The recent financial crisis was unkind to treasurers of many multinationals, in part because exposures they presumed to be uncorrelated–hence diversified and less risky–suddenly became highly correlated. Most foreign exchange rates, for example, were assumed to be largely uncorrelated, but in the crisis the U.S. dollar rallied almost uniformly against all world currencies.
"Correlations move closer to one when the world is about to end. Without taking this into account, many risk managers are relying on a diversification benefit exactly when it isn't going to be there," says Adrian Crockett, head of Credit Suisse Securities' strategic finance group.
Such unlikely "tail events" can wreak havoc on conventional risk management practices. Credit Suisse client Cisco Systems' cash flows actually benefited from the dollar's rally, because its non-dollar expenses exceeded its non-dollar revenue, causing a reduction in funding costs. Since extreme dollar moves could occur in the opposite direction, Cisco's treasury department decided to scrutinize its FX risk management practices.
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"We were concerned about the increasing frequency of extreme moves in asset prices and wanted to understand how different strategies would stand up to extreme moves," says Dan Lynch, senior treasury manager at Cisco.
Cisco sought input from several banks and consultants last fall on how most efficiently to hedge that risk. It began working closely with Credit Suisse early this year, prompting the bank to develop the Option Premium Allocation Model (OPAM). The quick, four-month development process, hastened by work Credit Suisse had already done, resulted in a Monte Carlo-based system that generates simulated FX rates and tests and compares them against a variety of risk management strategies.
OPAM models the correlation between two FX rates as a complete probability distribution, rather than most risk-management systems' single-number point estimate. This provides a more realistic view of diversification and factors in the possibility that correlations measured today "may not work tomorrow," Crockett says.
OPAM supplements the Value-at-Risk (VaR) measure, long the risk-evaluation cornerstone for most companies, with "expected tail loss" (ETL). ETL gives an average downside scenario, rather than VaR's best downside scenario, and so captures more information about extreme events.
Cisco wanted a solution to help it quantify downside interest rate risk while reducing costs to hedge that risk. To completely eliminate cash-flow risk stemming from FX changes, companies can purchase options and forward contracts on all of their exposures. In Cisco's case, the upfront costs for such an inefficient strategy would have totaled $115 million. OPAM, instead, ran billions of rate-correlation scenarios to determine which currency rates were likeliest (or not) to remain uncorrelated. Credit Suisse director Jamie Ballingall notes that less diversification means more hedging is required.
The OPAM analysis "led to recommendations to hedge currencies that otherwise would have been overlooked because it seemed–during the good times–that the risk associated with those currencies was diversified away," Ballingall says. "But that diversification could not really be trusted."
Ultimately, the analysis enabled Cisco to cut $75 million off the full-hedge scenario, according to Credit Suisse. Crockett estimates that OPAM produces typical option-premium savings of 30% to 40%, depending on the client's size and FX exposures.
The analysis enabled Cisco to better understand tail-risk scenarios and implement contingency planning. It was also able to concentrate its hedging on a small number of key currencies, reducing administrative costs as well as operational, forecasting and accounting requirements.
"Streamlining our cash flow hedging process freed up around 20% of our team's bandwidth," says Lynch, "allowing us to focus more time on bottom-line enhancing activities, like assisting with commercial negotiations and taking on internal consulting projects."
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