When Thomson Corp. acquired Reuters in 2008 to create Thomson Reuters, the merged entity's much larger geographic footprint dramatically increased its foreign exchange exposure. Measuring the cash flow risk and economic volatility of its global FX exposures was a daunting task put before the treasury organization.
Roughly 30% of Thomson Reuters' $13 billion in annual revenues and about 35% of expenses and capital expenditures were in currencies other than the U.S. dollar, driving significant cash flow risk. The largest mismatch was its meaningful euro revenues and large sterling cost base, which resulted in about $800 million long euro and $600 million short sterling cash flow exposures a year.
Added up, the potential annual cash flow risk related to the company's top eight exposures, considered individually, was more than $350 million. "We needed to roll up our sleeves to understand the FX exposures, build a model to measure the impact on our business, and then develop an effective FX hedging program to reduce economic FX risks," says David Shaw, treasurer and senior vice president of the New York-based information provider.
Treasury tackled the challenge by building a portfolio risk model that measures Value-at-Risk (VAR) from its FX operating exposures, taking into account the directions and magnitudes of the exposures, as well as currency correlations. "We found out that the diversification benefits generated by offsetting exposures significantly reduced our economic risk," Shaw explains. "For example, the worst-case annual cash flow impact related to the top eight non-U.S. dollar operational exposure currencies considered individually was reduced by about 65%, from more than $350 million to about $125 million."
Treasury also worked closely with global business teams to improve the company's FX experience by developing more specific pricing policies for both customers and vendors. This, too, is paying off. Shaw notes that senior management had previously been exploring a move to global U.S. dollar pricing for a significant portion of business to reduce FX exposure.
"We were able to determine that such a move would actually exacerbate the imbalance in our FX footprint and increase our global margin and cash flow risk due to FX," he says. That plan was abandoned for what Shaw calls "more beneficial actions."
The new FX hedging program leverages the portfolio risk model to assess the potential impact of various hedging approaches on both cash flow and earnings. "We determined that by hedging our three largest currencies at 50%, we could further reduce our annual cash flow risk by about 50%, and also reduce our current FX-related profit and loss volatility," says Michelle Scheer, vice president and assistant treasurer.
With regard to the latter, Scheer explains that the derivative mark-to-market would offset the FX volatility currently recorded in the P&L. "We thus implemented a corporate hedge program that we expect to significantly reduce our economic FX risk in an accounting-friendly way," she says.
The FX hedge program has been back-tested, and had it been implemented in the past, annual average volatility would have been reduced significantly, Shaw says.
"Employees across the organization are now more engaged in the efforts of managing FX risk," he adds. "The operating divisions take greater ownership of their global exposure forecast and seek treasury's advice on the FX impact of their potential commercial policy initiatives. All of this allows us to be very calm as the macroeconomic environment changes. No matter what is thrown at us, the models and initiatives have made us very comfortable about managing our FX risks consistently."