Understanding and Managing Foreign Exchange Risk

A Presentation to the CAURA Ontario Conference

Kingston, Ontario November 30, 2009

Presented by
Steve Boutilier, Managing Director
Distribution–Foreign Exchange & Investment Product
Overview

• CAURA Consideration
• Risks - Identify & Quantify
• Creating a Hedging Strategy
• TD University

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CAURA Consideration

• Risk Profile
• Cash Management
• Capacity to address

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CAURA Consideration
Daily QCAD= 10/01/2008 - 10/31/2008 (GMT)

Line, QCAD=, Bid(Last) Price

11/19/2009, 1.0545 /USD

1.26

• Market forces 1.24

1.22

1.2

– Volatility 1.18

1.16

Weekly QCAD= 1.14

01/01/2004 - 11/22/2009 (GMT)
– Trend Line, QCAD=, Bid(Last)
1.12

1.1
Price
11/22/2009, 1.0543 /USD
1.08

.1234
01 02 03 06 07 08 09 10 13 14 15 16 17 20 21 22 23 24 27 28 29 30 31
October 2008
1.3

1.25

1.2

1.15

1.1

1.05

.1234
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2004 2005 2006 2007 2008 2009

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 FX Risk Management Strategy

Foreign Exchange Risk Management products can be segmented to

reflect the objective of a company’s strategy:

Strategy Objective Products Risk Profile

Do Nothing Retain exposure to markets (up and down) Spot Fully exposed to market moves

Fixed Price Remove all exposure to markets Forwards Unable to participate in favorable market moves

Insurance Protect against negative market moves Options Dependent on option structure used

Implement the hedge that meets your objective!

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Hedging Strategy

• What is a hedge?
– Means of protecting yourself against loss, or at least reducing the
possibility of a loss

• Why hedge?
– Improve the ability of the company to weather market volatility
and protect the gross margin
– Provides predictability
– Be proactive versus reactive
– Strengthen your balance sheet

• Hedging is not speculative

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8 Steps to a FX Hedging Strategy

• Identify your exposure/Cash flow analysis

• Create internal hedges
• Understand the purpose behind hedging
• Determine the company’s foreign exchange goals
• Decide on a level of commitment from corporate resources
• Develop a market view / hedging horizon
• Identify hedging products
• Create a hedging strategy

TD Securities will assist you in developing

a specialized FX Hedging Strategy

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Identify Risk

• What kind of financial risk are you exposed to

– Transaction vs Translation?

• What volumes are anticipated?

• When are they expected to occur?

• How reliable are these cash flows?

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Quantify Risk / Cash Flow Analysis

• Sensitivity analysis
– Can changes in currency be absorbed?
– How material are FX rates to meeting your budget?
– What does a 1% change in the currency rate do to the bottom line?

Impact on $1 Million Exposure

1.20
1.15
Gain/(Loss)

1.10
1.05
1.00
0.95
0.90
(150,000) (100,000) (50,000) - 50,000 100,000 150,000
Spot rate

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Create Internal Hedges

• Negotiate Canadian dollar terms where economic and where possible

• Differentiate gross exposure from cash flow mismatches

• Explore relative to overall University exposure where permitted

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Understand the Purpose Behind Hedging

• What are you trying to achieve?

• Is hedging viewed as a win/lose proposition?

• The purpose of hedging is viewed to offset risk

• Once again, hedging is not speculating. It should be used as a

method of protecting profit margins and achieving a budgeted rate

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Determine Foreign Exchange Goals

• A hedging policy is essential - senior management must buy into the

policy
• Set realistic budget rates
• What is your risk tolerance?
• Who will look after the hedging strategy?
• What level of expertise is required?

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Market View

• Developing a market view is essential in creating a hedging strategy

• Two different market views will suggest two different strategies
• Sources for market information - is this information reliable?

How can you achieve this?

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Know the Hedging Products

• Spot
– Buy/sell an underlying currency for same or next day delivery
• Forward
– Lock in today’s rate to be used in the future
– Outright vs. Option dated
• Swaps
• Options
– owner has the right but not the obligation to buy or sell at a
specific price on/or before a specific date
¾ Puts/calls
¾ Zero cost collar
• Leave orders

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 Forward Contract

Definition: To buy/sell a currency for delivery on a specific date at

a specific price.
Option-dated forward: A forward contract with a 30 day window.
¾ Advantages
– Eliminates exposure to spot movement.
– Limits risk - currency exchange rate is known.
– Flexible - option dated contract gives clients 30 days to
use the contract.
– Makes budgeting easier.
¾ Disadvantage
– No opportunity to benefit if the exchange rate moves in
the client’s favor.

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Forward Contract

• The price of a forward contract reflects the difference in interest rates

between two countries. It does NOT reflect the market prediction of
future spot exchange rates.

• The currency of a country with higher interest rates than Canada will
trade at a discount.
¾ Example - USD Seller
– Spot 1.0500
– Discount (3 months forward) -0.0005
– All in forward price 1.0495

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Currency Option

• Definition of an option:
– Gives the owner the right but not the obligation to buy or sell a
currency at a specific price on/or before a specific date

¾ Put: the right to sell a specific currency

• a Canadian $ put is the right to sell CAD$ and buy USD$

¾ Call: the right to buy a specific currency

• a Canadian $ Call is the right to buy CAD$ and sell USD$

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Currency Option

• Advantages
– Provides full protection against unfavorable movements in a
specific currency
– Has the ability to participate in a favorable move in the underlying
currency
– Can be sold back at any time (price will be function of: time left
on the option and by how much it is ‘in the money’)

• Disadvantages
– Premium paid to acquire the option

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Example

• Example: Buy a USD $100,000 Cad call (sell USD) with a strike price
of 1.0400 expiry date of February 16, 2010

Spot: 1.0500
All-In Forward: 1.0495
Premium: US $2,858

Same as above with strike of 1.0200

Cost of option (premium): US $2,030

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Zero Cost Option

• Definition of a zero cost option:

– A hybrid option that combines both a put and a call with identical
currency amounts and expiry dates to lock in a range of exchange
rates at which a client can buy and sell an underlying currency.
The options premiums to buy and sell cancel each other out and
net to zero.

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Zero Cost Option

• Advantage

– Provides customers with the opportunity to participate in favorable

exchange rate movements while providing 100% protection
(within a predetermined range) against unfavorable movements
with no upfront cost or premium.

• Disadvantage

– Upside is limited

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Example:

• Example: buy USD $100,000 CAD call with a strike price of 1.0200
and at the same time sell a CAD put with a strike price of 1.0700 with
an expiry date of February 16, 2010

Spot: 1.0500
All-In Forward: 1.0495
Hedged range: 1.0200 – 1.0700

Same as above with a protection of

Hedged range: 1.0000 – 1.0850

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Analysis at Maturity

• If CAD$ < 1.0200 exercise CAD call - sell USD $ at 1.0200

• If 1.0200 < CAD$ < 1.0700 options expire unused - sell USD $ in
spot market

• If CAD$ > 1.0700 TD exercises CAD put - customer sells

USD at 1.0700

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CASE STUDY - TDU

∗ 2010 Budget
– US$ cash flow $2MM inbound
– Equipment purchase scheduled for US $500,000
∗ US$ exchange rate 1.15 for 2010 Forecast
∗ CDN$ costs budgeted at $1,725,000

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