Treasury & Risk's 6th Annual Alexander Hamilton Best Practices Summit — October 2 and 3, 2001
2001 — Financial Risk Winners: Gold—Microsoft Corp. ; Silver: Duke Energy Corp. ; Bronze: Providian Financial Corp.
HEDGING THE GLOBE
Microsoft Corp. wins gold in Financial Risk Management
GOLD FINANCIAL RISK MANAGEMENT WINNER—Microsoft's $25.3 billion in sales involves nearly a dozen currencies, and its business in long-term contracts with fixed foreign currency payments is growing. With year-on-year revenue growth slowing from about 30% to roughly 12%, exacerbating the potential of currency exchange rate impact, Microsoft's treasury needed a multiyear hedging program to address the increased global risk.
The challenge was to craft one that hedges for more than one year, but still hews to the existing single-year program's risk/reward profile and stabilizes the financial results through accounting treatment matching the underlying risk. Treasury's new program meets all three, and in a year has contributed some $36 million to revenues and cut premium expense about 30%.
The first assumption: exposure to rate moves on long-term contracts is up to 25% of a two- and three-year forecast. We needed to recognize and measure this exposure that clearly extended beyond one year, says Michael Morrow, Microsoft's senior foreign exchange manager.
Under its single-year program, which has offset a significant amount of foreign exchange risk since its inception in 1995, treasury buys individual average-rate put options that offer a limited downside, match the corporation's risk tolerance and qualify for hedge accounting treatment. The multiyear model had to maintain these characteristics while extending protection beyond the usual one-year forecasts. In tackling the problem beyond one year, there was a natural extension to simply buy longer-dated options, Morrow says. But they become more costly. We wanted to keep our premium low and similar to historical levels.
Treasury's multiyear strategy uses basket rather than individual put options, saving roughly 30% of premium cost while hedging net currency exposure. But because the basket option does not get hedge accounting, treasury decided to break up the basket and buy single-currency, average-rate puts that do get hedge accounting and sell a correlation option (defined as basket put minus the sum of single-currency puts) that does not qualify. You have a set of options that gets hedge accounting and one that doesn't but does have a nice economic benefit, says Morrow. By breaking up contracts, you can end up with hedge accounting where you might not have thought you had it. "
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SILVER FINANCIAL RISK MANAGEMENT WINNER—Wanting to minimize interest expense, Duke Energy sought to manage its growing, largely dollar-denominated debt portfolio more closely. The $11 billion (as of year-end 2000) portfolio was being managed inefficiently, management thought, with its traditional fixed/floating rate mix favoring liquidity over cost of money. Decisions on interest rate derivatives to fix a future debt issue or add floating rate exposure were being made ad hoc. Duke needed a more active style of incorporating liquidity and price risk and measuring cash and derivatives effectiveness. Treasury's response: a new liability benchmark system, offering a yardstick to measure new financing decisions, an interest expense level for treasury to actively manage against and a clear demarcation between liquidity and price risks.
After setting a cost-of-funds benchmark, Duke's treasury separated its debt portfolio into four buckets, each representing a percentage of debt to re-price during a given time frame, allowing management to see changing rate risk as far as 10 years into the future. In addition, a new policy gives treasury authority to trade derivatives within a limit of +/– 10% across each bucket to tilt the portfolio toward floating or fixed rates, as needed.
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BRONZE FINANCIAL RISK MANAGEMENT WINNER—FAS 133 makes hedging difficult because the ineffectiveness arising from the difference between a marked-to-market derivative and its underlying asset can create balance sheet volatility. The new standard requires identification of individual assets and liabilities for hedging while disallowing portfolio hedging. This complicates life for credit card lenders like San Francisco-based Providian Financial, which would rather manage interest rate risk on a portfolio basis.
Providian came up with an optimal hedge program that turns conventional hedge thinking upside down. By assuming upfront a desired hedge position and then finding a FAS 133-compliant asset/liability mix that triggers minimal ineffectiveness, the model minimizes income statement volatility even for large derivative hedging programs. Providian's method takes advantage of FAS 133's allowance of partial hedging into component cash flows and of hedging risk solely due to a change in the swap curve. In the 2001 first quarter, hedge ineffectiveness on Providian's entire derivatives book was less than two basis points, and more recently has fallen to 0.2 basis points on new hedges.
—As seen in the November 2001 issue of Treasury & Risk magazine