonathan Marcus SVP, Director Int’l Banking Eastern Bank

2. Where FX May Impact Your Business • Foreign exchange rates affectvirtually every aspect of a company’s business: • Sales income • Labor costs • Material costs • Financing costs • Capital purchases • Pricing • Margins • Competition • Market share

3. FOREIGN EXCHANGE EXPOSURE MANAGEMENT • Doing business outside your home country creates exposure to currency movements. Doing business inside your home country can have foreign currency implications, too! • Global business, regardless of geographic borders, generates exposure to currency swings. • Unless all exposure is understood and quantified, management decisions put your company at risk not only to margin and profit disruptions, but also to share price ramifications.

4. COMPANY EXPOSURES TYPES DEFINITIONS TRANSACTION EXPOSURE Arises whenever any company unit commits to pay or receive funds in a currency other than its national currency. TRANSLATION EXPOSURE The risk that financial statements of overseas subsidiaries will gain or lose value because of exchange rate movements when translated into the currency of the parent company upon consolidation. CONTINGENT EXPOSURE Exists when the dollar value of anticipated but not yet committed cash flows are subject to changes in exchange rates. ECONOMIC EXPOSURE Impact of foreign exchange rate changes on the value of the firm. COMPETITIVE EXPOSURE Impact of foreign exchange rate changes on the competitiveness of a firm’s products.

5. Political Stability Economic Performance Exchange Rates Interest Rates Inflation Commercial Activity Central Bank

6. Netting • Simple and CHEAP! • Reduce overall exposure and need to hedge by netting local payables against local receivables. • Increase effectiveness through coordinated timing • Includes - payrolls, rent, local sourcing of goods and services, taxes, local sales, advertising

7. Selecting the “Right” Approach • The right hedge for your company will depend upon the exposure, your market view, and your corporate philosophy toward managing risk. • Your Perspective - • The exposure is a firm commitment. Your goal is to know the exact USD value of future foreign payments/receivables. You are not concerned about sacrificing upside potential. - Forward • There may be some uncertainty regarding the amounts and timing of your exposure. You want to retain upside potential and do not mind paying a premium for it. - Option • You can tolerate some variance due to FX movements. Your job is to protect against large negative surprises. You would like to retain some upside potential, but are unwilling to pay any premium for hedge protection. Range Forward/Participating Forward

8. FORWARDS • STRATEGY 1: FORWARD • One simple way to eliminate exchange rate risk is to enter into a contract that locks in a guaranteed exchange rate for converting foreign currency to U.S. dollars (USD). • • A forward rate agreed upon today for a future currency transaction. • • Exchange rate will be no worse and no better than the agreed forward rate. Hence, you will forego the potential to do any better than the forward rate. • • No up-front fee. • • Forward exchange rate will be a function of the spot rate and interest rate differentials between the two currencies. • • Can be made into a window forward in order to accommodate the need for flexible delivery dates. No money changes hands until customer requests their specified contract draw down within a designated window period.

9. Forward Hedge • EXAMPLE:Customer to receive EUR 5,000,000 in 3 months • spot = EUR 1.24; 3 Month forward = -28.8 • at spot: EUR 5,000,000 * 1.24 = $6,200,000 • forward: EUR 5,000,000 * 1.2371 =$6,185,600 • By locking in the rate the customer has fixed the U.S. amount to be received ($6,185,600). • Suppose in three months time, spot EUR is 1.15. The customer would have received $5,750,000 had the forward not been in place. Conversely, if spot is 1.35 the amount received would have been $6,750,000. • SPOT RATE IN THREE MONTHS IS: • EUR 1.15 EUR 1.24 EUR 1.35 • HEDGED $6,185,600 $6,185,600 $6,185,600 • UNHEDGED $5,750,000 $6,200,000 $6,750,000

10. Summary of Forward Rates • Forward exchange rate is not a forecast • Both parties are contractually obligated to settle at maturity • Funds are settled at maturity • Difference between spot and forward rates are interest rate differentials • Only one forward rate for a currency on a particular date

11. Currency Options • A foreign currency option is the right, not the obligation, to buy or sell a predetermined amount of currency against another, at a specific exchange rate, at (or within) a certain time. An up front fee, or premium, allows you to purchase this right. • APUT is the right to SELL a currency to protect, or hedge, against its potential depreciation. • A CALL is the right to BUY a currency to protect, or hedge, against its potential appreciation. • Expiry: Final maturity past which your option can no longer be exercised. • Amount: Face amount on which the contract is made.

12. Currency Options • European Style Options: exercisable only on expiry date. • American Style Options: exercisable anytime during the life of the option. • Strike: Price at which a holder may buy (call) or sell (put) the underlying currency • Premium: Cost of purchasing the option contract, generally expressed as a percentage of the nominal

13. Hedging With Options • Example: You expect to receive 100,000 CAD in 3 months and want to lock in a minimum • rate at which to sell CAD against USD. You buy a CAD put: • Current Spot Rate USD/CAD: 1.3700 • Strike Price: 1.3761 • Maturity: 3 months • Style: European • Premium: 1.22% • This option gives you the right, but not the obligation, to sell CAD at 1.3761 at maturity. • Your cost for this option is USD $886.56 • Scenarios at Maturity with an option hedge: • CAD appreciates: USD/CAD =1.2500 • You choose not to exercise your option because you can sell your USD/CAD at the prevailing market rate. Net of the premium you receive is $79,113.44. • CAD depreciates: USD/CAD = 1.4900 • You choose to exercise your option and sell your CAD at 1.3761, receiving $72,669.14 versus the prevailing market rate where you would only receive $67,114.09. Net of the premium you receive is $71,782.58.

14. Advantages Total protection against adverse currency moves Profit potential from full participation in a favorable currency move No potential currency exposure if the receivable is not realized Buying an option does not obligate currency delivery Disadvantages Reduction of potential participation in favorable currency movement by the premium charge (premium outweighs the savings) Hedging with Options

15. Buy a cap, sell a floor - Definition: A zero cost collar consists of the simultaneous purchase of one option and sale of another at different strikes, both for the same amount, for the same time frame. This offers complete protection against adverse currency moves beyond a certain level. This is paid for by giving up gains beyond a second (more favorable) rate. Market Conventions & Language: Zero Cost Collars are also called Risk Reversals, Range Forwards, Tunnels, Caps and Floors. Implied View: · Complete protection desired against adverse currency moves beyond a floor level.· Limited beneficial move expected. · Complete gains desired from beneficial move up to a ceiling level. Options - “Zero Cost” Collars

16. OPTIONS - The “Zero Cost” Collar • Advantages • · Complete protection against adverse currency moves beyond the floor level. · Zero transaction cost.· Complete gains from beneficial moves up to a limit. • Disadvantages • · Benefit given up beyond a certain point.

17. If your company exports goods to the U.S., you need to buy Canadian dollars (sell U.S. dollars) to convert your U.S. receivables. You will lose money if the Canadian dollar rises in value because your U.S. dollar receivables will buy fewer of them. Combining options to create a Zero-Cost Range Forward can protect you against this by giving you a range of exchange rates within which you may buy Canadian dollars at expiry. By using the income from the sale of one option to purchase another, you can cover your exposure with no premium paid up front. As an example, assume: Expiry in three months Spot (CAD$ it takes to buy U.S.$) 1.3600 Forward rate - .0060 _______ All-in forward rate 1.3540 You purchase an "out of the money" Canadian Dollar Call at 1.3240. This gives you the right to buy Canadian dollars at a lower rate than the current forward rate. You sell an "out of the money" Canadian Dollar Put at 1.3740. This obliges you to buy Canadian dollars at a higher rate than the current forward rate. These combined contracts create a Zero-Cost Range Forward that defines a range of 1.3240--1.3740 within which your company will buy Canadian dollars at expiry: If, at expiry, the Canadian dollar has strengthened to a spot rate below 1.3240, you exercise your Call option and buy Canadian dollars at 1.3240. This is your maximum downside risk. The Put option will simply expire. If the Canadian dollar has weakened to a spot rate above 1.3740, the bank will exercise the Put option and your company must buy Canadian dollars at 1.3740. This is your maximum upside potential. If the Canadian dollar spot rate is between 1.3240 and 1.3740, you let both the Call and Put options expire and simply buy Canadian dollars at the prevailing spot rate. Zero Cost Collars for Exporters

18. If your company imports goods from the U.S., you will need to sell Canadian dollars (buy U.S. dollars) to pay these U.S. bills. You will lose money if the Canadian dollar falls in value because it will take more of your Canadian dollars to cover the same U.S. payables. Combining options to create a Zero-Cost Range Forward can protect you against this by giving you a range of exchange rates within which you may sell Canadian dollars at expiry. By using the income from the sale of one option to purchase another, you can cover your exposure at no cost. As an example, assume: Expiry in three months Spot (CAD$ it takes to buy U.S.$) 1.3600 Forward rate -.0050 _______ All-in forward rate 1.3550 You purchase an "out of the money" Canadian Dollar Put at 1.3800. This gives you the right to sell Canadian dollars (buy U.S. dollars) at a higher rate than the current forward rate. You sell an "out of the money" Canadian Dollar Call at 1.3300. This obliges you to sell Canadian dollars at a lower rate than the current forward rate. These combined contracts create a Zero-Cost Range Forward that defines a range of 1.3300--1.3800 within which your company will sell Canadian dollars at expiry: If, at expiry, the Canadian dollar has weakened to a spot rate above 1.3800, you exercise your Put option and sell Canadian dollars at 1.3800. This is your maximum downside risk. The Call option will simply expire. If the Canadian dollar has strengthened to a spot rate below 1.3300, the bank will exercise the Call option and your company must sell Canadian dollars at 1.3300. This is your maximum upside potential. If the Canadian dollar spot rate is between 1.3300 and 1.3800, you let both the Put and Call options expire and simply sell Canadian dollars at the prevailing spot rate. Zero Cost Collars for Importers

19. RANGE FORWARDS STRATEGY 2: RANGE FORWARD aka ZERO COST COLLAR You can enter into a Range Forward to establish a worst-case (floor) and best-case (cap) exchange rate for a future currency transaction. • The range can be as wide or as narrow as you wish depending on your risk tolerance. • The range will be centered around the current forward rate. • No up-front fee. • Protects against any weakening of the currency against the USD below the floor rate. • You retain upside potential associated with a strengthening of the currency against the USD up to the cap rate. • May also be structured with a window to allow for payment date uncertainty.

20. 50% PARTICIPATING FORWARD STRATEGY 3: 50% PARTICIPATING FORWARD The participating forward combines the best features of a conventional currency forward and a currency option. Like a conventional forward, the participating forward provides guaranteed protection against adverse exchange rate movements with no up-front premium. Like a currency option, the participating forward offers unlimited upside potential if the exchange rate subsequently moves in your favor. • Known worst-case rate • Ability to participate in up to 50% of favorable market movements. • No up-front fee • Worst-case rate for participating forward will be somewhat less favorable than current forward rate to finance the upside potential inherent in the participating forward. • Significantly more upside potential than a Range Forward. • May also be structured with a window to allow for payment date uncertainty.

21. FORWARD EXTRA STRATEGY 4: FORWARD EXTRA Forward Extras provide protection against adverse currency rate fluctuations while allowing you to take advantage of favorable currency movement up to a negotiated "trigger" rate. As long as spot rates never reach the "trigger" rate, you receive the full benefit of favorable exchange rate activity. The installation of the "trigger" rate into the option reduces or can eliminate the premium of the option purchased. Should the spot rate touch the "trigger" rate anytime during the course of the contract the fixed exchange rate immediately reverts back to the original strike price. The customer would then be locked into the fixed exchange rate, like a forward contract, for the duration of the contract.