Taking the Foreign Currency Risk out of Foreign Investment

Asia Pacific Business OutlookUniversity of Southern California

March 27, 2007

Presented By: David Gopal, Wells Fargo

2APBO – 2007 David Gopal, Wells Fargo

“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!

Managing Foreign Exchange Risk

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Table of Contents

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

Overview of Hedging Foreign Currency

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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)

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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.

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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

Inception T1 T2 Maturity

(1B JPY) 100MM JPY 100MM JPY 1.25B JPY

(8.47MM USD) 847K USD 847K USD 10.59MM USD

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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!

Inception T1 T2 Maturity

(1B JPY) 100MM JPY 100MM JPY 1.25B JPY

(8.47MM USD) 770K USD 770K USD 9.63MM USD

Hedging Foreign Exchange Risk

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Hedging Considerations

Certainty of cash flows Timing Amount

Risk tolerance Return requirements Company policy Accounting implications Access to markets

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Product Considerations

Derivatives Forwards Options Swaps

Structural decisions Borrowing base Contract currencies

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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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Cross-Currency Swaps (CCS) are used to convert debt from one currency to another.

CCS’s allow companies to synthetically create debt in a currency, which they may normally not be able to access.

An initial exchange is not necessary.

Product – Cross-Currency Swap

Initial Exchange of Principal

XYZ CorpCross-Currency Swap

3M JPY Libor + 250 bps

USD Debt3M USD LIBOR +250 bps 3M USD LIBOR +250 bps

Exchange of Principal – At Maturity

XYZ CorpCross-Currency Swap

21B JPY JPY Investment

8.47MM USD 8.47MM USD USD Debt

JPY Cash Flow

1B JPY

JPY Investment

XYZ CorpCross-Currency Swap

1B JPY

8.47MM USD 8.47MM USD USD Debt

JPY Investment1B JPY

Periodic Interest Payments

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CCS – Synthetic Foreign Denominated Loan From XYZ’s 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.

Product – Cross-Currency Swap

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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.

Inception T1 T2 Maturity

(1B JPY) 100MM JPY 100MM JPY 1.25B JPY

(8.47MM USD) 1.2MM USD 1.2MM USD 10.59MM USD

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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.

Global Rate EnvironmentPast, Present, Future

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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 mean…and then some

DXY

60

70

80

90

100

110

120

130

Dec

-88

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-89

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-90

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-91

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-92

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-95

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-98

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-99

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-00

Dec

-01

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-02

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-03

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-04

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-05

Dec

-06

USD-JPY

80

90

100

110

120

130

140

150

160

Dec

-88

Dec

-89

Dec

-90

Dec

-91

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-92

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-93

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-94

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-95

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-96

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-99

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-00

Dec

-01

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-02

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-03

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-04

Dec

-05

Dec

-06

Source - Bloomberg

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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!

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Dec-

98

Jun-

99

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99

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00

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00

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01

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01

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02

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02

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03

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03

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04

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05

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3M USD LIBOR

3M EURIBOR

3M JPY LIBOR

Source - Bloomberg

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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

LIBOR Based Yield Curves

0.00

1.00

2.00

3.00

4.00

5.00

6.00

3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y

USD

EUR

JPY

Source - Bloomberg

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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

23APBO – 2007 David Gopal, Wells Fargo

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.

David Gopal (415) 371-6651

24APBO – 2007 David Gopal, Wells Fargo

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