The State of Financial Risk Management

The State of Financial Risk Management Quantitative Benchmark Report an independent study of more than 1,000 US, public companies examining their risk exposures, hedging, and hedge accounting practices 2013 Chatham Financial All Rights Reserved KENNETT SQUARE LONDON DENVER SINGAPORE KRAKOW CHATHAMFINANCIAL.COM

The State of Financial Risk Management Quantitative Benchmark Report Study Results 235 Whitehorse Lane Kennett Square, PA 19348 610.925.3120 chathamfinancial.com 2013 Chatham Financial Corp. All rights reserved. No reproduction, distribution, copy, modification or adaptation of this report or the study data is permitted without the express written permission of Chatham Financial Corp. If you wish to request permission, please contact the Marketing Department at info@chathamfinancial.com. chathamfinancial.com

table of contents executive summary...1 study methodology...2 a primer to financial risk...3 part I: risk management by asset class... 4 currency risk management... 4 commodity risk management...5 combined currency & commodity risk...7 interest rate risk management...8 part II: hedge accounting...8 part III: other approaches to analyzing the data... 9 company hedging practices by revenue... 9 company hedging practices by industry...10 conclusion... 12 about the team... 13 chathamfinancial.com

The State of Financial Risk Management: Quantitative Benchmark Study executive summary Financial risk management practices vary widely across corporate America. For many companies in the aftermath of the financial crisis and the resultant market volatility, financial risk management gained higher visibility at senior management and board levels. In order to provide CFOs and treasury professionals with greater insight, Chatham Financial conducted an extensive research study of the annual filings of 1,075 publicly listed corporations and found both expected and unanticipated results. One of these discoveries is the pervasive lack of financial risk management within certain asset classes and industries. The study found that more than 75% of the companies analyzed have exposure to foreign currency risk, but only half of those companies are managing that risk through hedging. Additionally, a bit more than half of the companies studied have stated exposure to commodities, yet only 43% of those companies are managing that risk through hedging with financial derivatives. Not surprising, the most common exposure across the companies was to interest rates, with 89% having exposure. The 41% of companies hedging their interest rate risk with derivatives was also not surprising given the exceptionally low rate environment of recent years. Among companies choosing to manage risk through hedging, the practice of hedge accounting to reduce the profit and loss impact of derivatives use is prevalent. This is especially true in companies hedging interest rates, where 77% of companies are applying hedge accounting. For those with cash flow currency hedging programs, 81% of those companies are leveraging hedge accounting. A significant drop-off in hedge accounting practices can be found in those companies hedging commodity risk, with less than 60% applying hedge accounting. Within both hedging and hedge accounting practices, the study found variability between companies of different sizes and more so within different industries. The data highlighted in this report provides an in-depth view of the landscape of current risk management practices in the US. Combining this data with insight gleaned across Chatham Financial s client base of more than 1,200 companies and interactions with thousands of companies globally, it is clear that significant hurdles remain for most corporations to become best in class within their financial risk management programs. Behind the data and percentages, Chatham Financial cites three main challenges corporations face in implementing and maintaining active risk management programs: 1. Hedge accounting can be an obstacle for companies due to the specific expertise required and need for careful interpretation of the accounting standards. 2. Gathering exposures is a complicated and difficult effort for most corporations, thus inhibiting their ability to develop and implement financial risk management programs. 3. Multiple divisions within an organization may have responsibility for financial risk management, such as procurement for commodities or regional managers for their own P&Ls, resulting in disparate understanding of exposure and financial risk management options. 1 chathamfinancial.com

Chatham Financial study methodology The objective of the study was to review, analyze, and identify insights about the financial exposures and risk management practices of corporations in the United States. This study was conducted using the US Securities and Exchange Commission Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database. Data was gathered through individual review of more than 1,000 US public company annual 10-K financial statement filings. Companies included in the sample set were those based in the US, publicly held, and with annual revenues between $500 million and $20 billion. Due to the study s intent to understand common financial risk management practices, certain industries with a specialized financial nature and significant differences from average corporations were omitted. The excluded industries included Banks, Credit Reporting, Financial Services, Insurance, Investment Banking, Investment Services, Investment Trusts, and Property and Casualty Insurance. From the entire eligible set of companies, 1,125 companies were randomly selected to be a part of this study. In the course of this research, 50 companies were additionally excluded due to reasons including transitions from public to private company structure and company acquisition. The remaining 1,075 companies comprised the sample population for this study. Of these, eight companies categorized as Other industries were excluded from the industry-specific insights in this report, due to the small population and disproportionate percentages they represented. Companies were classified into groupings based on annual revenue, and into sector and subsectors using the North American Industry Classification System (NAICS). For analysis purposes, four revenue groupings and ten super sectors and numerous sub-sectors were identified to compare and contrast companies in the data set. The most recent 10-K filings were used for the purposes of this research. For the majority of companies analyzed, the filing was for the fiscal year completed at the end of 2012. Each filing was reviewed to determine a number of key variables for each asset class of interest rates, currency, and commodities. Some of the variables included: 1. Exposure by asset class 2. Use of derivatives by asset class 3. Type of currency program utilized: balance sheet and cash flow 4. Application of hedge accounting by asset class chathamfinancial.com 2

The State of Financial Risk Management: Quantitative Benchmark Study a primer to financial risk Treasury teams have spent the last several years increasing their focus on financial risk management. Typically, this responsibility has encompassed three key asset classes: currency, commodity, and interest rate. Of these, interest rate risk management is most prevalent nearly all companies have some type of risk to interest rates in the form of floating rate debt, potential future issuance of debt, or interest bearing assets on the balance sheet. Treasurers can manage their interest rate risk naturally (debt selection and investment choices, for example) or synthetically, using derivatives. Often, companies will target fixed-floating debt ratios as a metric to guide decision making. Alternatively, analysis of potential interest expense and impact on key metrics, such as earnings per share, is utilized to make decisions around this key area of risk management. Interest rate risk management is most often evaluated in the context of financing activities, such as new debt issuance or M&A activities. Currency risk management is generally managed as an on-going program, one that requires constant attention and may be monitored as frequently as daily by a treasury team. The two most popular types of currency risk management programs run by treasury teams are cash flow hedging programs and balance sheet hedging programs. Cash flow programs tend to focus on future revenues, expenses, or capital expenditures items that have not been booked yet on the income statement or balance sheet, but that the company reasonably expects to incur at some point in the future. Running this type of program typically requires treasury teams to work with various members of the organization to obtain forecast data. Additionally, in order to match hedge gains and losses with the timing of forecasted exposures, companies tend to apply hedge accounting (ASC 815, formerly FAS 133) to their cash flow programs. The goal of cash flow hedging programs is to ultimately reduce volatility in one or more of several metrics, including revenue, expense, operating income, margins, EBITDA, and net income. Unlike cash flow programs, balance sheet currency hedging programs focus on reducing the volatility of the foreign exchange (FX) remeasurement line item that contributes to other income/expense in income statements. The exposures for balance sheet programs are booked monetary assets and liabilities that are remeasured back into the functional currency of the entity in which they occur. Companies often focus on aggregating data that is housed within their ERP systems using a series of queries, and build hedging programs from this data. Because these exposures may change daily, some companies hedge on a very frequent or daily basis, while others may hedge monthly or quarterly. Because the gains and losses on the exposures go directly to the income statement in the current reporting period, there is generally little to no benefit to applying hedge accounting to balance sheet programs, and companies tend to refrain from applying it as a result. Ultimately, the success of balance sheet programs is measured by the amount of remeasurement income or expense incurred by the company; while it is nearly impossible to reduce it to zero, balance sheet programs can substantially mitigate this volatile line item. Finally, commodity hedging is perhaps the most complicated of the three asset classes covered by treasury, partly because treasury is not always completely in charge of commodity hedging programs. Often, these risk management programs will be run by procurement or supply chain groups, and equally often, the tool of choice for reducing price risk is to negotiate contracts with suppliers with commodity prices locked down for a period of several months. Companies dealing in commodities also have a few ways to consider their exposure. For example, corporations could pass through cost, they could be dealing in a commodity that is not hedgeable, or investors could desire to have the exposure reflected in financials, such as oil and fuel producing companies. Increasingly, corporations are taking a more holistic approach to understanding their commodity risk, which is inevitably tied in with their overall business. Treasury teams are more likely today than five years ago to have some level of responsibility for commodity risk management, as well as interest rate and currency risk management. This creates a new dynamic to consider in the intersections of these risks. 3 chathamfinancial.com

Chatham Financial part I: risk management by asset class Prudent financial risk management can utilize many methods, which may be unique to specific businesses. This study specifically considers the use of financial derivatives across industry types in effort to gain meaningful insights about the current practices leveraged by US public companies. Currency Risk Management Most companies over $500 million have become increasingly more multinational or global over the past decade or so, finding customers abroad and diversifying their supply chains. The resultant impact has been a marked increase in currency risk, which manifests itself within financial statements. These impacts primarily arise within the income statement, either within revenues, expenses, or other income/expense (from balance sheet remeasurement). Chart 1 below illustrates the pervasiveness of market risk across the company sample set. Over 75% of all corporations included in the study have stated or implied exposure to currencies outside the US. This exposure has been increasing over time. Of these companies with currency risk, only about half are actively hedging their exposure, a surprisingly low percentage given the extreme volatility around the currencies to which the companies have exposure. Chart 1: Subject Group Overall Risk Exposure vs. Hedging Percentages More than half of the companies included in this study hedge their FX exposure with financial derivatives. The percentage is lower for other types of risk. For those that hedge their risk, the study found that the two most common programs utilized by companies are cash flow and balance sheet programs. Cash flow programs are typically utilized to reduce volatility to revenues and expenses, whereas balance chathamfinancial.com 4

The State of Financial Risk Management: Quantitative Benchmark Study sheet programs are focused on reducing volatility around other income and expense that arises from remeasurement of monetary assets and liabilities. It is most common for companies to run both types of programs, according to the study s findings, as remeasurement tends to be quite visible but revenue and expense risk tends to be significantly higher in earnings impact. Smaller companies (under $1 billion) tend to begin by putting in place balance sheet programs, as the exposures are relatively easy to gather and quantify. This exposure visibility is often cited as the number one factor that drives the development of balance sheet programs. The difficulty in forecasting exposures at smaller companies can hinder the initiation of a cash flow program. But eventually, as companies grow along with their exposures, they begin adding cash flow programs. Larger corporations (over $5 billion) see the impact from cash flow risk and have a bias towards cash flow programs relative to balance sheet only programs. As Chart 2 below shows, these larger companies tend to run both a cash flow and a balance sheet program. In general, they have the resources to apply hedge accounting and forecast revenues and expenses on a global basis, often led by treasury working alongside business units and regional finance team members. Chart 2: FX Balance Sheet and Cash Flow Hedges As companies increase in size, their approach to currency risk management becomes more integrated and holistic. Commodity Risk Management As previously seen in Chart 1, fewer companies face commodity risk than those with currency risk. While more than 75% of all companies had exposure to currency, only 52% of companies had exposure to commodities within their business. Of those with risk, fewer than half (42%) are hedging their commodity risk using financial contracts. Initially this is a surprising result given the important input status that commodities can have for many businesses, but it highlights an area where hedging may be accomplished by means that are not well-articulated to investors. Namely, much hedging of financial risk may happen within the purchasing or procurement function through the use of supplier contracts rather than financial derivatives. This dynamic creates a strong need for companies to interact across multiple organizational functions to ensure that the best approach is being utilized between supplier contracts and financial derivatives. Many larger companies have come to realize this need for tight coupling of functions 5 chathamfinancial.com

Chatham Financial like treasury and procurement, considering larger companies are more likely to hedge commodity exposure using financial derivatives relative to smaller companies, according to the study data. (See Chart 3.) Chart 3: Commodity Risk Hedging Percentage by Company Size Larger companies are more likely to hedge commodity exposure using financial derivatives relative to smaller companies. When viewed by industry in Chart 4, it is clear that companies where commodity risk is core to their business have a higher propensity to hedge using financial derivatives. Given the complexity of hedging commodities in the financial markets, it appears as though only sufficiently sophisticated corporations with commodities as a core exposure have a tendency to hedge in this manner. Chart 4: Commodity Risk Exposure vs. Hedging Percentages by Industry Type Transportation and Mining industries have the largest commodity exposure and have a higher propensity to hedge using financial derivatives. chathamfinancial.com 6

The State of Financial Risk Management: Quantitative Benchmark Study Combined Currency and Commodity Risk One other critical factor to consider is the interaction of commodity and currency risk. Specifically, many companies have exposure to both currency and commodity prices. Corporations may be hedging only their currency exposure within treasury, while hedging their commodity risk within procurement. Under this approach they may not be viewing their risk holistically. Practically, this could mean that the hedging done by the different areas of the company are offsetting one another and potentially increasing overall earnings risk for the company. Although it cannot be immediately determined from reviewing 10-K reports, generally commodity risk does tend to be a greater driver of volatility for corporations that carry both currency and commodity risk. Chart 5 below illustrates the percentage of companies that have both currency and commodity risks. It also displays the percentage that are hedging both risks using financial derivatives and the percentage that are hedging one or the other. Chart 5: FX and Commodity Risk Exposures vs. Hedging Percentage Companies that have both FX and commodity exposures adopt different hedging approaches. From Chatham Financial s experience, companies that have both FX and commodity exposures should focus on hedging the commodity exposure as the first priority, since it tends to be a main driver of earnings at risk. Risk mitigation can be implemented either through financial derivatives or through a company analysis that identifies existing offsetting FX exposures. Additionally, companies with exposure to both commodity and foreign currency that are hedging currency exposure only are probably missing a significant source of risk. As mentioned above, the largest challenge for treasury teams in implementing commodity hedging programs tends to be the fact that procurement or supply chain often owns the exposure management for commodities. As a result, many treasury teams quickly turn to focusing on that which is in their control (currency), rather than engaging in a deeper discussion within the organization to determine the best approach and method of control for commodity exposure. 7 chathamfinancial.com

Chatham Financial Interest Rate Risk Management Interest rate risk is by far the most common type of financial risk faced by companies. Through borrowing in various forms, such as credit agreements, asset backed facilities, or bonds, a large majority (89%) of corporations in the study have some level of interest rate risk exposure. The study finds that only 41% of these companies use financial derivatives as the means of hedging interest rate exposure. Many companies issue a desired mix of fixed and floating rate debt to manage interest rate risk without any derivatives. Also, the expectation that currently low interest rates will not change for some time has made higher floating to fixed ratios appealing. This mix is often achieved by not hedging floating rate debt instruments. For other treasury groups, interest rate risk has been managed by issuing fixed rate bonds at recent levels that were touching upon or breaking through all-time lows. Further study will be conducted on companies usage of interest rate hedging practices over time to investigate trends on this highly cyclical and rate-dependent area of financial risk. part II: hedge accounting The use of hedge accounting treatment for derivatives under ASC 815 (formerly FAS 133) is pervasive among companies that are using derivatives to hedge their exposures. As shown in Chart 6 below, more than 75% of companies using interest rate derivatives are applying hedge accounting, while fewer than 60% of those utilizing commodity derivatives are applying hedge accounting. Only 66% of companies with currency hedging programs are applying hedge accounting, but it is a little more complicated than this, as there are two types of currency programs studied, balance sheet and cash flow programs. Balance sheet programs generally do not require the use of hedge accounting, while cash flow programs tend to go hand-in-hand with its application. Chart 6: Hedge Accounting Percentage by Risk Exposure More than 75% of companies hedging interest rate and more than 80% hedging FX cash flow risks adopt hedge accounting treatment for the financial derivatives used to mitigate those risks. chathamfinancial.com 8

The State of Financial Risk Management: Quantitative Benchmark Study The research found 81% of companies utilizing cash flow programs are also applying hedge accounting. Nearly every corporation that considers entering into a cash flow hedging program brings up the topic of hedge accounting. Investors essentially expect that companies will apply hedge accounting to these types of programs; otherwise, it creates more volatility due to running derivatives gains and losses through the income statement at different times than when revenues or expenses are recognized. Broadly, the study found that corporations overwhelmingly utilize hedge accounting when using derivatives to hedge financial risks. However, the complexity of applying hedge accounting has deterred many companies from pursuing hedging programs, particularly with respect to commodity and currency hedging programs. Hedge accounting treatment is an integral part of a company s risk management strategy. The decision to pursue hedge accounting contributes to the cost/benefit trade-off of matching the hedging instrument s financial statement footprint with the economic intent of the hedge, and requires increased resources dedicated to managing such a program. From Chatham Financial s experience, most companies that have decided to undertake a hedge accounting program either dedicate resources to increase their capacity to administer the complexity of a hedging program, or they pursue external resources to manage the hedge accounting process. part III: other approaches to analyzing the data Company Hedging Practices by Revenue Generally, it is expected that larger companies with more types of exposure do in fact hedge that exposure, and would be willing and able to apply hedge accounting despite its complexity. Chart 7 illustrates this concept. What drives this expectation? Smaller corporations tend to have less risk in general. For example, they may not have expanded enough internationally yet to incur currency risk. Chart 7: Percentage of Companies Hedging and Applying Hedge Accounting by Revenue Groups As companies increase in size, they tend to hedge risk exposures in a more systematic fashion, and when hedging they are more likely to apply hedge accounting. 9 chathamfinancial.com

Chatham Financial In addition, larger companies tend to have larger staff and more funds available to solve complex problems. As an example, in order to apply hedge accounting to commodity derivative transactions, companies not only need to be able to understand the drivers of their exposure, but they also must identify the appropriate indices and mismatches between the potential hedging instruments and the underlying exposure. All of this requires coordination across multiple areas of the business, and the ability to model risk and conduct different types of analyses. The one anomaly seen in the study is that companies in the $2 to $5 billion range tend to apply hedge accounting for commodity hedging more often than companies over $5 billion. This is driven more by the existence of a larger proportion of manufacturing and mining companies within this revenue sub-group, which have a higher tendency to hedge commodity risk than others. Company Hedging Practices by Industry Of the 1,075 companies studied, 32% are classified as manufacturing companies, making it the most populous company category in the study sample set. As seen in Chart 8 below, manufacturing and financial activities most commonly hedge foreign currency exposure. Due to the nature of the businesses, mining and transportation companies are more likely to hedge their commodity exposures. Hedging of interest rate risk using financial derivatives drops for the manufacturing companies, but can be seen as a more active practice for leisure and hospitality and financial activities corporations. Chart 8: Percentage of Companies Hedging by Industry chathamfinancial.com 10

The State of Financial Risk Management: Quantitative Benchmark Study Further exploration into industry-specific data adds many insights that are not readily apparent when looking at the data set in whole. Commodity hedging, for example, is most impacted by the type of industry. The approach to commodities risk management is separated into three broad categories: (1) pervasive hedging, (2) elective hedging, and (3) limited financial hedging. The pervasive hedging category is used to describe industries in which at least 75% of sampled companies use financial derivatives. Pervasive hedging occurs when the underlying exposure is hedgeable and the changes in commodity prices are not passed along. One example of pervasive hedging is in the beverages industry where producers, alcoholic and non-alcoholic, hedge input costs and fuel costs. On the other hand, the limited financial hedging category includes industries in which commodity costs are passed along or in which the commodity exposure is not readily hedgeable. One example of limited financial hedging is the specialty chemicals industry, in which changes in chemical costs can dramatically impact profitability but no financial market exists to hedge the exposure. Another nuanced case of limited financial hedging can occur if an industry exists as a means to offer investors exposure to a certain commodity type. For example, precious metals mining companies do not hedge their output because investors want the exposure. In the middle of the hedging spectrum, some industry segments are defined by elective hedging. Some companies may deem there to be an advantage to hedging while others may not be able to decide on a hedging strategy or may elect to weather the volatility. Given the nuanced nature of companies with commodity exposure, more analysis that considers industry specifics may prove illustrative. The application of hedge accounting tends to have less variance across industries. For instance, most corporations hedging interest rate tend to apply hedge accounting. Similarly, a high percentage of companies apply hedge accounting to currency hedging programs, as well as to commodity programs. The pervasive application of hedge accounting, regardless of industry type, is not surprising since it is the most effective way to demonstrate the mitigated risk in financial earnings. (See Chart 9.) Chart 9: Practice of Hedge Accounting by Risk Exposure 11 chathamfinancial.com

The State of Financial Risk Management: Quantitative Benchmark Study conclusion This study provides practical guidance on the key questions that often come from senior management: What are other companies doing, and why? At a minimum, the knowledge from this study can help guide CFOs and Treasurers as they evaluate their existing financial risk management programs, and help to support strategic decisions. Given the extreme volatility in financial markets over the past several years, more and more companies are taking a fresh look at their hedging programs, reviewing everything from strategic objectives to work flow and program costs. What worked a few years ago no longer feels appropriate given the change in the financial climate and underlying business environment. With the increasing impact of regulation (such as Dodd-Frank in the US and EMIR in Europe) and impending changes in hedge accounting standards, forward thinking treasury teams are staying ahead of these changes by evaluating and rethinking their current practices. Chatham Financial provides a holistic approach to financial risk management to hundreds of corporations throughout the United States, Europe, and Asia. Chatham Financial serves clients in the areas of interest rate, foreign currency, and commodity hedging, hedge accounting, regulatory compliance, and debt and derivatives valuations. Founded in 1991, Chatham serves more than 1,200 companies annually, bringing deep derivatives expertise, services, and technology solutions to clients through a global team of risk management professionals, CPAs, analysts, and technology developers. With vast, realworld experience in financial risk management, Chatham Financial is an ideal partner for companies looking to evaluate, initiate, or improve their financial risk management programs. Contact a Chatham Financial advisor to learn more about how Chatham can work with you to evaluate how your company compares against the 1,075 companies analyzed in this quantitative financial risk management study. 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 is a solicitation for entering into a derivatives transaction. This research report prepared by Chatham Hedging Advisors is not for the purpose of entering into any swap transaction. 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. 12 chathamfinancial.com

Chatham Financial about the team Chatham Financial Corporates Financial Risk Management Team Sought out for their deep expertise in derivatives hedging and hedge accounting, the Corporates Financial Risk Management team at Chatham is comprised of experienced practitioners respected for their comprehensive financial risk knowledge. Hedging experts with over a decade of realworld experience in capital markets, along with former auditor and FASB staff, advise hundreds of clients a year on effective risk management practices. Primary Study Contributors Amol Dhargalkar Amol leads Chatham s risk management practice serving the corporate sector. During his more than 10 years at Chatham, Amol has advised a broad spectrum of public and privately held companies, as well as corporate private equity sponsors on the structuring, implementation, and accounting of their risk management programs totaling over USD 500 billion in hedged notional. Amol graduated from Pennsylvania State University with a BS in Chemical Engineering and a BS in Economics. He also received his MBA from The Wharton School at the University of Pennsylvania, where he was a Palmer Scholar. CONTACT: AMOL DHARGALKAR 484.731.0226 amol@chathamfinancial.com Joe Geissenhainer Joe was a primary analyst on Chatham Financial s Financial Risk Management Quantitative Benchmark study, during his internship in 2013. Joe is currently pursuing an MBA at the Darden School of Business at the University of Virginia. Before returning to pursue his Masters, Joe worked at Dyson Capital Advisors, where he was responsible for investment manager diligence and selection as well as client relationship management. Prior to Dyson, Joe spent four years with J.P. Morgan in a variety of positions in the firm s Private Bank and Investment Bank divisions. Joe graduated from Villanova University in 2006 with a Bachelor of Arts in English Literature. Juan Cox Juan was a primary analyst on Chatham Financial s Financial Risk Management Quantitative Benchmark study, during his internship in 2013. Juan is currently an MBA student at The Fuqua School of Business at Duke University. He also has the title of Agribusiness Engineer from Universidad Católica de Chile. Prior to business school, Juan worked in the agriculture sector in California and Chile. He also worked for the Chilean government, where he designed a price insurance program, hedging corn for 3,000 small farmers through an option of corn and foreign exchange. Additional Study Contributors Phil Weeber - Chatham Financial - Director, Commodity Risk Management Jonah Rouizem - Chatham Financial - Corporate Financial Risk Management Yusuf Erkli - Chatham Financial - Corporate Financial Risk Management Contact Chatham Financial About This Report risk@chathamfinancial.com 610.925.3120 chathamfinancial.com 13

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