From the November 2005 issue of Treasury & Risk magazine

Financial Risk Management

GOLD AWARD WINNER

Dade Behring Inc.

If there is one thing Dade Behring Inc. guards assiduously, it is the company's credit rating. After staging a stunning bounceback in 2003, the Chicago-based medical diagnostic equipment manufactur-

er emerged from Chapter 11 protection--after just two years--to qualify for unsecured credit just 62.5 basis points above LIBOR. Now, it carefully avoids bumps in the road that could upset its lenders. And as far as treasurer Mark Moran was concerned, one potential sinkhole was the company's sizable exposure--51% of its $1.6 billion annual revenues--to the vagaries of foreign exchange, particularly given the dollar's precarious health.

The company sells into more than 100 foreign countries in 22 currencies, so hedging some part of that currency exposure would be a no-brainer for any organization. But Dade Behring takes a distinctly brainy approach to its financial risk management, hedging the euro (36% of its exposure), the yen (19%) and six others (23%), relying on an options strategy far more sophisticated than most corporate treasurers could even get their CFOs to consider.

So for Moran, his first big challenge was getting sign-off. In his sales effort, he enjoyed a couple of advantages. First, Dade Behring's CEO Jim Reid-Anderson used to be CFO of the company. Second, the company already had a risk committee that included not only CFO John Duffey, but also all the other executives to whom he would have to answer if the approach failed. Finally, Moran had a leg up because of the financial expertise on his staff: Assistant treasurer Stephen Purtell, a Wharton M.B.A., was recruited in 2003 from IMC Global Inc., where he was assistant treasurer, and Dade's manager of treasury operations, Craig Root, is a University of Chicago M.B.A. with expertise in sophisticated financial instruments who came via medical products maker Hollister Inc.

Moran's earlier options hedging also proved highly successful. In 2003 and 2004, the company's options paid off big time when the dollar lost value against the euro, yen and most other currencies where Dade Behring was long. For instance, a 2003 $4 million investment in conventional put options delivered a potential gain in found EBITDA of $19 million the next year. "If we had locked in rates with forward contracts, we would not have benefited from that rise. By using options, we did," explains Moran. "We're willing to pay a premium to preserve our chance to participate in those gains."

Dade Behring wanted to get even brainier. The now low strike rate of the 2003 options offered scant protection, and the potential profit of the currency gains could evaporate if foreign currencies dropped. The answer: adopt an active management strategy and invest another $2 million in new options. At the same time, after consulting with its dealers, Dade Behring's treasury took another even more gutsy step: It invested in an unconventional instrument called the double average rate option (DARO) to hedge new forecasted exposures, becoming one of a handful of sophisticated hedgers that use the DARO to smooth out currency market volatility.

Buying a conventional put option is an event. What you pay and get reflects the market at the time of that event. In a volatile market, there's always a chance that you could buy on a bad day--a day when the dollar spiked abnormally high. That was a risk Dade Behring chose not to take, so it went with the DARO. Instead of taking the spot rate on a given day, both the strike price and the payout on a DARO are based on the average over a period of time--in Dade Behring's case, one month. It's the logical antidote to daily volatility; the average rate reflects market reality more reliably than the spot rate on a particular day.

For example, Dade Behring's DARO contracts for a January 2006 sale of euros are based on the average exchange rate for the euro in January 2005. "We benefit from picking an average strike price," Moran says. "If the market was having a bad day when we bought a conventional option, we'd get a bad rate."

While the DARO costs no more than a conventional hedge, it's seldom used. Moran reports that in conversations with eight of the top 10 FX dealers, none had more than a dozen corporate customers using them and most had fewer than 10. "They're a largely undiscovered jewel, even though they've been around for about five years," he says. "They have a reputation for being exotic, which discourages some hedgers, and you don't know the strike price ahead of time, like you do with a conventional option, which may discourage others."

Dade Behring's FX dealers agree. "[Use of the DARO] smoothes out the hedging process and more perfectly matches cash flows for companies that get a continuous stream of payments from overseas or translate FX exposures at an average rate," notes Mark Mullet, managing director in Bank of America's global foreign exchange unit. Commonly, they take a three-month average of the daily spot rate--say for the fourth quarter of this year--and use that average to fix their price for the fourth quarter of next year, he explains.

The DARO has become a useful tool in Dade Behring's switch to an active hedging strategy. A fairly passive, more or less automatic hedging program is easier to administer, but research shows that active hedging programs outperform passive ones when markets are volatile, and Moran and his team wanted to outperform.

Rather than rely solely on trader advice, Dade Behring built its own model with metrics that track the size of currency movements and the gap between the option price and the underlying price. Armed with this intelligence, Dade Behring's treasury feels confident enough to make moves to lock in profits or increase protection levels. "We actively manage the program to reduce cost, recouping some of the money we paid for options," Moran says. "If our options are way in the money, we sell them and take those gains off the table, then buy new options at the appropriate current rate and strike price."

In 2004, Dade Behring implemented its active hedging program and its use of DAROs. The result has been a gain of $10.6 million, the upside of foreign currency gains that the company could pocket by not exercising its options. Active hedging has reduced the net cost of the program by $1.2 million, as well as providing higher protection levels. Through the first five months of 2005, active management cut net costs by $1.1 million and increased protection by $1.8 million for the remainder of the year.

Sophisticated companies use DAROs and forwards as an acceptable way to hedge the balance sheet and smooth year-on-year earnings by protecting them from FX volatility, he notes. "It can be useful for public companies that focus on earnings per share," says BofA's Mullet. And as Moran would say, who doesn't?

SILVER AWARD WINNER

Alcoa Inc.

Alcoa Inc. knows a thing or two about paying utility bills. The world's largest aluminum producer typically spends several billion dollars annually on natural gas and electricity. So utility deregulation and soaring energy prices have placed a powerful premium on energy price risk management, which was transferred to treasury in 2001.

Alcoa's old model--hedge most heavily when prices are low by historical standards, hedge little when they're high--resulted in "paralysis" when prices broke through the ceiling and kept rising. "We had no decision rules to protect from an upward trending market out of the historic range," reports Andrew Logsdon, director of energy risk management. The result was "tension," he says. Business units clamored for permission to hedge before prices went even higher.

Treasury quickly kicked off a project to bring sophistication to natural gas hedging that has paid off. At the end of 2004, Alcoa's commodity hedge position had an unrealized gain of $53 million; that gain was $73 million at yearend 2003. "The vast majority of these gains came from the natural gas program," Logsdon reports. Gone was the commodity price guru who had sole responsibility for energy hedging decisions. In his place was a computer model, built from scratch by two treasury staffers, which relied heavily on value at risk (VAR).

The model was built to keep $22 billion Alcoa from exceeding a maximum amount budgeted for a given month--a spend limit on natural gas purchases. When rising prices endanger the spend limit, the model directs action to lay on hedges gradually. When falling prices indicate that spending will be below the cap, the spend limit is reduced. Limits keep hedging below 80% of exposures. All hedges are kept until they naturally mature. "We never trade our position. We won't cultivate a trading mentality," Logsdon observes.

So far it has worked well. "The model led us to put on positions that seemed inappropriate at the time but proved to be profitable," Logsdon says. "The model also caused us to hedge more than our peers, based on anecdotal evidence, and that saved us a lot of money. I'm sure we have delivered tens of millions of dollars of savings so far, but the model has yet to be tested in a downward trending market."

BRONZE AWARD WINNER

Yahoo! Inc.

Things change fast at Yahoo! Inc. But the acquisition of $1.9 billion, Pasadena-based Overture Services Inc. in October 2003 was a transforming event that doubled the company's revenues, thrust it into foreign currency risk management and brought with it a new, complex commissionaire tax structure tied to a Dublin shared service center.

Until then, FX risk management did not have to be a priority for Yahoo!'s treasury. Most third-party vendor contracts were in functional currencies, and inter-company balances were minimal. But Overture came with a substantial book of global business; large, poorly documented inter-company balances; and far greater use of nonfunctional currencies. Faced with more significant exposures and little confidence in exposure data, Yahoo! treasury embarked on a nine-month project to discover, quantify and manage FX exposures.

Overture had allowed inter-company balances to balloon, even when the cash was there to settle them. Transaction and translation risk piled up. In the second quarter of 2004, Ireland was owed the equivalent of over $114 million from the UK subsidiary, $59 million from the Japanese subsidiary and $30 million from the Korean subsidiary. Ireland owed U.S. headquarters over $250 million. These balances had to be validated, classified as long-term or short-term and settled whenever possible, explains Cipora Herman, director of corporate treasury.

After the merger, each entity in the commissionaire structure sent cash forecasts to corporate treasury and worked with treasury to determine how to use excess cash to settle legacy balances. In November 2004, with the support of local finance groups, corporate treasury initiated euro-to-dollar, yen-to-dollar and pound-to-dollar trades to settle about $109 million inter-company balances. Bringing back to headquarters $109 million in inter-company balances allowed treasury in the U.S. to invest that money for a return at least 50 basis points higher than it was earning abroad, Herman says.

Yahoo! adopted a sophisticated risk management system--probabilistic analysis, using currency market volatility data and Monte Carlo simulation--but chose to hedge its risk not with derivatives but with process changes. For example, Dublin was converting receipts in pounds and yen to euros, its functional currency, then converting back to these currencies to make payments, incurring double spot-trading costs and increasing a euro exposure. Maintaining Dublin accounts in yen and pounds was a risk-mitigating process change, Herman explains. "We did it all with natural hedges," she says.

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