Best Practices in Currency Risk Management

1. Best Practices in • Currency Risk Management “Protecting profits from Foreign Exchange (FX) Volatility”

2. Table of Contents I. What is FX Risk? II. What do Smart CFOs do about FX risk? III. What is Hedging? • Benefits to Hedging • Case Studies • Implementing a Hedging Program • How We Assist • Costs IX. Summary X. Management and Contact Information XI. Appendix & FAQ

3. What is FX Risk? • US Fortune 100 companies lost between $15B and $20B due to unhedged currency moves in 2009. Some more recent examples: • Google lost $300M in Q3 ‘09 due to unhedged FX • Continental Airlines lost $10m in Q2 2010 • Canadian optics company EXFO reported net earnings of $1.2M after FX loses of $2M in Q2 2010 • MDS Nordion, a Canadian international health services and products provider, reported $27M non cash FX loss Q2 2010 • Armstrong World, a global flooring producer, reported a $19M FX loss (3% of revenue) in Q1 2010 • In 2007, Airbus CEO Gallois estimated for every 10 cents of Euro appreciation, Airbus loses €1B

4. What is FX Risk? • FX Risk can be categorized as: • Operational- When a company generates sales in one currency and costs in another, it will have FX risk. A great example is Airbus- their manufacturing costs are in euros, but the majority of their sales are in USD. Difficult to mitigate • Translational- effects of FX changes between a company’s reporting currency and currencies in which the companies foreign assets and liabilities are denominated. This often occurs with foreign-based subsidiaries or offshore manufacturing. Difficult or impossible to mitigate • Transactional - When a customer is invoiced in a foreign currency, and there is significant delay between contract and payment. Exchange rate changes will increase or decrease the price paid or received. Easy to mitigate

5. Exposure to F/X Volatility What is FX Risk? • Even in the G-10 currencies, volatility normally ranges 5-7% in a quarter and this can translate into unwanted earning surprises. • In times of stress those volatilities can easily double, severely impacting profit margins. Non-G-10 currencies (e.g. Mexican and Argentinean Peso, Brazilian Real, Indian Rupee, Turkish Lira) can be even higher. In just two days in October 2008, the Icelandic Krona lost 20% of its value vs. USD. Two days later, it gained back 28% of that value. And if that wasn’t enough, in the ensuing 30 days it then lost half its value. • These events are not rare. In 1998, the Asian meltdown and the Russian default, 9/11, Lehman Bros/AIG in 2008, and most recently the Greek tragedy all had profound effects on all exchange rates…These events are neither rare, nor insignificant in their effects.

6. What is FX Risk?

7. Common FX Misconceptions What is FX Risk? • Assuming Purchasing Price Parity (PPP) drives exchange-rate equilibrium • Assuming F/X rates will “even out” over time • Neglecting tail risk - “Black Swans” (9/11, Lehman Bros, Greece) • Assuming that hedging is too expensive or complicated Note how the USD TWI (Trade-Weighted Index, a proxy for all F/X) varies +/- 20% around the PPP over many years. Mean reversion is evident only over decade-long time frames

8. What is FX Risk? A recent Duke University/CFO Magazine worldwide surveyof CFOs showed currency volatility is the # 3 (Asia) or #4 (US & EZ) out of top 10 concerns That’s second only to consumer demand (#1) and credit markets/interest rates (#2)

9. Foreign Transactional Invoicing Effects What is FX Risk? • Invoice in home currency • Simplest • No Transactional FX Risk, but… • Exposure to Competitive and Operational Risk • Slower wire transfers • Invoice in customer’s currency • No Operational Risk, but… • Exposure to Transaction Risk • Worst choice • Invoice in customer’s currency and hedge exposure • No Risks • Requires implementing a hedging program • Highest profitability, earnings stability and competitiveness Often Chosen to “Avoid” FX Risk

10. How Smart CFOs Handle FX Risk • Change operational risk into transactional risk • Reduces customer or distributor pricing leverage • Increases competitiveness • Faster foreign cash transfers • Minimize net risk before hedging • Utilize natural hedges • Leading/lagging (e.g. pay strong currencies quickly, weak ones slowly) • Hedge remaining transactional risk • FX risk management policy, team • Hedge strategy and selection • Performance metrics • Accounting processes in place

11. + Exchange Rate (foreign/home) Impact on contract Exchange Rate at Time of Contract - What is Hedging? Hedging is a mechanism for managing FX risk EUR/USD As the exchange rate rises, the value of the contract rises. Conversely, as the exchange rate falls, the value of the contract falls

12. What is Hedging? Effect of Exchange Rate on contract value with hedging + Contract Value vs. Exchange Rate Exchange Rate (foreign/home) Impact on contract Hedge Value vs. Exchange Rate - A perfect hedge moves opposite to the contract value, offsetting any changes in contract value

13. If you were a banker, would you lend to Company A or Company B? Benefits to Hedging Euro-based Company A has earnings of $US500,000 per month Euro-based Company B also has earnings of $US500,000 per month, and hedges its FX exposure

14. Earnings Stability Supports Growth via Better Access to Capital Benefits to Hedging • Credit Rating and Cost of Capital • Moodys lists earnings volatility as a key rating factor1 • Capital Sources • Debt (interest rate risk premium) • Equity (Investors seek maximum Sharpe ratios2) • Internal investment • Predictable cash flows = more investment • Firms near a credit rating downgrade spend less on investments3 • Competitiveness • Lower channel costs • Competitor pricing 1 Moodys rating methodology, June 2006 2 Sharpe Ratio = (Return –Risk Free Rate)/(Standard Deviation of Return) 3 Shah 2007

15. Earnings Stability Increases Firm Value Benefits to Hedging A one standard deviation decrease in earnings volatility is associated with an approximate 9% increase in firm value1 1 Allyannis et al 2006

16. USD/CHF Assumptions Case Study • Deal Points • Swiss Firm exporting to the US • Aggregated Purchase Orders for the current month total $300,000 • Due in 90 days net (July 22) • PO signed today, April 22. • Financial Market Data • USD/CHF 3 month volatility 10.45% • Current USD/CHF exchange rate is1.0780

17. Through hedging, we created a less risky earnings profile. Case Study Deal Size is $300,000 USD. Hedge is 30 long puts @ 1.075 (-6,690 CHF), 30 short calls @ 1.080 (+6,360 CHF) Net -330 CHF

18. Implementing a Hedging Program • C-Level • Establish FX Risk Management Policies • Establish Internal Communications Processes (Transparency) • Commit Resources for Implementation and Operations (Outsource?) • Program strategy • Trading Rules (e.g. no early removal of hedges for “profit”, “at risk” limits) • Is it Protect Profits, or Produce Profits (Speculative elements?) • Leading, Lagging, other strategies (Aggregate all currency/treasury?) • Performance Metrics • Mark to Earnings (future period results) • Opportunity cost of not hedging • FAS 133 “Ineffectiveness” • New Accounting Processes • Tracking F/X Exposure is covered in FAS 52, and hedge accounting is covered in FAS 133

19. Outsourcing FX Risk Management is a great solution for small to mid-sized companies for the reasons above. Implementing a Hedging Program Potential Challenges that We Can Help You Overcome • Lacking internal resources who can dedicate their time • Lacking internal knowledge on how to manage F/X Risk • Difficulty calculating exposure • Transaction, translation • Finding and Using Natural hedges • (offsetting transactions) • Designing Financial Hedges • (options, futures, money market, currency swaps) • Developing policies and measures

20. How We Can Assist • Try One Hedge- • This can be a single transaction, or a single months cash flow • F/X Risk Survey • CRM, LLC will review order flow, forecasts, currencies, sales channel, and produce report • Establish F/X Management Team • Finance, marketing, executive, accounting, CRM, LLC • Establish Objectives, Policies, Information Management and Metrics • CRM, LLC will help with templates and proposals. To be documented and understood across organization • Assign Trading Responsibility • Implement Hedging Program • CRM,LLC will monitor exposure, update hedges, effectiveness, positions, metrics

21. Cost of Hedging • Financial instruments used to hedge (typically < 1% of transaction) • Compliance with hedge accounting requirements (e.g. FAS 133, FAS 57) • CRM fees (0.5% of contract size)

22. Time Period influences Hedging Structure FAQ Example: a US company will receive£1M (GBP) • 1 Month to 1 Year Use Options Create synthetic GBP/USD short by buying 100 Puts and selling 100 Calls with 6 month expiry (using Put-Call Forward Parity) Or Forwards/Futures Sell 6 month GBP forward, lock in current rate, close out when £1M received • 6 Months to 2 Years Use Money Market Borrow the Present Value of £1M, convert to $, invest that in US Treasuries (or AAA corporate bonds) for 6 months. At the end of 6 months, collect the £1M receivable and repay the loan with it • 2 to 10 Years Use Currency Swaps Agreement with counterparty to exchange cash flows (interest payments) during the hedge period, and principle (at agreed upon rate) at some point in the future

23. Hedge Derivative Accounting FAQ • Hedges must be deemed “highly effective”, passing a documented test. • Derivatives must always be marked to market • Recorded as assets or liabilities on the balance sheet. • The change in value is allocated into 3 portions: “effective”, ineffective”, and “excluded”. • Hedging existing or committed exposures is called a “fair value hedge”. • The underlying exposure must also be marked to market due to the risk being hedged, and thus offsets the change in the effective portion of the derivative. • Hedging forecasted sales is called a “cash flow hedge”. • It’s best to hedge over longer periods (ie quarters) to minimize forecast errors • Ineffective components must be realized in current income.. • The effective portion is initially posted to OCI, then AOCI, and re-classified into P&L when the underlying hedged item affects earnings

24. Summary • FX poses earnings risk to companies operating internationally • Transactional FX risk can be minimized by hedging • Hedging transactional FX risk has additional benefits • Enhances company credit rating, lowering cost of capital • Enables increased internal investment • Enhances company value • Outsourcing those resources is a viable alternative for small to mid sized companies

25. Management Team • Paul Stafford • Chief Executive Officer • BS Engineering, UC Berkeley; MS Engineering, Stanford • SEC series 65 (Investment Adviser, Series 22, 63 (Registered Representative) • Author, Trading Forex with Options; Publisher, Currency Briefing and FX Options Adviser • Patent holder, Speaker, Commercial Real Estate Broker, Instrument-rated Pilot • Kris Matthews • Partner and Director of Client Relations • BS UC Berkeley, PHD Cornell in Engineering and Energy Economics • Entrepreneur and Business Consultant • FX and Derivatives Trader, Author and Speaker

26. Contact Information Contact: Paul Stafford Office 1.406.626.1546 Email: pstafford@hedgeforeignexchange.com Website: www.hedgeforeignexchange.com

27. Questions?

28. Banking • Saxo Bank • 927 Employees • 2009 Total Assets 16.0B DKK ($US2.7B), Total Equity 2.33B DKK ($US 395M) • ICAAP requires 8% capital adequacy, Saxo has 237% of require capital (a buffer of 861M DKK, $US146M) • Offices in Amsterdam, London, Singapore, Dubai, Athens, Tokyo, Beijing • Fully licensed European bank since 2001 • Your Bank • If your current bank offers the required trading instruments, there is no need for you to establish a new banking relationship

29. Advisory Board Scott Burke President, First Security Bank Gerald McConnell CEO, Spectrum Products Robert Bell Partner, Reep, Bell, Laird PC Michael Harrington Dean, U of M Business School

30. Further Examples of Operational Risk Appendix and FAQ • A US company invoicing foreign customers (or distributors) in US dollars risks loss of business to any competitor, US or otherwise, willing to invoice in the customer’s currency. This is especially significant if the US dollar is appreciating. • Volvo produces its cars in Sweden, but buys parts from Germany, and the US is an important market. Volvo management believed an appreciating Krona/Euro would be beneficial but found the opposite to be true! Why? Volvo’s major competitors are BMW and Mercedes. • A ski resort in Colorado, which has no direct transactional risk at all, is hurt when the Euro falls in value - European ski vacations become cheaper for US skiers, and European skiers stay home.

31. Price List/ Tender Order Receipt from Foreign buyer Production Ship Invoice Receipt of Foreign Currency Pre-Transaction Exposure Transaction Exposure Accounting Exposure Transactional F/X Exposure details Appendix and FAQ

32. Earnings Volatility Increases WACC Appendix and FAQ • Rd is the cost of debt (interest rate). It is equal to the risk-free rate plus a company-specific risk premium or spread • The higher the earnings volatility, the higher the risk premium, higher Rd, and therefore higher WACC • Higher WACC increases project costs and product pricing • Higher WACC = lower shareholder value D = Corporate debt E = Corporate equity Rd = Cost of debt Re = Cost of equity ω = Corporate tax rate

33. Payoff Payoff Short Call Long Call Spot Spot Short Put Long Put Spot Spot Options Hedging Details Options are the right (but not obligation) to purchase (Call) or sell (Put) an underlying asset Options are specified by the executable purchase or sale price (Strike), and an Expiry date Option values (the Premium) are determined by moneyness, time value and volatility

34. Option Hedge Hedging Details Short Call Long Underlying Spot Spot + Long Put = Spot Spot Synthetic Short Underlying

35. Option Spread Example Hedging Details a Swiss Exporter will receive US$300,000 (CHF 323,400 at today’s Spot Rate) in 3 months • Financial Market Data • USD/CHF 3 month volatility is 10.45% • Current USD/CHF exchange rate is 1.0780 • Each option is for 10,000 units of base currency • Deal size and duration determine options used • CHF 323,400, so 32 Long Puts, 32 short Calls at 1.075/8 strike • 90 days net, so set expiry 90+ days out

36. Hedged Using Option Spread Hedging Details Hedge is 32 long puts @ 1.075 (-6,690 CHF), 32 short calls @ 1.080 (+6,360 CHF), Net -330 CHF

37. Forwards/Futures Hedging Details • A Forward or Future is a contract (a commitment) to buy or sell an asset (such as a currency) at a certain price, on a certain date. • Futures are traded on an exchange, and thus have a standard set of contract sizes and delivery dates. • Forwards are custom contracts traded “Over The Counter” or OTC directly with a counterparty. Payoff Payoff Spot Spot Delivery Price Long Position Short Position

38. Forwards/Futures Hedging Details • The value of a Future is settled daily on the exchange (ie marked to market). • Forwards are only settled at the end of the contract period • A minimum margin (like a performance bond) needs to be maintained. Margin is usually a small fraction of the contract size. • If the value of the contract falls, and there are insufficient funds in the brokerage account, a margin call requires the trader to add funds to the account. Margin requirements for bona-fide hedgers are lower than for traders, as there is less risk of default.

39. Pricing the Forward rate Hedging Details • Today’s Spot Rate 1.4300 • GBP interest rate 3.0% (BoE overnight rate) • USD interest rate 1.0% (FED overnight rate) One year forward forward rate 1.43*(1.01/1.03) = 1.402 The one year forward is derived from what each currency should be worth in one year. £1000 invested for one year is £1,000* 1.03 = £1,030. $1430 invested for one year is $1,430 * 1.01 = $1,444. So the one year forward is selling $1,444 in exchange for £1,030, or 1.402

40. Forward as Hedge Hedging Details a US Exporter will receive£5M ($7,150,000 at today’s Spot Rate) in 12 months Exporter promises to deliver £5M To Bank (ie Exporter is short the forward) Short Forward Contract Sale contract Margin Deposit Customer Exporter Bank Product Delivery Bank delivers $ at forward rate of 1.402 Exporter delivers £5M To Bank US$7.010M £5M £5M

41. Money Market Hedging Hedging Details a US Exporter will receive€5M (= $6M today) in 2 years • Today’s Spot Rate 1.2000 • EUR interest rate 4.0% • USD interest rate 3.0%

42. US Treasuries/ AAA Corp Bonds Exporter converts € to $ at today’s spot. Buys 2 yr UST or AAA Bonds $6M $180k $180k $6M Exporter borrows €5M from Bank Sale contract €5M Product Delivery €200k Exporter repays €5M loan to Bank €5M €5M Money Market Hedging Hedging Details a US Exporter will receive€5M (= $6M today) in 2 years Customer Exporter Bank Exporter pays 1% annual interest on loan €200k

43. Currency Swap Hedging Details a US Exporter will receiveC$10M (=US$9.67M)in 18 months • Today’s exchange rate 1.0337 • CAD interest rate 0.5% (BoC overnight rate) • USD interest rate 0.2% (FED overnight rate) • Implied forward rate 1.0337*(1.005/1.003)**1.5

44. Currency Swap Hedging Details a US Exporter will receiveC$10M (= US$9.67M)in 18 months 1st Semi annual interest 0.2% on US$ 9.676M 0.5% on C$10M US$ 9.67k Sale contract C$ 25k Customer Exporter Bank 2nd Semi annual interest 0.2% on US$ 9.676M 0.5% on C$10M US$ 9.67k C$ 25k Product Delivery 3rd & Final annual interest 0.2% on US$ 9.676M 0.5% on C$10M US$ 9.67k C$ 25k C$ 10M C$ 10M Exchange of principle US$ 9.67M