Case Questions – FX Risk Hedging at EADS
1. Explain why foreign exchange (FX) risk management is such a
pressing issue for EADS and describe the company’s
double-pronged approach.
Because airbus’ ability to compete against us based manufacturers in
the usd priced aircraft market was strongly affected by the euro’s and
the pound’s exchange rate to the us dollar.
Airbus dollar revenues converted to euros declined because of
economic recessions. It had significant impact of fx risk on eads’
financial results. According to the financial report, every 10cent
movement in the dollar to euro exchange rate against is a billion euro
impact at EADS.
Airbus priced planes in dollars, reducing the value of sales when the
value of dollars decreased. Otherwise, airbus also incurred the bulk
of expenses in euro, leaving little room to combat the impact of
fluctuating rates.
Double-pronged approached to FX risk management consists of FX risk
mitigation and FX risk transfer.
FX risk mitigation implies that EADS sources largely from the U.S or countries
whose monetary systems use exchange rates pegged to dollar. It decreases
the portion of costs, incurred in euro, as well as reduces risks of unexpected
cost base growth because of dollar/euro fluctuations.
FX risk mitigation also includes restructuring programs (i.e “Power 8
program”) which allow converting euro-denominated cost base into dollars.
Such programs intended to reduce workforce and withdraw capital from
European production sites as well as re-price it into U.S dollars.
FX risk transfer is based upon using of derivatives, mostly forward contracts.
Forward contracts are implemented to lock-in appropriate future exchange
rate, at which future receivables will be converted into euro, and, in this way,
protect company’s EBIT from losses because of dollar decline. According to
Pons, this financial tool is an integral part of the business and used to prevent
losses from dollar/euro fluctuations and gain time for the adjustment of
“Power8 program.”
2. What is the Speed Grid and what purpose does it serve in achieving
EADS’s FX hedging policy?
Speed grid: a mechanical hedging approach that is aimed to
determine the weekly amounts of fx forward contracts to purchase in
order to execute eads’ hedging policy. The purchasing pace or hedging
speed actually depends on the two following factors: year to hedge and dollar
to euro forward exchange rate, i.e. the further ahead, the less is hedged per
week; and the stronger the forward exchange rate was for the dollar against
the euro, the higher were weekly amounts of forward contracts that traders
had to purchase and vice versa.
The underlying time diversification of the Speed Greed is defining in main
purpose of EADS’ FX hedging policy that is to determine the speed of hedging
or in other words the amount of forward contracts to purchase and therefore
to protect company’s EBIT from losses because of dollar decline.
However, considering the time diversification as one of the main advantage
there are still two cons of Speed Grid approach. In extreme cases the Speed
Grid’s functioning is not appropriate to EADS’ FX hedging policy. One of them
reflects nowadays company’s situation i.e. the formation of significant gap
between total amount of eligible exposure and company’s hedge book as the
amounts of hedging according to Speed Grid model is too low. And another
one is response of Speed Grid approach to reverse exchange rate movement,
for instance, significant dollar increase goes beyond the $/€ forward rate in
the model and leads to a very high speed of hedging, which in conditions of
constantly increasing dollar makes this model insufficient.
3. Comment on the appropriateness of EADS’s current FX hedging
policy with their business environment? Evaluate alternatives to their
current approach and recommend a plan of action to Pons and the
FX Hedging Policy Committee.
4.
5. The cash flow hedging treatment of the USD hedge allows
mark-to-market variations to bypass the income statement, but
EADS' shareholders are still exposed to both counter-party default
risk and credit spread volatility risk. How can this be mitigated while
maintaining the cash flow hedging treatment?
