jpmorgan corporate finance advisory riskiercurrencyenvironment

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OCTOBER 2012

Riding the foreign exchange roller coasterCorporate finance implications of a riskier

currency environment



Published by Corporate Finance Advisory

For questions or further information,

please contact:

Corporate Finance Advisory

Marc Zenner

[email protected]

(212) 834-4330

Tomer [email protected]

(212) 834-2465



RIDING THE FOREIGN EXCHANGE ROLLER COASTER | 1

1. Dealing with the currency environment you have

(rather than the one youd like to have)Slower growth in developed economies relative to emerging markets, advances in transpor-

tation and telecommunication infrastructure and lower international trade barriers have led

many U.S. companies to expand their offshore operations in recent years. Whether through

M&A or organic growth, large multinationals derive a growing part of their revenue from

non-domestic markets. For example, for the 25 largest companies in the S&P 100 index,

the portion of non-U.S. revenues increased from almost 45% in 2006 to over 55% in 2011.

However, with the benefits of faster growing non-domestic markets come the risks of

foreign currency fluctuations.Figure 1

Non-domestic revenues are becoming increasingly important for large global firms

Median % of revenue outside of North America1

Senior managers and capital market participants are used to dealing with risky operations

and changing markets and prices. With ever-expanding non-domestic sales, however, the

impact of currency fluctuations in predicting earnings and cash flows becomes paramount.Figure 2

Increasingly volatile FX environment calls for action

This riskier currency environment profoundly impacts all aspects of corporate finance

decision-making, from risk management to dividend policy, capital structure and M&A.

To guide senior executives, we provide a roadmap that highlights key challenges and

helps users avoid the most common pitfalls of this riskier currency environment.

2006 2007 2008 2009 2010

53.9%

2011

44.7%

47.2% 49.3% 50.1%

55.6%

CAGR200620

11:4.5%

Source: Bloomberg, FactSet1Top 25 S&P 100 companies by market cap

Companies needto reexamine

their FX strategy

FX environment

More volatile Harder to predict Limited benefits of

diversification

Corporate environment

Greater revenuesoshore

Increased investor

attention to FX Increased FX-related

earnings volatility

Source: J.P. Morgan



2 | Corporate Finance Advisory

2. How do you define your currency risk exposure?

Following the recent (and some would say, ongoing) financial crisis and the flock of associ-

ated black swans, senior decision-makers are even more focused on measuring and manag-

ing risk. The traditional view is that investors expect higher returns when exposed to higher

systematic risk (beta).

We believe that there is another categorization of risk that is useful in the context ofcurrency exposure: Core versus non-core equity risk. Core equity riskis a key risk

borne by a firm due to the nature of its business; investors would likely choose to have

exposure to this particular risk to enhance their returns. Asymmetric risk, however,

creates exposure to a risk that investors are not necessarily seeking out when purchasing

a stock. They can be material but are not key drivers of the firms investment thesis

(see examples of core and asymmetric risks in Figure 3).

Figure 3

Core versus asymmetric risk exposures

We believe that for most firms, currency risk falls in the category of asymmetric risk.

As a result, the growing impact of currency fluctuations is likely to be asymmetric. That is,

the perceived shareholder benefit of a favorable currency outcome will be overshadowed

by the penalty due to an unfavorable currency outcome. If currency volatility increases, ex-

posure to asymmetric risk will be higher and corporate finance implications would likely

be more severe.

EXECUTIVE TAKEAWAY

Large global firms realize a growing part

of their sales from non-domestic markets,

while currency volatilities have increased

relative to pre-crisis levels, and the benefits

of diversification have diminished. As a result,

currency swings will have a greater impact

on firm value going forward, unless decision-

makers adopt a proactive approach to dealing

with this new reality.

Core Asymmetric

Definition Risk fundamental to main business activity Risk that is not fundamental to main business activity

Investors

perspective

Investors purchase shares to achieve exposure to

the core risk

Investors do not purchase the stock to obtain exposureto this risk

Investors may penalize the rm more for adverse

outcomes than they reward it for favorable outcomes

Examples Company Risk exposure Company Risk exposure

Gas exploration

and production

Gas prices Waste management Trucking fuel

Real estateinvestment trust

Real estate market Food and beverage Aluminum prices

Oil rener Crack spreads Iron ore Copper prices

Gold mine Gold prices Global corporations Currency risk?

Source: J.P. Morgan




3. A riskier currency environment3.1. Sustained higher volatility level

During crises, volatilities of financial assets tend to spike. At the peak of the recent financial

crisis, equity volatility (as measured by the VIX index) jumped from a pre-crisis average of

about 15% to as high as 80% on October 27, 2008. Following this trend, currency volatilities

also spiked during the crisis, from a pre-crisis average of about 9% to about 13%. Despite

the significant economic, regulatory, financial systemic and geopolitical risks, equity volatil-ity has dropped back to pre-crisis levels of about 15 to 20%. In contrast, currency volatility

has not yet returned to prior levels in all markets (particularly the Euro/USD rate). As one

can see in Figure 4 below, currency volatilities have settled at a level that is about 50%

higher than that prior to the crisis. The uncertainty around the future of the Euro, concerns

about global economic slowdown, the U.S. elections and the fiscal cliff constitute a large

part of this volatility.

What does this mean for corporate decision-makers?For firms operating in non-domestic

markets, this higher volatility implies more severe shocks to non-domestic revenues and

earnings.

Figure 4

Currency volatilities are still elevated in some markets

Expected volatility of foreign exchange rates1

EXECUTIVE TAKEAWAY

All firms take on risk. Investors select equity

investments based on the balance between

expected returns and risk. Some firms provide

risk exposures that are uniquely attractive to

some investors. For most firms, currency risk

does not, however, fall into this category. As a

result, firms will be more negatively impacted

by adverse currency movements rather than

positively impacted by favorable ones.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

01/28/2003 06/15/2004 11/01/2005 03/20/2007 08/05/2008 12/22/2009 05/10/2011

Euro/USD volatility JPY/USD volatility GBP/USD volatility

Post-crisis median: 12.9%

Pre-crisis median: 8.8%

Source: Bloomberg1One-year option-implied volatility




3.2. Reduced ability to predict currency volatility

A more volatile foreign exchange environment makes it more challenging to forecast ratechanges. In May 2007, when currency volatility was relatively low, most economists had

roughly similar forecasts regarding future rates of the Euro. This estimated consensus was

wrong. By the end of the third quarter, the Euro already spiked beyond the highest analyst

forecast of just four months earlier and a similar trend was recognized during the following

two quarters. When currency volatility reached its peak (at the end of 2008), the diver-

gence in economists views almost tripled. Still, the actual spot rate was close to the highest

estimate and significantly away from the median.

What does this mean for corporate decision-makers?Firms often rely on economists

forecasts and the forward curve to budget foreign earnings and cash flows that will betranslated into USD. Whether evaluating a new project or M&A opportunity, the ability to

forecast USD returns on investments is critical. When realized spot rates are drastically

different from the rates used for calculating the expected ROIC, unhedged investments

may turn dilutive (from both economic and accounting perspectives), even if the foreign

currency cash flows of the project or the subsidiary perform as expected.

Figure 5

Economists disagreement about future currency rates is growing

Economists forecasts for the Euro spot price

3.3. Greater difficulty in diversifying foreign currency risk

Global companies operating in various international markets often rely on the diversifica-

tion among different currencies to mitigate the net impact of currency fluctuations on their

cash flows. In particular, the correlation between emerging market currencies, such as the

Brazilian Real (BRL) and Indian Rupee (INR), and developed market currencies, was close

to zero in the pre-crisis environment. Figure 6 shows, however, that in the new currency

environment, the correlation between foreign exchange rates of emerging and developed

markets has spiked. For example, the Euro/BRL correlation has jumped from zero to 60%.

Source: Bloomberg, FactSetNote: Standard deviation refers to the average of the four periods standard deviation of economist forecasts1Trough implied Euro volatility and analyst estimates as of May 8, 20072Peak implied Euro volatility and analyst estimates as of December 30, 2008

. ..

.

1.41

$1.07$1.10

$1.05$1.00

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

Q1 2009 Q2 2009 Q3 2009 Q4 2009

$1.40 $1.40 $1.40$1.42

$1.35

$1.26$1.22

$1.16$1.12

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

Q2 2007 Q3 2007 Q4 2007 Q1 2008

Standard

deviation4%

Standard

deviation11%

Trough1expected currency volatility Peak2expected currency volatility

Economists forecasts

Euro spot price

Economists forecasts

Euro spot price




The increased correlation is a result of several factors. First, integration of global

economies and capital markets, combined with innovations in the financial industry, has

led to increased correlation between markets. Similarly, the correlation between emerging

and developed markets equities has increased significantly in recent years. Last, the use of

U.S. Treasuries as a safe haven and more macro-driven investments are driving correlations

closer to one.

What does this mean for corporate decision-makers?The value of diversification across

different currencies is diminishing, leading more global firms to be more aggressive about

hedging alternatives.

Figure 6

Benefits of currency diversification are reduced in todays environment

Source: Bloomberg

Euro/AUD correlation

-0.10.00.10.20.30.40.50.60.70.80.9

-0.10.00.10.20.30.40.50.60.70.80.9Euro/INR correlation

Developed marketsEmerging markets

1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12

Euro/CAD correlation

-0.10.00.10.20.30.40.50.60.70.80.9

-0.10.00.10.20.30.40.50.60.70.80.9Euro/BRL correlation

1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12

One-year rolling correlation of Euro/Indian Rupee

One-year rolling correlation of Euro/Brazil Real

One-year rolling correlation of Euro/Australian Dollar

One-year rolling correlation of Euro/Canadian Dollar

EXECUTIVE TAKEAWAY

The new currency environment presents

significant challenges to corporate executives.

Foreign exchange rates are more volatile and

harder to predict. Moreover, diversification

offers limited value as correlations have

increased.




4. Analysts and equity investors pay attention

The new foreign exchange environment and its impact on corporate earnings have

not gone unnoticed by equity analysts and investors. For some global consumer retail,

pharmaceutical and technology companies, the foreign exchange impact on second quarter

sales this year was up to 15% of revenues or US$3.0 billion (see Figure 7A). Following this

significant impact on revenues, equity analysts are now more focused on FX. For example,

in second quarter earnings calls, 34% of multinational companies were questioned by

analysts about FX, versus only 23% in the first quarter of 2012 (see Figure 7B).

During the third quarter, investors have returned to risk on trades causing the USD to

weaken again, which should have had a positive impact on the revenue of U.S. companiesthat operate globally. The volatility in FX rates remains a major issue, however, and adds

to the uncertainty regarding future earnings and cash flows. If currency risk is perceived

as asymmetric by investors (as discussed in Section 2), then adverse moves in FX rates

will lead to increased investor attention and negative market reaction, while favorable

FX trends will not be rewarded because they are not viewed as sustainable drivers of long-

term growth.

Figure 7A

Investors are becoming increasingly focused on currency losses

Notable impact of FX fluctuations on Q2 2012 revenues

Teleco

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Medic

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Intern

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Integr

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Indust

rialco

nglom

erate

Chemica

l

Pharm

aceuti

cal

Pharm

aceuti

cal

Food&

bever

age

Pharm

aceuti

cal

Indust

rialco

nglom

erate

Aeros

pace&

defen

se

ITcons

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Super

center

s

House

holdp

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Type of company

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

0%

5%

10%

15%Absolute FX impact on revenues

FX impact as a % of revenues

U

S$mm

%o

frevenues

$84 $102 $119$200

$301$430 $441 $492

$523$690 $692

$900$1,000

$2,200

$3,000

Source: Press releases, Company filings, earnings calls transcripts




Figure 7B

Investors are becoming increasingly focused on currency losses (contd)

Multinational firms questioned by analysts about FX1

5. A roadmap to avoid the most common pitfalls

Foreign exchange rates affect various aspects of a firms corporate finance strategy. As

U.S. firms generate a larger portion of their revenue offshore and the foreign exchange

environment remains more volatile and harder to predict, companies should reexamine

their strategy. Figure 8 offers a corporate action plan for decision-makers to potentially

mitigate risk exposure to the increasing currency volatility.Companies should measure the impact of FX fluctuations not only on their earnings and

cash flows, but also on their leverage metrics, payout ratios and liquidity position. Hedging

should be considered, especially if the company believes that FX exposure is asymmetric

and non-core to the business. In addition to forward contracts and cross-currency swaps,

companies can use option strategies to keep some exposure but protect against tail

risk. The application of hedge accounting will also be important in certain situations and

companies need to be aware of the rules in order to avoid increasing earnings volatility

while hedging economic risk.

Source: Press releases1According to a review by foreign exchange risk management company FiREapps

34%

0%

5%

10%

15%

20%

25%

30%

35%

40%

23%

Q1 2012 Q2 2012

EXECUTIVE TAKEAWAY

Heightened uncertainty in the foreign

exchange market is attracting the attention

of equity analysts and investors, who are

concerned about its impact on corporate

earnings. Corporate executives, who are

already receiving more FX questions from

analysts during earnings calls, are currently

reexamining their FX strategy in light of this

new environment.




Figure 8

A roadmap to avoid the most common pitfalls

Action plan

1. Valuation

and earnings

Assess the potential impact of FX volatility on your companys earnings guidance

Focus not only on net currency exposure, but also impact on top line growth

2. Operations Consider USD denominated contracts in foreign countries as a natural oset to FX volatility

Take into account that FX movements will still impact your rms competitiveness versus

local peers

3. Hedging

strategy Debate de-risking strategies, especially if your company has concentrated currency exposures,

limited liquidity and modest flexibility with your credit rating Recent spike in correlations across currencies underscores the limits of diversication

Centralizing risk can provide a better perspective on company-wide currency exposure

4. Capital structure/

ratings Maintain EBITDA cushion within your rating category (and nancial covenants) or think about

hedging to protect against the impact of FX on leverage metrics

Match the currency mix of your debt to the EBITDA, either through issuance in local markets

or synthetically

5. M&A and capital

allocation Weigh the valuation of foreign M&A targets in both the local currency and the USD

Though theoretically the two methodologies should result in similar valuations, recent market

dislocations and practical limitations often lead to dierent valuations

6. Liquidity

management

Convert excess liquidity (such as trapped oshore cash) to match the currency of your liabilities

7. Shareholder

distributions

Test the sustainability of your companys dividend payments under a downside scenario, taking

the impact of FX into account

EXECUTIVE TAKEAWAY

In todays global economic environment,

the importance of managing the impact of

foreign exchange rates on companies becomes

increasingly important. In contrast, the ability

to predict currency movements and the use

of diversification to protect against adverse

rate changes are declining. Many companies

are currently analyzing the corporate finance

implications of this new environment and

reconsidering their FX strategy. We offer a

corporate finance action plan that addresses

the key factors affecting global companies.

Source: J.P. Morgan



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Special thanks go to Jessica Lupovici, Matt

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