Taking the Foreign Currency Risk out of Foreign Investment

1
Taking the Foreign Currency Risk out of Foreign
Investment

• Asia Pacific Business Outlook
• University of Southern CaliforniaMarch 27, 2007
• Presented By David Gopal, Wells Fargo

2
Managing Foreign Exchange Risk

• We experienced an unfavorable impact to other
  international revenues due to the strengthening
  of the dollar relative to other foreign
  currencies primarily the Euro and the Japanese
  Yen.Google Inc. 12/31/05 10-K
• Foreign exchange had a negative 1 impact on
  net sales growth, primarily due to the
  strengthening of the U.S. dollar relative to the
  Euro, British Pound and Japanese Yen.Procter
  Gamble Co. 6/30/06 10-K
• Overseas investing has its own unique set of
  risks and foreign exchange is one of the most
  prevalent!
  

3
Table of Contents

• Overview of Hedging Foreign Currency
• Hedging Foreign Exchange Risk
• Global Rate Environment Past, Present and
  Future
  

4
Overview of Hedging Foreign Currency
5
The Foreign Currency Market

• Scope of foreign exchange market
• Volume over 2 Trillion / day
• Expansion of product type
• Spot, forwards
• Options of all types
• Cross-currency swaps
• Hybrids
• The participants
• Commercial and investment banks (providers)
• Companies (hedgers)
• Central Banks / Governments
• Private Equity hedge funds (hedgers and
  speculators)
  
• Wealthy individuals (hedgers and speculators)

6
The Unintended Foreign Currency Position

• Why are companies investing overseas?
• New markets
• Greater returns
• Generally better or different opportunities
• Any of the above situations without a foreign
  currency hedge equals a speculative foreign
  currency position.
  

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Preservation of Value

• Review of value
• The present value of all future cash flows.
• Good cash flow estimates and good investment
  valuation does not mean good return. If the
  foreign currency weakens, returns will suffer.
  
• Transaction price
• The purchase price in foreign currency OR
  eventual sales price in foreign currency.
  
• An investment into Japan may perform well in
  local currency, but if the Yen weakens, the
  realized US dollar sales price will suffer.
  

8
Private Equity Investment Example

• Scenario Private Equity Firm ABC USA purchases
  a Japanese Company for 1B Japanese Yen.
  
• Assumptions
• 10 annual cash flow
• 25 growth at maturity
• Current JPY/USD exchange rate is 118
• The exchange rate will remain constant at 118

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Private Equity Investment Example

• The future USD amounts depend on the future
  exchange rate
  
• If JPY drops by 10 (to 130) after
  investment..
  
• 1B JPY 8.47MM USD investment today (done at
  initiation)
  
• 100MM JPY 770K USD (77K less due to weaker
  JPY)
  
• 1.25B JPY 9.63MM USD (1MM less due to weaker
  JPY)
  
• Returns can suffer dramatically due to currency
  fluctuations!
  

10
Hedging Foreign Exchange Risk
11
Hedging Considerations

• Certainty of cash flows
• Timing
• Amount
• Risk tolerance
• Return requirements
• Company policy
• Accounting implications
• Access to markets

12
Product Considerations

• Derivatives
• Forwards
• Options
• Swaps
• Structural decisions
• Borrowing base
• Contract currencies

13
Hedge Products

• Short-dated hedges
• Forwards
• Provides a known USD amount against a known
  currency amount.
  
• Used when there is a known currency amount to be
  paid (received) in the near future.
  
• Options
• Provides a worst case USD amount against a known
  currency amount.
  
• Used when there is less certainty around whether
  there will be a currency need or to maintain
  upside potential.
  
• Long-dated hedges
• Cross-Currency Swaps
• Converts a set of cash flow in currency to USD
  (or vice-versa).
  
• Used when the exposure is long-term or perpetual
  in nature.

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Product Cross-Currency Swap

• Cross-Currency Swaps (CCS) are used to convert
  debt from one currency to another.
  
• CCSs allow companies to synthetically create
  debt in a currency, which they may normally not
  be able to access.
  
• An initial exchange is not necessary.

Initial Exchange of Principal
1B JPY
1B JPY
XYZ Corp
Cross-Currency Swap
JPY Investment
USD Debt
8.47MM USD
8.47MM USD
Periodic Interest Payments
3M JPY Libor 250 bps
JPY Cash Flow
XYZ Corp
Cross-Currency Swap
JPY Investment
USD Debt
3M USD LIBOR 250 bps
3M USD LIBOR 250 bps
Exchange of Principal At Maturity
21B JPY
1B JPY
XYZ Corp
Cross-Currency Swap
JPY Investment
USD Debt
8.47MM USD
8.47MM USD
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Product Cross-Currency Swap

• CCS Synthetic Foreign Denominated Loan
• From XYZs perspective, all USD payments
  (principal and interest) net to zero. They are
  left with a principal inflow in JPY at inception,
  JPY interest payments throughout the life of the
  transaction, and a final JPY principal repayment.
  This perfectly replicates a loan in JPY. In
  other words, XYZ has borrowed JPY synthetically.
  
• CCS Rationale for Hedging
• The initial exchange provides JPY funding for the
  investor. The final exchange provides a return
  of principal at the initial exchange rate,
  thereby hedging the currency risk.
• Interest rate savings It is often possible to
  swap to a lower non-US rate environment. In this
  example, the company is saving nearly 5
  annually, which greatly enhances investment
  returns.
• Access to capital Many companies do not have
  access to foreign capital. Others can tap
  foreign markets, but not efficiently. In this
  case, synthetic borrowing can be cheaper.
• No requirement for new capital Companies can
  swap pre-existing debt to other currencies at any
  time.

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Private Equity Investment Example - Hedged

• Same Investment Cross-Currency Swap
• The Investor can deliver 100MM JPY / Year and
  1.25B JPY in 2 years.
  
• The Investor will receive 847K USD annually PLUS
  an additional amount due to the higher interest
  rates in the US. This additional amount is
  approximately 350K. So the total annual cash
  flow will be 1.2MM USD.
• The Investor will receive back 10.59MM USD at
  maturity.
  
• Results of hedge
• Currency risk is eliminated
• Return is enhanced

The enhancement is directly related to the
interest differential. When hedging back to a
currency with a higher interest rate, the
differential can be earned.
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Foreign Investments without Currency Risk

• Not all foreign investments are foreign currency
  investments
  
• Offshore manufacturing of product to be sold in
  USD
  
• China or Hong Kong investment where the currency
  is fixed to the USD
  
• Desired foreign currency risk / portfolio
  diversification
  
• Business risk / currency correlation Business
  improves when foreign currency weakens and vice
  versa
  
• There is no guarantee that these exchange rates
  will stay fixed in the future.

18
Global Rate EnvironmentPast, Present, Future
19
The Dollar

• The dollar appreciated from 1995 - 2001
• Strong Economic Growth
• Low Inflation / High Productivity
• Equity Markets providing high returns
• The dollar reversed from 2001 - 2004
• Equity bubble popped
• The Fed cut interest rates drastically
• The dollar reverted to the meanand then some

Source - Bloomberg
20
Historical Interest Rates

• Today, Central Banks tend to have more stable and
  transparent policies
  
• Rates are less choppy
• Transparency reduces volatility
• Japanese rates have not always been zero!

Source - Bloomberg
21
Current Interest Rate Environment

• US rates are relatively high
• A long string of Fed hikes has put US rates above
  most other countries
  
• The ECB has been less hawkish as European
  growth has been sluggish
  
• The BOJ has kept rates abnormally low as the
  Japanese economy has suffered a long bout of
  economic weakness

Source - Bloomberg
22
Foreign Currency Outlook

• According to Bloomberg surveys
• The Euro will finish 2007 slightly stronger
• The Yen will appreciate 5
• The Fed Funds rate will be 5 (one more rate
  cut)
  
• According to market pricing
• The Euro will finish 2007 slightly stronger
• The Yen will appreciate 4
• The Fed will cut one or two more times
• Considerations
• Strong US economy - Unemployment and growth 4.5
  and 2.0, respectively
  
• Moderate Euro economy Unemployment and growth
  7.4 and 0.9, respectively
  
• Recovering (?) JPY economy - Unemployment and
  growth 4.0 and 2.3, respectively
  

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David Gopal [phone]

• David Gopal is a Derivatives Specialist working
  for the Wells Fargo Risk Management group in San
  Francisco. Specializing in cross-currency swaps,
  David focuses on developing effective solutions
  for clients that minimize their foreign currency
  and interest rate exposure. He is also an expert
  on accounting regulations inherent within foreign
  currency and interest rate derivative structures
  and is able to help his clients by utilizing his
  strong knowledge of world currency and interest
  rate markets. David comes to the Risk
  Management team with over nine years of
  international finance experience gained from his
  tenure with a major east coast bank. He
  specialized in trading spot, forward and option
  products and was later charged with selling FX
  and interest rate products to corporate clients
  before joining Wells Fargo. David earned his
  MBA from the Duke Fuqua School of Business
  Durham, North Carolina and received a BA in
  economics and psychology from Claremont McKenna
  College in Claremont, CA. He also holds the
  Chartered Financial Analyst (CFA) designation.

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