OCTOBER 2012

Riding the foreign exchange roller coaster

Corporate nance implications of a riskier
currency environment
Published by Corporate Finance Advisory
For questions or further information,
please contact:
Corporate Finance Advisory
Marc Zenner
marc.p.zenner@jpmorgan.com
(212) 834-4330
Tomer Berkovitz
tomer.x.berkovitz@jpmorgan.com
(212) 834-2465
RIDING THE FOREIGN EXCHANGE ROLLER COASTER
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1
1. Dealing with the currency environment you have
(rather than the one youd like to have)
Slower growth in developed economies relative to emerging markets, advances in transpor-
tation and telecommunication infrastructure and lower international trade barriers have led
many U.S. companies to expand their ofshore operations in recent years. Whether through
M&A or organic growth, large multinationals derive a growing part of their revenue from
non-domestic markets. For example, for the 25 largest companies in the S&P 100 index,
the portion of non-U.S. revenues increased from almost 45% in 2006 to over 55% in 2011.
However, with the benets of faster growing non-domestic markets come the risks of
foreign currency uctuations.
Figure 1
Non-domestic revenues are becoming increasingly important for large global rms
Median % of revenue outside of North America
1
Senior managers and capital market participants are used to dealing with risky operations
and changing markets and prices. With ever-expanding non-domestic sales, however, the
impact of currency uctuations in predicting earnings and cash ows becomes paramount.
Figure 2
Increasingly volatile FX environment calls for action
This riskier currency environment profoundly impacts all aspects of corporate nance
decision-making, from risk management to dividend policy, capital structure and M&A.
To guide senior executives, we provide a roadmap that highlights key challenges and
helps users avoid the most common pitfalls of this riskier currency environment.
2006 2007 2008 2009 2010
53.9%
2011
44.7%
47.2%
49.3%
50.1%
55.6%
CAGR 20062011: 4.5%
Source: Bloomberg, FactSet
1
Top 25 S&P 100 companies by market cap
Companies need
to reexamine
their FX strategy
FX environment
More volatile
Harder to predict
Limited benets of
diversication
Corporate environment
Greater revenues
ofshore
Increased investor
attention to FX
Increased FX-related
earnings volatility
Source: J.P. Morgan
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Corporate Finance Advisory
2. How do you dene your currency risk exposure?
Following the recent (and some would say, ongoing) nancial crisis and the ock of associ-
ated black swans, senior decision-makers are even more focused on measuring and manag-
ing risk. The traditional view is that investors expect higher returns when exposed to higher
systematic risk (beta).
We believe that there is another categorization of risk that is useful in the context of
currency exposure: Core versus non-core equity risk. Core equity risk is a key risk
borne by a rm due to the nature of its business; investors would likely choose to have
exposure to this particular risk to enhance their returns. Asymmetric risk, however,
creates exposure to a risk that investors are not necessarily seeking out when purchasing
a stock. They can be material but are not key drivers of the rms investment thesis
(see examples of core and asymmetric risks in Figure 3).
Figure 3
Core versus asymmetric risk exposures
We believe that for most rms, currency risk falls in the category of asymmetric risk.
As a result, the growing impact of currency uctuations is likely to be asymmetric. That is,
the perceived shareholder benet of a favorable currency outcome will be overshadowed
by the penalty due to an unfavorable currency outcome. If currency volatility increases, ex-
posure to asymmetric risk will be higher and corporate nance implications would likely
be more severe.
EXECUTIVE TAKEAWAY
Large global rms realize a growing part
of their sales from non-domestic markets,
while currency volatilities have increased
relative to pre-crisis levels, and the benets
of diversication have diminished. As a result,
currency swings will have a greater impact
on rm value going forward, unless decision-
makers adopt a proactive approach to dealing
with this new reality.
Core Asymmetric
Denition
Risk fundamental to main business activity Risk that is not fundamental to main business activity
Investors
perspective
Investors purchase shares to achieve exposure to
the core risk
Investors do not purchase the stock to obtain exposure
to this risk
Investors may penalize the frm more for adverse
outcomes than they reward it for favorable outcomes
Examples
Company Risk exposure Company Risk exposure
Gas exploration
and production
Gas prices Waste management Trucking fuel
Real estate
investment trust
Real estate market Food and beverage Aluminum prices
Oil refner Crack spreads Iron ore Copper prices
Gold mine Gold prices Global corporations Currency risk?
Source: J.P. Morgan
RIDING THE FOREIGN EXCHANGE ROLLER COASTER
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3. A riskier currency environment
3.1. Sustained higher volatility level
During crises, volatilities of nancial assets tend to spike. At the peak of the recent nancial
crisis, equity volatility (as measured by the VIX index) jumped from a pre-crisis average of
about 15% to as high as 80% on October 27, 2008. Following this trend, currency volatilities
also spiked during the crisis, from a pre-crisis average of about 9% to about 13%. Despite
the signicant economic, regulatory, nancial systemic and geopolitical risks, equity volatil-
ity has dropped back to pre-crisis levels of about 15 to 20%. In contrast, currency volatility
has not yet returned to prior levels in all markets (particularly the Euro/USD rate). As one
can see in Figure 4 below, currency volatilities have settled at a level that is about 50%
higher than that prior to the crisis. The uncertainty around the future of the Euro, concerns
about global economic slowdown, the U.S. elections and the scal clif constitute a large
part of this volatility.
What does this mean for corporate decision-makers? For rms operating in non-domestic
markets, this higher volatility implies more severe shocks to non-domestic revenues and
earnings.
Figure 4
Currency volatilities are still elevated in some markets
Expected volatility of foreign exchange rates
1
EXECUTIVE TAKEAWAY
All rms take on risk. Investors select equity
investments based on the balance between
expected returns and risk. Some rms provide
risk exposures that are uniquely attractive to
some investors. For most rms, currency risk
does not, however, fall into this category. As a
result, rms will be more negatively impacted
by adverse currency movements rather than
positively impacted by favorable ones.
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
24.0%
01/28/2003 06/15/2004 11/01/2005 03/20/2007 08/05/2008 12/22/2009 05/10/2011
Euro/USD volatility JPY/USD volatility GBP/USD volatility
Post-crisis median: 12.9%
Pre-crisis median: 8.8%
Source: Bloomberg
1
One-year option-implied volatility
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Corporate Finance Advisory
3.2. Reduced ability to predict currency volatility
A more volatile foreign exchange environment makes it more challenging to forecast rate
changes. In May 2007, when currency volatility was relatively low, most economists had
roughly similar forecasts regarding future rates of the Euro. This estimated consensus was
wrong. By the end of the third quarter, the Euro already spiked beyond the highest analyst
forecast of just four months earlier and a similar trend was recognized during the following
two quarters. When currency volatility reached its peak (at the end of 2008), the diver-
gence in economists views almost tripled. Still, the actual spot rate was close to the highest
estimate and signicantly away from the median.
What does this mean for corporate decision-makers? Firms often rely on economists
forecasts and the forward curve to budget foreign earnings and cash ows that will be
translated into USD. Whether evaluating a new project or M&A opportunity, the ability to
forecast USD returns on investments is critical. When realized spot rates are drastically
diferent from the rates used for calculating the expected ROIC, unhedged investments
may turn dilutive (from both economic and accounting perspectives), even if the foreign
currency cash ows of the project or the subsidiary perform as expected.
Figure 5
Economists disagreement about future currency rates is growing
Economists forecasts for the Euro spot price
3.3. Greater difculty in diversifying foreign currency risk
Global companies operating in various international markets often rely on the diversica-
tion among diferent currencies to mitigate the net impact of currency uctuations on their
cash ows. In particular, the correlation between emerging market currencies, such as the
Brazilian Real (BRL) and Indian Rupee (INR), and developed market currencies, was close
to zero in the pre-crisis environment. Figure 6 shows, however, that in the new currency
environment, the correlation between foreign exchange rates of emerging and developed
markets has spiked. For example, the Euro/BRL correlation has jumped from zero to 60%.
Source: Bloomberg, FactSet
Note: Standard deviation refers to the average of the four periods standard deviation of economist forecasts
1
Trough implied Euro volatility and analyst estimates as of May 8, 2007
2
Peak implied Euro volatility and analyst estimates as of December 30, 2008
$1.48 $1.48
$1.52
$1.55
$1.41
$1.07
$1.10
$1.05
$1.00
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
Q1 2009 Q2 2009 Q3 2009 Q4 2009
$1.40 $1.40
$1.40
$1.42
$1.35
$1.26
$1.22
$1.16
$1.12
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
Q2 2007 Q3 2007 Q4 2007 Q1 2008
Standard
deviation
4%
Standard
deviation
11%

Trough
1
expected currency volatility Peak
2
expected currency volatility
Economists forecasts
Euro spot price
Economists forecasts
Euro spot price
RIDING THE FOREIGN EXCHANGE ROLLER COASTER
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The increased correlation is a result of several factors. First, integration of global
economies and capital markets, combined with innovations in the nancial industry, has
led to increased correlation between markets. Similarly, the correlation between emerging
and developed markets equities has increased signicantly in recent years. Last, the use of
U.S. Treasuries as a safe haven and more macro-driven investments are driving correlations
closer to one.
What does this mean for corporate decision-makers? The value of diversication across
diferent currencies is diminishing, leading more global rms to be more aggressive about
hedging alternatives.
Figure 6
Benets of currency diversication are reduced in todays environment
Source: Bloomberg
Euro/AUD correlation
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Euro/INR correlation
Developed markets Emerging markets
1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12
Euro/CAD correlation
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Euro/BRL correlation
1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12
One-year rolling correlation of Euro/Indian Rupee
One-year rolling correlation of Euro/Brazil Real
One-year rolling correlation of Euro/Australian Dollar
One-year rolling correlation of Euro/Canadian Dollar
EXECUTIVE TAKEAWAY
The new currency environment presents
signicant challenges to corporate executives.
Foreign exchange rates are more volatile and
harder to predict. Moreover, diversication
ofers limited value as correlations have
increased.
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Corporate Finance Advisory
4. Analysts and equity investors pay attention
The new foreign exchange environment and its impact on corporate earnings have
not gone unnoticed by equity analysts and investors. For some global consumer retail,
pharmaceutical and technology companies, the foreign exchange impact on second quarter
sales this year was up to 15% of revenues or US$3.0 billion (see Figure 7A). Following this
signicant impact on revenues, equity analysts are now more focused on FX. For example,
in second quarter earnings calls, 34% of multinational companies were questioned by
analysts about FX, versus only 23% in the rst quarter of 2012 (see Figure 7B).
During the third quarter, investors have returned to risk on trades causing the USD to
weaken again, which should have had a positive impact on the revenue of U.S. companies
that operate globally. The volatility in FX rates remains a major issue, however, and adds
to the uncertainty regarding future earnings and cash ows. If currency risk is perceived
as asymmetric by investors (as discussed in Section 2), then adverse moves in FX rates
will lead to increased investor attention and negative market reaction, while favorable
FX trends will not be rewarded because they are not viewed as sustainable drivers of long-
term growth.
Figure 7A
Investors are becoming increasingly focused on currency losses
Notable impact of FX uctuations on Q2 2012 revenues
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$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
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5%
10%
15%
Absolute FX impact on revenues
FX impact as a % of revenues
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$84
$102 $119
$200
$301
$430
$441
$492
$523
$690 $692
$900
$1,000
$2,200
$3,000
Source: Press releases, Company lings, earnings calls transcripts
RIDING THE FOREIGN EXCHANGE ROLLER COASTER
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Figure 7B
Investors are becoming increasingly focused on currency losses (contd)
Multinational rms questioned by analysts about FX
1
5. A roadmap to avoid the most common pitfalls
Foreign exchange rates afect various aspects of a rms corporate nance strategy. As
U.S. rms generate a larger portion of their revenue ofshore and the foreign exchange
environment remains more volatile and harder to predict, companies should reexamine
their strategy. Figure 8 ofers a corporate action plan for decision-makers to potentially
mitigate risk exposure to the increasing currency volatility.
Companies should measure the impact of FX uctuations not only on their earnings and
cash ows, but also on their leverage metrics, payout ratios and liquidity position. Hedging
should be considered, especially if the company believes that FX exposure is asymmetric
and non-core to the business. In addition to forward contracts and cross-currency swaps,
companies can use option strategies to keep some exposure but protect against tail
risk. The application of hedge accounting will also be important in certain situations and
companies need to be aware of the rules in order to avoid increasing earnings volatility
while hedging economic risk.
Source: Press releases
1
According to a review by foreign exchange risk management company FiREapps
34%
0%
5%
10%
15%
20%
25%
30%
35%
40%
23%
Q1 2012 Q2 2012
EXECUTIVE TAKEAWAY
Heightened uncertainty in the foreign
exchange market is attracting the attention
of equity analysts and investors, who are
concerned about its impact on corporate
earnings. Corporate executives, who are
already receiving more FX questions from
analysts during earnings calls, are currently
reexamining their FX strategy in light of this
new environment.
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Corporate Finance Advisory
Figure 8
A roadmap to avoid the most common pitfalls
Action plan
1. Valuation
and earnings
Assess the potential impact of FX volatility on your companys earnings guidance
Focus not only on net currency exposure, but also impact on top line growth
2. Operations Consider USD denominated contracts in foreign countries as a natural ofset to FX volatility
Take into account that FX movements will still impact your frms competitiveness versus
local peers
3. Hedging
strategy
Debate de-risking strategies, especially if your company has concentrated currency exposures,
limited liquidity and modest exibility with your credit rating
Recent spike in correlations across currencies underscores the limits of diversifcation
Centralizing risk can provide a better perspective on company-wide currency exposure
4. Capital structure/
ratings
Maintain EBITDA cushion within your rating category (and fnancial covenants) or think about
hedging to protect against the impact of FX on leverage metrics
Match the currency mix of your debt to the EBITDA, either through issuance in local markets
or synthetically
5. M&A and capital
allocation
Weigh the valuation of foreign M&A targets in both the local currency and the USD
Though theoretically the two methodologies should result in similar valuations, recent market
dislocations and practical limitations often lead to diferent valuations
6. Liquidity
management
Convert excess liquidity (such as trapped ofshore cash) to match the currency of your liabilities
7. Shareholder
distributions
Test the sustainability of your companys dividend payments under a downside scenario, taking
the impact of FX into account
EXECUTIVE TAKEAWAY
In todays global economic environment,
the importance of managing the impact of
foreign exchange rates on companies becomes
increasingly important. In contrast, the ability
to predict currency movements and the use
of diversication to protect against adverse
rate changes are declining. Many companies
are currently analyzing the corporate nance
implications of this new environment and
reconsidering their FX strategy. We ofer a
corporate nance action plan that addresses
the key factors afecting global companies.
Source: J.P. Morgan
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Special thanks go to Jessica Lupovici, Matt
Matthews, Allison Greenwald and Noam Gilead
for their invaluable contributions in shaping
this report. We appreciate Mark De Rocco,
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