Strategic Risk Management: Making Risk Informed Decisions

Transcription

1 Strategic Risk Management: Making Risk Informed Decisions March 20, 2014 FEI Colorado Amanda Breslin, CFA Aaron Cowan, CFA, CPA 1 Disclaimer TRANSACTIONS IN OVER THE COUNTER DERIVATIVES (OR SWAPS ) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS.THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS. 2 1

2 Introduction to Chatham Financial clients both public and private, rely on Chatham for an end-to-end hedge advisory, execution, and technology solution that brings transparency to the market 450+ accounting clients rely on Chatham for hedge accounting and CVAs 2,000+ ISDAs and related documents are negotiated by Chatham annually $350+ billion worth of hedges executed for clients each year Chatham Financial serves hundreds of corporations by providing advisory, structuring, execution, & technology solutions Select Clients AMC Theatres Atmos Energy AES Dunkin Donuts DTE Energy HCA Holdings Hilton Hotels Nielsen Holdings PAREXEL Royal Caribbean Rovi Corp Skullcandy Staples Time Warner Cable Toys R Us Univision Vistaprint Virgin America Wal-Mart Western Union 3 Today s Agenda 1 2 Introduction to Chatham Financial Strategic Risk Management Economic Exposure Hedge Accounting Cost Benefit Analysis Case Studies Best Practices Questions 4 2

3 Strategic Risk Management Benchmarking Study COMPANIES BY INDUSTRY COMPANIES HEDGING EXPOSURES 5 Strategic Risk Management Varying factors require a customized hedging strategy 100% 90% 80% 70% 60% 50% 40% Benchmark Study 76% 52% Factor to Consider Exposure Profile Various Currency Pairs How to Think About it Identify how and where the company s business model and operational structure create FX risks across the organization How do you decide on what currency pairs to hedge (and what not to hedge?) 30% 20% 10% Relevant Financial Metrics Does accounting matter? How do you resolve conflicts between different metrics (parent s consolidated vs. business units )? 0% Exposure to FX Risk Hedging FX Risk Cost of Hedging What exposures are efficient to hedge? Is the program manageable? 6 3

4 Strategic Risk Management Strategic decisions should be risk-informed Winning business Example: Paper product company wanting to bid in local currencies M&A Competitive Dynamics Managing costs Example: Manufacturer of power conversion equipment considering supplier contracts modifications Capital structure Example: Conglomerate is weighing the synergy of acquiring a polymer producer Example: Hotel company considering increased floating rate debt to match ability to reprice 7 Strategic Risk Management Who Are Your Stakeholders? What are your Metrics? Compliance Reporting Suitability EBITDA Net Income Risk Profile EBITDA Cash flow Covenants EPS Net Income Cash flow Cash flow Debt Covenants Regulators Auditors Board Subsidiaries Lenders Investors External Stakeholders Executive Management Internal Stakeholders Treasury Risks should be tackled early, holistically, collaboratively, and regularly 8 4

5 Strategic Risk Management The Building Blocks of a Best-in-Class Policy and Program 9 Strategic Risk Management 3 Key Pillars to Evaluate Exposure Profile Cost Benefit Analysis Hedge Accounting 10 5

6 Exposure Profile 11 Exposure Profile 1m LIBOR Forward Curve 12.0% Current Rate Environment 1mL Swap Rate 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 3/1/14 3/1/15 3/1/16 3/1/17 3/1/18 3/1/

7 Exposure Profile Rates are Going Up! 13 Exposure Profile 1m LIBOR Hairy Chart 9.0% 8.0% 7.0% Actual 1m Libor vs. Historical Forward Curves Source: Bloomberg 1 Month Libor Projected 1 Month LIBOR (Even Quarters) Projected 1 Month LIBOR (Odd Quarters) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Forward curve undershot the realized curve Forward curve undershot the realized curve Dec 94 Dec 95 Dec 96 Dec 97 Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Dec 16 Dec

8 Exposure Profile Forward Curve Scenarios 12.0% 10.0% +2SD +1SD Current Rate Environment 1SD 2SD 8.0% 95% Probability 6.0% 4.0% 68% Probability 2.0% 0.0% 3/1/14 3/1/15 3/1/16 3/1/17 3/1/18 3/1/19 15 Exposure Profile FX Rate Cones 68% 95% 98% USD INR USD UAH

9 Hedge Accounting 17 Hedge Accounting What is Hedge Accounting Treatment? Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Without hedge accounting, all MTM changes on hedges flow directly into earnings (gains/losses related to many future months impact P&L now) 18 9

10 Hedge Accounting What is Hedge Accounting Treatment? Equity Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 With hedge accounting, gains/losses on hedges are initially deferred to the balance sheet (Other Comprehensive Income) and subsequently reclassified to earnings to align with the recognition of the associated hedged transactions 19 Hedge Accounting Why Hedge Accounting or Why Not? When to apply hedge accounting Many investors that are sensitive to P&L volatility / peers use hedge accounting Desire to reflect the impact of the hedging program in the financials Senior Management / Board interest or request When further analysis is needed Portfolio contains natural hedges further analysis needed to assess risk profile Conflicting performance metrics at parent and subsidiaries Application of hedge accounting is particularly complex When NOT to apply hedge accounting Most, if not all, peers do not use hedge accounting Small group of investors/lenders that are closely involved with management and hedging program ability to add back unrealized gains and losses 20 10

11 Hedge Accounting Hedge accounting requires adherence to stringent rules, but it s doable. Don t be scared away without evaluating what it would take. Assessing Effectiveness Unique FX Requirements Measuring Ineffectiveness Quantify the P&L Impact selection of an approach Highly effective threshold. Critical terms match versus long haul. Complying with requirements unique to foreign currency Qualification (Hedged Items / Transactions) Qualification (Hedged Risk) Proper identification/ description and qualification Start Hedge Documentation Qualification (Hedging Instruments) Specific identification and subsequent monitoring Preparing formal, contemporaneous hedge documentation Linkage with hedged transactions and layering 21 Cost Benefit Analysis 22 11

12 Cost Benefit Analysis Evaluating a Hedging Program Reduce P&L Volatility Manage Covenants Cash Flow Certainty Quantify Risk Exposure Program Costs Trading Costs Program Management Cost of Not Hedging? Program Benefits 23 Cost Benefit Analysis Understanding Key Cost Drivers High Profile Beneath the Surface Market Rates or Option Cost Bid/Ask Spread Exposure Aggregation Credit Charges Gain or Loss on Trades Hedge Accounting Process Maintenance Developing Expertise Regulatory Compliance Lack of correlation/effectiveness 24 12

13 Cost Benefit Analysis Hidden Cost Drivers: Program Maintenance OUTSOURCED EXPERTISE Hedge Accounting Resources Tax Considerations Hedge Structuring & Trade Execution Expertise Monitoring Counterparty Risk and Exposure Collateral Management Regulatory (EMIR, Dodd Frank, Basel III) Valuations and Reporting Technology & Automation Documentation Negotiations Performance Monitoring Against Policy IN HOUSE EXPERTISE 25 Cost Benefit Analysis Evaluating the Cost of Not Hedging Cost of Hedging Cost of Not Hedging USD millions 26 13

14 Case Study 27 Case Study PROBLEM: A publicly traded services firm was concerned about its ability to meet debt service obligations on floating debt in a rising rate environment. Their Board was concerned about the exposure to rates, but equally concerned with the use of derivatives and auditor scrutiny on the associated accounting treatment. SOLUTION: The company identified risk metrics and constraints to apply to their current debt profile, along with anticipated acquisition activity. We worked with the company to determine an appropriate planning horizon, and evaluated different hedging profiles with respect to remaining risk, accounting treatment, and flexibility. HOW? Our Role Quantification of Risk Hedge Accounting Formalized Risk Policy Execute Transactions ISDAs NEGOTIATED Established Trading Lines with Counterparties RISK REDUCTION 50% TIME SAVINGS 75% 28 14

15 Case Study Applying Scenario Analysis 12.0% 10.0% +2SD +1SD Current Rate Environment 1SD 2SD 8.0% 95% Probability 6.0% 4.0% 68% Probability 2.0% 0.0% 3/1/14 3/1/15 3/1/16 3/1/17 3/1/18 3/1/19 29 Case Study Evaluating Metric-at-Risk 30 15

16 Case Study PROBLEM: A publicly traded services firm was concerned about its ability to meet debt service obligations on floating debt in a rising rate environment. Their Board was concerned about the exposure to rates, but equally concerned with the use of derivatives and auditor scrutiny on the associated accounting treatment. SOLUTION: The company identified risk metrics and constraints to apply to their current debt profile, along with anticipated acquisition activity. We worked with the company to determine an appropriate planning horizon, and evaluated different hedging profiles with respect to remaining risk, accounting treatment, and flexibility. HOW? Our Role Quantification of Risk Hedge Accounting Formalized Risk Policy Execute Transactions ISDAs NEGOTIATED Established Trading Lines with Counterparties RISK REDUCTION 50% TIME SAVINGS 75% 31 Case Study PROBLEM: A publicly listed global pharmaceutical services company had an existing program focusing primarily on balance sheet risks. The Board of Directors and management became concerned with the impact of accelerating non USD revenue growth on financial statements, but were confident in the treasury team s ability to implement any appropriate hedging strategy. Chatham was engaged to develop a hedging strategy and assist in implementation. SOLUTION: Upon development of the optimal hedging strategy for the firm, Chatham began an education process on the benefits and requirements of implementing ASC 815 for the FX hedging program. Chatham implemented ChathamDirect, a SaaS platform for exposure management and hedge accounting, which allowed the company to easily implement hedge accounting for hundreds of transactions per year while reducing re statement risk. HOW? Our Role Educate C Level Team Implement SaaS Solution Provide Advisory Services BIDDING ADVANTAGE Client became more competitive EPS FORECASTING Stabilized Significantly TIME SAVINGS >70% 32 16

17 Best Practices 33 Best Practices Checklist 1. STRATEGIC RISK MANAGEMENT 3. HEDGE ACCOUNTING Think holistically about organizational risk Evaluate hedge accounting capacity Evaluate program and resources as routine Understand exposure profile relative to business model Explore natural hedges and offsets Incorporate stakeholder needs across the organization Communicate risk management program through policy 2. ECONOMIC EXPOSURE Quantify exposure by relevant metric Identify risk reduction needs, tolerance Use data to drive efficient/effective hedging Understand risk in the context of scenario analysis Understand the impacts of HA to financials Benchmark against peers (with caution) Involve auditors early and often Understand the expertise and resources required on an ongoing basis 4. COST BENEFIT ANALYSIS Incorporate both visible and hidden costs Invest time/energy in scalable tools Understand market pricing factors Evaluate program impact on resources Identify tangible and intangible costs of not hedging 34 17

18 Educational Content & Resources Webinars Upcoming Webinars [CPE Credit Available] Interest Rate Hedging (1 of 3): Unveiling Market Complexities March 26th, 12 1pm MT Interest Rate Hedging (2 of 3): Crafting a Meaningful and Effective Policy April 30th, 12 1pm MT Interest Rate Hedging (3 of 3): Hot Topics in Hedge Accounting May 21 st, 12 1pm MT Recently Completed Webinars Download Slides or Recording How Strong is Your FX Hedge Accounting Foundation? Mandatory Trade Reporting under EMIR: Who, What, When, & How Key Considerations for Measuring the Fair Value of Derivatives under ASC 820 The Prepayment Decision: Strategies for Analyzing and Executing Debt Prepayments Feeling Exposed? Top 10 Questions for your FX Program Understanding the True Cost of your Hedging Program IFRS13: The Impact on Derivative Valuation, Hedge Accounting and Financial Reporting The Nitty Gritty of Commodity Hedge Accounting White papers Considerations for Repricing Debt: Dealing with Embedded Floors 6 Things Every Treasury Practitioner Should Know About Cross Currency Swaps Recent Publications The State of Financial Risk Management: Quantitative Benchmark Report Dodd Frank End User Clearing Exception: Practical Considerations for Preparing Your Board All Chatham articles and news contributions are available here 35 Questions? Kennett Square 235 Whitehorse Lane Kennett Square, PA Amanda Breslin, CFA Director Financial Risk Management [email protected] T: Aaron Cowan, CFA, CPA Director Hedge Accounting Risk Management [email protected] T: Denver West San Juan Way, Ste 150 Littleton, CO London 4th Floor, 16 Garrick Street London WC2E 9BA United Kingdom +44 (0) Singapore 20 Cross Street China Square Central #02 16/17 Singapore, Krakow ul. Rakowicka 7, III p Kraków Poland +48 (0)