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Foreign Exchange Risk Management Practices Survey was conducted from January 18 to February 15, 2011. The survey represents the third time in four years in which Wells Fargo Foreign Exchange has obtained information about FX risk management practices from a broad cross-section of our customer base.
Foreign Exchange Risk Management Practices Survey was conducted from January 18 to February 15, 2011. The survey represents the third time in four years in which Wells Fargo Foreign Exchange has obtained information about FX risk management practices from a broad cross-section of our customer base.
Foreign Exchange Risk Management Practices Survey was conducted from January 18 to February 15, 2011. The survey represents the third time in four years in which Wells Fargo Foreign Exchange has obtained information about FX risk management practices from a broad cross-section of our customer base.
2 | Foreign Exchange Risk Management Practices Survey wellsfargo.com 2011 Foreign Exchange Risk Management Practices Survey Prepared by: Wells Fargo Foreign Exchange Wells Fargo Foreign Exchange is pleased to release the summary ndings of our Foreign Exchange Risk Management Practices Survey conducted from January 18 to February 15, 2011. The purpose of the survey is to gather information about FX risk management practices and policies from a representative sample of our foreign exchange customer base. This information, in turn, can provide you with a benchmark measure of how your peers are addressing foreign exchange risks. This survey represents the third time in four years in which Wells Fargo Foreign Exchange has obtained information about FX risk management practices from a broad cross-section of our customer base. The years 2008 and 2009 provided a close comparison of practices and trends separated by a single year. With our 2011 survey, we add to the composite picture of risk management practices. In most instances, the practices that we observed from the rst two surveys have been reinforced by our third prole of respondents. This theme will recur throughout our summary ndings. This series of surveys is distinguished by a signicant turnover of participants from year to year. We believe that the cumulative feedback of so many unique respondents, reecting a critical mass of viewpoints, provides results that are highly reective of the state of FX risk management in corporate America today. 3 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Table of contents u Executive summary 5 The current risk management environment ........................................................................5 Risk management objectives .........................................................................................................5 Exposures hedged ................................................................................................................................5 Hedging instruments ........................................................................................................................ 6 Foreign exchange policy ................................................................................................................. 6 Hedging strategy ................................................................................................................................. 6 Risk management challenges ...................................................................................................... 6 u Survey participants 7 u Risk management practices 8 Management of FX exposures......................................................................................................8 Risk management objectives .........................................................................................................8 Formal FX risk management policy ....................................................................................... 10 Counterparty credit ratings ......................................................................................................... 10 Budget rates ........................................................................................................................................... 11 Attitude toward risk management ........................................................................................... 11 u FX exposures 12 Booked foreign currency assets or liabilities ................................................................... 12 Forecasted foreign currency revenues or expenses ......................................................13 Translated net income from foreign subsidiaries and ................................................13 net investments in foreign subsidiaries u Hedging practices: Balance sheet hedges 14 Percent of balance sheet positions hedged ....................................................................... 14 Maturities of balance sheet hedges ........................................................................................ 15 Balance sheet hedge instruments ............................................................................................ 15 Hedge accounting election for balance sheet hedges ................................................ 16 u Hedging practices: Forecasted transactions 17 Percent of forecasted transactions hedged .........................................................................17 Maturities of forecasted transactions .................................................................................... 18 Layered hedge program for forecasted transactions ................................................... 19 Forecasted transaction hedge instruments ....................................................................... 19 Hedge accounting election for forecasted transactions ........................................... 20 4 | Foreign Exchange Risk Management Practices Survey wellsfargo.com u Translated net income from foreign subsidiaries and 21 net investments in foreign subsidiaries u Additional risk management practices 22 Accounting conventions ...............................................................................................................22 Risk management approach .......................................................................................................22 Providing a budget for hedging ...............................................................................................23 Centralized risk management ....................................................................................................23 u Biggest challenges related to FX risk management 24 Accuracy and timeliness of exposures and forecasts ..................................................24 Market volatility, when to hedge, and using the proper strategy ........................24 Approvals, communications, and internal resources ..................................................24 Hedge accounting and compliance ........................................................................................24 u Summary and conclusion 25 5 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Executive summary u The current risk management environment While market conditions have stabilized from the nancial turmoil of 2008 and 2009, 36% of 2011 respondents stated that foreign exchange became of greater concern to them in the past twelve months. For those who expressed greater concern, 52% increased the amount of exposure being hedged. u Risk management objectives As was the case in 2009, companies rank eliminating FX gains and losses as their most important risk management objective. u Exposures hedged A majority (68%) of companies actively hedge foreign currency balance sheet positions that afect foreign exchange prot and loss results and realized cash ows. Between 2009 and 2011, behavior toward hedging future business activities stabilized. Among companies that recognize forecasted foreign currency revenues and expenses as exposures, 48% employ derivative hedges to manage the economic impact of these exposures. In 2009, 53% hedged forecasted transactions. 6 | Foreign Exchange Risk Management Practices Survey wellsfargo.com u Hedging instruments Use of forward contracts remains a prevalent practice. About one-third of companies use options to hedge balance sheet exposures and 38% use options to hedge forecasted transactions. In order to manage earnings more efectively, hedge accounting under FAS 133 (ASC 815, but referred to throughout by its original name) is employed more frequently by public rms with larger revenues, as compared to private and/or smaller revenue companies. Of the companies that hedge forecasted transactions, 68% hedge exposures with maturities of twelve months or longer. u Foreign exchange policy The existence of a formal written policy for managing foreign exchange increased marginally in 2011 (58%) from 2009 (54%). Companies with policies have become more attentive to counterparty credit risk. Those with a specied minimum credit rating for counterparty risk increased to 65% from 57% in both of the prior surveys. u Hedging strategy Systematic risk management, identied by 55% of respondents, is the predominant style for managing FX risk. The percentages for the style described as active hedging increased somewhat from the prior studies. The prevalence of dynamic hedging remains basically unchanged. Most companies (84%) manage risk on a centralized basis, with larger, public companies most likely to do so. u Risk management challenges The most often cited risk management challenge facing companies is understanding, identifying, and quantifying exposures. Most companies (79%) set budget rates as part of their formal planning process, but the process used for determining a budget rate is highly variable. 7 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Survey participants The respondents to this survey represent a broad cross-section of companies in the Wells Fargo customer base employing risk management techniques to control their FX exposures. The array of respondents was spread evenly from very small businesses (annual revenues less than $25 million) to the large corporate marketplace (annual revenues greater than $5 billion). As was the case for the 2009 survey, this survey represents practices of both private and public corporations. The percentages from these sectors are the same for 2011 and 2009: 56% of responses were from private entities and 44% from public companies. Also, both surveys drew 86% of respondents from companies based in the United States, and 77% of respondents indicated that they have foreign subsidiaries. Finally, the preponderance (71%) of replies came from companies in the manufacturing, wholesale trade, and technology elds, with additional representative responses from several other industries. The 2011 survey is the third FX risk management survey conducted by Wells Fargo Foreign Exchange in the last four years. The prior two surveys were from 2008 and 2009. We noted in 2009 that 79% of the respondents to the survey were new respondents. In other words, they had not responded to the 2008 survey. We noted further that in many respects, the responses from 2009 were very similar to 2008. This year, 71% of respondents are new responders to the 2011 survey, meaning that a substantially new base of companies described their risk management practices that were not included in the prior survey. In most instances, the 2011 responses were similar to the 2009 survey. It, in turn, as noted above, had responses similar to the 2008 survey. Taken together, these three surveys all with similar results present increasingly robust ndings about the state of FX risk management over the four-year time span. Indeed, when assessed as a whole, we received 755 total responses to these three surveys, with 633 unique entities responding to one or more in order to aggregate the 755 total. We believe that the combination of so many unique respondents producing such similar results for each of the three surveys paints a highly reliable prole of how companies are managing risk. While our initial instinct is to look for emerging trends in risk management, trending outcomes have not been particularly notable. Instead, what has been striking is the stability of risk management practices over a four-year time span. By obtaining similar results in successive surveys, each survey has reinforced the validity of the prior results because the turnover of respondents has been so substantial. Parent company based U.S. 86% Abroad 14% Have foreign subsidiaries Yes 77% No 23% Company annual revenue Less than $25 million 9% $25 million - $100 million 17% $100 million - $250 million 17% $250 million - $500 million 13% $500 million - $1 billion 11% $1 billion - $5 billion 23% Greater than $5 billion 10% Industry Manufacturing 44% Wholesale trade 14% Technology 14% Retail 6% Finance, insurance, RE 4% Construction 2% Healthcare 1% Education 1% Non Prot/government 1% Other 13% 8 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Risk management practices Management of FX exposures At the highest level of inquiry in the survey, 79% of respondents stated that they have exposure to trade related or nancing related non-functional currency exposures. The survey targeted behaviors in these two areas because in our experience, most companies that actively manage or hedge foreign exchange exposures are afected primarily by ongoing activities in these categories. Those who indicated that they do not have exposure in either area generally come from industry groupings such as government, education, and health care, where commercial activities may involve foreign exchange, but do not require the same hedging and risk management needs as most respondents from the manufacturing, wholesale trade, and technology sectors. Risk management objectives Foreign exchange risk can afect a companys operations in a number of ways. In order to measure at a high level, the most important risk management objectives among companies, we asked respondents to rank ve variables from most to least important. The most important objective was to eliminate FX gains and losses, with 37% of respondents ranking this rst. The next most important objective was to minimize earnings volatility, with 26% ranking this rst. When rst and second rankings are added together for each objective, minimizing earnings volatility at a sum of 58% becomes the most important objective, followed by eliminating FX gains and losses at 56%. Importance of risk management objectives Eliminate FX gains/ losses 37% 19% 19% 14% 11% Minimize earnings volatility 26% 32% 21% 13% 8% Optimize U.S. dollar cash ow 17% 16% 16% 24% 27% Protect budget rate 14% 17% 19% 23% 27% Maintain competitive advantage 6% 17% 25% 26% 26% Ranked rst Second Third Fourth Ranked last Eliminating gains and losses and minimizing earnings volatility are most often ranked one or two in order of importance. 9 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Analyzing the data more nely for distinctions between public and private rms reveals some interesting nuances. The top priority for public rms is to minimize earnings volatility, with 38% rating this their primary goal. In addition, 30% of public companies stated that this objective was their second most important priority. With just over two-thirds of public companies rating this objective their top or second priority, it reinforces how much importance public companies place on their reported earnings. Importance of risk management objectives: Public Eliminate FX gains/ losses 30% 24% 20% 14% 12% Minimize earnings volatility 38% 30% 17% 10% 5% Optimize U.S. dollar 19% 15% 16% 24% 26% cash ow Protect budget rate 7% 19% 21% 26% 27% Maintain competitive advantage 6% 12% 26% 26% 30% Ranked rst Second Third Fourth Ranked last In contrast, the most important objective for private companies is to eliminate FX gains and losses, with 41% of respondents giving this objective a number one ranking. When including those companies that ranked this as the second most important objective, the total percentage of a one or two rating grows to a total of 56%. In the private world, reported earnings are less important since they do not need to be reported to a broad base of shareholders. Importance of risk management objectives: Private Eliminate FX gains/ losses 41% 15% 19% 14% 11% Minimize earnings volatility 17% 34% 23% 16% 10% Optimize U.S. dollar cash ow 17% 15% 16% 25% 27% Protect budget rate 19% 15% 18% 20% 28% Maintain competitive advantage 7% 21% 24% 25% 23% Ranked rst Second Third Fourth Ranked last It is also interesting that 28% of private companies rated maintaining a competitive advantage either one or two in their rankings, whereas only 18% of public rms rated this objective (ranked lowest overall) that high in their rankings. While not a huge diference, the data suggests that private rms are more sensitive to competitive issues in their markets. It is worth noting here that among our respondents, 69% of public companies had revenues of greater than $500 million, while only 25% of private companies exceeded that level of revenue. This fact further strengthens the inference that private companies may need to be more nimble to maintain a competitive advantage if they lack a critical mass of market penetration in their particular industry or service. 10 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Formal FX risk management policy Overall, 58% of respondents stated that they have a formal written policy for managing foreign exchange. While not a huge change, this gure is an increase from a 54% result in 2009. Eighty percent of public companies reported having formal policies, while only 42% of private companies responded in the afrmative. Likewise, larger companies, with revenue in excess of $500 million, are more likely to have formal policies, as 85% meeting this revenue criteria stated they have an FX policy. Conversely, only 39% of companies with revenues of less than $500 million have a policy. Our continuing conclusion is that public companies, more accustomed to a Sarbanes-Oxley controls environment and additional public scrutiny, are more likely to implement formal policies that describe the responsibilities for FX risk management and establish appropriate controls and authority for such actions. Nonetheless, we remain surprised that having a formal policy is not more prevalent. Counterparty credit ratings With respect to counterparty credit ratings, 65% of respondents indicated that they specify a minimum credit rating for counterparty exposure. This is an increase from 2009, when the result was 57%. Once again, public companies are considerably more vigilant about the credit quality of their dealing counterparties, with responses of 80% and 41% for public and private entities, respectively. In 2008, when 56% of respondents said they maintained minimum levels for counterparty credit ratings, we speculated that the strains in the nancial market that were becoming prevalent would provoke increased vigilance with respect to minimal levels of counterparty credit ratings. Since then, behavior, while somewhat more prevalent for providing counterparty credit limits, has not changed dramatically. Therefore, we continue to believe that establishing minimal levels for counterparty credit ratings remains an area for increased attention in the corporate community. Have a formal written policy Public 80% Private 42% > $500 million 85% < $500 million 39% Minimum credit rating for counterparties Public 80% Private 41% > $500 million 73% < $500 million 48% 11 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Budget rates The 2011 survey indicates that 69% of companies set budget rates as part of their formal planning process for managing FX risk. This outcome is down substantially from an 85% outcome in 2009 and an 80% response rate in 2008. Unlike previous surveys in which there was little variation in behavior about budget rates when comparing public and private as well as large and small revenue companies, 2011 saw some diferences. Public companies use budget rates at an 82% response rate versus only 55% for private companies. Large companies responded at an 83% rate versus a 55% rate for small companies. While these measurements changed, the customary variability characterizing how budget rates are set persisted in this survey. This range of practices reveals that there is little consensus about the method used to set budget rates. Using consensus forecasted rates continues to be the preferred approach, selected by 42% of respondents, which is up from 35% in 2009, but marginally lower from a 45% response rate in 2008. The Wells Fargo recommended method for setting budget rates using prevailing forward rates increased in 2011 to 21% from 17% last year, and from only 14% in 2008. However, using prevailing forward rates still trails consensus forecasted rates and prevailing spot rates as a method when setting a budget rate. Attitude toward risk management In an efort to take the pulse of the market about the overall concern toward international exposures, the 2011 survey asked companies to rate whether in the last twelve months their attitude toward foreign exchange risk management was a reduced concern, unchanged, or of greater concern. A majority, 61%, stated their attitude was unchanged. A decided minority, 4%, replied that their concern had actually become reduced. But more than a third 36% stated that foreign exchange risk management had become a greater concern. We asked those expressing a greater concern to characterize how they have changed their behavior. Most (52%) stated that they had increased the amount of their exposure being hedged. The next most often cited responses were to develop or revise an FX policy (37%) and to extend the average maturity of their hedges (25%). A smaller percentage of companies (10%) responded by decreasing the amount of exposures hedged and 5% stated that they shortened the average maturity of their hedges. Overall, these results suggest that FX risk management continues to evolve at many companies, an outcome consistent with increased international opportunities as the global economy recovers from recession and a at world heightens competitive pressures. Source of budget rate Consensus 42% forecasted 35% rates 45% 21% Prevailing spot rates 25% 21% Prevailing 21% forward 17% rates 14% Historical 9% average 11% rates 10% 7% Other 12% 10% 2011 2009 2008 12 | Foreign Exchange Risk Management Practices Survey wellsfargo.com FX exposures The 2011 Risk Management Survey replicated a methodology introduced in the 2009 survey to gather information about corporate behaviors. Specically, both surveys sought to prole specic corporate foreign exchange behaviors by concentrating on two high-level categories of exposure: 1) transactional exposure and 2) translational exposure. Within each of these categories, there were further distinctions to explore. Transactional exposure was comprised of two sub-levels: 1) trade related exposures that give rise to non-functional currency trade accounts receivable and/or payable and 2) nancing related exposures that give rise to interest- bearing non-functional currency assets and/or liabilities. Translational exposure was comprised of two sub-levels: 1) translation of a foreign currency functional subsidiarys income statement and 2) translation of a foreign currency functional subsidiarys balance sheet, both for the purpose of presenting consolidated nancial statements at the parent level. Booked foreign currency assets or liabilities From the survey data, 74% of respondents indicated they had exposure to trade related accounts receivable and payable, and 37% acknowledged the existence of interest-bearing, non-functional currency assets or liabilities. These exposures are often referred to in a short-hand manner as foreign currency balance sheet positions. The sum of the percentages exceeds 100% because some companies have both exposures. Since 21% of respondents acknowledged exposure to neither, it may be inferred that 79% of the survey respondents had exposure to this category of risk. Entities acknowledging the presence of neither exposure generally came from industry groupings such as government, education, and health care, where exposure to currency risk typically arises on an ad hoc basis, such as the need to fund international research or educational programs. 13 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Forecasted foreign currency revenues or expenses The methodology of the survey assumes that the same 74% of respondents who acknowledged they have exposure to trade related accounts receivable and payable also have exposure to forecasted foreign currency revenues and expenses. Our logic is that any company with ongoing transactions that generate foreign currency settlements would also be afected by future rate movements that could alter the terms of trade. In the broadest terms, forecasted revenues or expenses denominated in a foreign currency represent economic exposure to the currency markets, reecting the potential for revenues or expenses to be afected either positively or adversely by future, unpredictable exchange rate movements. Translated net income from foreign subsidiaries and net investments in foreign subsidiaries To explore practices with respect to these translation exposures, the survey rst identied the universe of respondents with foreign subsidiaries. As was the case in our last survey, roughly three in four respondents (77%) indicated that they had at least one foreign subsidiary as a result of their international operations. A large majority indicated that the functional currency of the subsidiaries is the local or foreign currency. This gure was well in excess of 90% for the most frequently cited geographic regions. Thus, by denition, when following US GAAP, the existence of these subsidiaries would mean that consolidated nancial statement results would be afected by FX rate volatility and its efects on the translation of foreign subsidiary income statements and balance sheets. 14 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Hedging practices: Balance sheet hedges Of the respondents who identied booked foreign currency monetary assets and liabilities as an exposure on their balance sheets, 68% acknowledged that they actively manage the exposure. There were no notable diferences between the behaviors of private and public companies, or by revenue size of companies. This outcome reects almost unchanged behavior from 2009, when 66% stated that they managed this exposure. The highest level of activity came from 2008, when 74% hedged this exposure. We have consistently expressed mild surprise that the percentage of companies actively managing this exposure is not higher. The P&L resulting from the remeasurement of booked foreign currency accounts receivable and payable is typically captured in an FX Gain/Loss line of the income statement. Explaining gains and losses attributable to FX P&L is something that management usually seeks to avoid, since FX P&L, whether a gain or a loss, often calls into question whether risk management practices have been adequately dened. Regardless of our reaction, the three surveys taken as a whole reveal that a strong majority of companies hedge balance sheet exposures, but by no means is it a universal practice. Percent of balance sheet positions hedged With respect to the amount of the exposure hedged, the results form a bit of a barbell distribution, with less than 25% and more than 75% being the most heavily cited practices. Once again, behavior among customer segments as distinguished between public and private and small and large revenue customers did not reect any special patterns. Practices were quite consistent across the board. The strongest point of contrast would be that public companies and larger companies are more likely to hedge a greater percentage of their exposures. The results for hedging 75% or more of balance sheet exposures were 34% and 27% for public and private rms, respectively. Similarly, 36% and 25% applied to rms with revenues greater than $500 million and less than $500 million. Results from both years indicate that companies in general are cautious about hedging this exposure. In the 2008 survey, only 58% of companies hedged more than 50% of balance sheet positions. In 2009, the outcome grew marginally to 62%. The 2011 result was 56% the lowest of the three surveys. We have been surprised that a larger portion of the exposure is not hedged, since theoretically, these are known and booked positions. An ongoing theme from the surveys, however, is the uncertainty around measuring exposures. In our surveys, we have posed the question, What are your companys biggest challenges related to foreign exchange risk management? In each survey, the most often cited response has been the challenge of understanding, identifying, and quantifying exposures. This response strongly indicates that the lack of reliable data is why more respondents do not hedge a larger percentage of their balance sheet exposures. Approximately what percent of your companys balance sheet positions are typically hedged? Percent hedged 30% Less than 25% 28% 27% 14% 25% to 50% 10% 15% 24% 50% to 75% 22% 25% 32% More than 75% 40% 33% 2011 2009 2008 15 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Maturities of balance sheet hedges When entering balance sheet hedges, 63% of respondents say that they hedge with maturities of three months or less, an outcome unchanged from 2009. Short- term hedges are much more likely to be used by public and larger companies. For example, 74% of public companies hedge with maturities of three months or less, while private companies responded at a 56% rate for the same measure. Similarly, 68% of companies with revenues in excess of $500 million annually use hedges with maturities of three months or less, whereas 56% of smaller companies hedge with these maturities. Our inference is that public companies with larger revenues have more robust methodologies for capturing exposures, allowing them to use relatively short-term hedging programs that are adjusted frequently to true-up hedges to exposures to neutralize the risk of balance sheet exposures. Balance sheet hedge instruments With regard to hedging instruments, 96% of companies hedging balance sheet exposures use forward contracts. This outcome is consistent with the objective of using a derivative that secures the value of a known and booked exposure, protecting against FX losses while equally giving up the potential for FX gains. In addition to forward contracts, 32% of respondents acknowledged using some form of an option-based derivative or forward contract alternative to hedge this exposure. This outcome is marginally higher than the 2009 result when 25% used some alternative to a forward contract hedge. As we found in past surveys, further analysis indicates that companies that use other derivatives as an alternative to forward contracts for hedging balance sheet positions tend to be private and small revenue companies versus public, large revenue companies. Specically, 39% of private companies reported using a hedge other than a forward, while only 6% of public companies did so. Since more private companies in the survey are described by our smaller categorization, the outcome is reinforced by that metric. Only 14% of large revenue companies report using options for this exposure, while 37% of small revenue companies did. These results reinforce our conclusion that smaller, private companies are less likely to be constrained in their use of derivatives compared to larger, public companies. This may reect that the decision-making process in a smaller company is more efcient when managerial consensus is easier to achieve. It is also noteworthy that many respondents expressed in their qualitative challenges that explaining hedges and nancial reporting to management and the international network is a difcult task. In such an environment, the relative simplicity of a forward contract may well reect the path of least resistance for risk management. Hedge instruments balance sheet hedges What is the typical maturity of your balance sheet hedges? Forward contracts 96% Option collars 10% Participating forwards 7% Cross-currency swaps 6% Purchased options 5% Forward extras 4% 32% of respondents use at least one option-based derivative or forward contract alternative to hedge balance sheet exposures. } Hedge horizon 27% 1 month or less 28% 27% 36% Between 1 and 3 months 35% 34% 17% Between 3 and 6 months 23% 22% 20% More than 6 months 14% 17% 2011 2009 2008 16 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Hedge accounting election for balance sheet hedges In 2011, 29% of respondents that hedge balance sheet exposure indicated that they elect hedge accounting. This result compares to 36% in 2009 and 19% in 2008. These outcomes conrm that a minority of companies elect hedge accounting under FAS 133 for hedges of booked foreign currency monetary assets and liabilities. This outcome is consistent with our experience for this aspect of nancial reporting. Most foreign currency monetary assets and liabilities held on the balance sheet are trade related, and we believe that hedge accounting for hedges of these exposures is generally an unnecessary election under FAS 133. The basic accounting guidance under FAS 52 (ASC 830) and FAS 133 dictates that the P&L remeasurement of both the underlying foreign currency balance sheet position and the of-setting hedge are reected on a current basis in the income statement in the FX P&L line. The symmetrical remeasurement treatment of the underlying exposure and hedge means that FX P&L is naturally of-set, eliminating the need for a hedge accounting election. Given this fact pattern, we are surprised that nearly a third of respondents continue to elect hedge accounting. We believe that despite its existence for ten years, FAS 133 is still often misunderstood and not applied uniformly throughout the nancial reporting industry. 17 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Hedging practices: Forecasted transactions We now turn to analyzing hedging practices with respect to forecasted transactions. The logic of the survey assumed that the 74% of respondents who acknowledged that they have exposure to foreign currency trade accounts receivable and payable also have exposure to forecasted foreign exchange transactions representing future revenues and expenses. While it is possible that there are exceptions to this assumption, for most companies, positions that arise from trade transactions are likely to be ongoing and represent future economic exposures. Thus, for every company with trade-related balance sheet positions, we sought further detail around the nature of those exposures. The rst major metric to observe is that of the 74% that fell into the category above, 48% acknowledged that they hedged these future foreign currency revenues and expenses. This outcome continues a declining trend of activity for this exposure as revealed by our three surveys. From the 2008, 2009, and 2011 surveys, the outcome for hedging forecasted transactions has been 77%, 53%, and now 48%, respectively. From 2008 to 2009, this decline in hedging activity was the most notable trend we observed. We concluded in 2009 that the economic environment for most companies had been very difcult due to the uncertainties of operating in a global recession. The unwillingness of an additional 24% of respondents in 2009 to hedge forecasted transactions as compared to the 2008 survey was symptomatic of their hesitancy to enter into hedge transactions when the underlying positions themselves were subject to doubt due to the faltering economy. The similarity of 2011s result as compared to 2009 suggests that there continues to be a hangover from the recession that results in hesitancy to hedge forecasted transactions. It seems certain that only a strengthening global economy will restore corporate condence to the point where levels of hedging will approach what we observed before the nancial crisis in 2008. Percent of forecasted transactions hedged Against this general pattern of decline for hedging forecasted transactions, the patterns of the percentage of forecasts hedged did not change dramatically. Those hedging 25% or less remained exactly the same as the prior surveys at 27%. The next quartiles of 25% to 50% and 50% to 75% groupings reected small changes that were not statistically signicant. Finally, 20% of respondents hedge 75% or more of their forecasted transactions. Percent hedged 27% Less than 25% 27% 27% 23% 25% to 50% 16% 28% 30% 50% to 75% 35% 24% 20% More than 75% 22% 21% 2011 2009 2008 Approximately what percent of your companys forcasted transactions are typically hedged? 18 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Maturities of forecasted transactions In response to the question about what is the longest period for which hedges of forecasted transactions are placed, the results are notably similar from all three surveys. Responses for each formed a roughly symmetrical distribution around the twelve-month period, where 30%, 36%, and 31% of respondents replied that it was the longest period for which they placed hedges for 2008, 2009, and 2011, respectively. As we have observed throughout our surveys, this result indicates that many companies plan around a twelve- month cycle, either capturing a full year at once in their planning and hedge implementation, or maintaining hedges with a rolling, four-quarter horizon. As a whole, 68% of respondents who hedge forecasted transactions use derivatives with maturities of twelve months or longer. This outcome is remarkably stable when compared to prior surveys, which reported 70% and 69% in 2009 and 2008, respectively. This pattern is even more striking in light of the fact it has persisted despite an overall fall in the number of companies hedging forecasted transactions. What is the longest time period for which you hedge forecasted foreign currency revenues or expenses? Maximum hedge horizon 11% 3 months or less 6% 12% 15% 6 months 18% 7% 6% 9 months 6% 12% 30% 12 months 36% 31% 15% 18 months 20% 17% 13% 2 years 5% 10% More than 2 years 10% 9% 11% 2011 2009 2008 19 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Layered hedge program for forecasted transactions In a related response, 60% of respondents who manage forecasted transactions also employ a layered hedge program. The comparable number in 2009 was 53%. In 2008, it was 62%. This response conrms our belief that many companies hedge diferent percentages of forecasted transactions for diferent time periods, adjusting the hedge amounts (typically to a higher percentage) through time as forecasts become more reliable. The practice was more prevalent among public (66%) and larger companies (66%). Comparable numbers for private companies and those with sales of less than $500 million were 53% and 50%, respectively. Forecasted transaction hedge instruments Forward contracts continue to be used by nearly all respondents (90%) for hedging forecasted transactions. Of all respondents, 38% also use some form of an option-based derivative or forward contract alternative for managing these exposures. This result was 45% in 2009 and 50% in 2008. While not a dramatic trend, the successive declines in the use of options during the four-year span of the three surveys do suggest a change in risk management behavior. Hedge instruments forecasted transactions Forward contracts 90% } Option collars 12% Purchased options 9% Participating forwards 8% Cross-currency swaps 6% Forward extras 3% 38% of respondents use at least one option-based derivative or forward contract equivalent to hedge forecasted transactions. To some degree, the reduced reliance on options may go hand in hand with the reduced activity for hedging forecasted transactions. In the same manner in which uncertainty about forecasts has curtailed overall hedging activity, corporations may be backing away from options solutions that are more difcult to explain. Forward contract hedges are easier to understand since they do not require a cash outlay and their ultimate payof is easily described. An unfortunate outcome of the nancial crisis precipitated by the collapse of the housing market is that in certain contexts, the term derivatives carries a somewhat negative connotation. Consequently, corporations may be shying away from hedging instruments other than the most basic forward contract. This is somewhat ironic, since the inherent qualities of option hedges often address the problem of uncertain forecasts by avoiding the creation of contingent liabilities. A contingent liability results from the necessity to absorb a loss on a hedging instrument when the underlying transaction fails to materialize as a natural ofset. Since forward contracts have an all-or- nothing outcome at settlement, they are most subject to the risk of creating 20 | Foreign Exchange Risk Management Practices Survey wellsfargo.com a contingent liability. At 38%, the percentage of companies using options for hedging forecasted transactions is not that much diferent from the percentage using them for hedging balance sheet positions (32%). Previous data had suggested that options were more likely to be used for hedging forecasted transactions than balance sheet positions. Forecasted transactions inherently extend further into the future and are consequently more likely to be afected by substantial foreign exchange market movements. By their very nature, option-based hedges are meant to provide rate protection while allowing the underlying exposures to benet from subsequent favorable FX rate movements. While this benet is undoubtedly appreciated by many hedgers, the overall conclusion to be drawn is that options usage is embraced by roughly a third of our respondents across all their exposures. Hedge accounting election for forecasted transactions Of the companies that hedge forecasted transactions, 59% elect hedge accounting under FAS 133. This is a modest decrease from 2009 when 62% said they elected hedge accounting and comparable to the 2008 outcome of 58%. Public companies, at a 73% rate, are more likely to employ hedge accounting than private companies at a 36% rate. Also, 70% of larger revenue companies elect hedge accounting, while 38% of smaller revenue companies do so. The preponderance of public companies electing hedge accounting can be easily explained. Due to the intense scrutiny around their earnings releases, public companies are typically more concerned about reported earnings and earnings per share results on a quarter by quarter basis. Hedge accounting allows the P&L impact of hedges meant to cover future periods of activity to be recognized in earnings in the same period in which the underlying hedged transactions occur. This accounting treatment avoids the potential for undesirable income statement volatility from the mark-to-market of derivatives targeted for future periods while still protecting the economic impact of foreign exchange exposure. Having said that, it is equally notable that an increasing number of public companies choose not to elect hedge accounting while still pursuing the economic benets of hedging forecasted transactions that expose the company to risk. The 73% outcome of public companies electing hedge accounting for 2011 compares to 85% in 2009 and 76% in 2008. Importantly, this outcome highlights the fact that hedge accounting is always an election, not a requirement. The trend also indicates that increasingly, public companies appear to have decided that the rigors of pursuing hedge accounting are not worth the efort, or that the exposures themselves are not sufciently material as to justify the practice. When electing hedge accounting, companies rely most heavily on their accounting or audit rm for assistance, with a 66% response rate. Banking partners are called upon but at a declining rate. Some 47% indicated reliance on banks in 2009. In 2011, that number slipped to 36%. Third party vendor software is garnering an increasing market share, growing to 28% of respondents in 2011 from 20% in 2009. Internal software solutions have hit a plateau at 14% of responses. Hedge accounting elected forecasted transactions Public Private 73% 36% Hedge accounting elected forecasted transactions 70% 38% >$500 Million <$500 Million 21 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Translated net income from foreign subsidiaries and net investments in foreign subsidiaries In contrast to fairly widespread hedging practices for transactional exposures, a decided minority of respondents acknowledged hedging either translated net income from foreign subsidiaries or their net investment exposures in foreign subsidiaries. Only 7% of respondents with foreign subsidiaries stated that they hedge the translation of net income. The 9% of respondents who indicated they hedge net equity exposure in foreign subs represents a noteworthy increase from 2009, when only 3% said they did so. The survey attempted to measure the materiality of exposure to foreign net income. Fourteen percent of respondents said that more than 50% of their revenues were sourced in foreign currency, and 14% said that more than 50% of expenses were in foreign currency. When the threshold is changed to include 25% or more of revenues and expenses, the numbers jump to 40% and 42%, respectively. Thus, the exposure is consequential. The relative scarcity of hedging for this exposure is mostly attributable to the prohibition of a hedge accounting election for the translation of foreign subsidiary net income. Hedging future net income without the benet of hedge accounting creates the possibility of introducing unwanted volatility to the income statement on an interim basis. Consequently, in an earnings driven market, companies are cautious about protecting this exposure, even though our work with a multitude of companies reveals that many would like to do so. The relative scarcity of hedging the translation of net investment or net equity exposure is similarly an earnings related phenomenon. The translation of a foreign currency functional subsidiarys net equity is captured in the cumulative translation adjustment (CTA) in other comprehensive income (OCI) in the equity section of the balance sheet. Since the translation does not afect earnings, it does not receive priority from a risk management viewpoint. This is an area of risk management where the general level of activity reected in the survey should not be confused with a best practice in the marketplace. Hedging a net investment exposure can provide numerous benets and is generally undertaken for highly tactical, special situations, such as foreign divestitures and dividend payments. The ability to transact hedges to protect foreign investments should not be underestimated in crafting an efective risk management policy. 22 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Additional risk management practices Accounting conventions Accounting can be an important driver of risk management practices. Despite seemingly well-dened rules in the accounting literature, our experience is that day-to-day practice varies widely among companies with respect to certain accounting conventions. To probe on that point, we asked the question, What accounting convention do you use to record foreign currency denominated revenues and expenses? Of particular interest to us was the fact that 21% indicated they use the prior month-end spot rate. This method ofers considerable advantages when implementing cash ow hedge accounting for forecasted transactions. While not specically spelled out in the literature, its presence represents the extent to which common practice can establish the legitimacy of an accounting convention. Accounting convention used - booking rate Average rate for the month 44% Daily spot rate 21% Prior month-end 21% spot rate Other 14% Risk management approach The survey asked respondents to identify a style of risk management that most closely matched their current practices. The three styles with percentage responses were as follows: Systematic risk management: 55% Hedging a xed amount of forecasted foreign currency transactions over a specic time period at regular intervals using specic hedge instruments. Active hedging: 36% Discretionary hedging of forecasted foreign currency transactions based on market conditions, that allows for extending the hedge horizon, changing targeted percentage amounts or discretion in the hedge instrument. Dynamic hedging: 9% Using discretion not only when initiating hedges, but also during the life of the hedge. Comparing the results of the three surveys, no dramatic shifts have occurred from year to year. Some modest growth in active hedging and a similar small contraction in systematic risk management have occurred. We note that 45% of respondents allow for some discretion with respect to amounts, time periods, and hedge instruments, but only a small number allow for discretion during the life of the hedge. 23 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Providing a budget for hedging The survey inquired whether companies provide a budget for expenses related to purchasing options for hedging activities. A minority of respondents, 7%, replied afrmatively. The overall rate in 2009 was 8%. This year, 12% of public companies say they provide a budget for options, while only 4% of private companies do so. The relative infrequency of providing a budget for purchasing options reveals that the concept of insurance to protect against highly unpredictable and volatile exchange rate movements has yet to gain a strong foothold among the corporate community. This result is consistent with the restrained use of options in general for hedging both balance sheet positions and forecasted transactions identied earlier in the summary. Centralized risk management A large percentage of companies (84%) manage risk on a centralized basis. The data was quite uniform across all respondents, with 91% of public companies and 79% of private companies stating that they managed FX risk on a centralized basis. In this instance, the prevalence of centralized risk management might well be identied as a best practice from a risk control standpoint. Other data indicates that centralized risk management is a somewhat greater challenge for public companies than private ones due to the breadth of their operations. Ninety-four percent of public companies responded that they have an international presence through foreign subsidiaries, while only 64% of private companies are similarly exposed. 24 | Foreign Exchange Risk Management Practices Survey wellsfargo.com Biggest challenges related to FX risk management As in previous surveys, respondents were asked the question, What are your companys biggest challenges related to foreign exchange risk management? The responses from all three surveys have been uncannily similar, both with respect to how they echoed the same general themes, as well as the number of responses for each category. The comments are summarized below, in order of those most often mentioned: Accuracy and timeliness of exposures and forecasted transactions By far, the most often cited challenges reected this theme. This theme came from 43% of respondents more than twice the next most often mentioned challenge. The responses expressed frustration with an inability to obtain company-wide data in a timely fashion. Similarly, obtaining accurate forecasts from business units was a challenge. Responses in this area reect the ongoing need for more efective systems to deal with capturing exposures, and/or better integration of already existing systems, such as ERP applications, which may be currently under-utilized for this purpose. Market volatility, when to hedge, and using the proper strategy Next most often, at a 20% rate, respondents cited problems with market volatility and the challenge of selecting the proper hedging strategy at the proper time. As recent market events have demonstrated, volatility has to be taken as a constant that will not cooperate with a wish for a stable international operating environment. Given the range of exibility that derivatives provide for hedging solutions, difculty with choosing the proper strategy indicates a fundamental uncertainty about what economic outcomes are desired. Usually when the nancial objective is well-dened, the choice of a hedging derivative becomes clear. Approvals, communications, and internal resources A number of responses are best captured by this broad summary item, often reecting the challenges of explaining risk management initiatives, obtaining approvals from senior management and directors, as well as gathering consensus about appropriate objectives from international subsidiaries. To a large degree, this response echoes the earlier nding that only 58% of respondents have a formal risk management policy. Having a policy in place can help alleviate this problem by ensuring that a company has well-dened, common goals for risk management. Similarly, many respondents indicated they would like to become more active risk managers, but lack the resources to fully implement more extensive programs. Hedge accounting and compliance In 2009, this was the third most often identied challenge, but in 2011, it has slipped to fourth place with a 7% response rate. Comments in this area cited the ongoing challenge of proper accounting and disclosure for derivatives and hedging activities, both in the FAS 133 and IAS 39 environments. Much of the survey data suggests that accounting is such a hurdle that it is a clear dis- incentive for implementing hedge programs that in the absence of burdensome hedge accounting regulations would be regarded as economically desirable. Summary and conclusion The 2011 Wells Fargo Foreign Exchange Risk Management Practices Survey represents an efort to identify risk management practices from a broad cross-section of our customer base. In this years survey, we observed many interesting patterns that reect the dynamics of current market conditions and that often reinforce the behaviors that became apparent in our prior surveys from 2008 and 2009. The breadth of respondents now compiled from the three surveys and the similarity of results from the prior years provide a robust measure of how rms are managing risks in the current challenging environment. We hope that this analysis generates ideas for further consideration in your organization as you pursue more efective risk management practices. We welcome any additional feedback and inquiry that this survey summary may inspire. Contact us For additional information about our risk management solutions, contact your local Wells Fargo Foreign Exchange Specialist: Atlanta 1-800-520-7058 Charlotte 1-866-803-6722 Chicago 1-877-443-9134 Dallas 1-800-793-7124 Denver 1-800-477-9989 Houston 1-800-357-3249 Los Angeles 1-800-932-5239 Minneapolis 1-800-299-5810 New York 1-866-650-8217 Phoenix 1-800-711-9050 St. Louis 1-800-832-6554 Salt Lake City 1-800-274-1046 San Francisco 1-800-548-1163 Seattle 1-800-985-8427 Legal disclosures Some of the information or opinions stated in this survey may have been obtained or developed by Wells Fargo from sources outside Wells Fargo. In such cases, Wells Fargo believes the information or opinions to be reliable. However, Wells Fargo will not have independently conrmed the reliability of such information or opinions and does not guarantee their accuracy or completeness or the reliability of their sources. 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