FX Risk Hedging at EADS

GROUP 1-
PRACHI GUPTA
PRANAV GUPTA
SARVAGYA JHA
HARSHVARDHAN SINGH
PUNEET GARG
Introduction

 European Aeronautic Defence and Space Company N.V. (EADS) is a leading global aerospace and defence company which
was established in 2000 when German DaimlerChrysler Aerospace AG, French Aérospatiale-Matra, and Construcciones
Aeronáuticas SA of Spain joined hands to counter consolidation in the aerospace and defence industry in the US.
 The case revolves around the necessity and nature of a hedging strategy, to hedge against foreign currency risk faced by
EADS’ commercial jet division, Airbus that depended heavily on the dollar-to-euro exchange rate for being profitable.
 Over the past three years, unfavourable FX movement meant that each dollar of revenue now yielded 25% fewer euros.
Dollar was the currency in which commercial aircraft transactions were billed.
 Questions to be Answered-

1. Whether or not to broaden the range of derivatives used, from FX forward contracts?
2. If yes, what will be the nature of hedging portfolio and estimate of the amount which needs to be hedged to prevent
either under or overhedging?
Industry Overview

 With Airbus’ arrival in the 1970s, the airliner sector had gradually internationalized and evolved towards a near-duopoly
between Boeing and Airbus, having a nearly 50% market share, both by value and volume of deliveries by 2007.
 In 2007, the airliner market stood at 894 jet deliveries and set a new record of 2,754 orders, yet some analysts anticipated a
steep decline to 1,350 orders in 2008.
 Given manufacturers’ backlogs, however, a delivery ramp-up to around 1,100 jets by 2011 was expected. The industry’s long-
term outlook was optimistic with 22,660 combined aircraft deliveries worth $2,600 billion expected by 2025.
 EADS’ Strategy and Financial Performance-
 In the short term, the board signalled possible acquisitions for the Defence and Security division, particularly in North
America, as a mean of balancing the portfolio and justifying production in the U.S. Finally, continued commitment to prudent
cash management in 2008 in support of the underlying goals.
 EADS’ strategic ambition for 2020 was to become the worldwide leader in air and space platforms and systems. A roadmap
to this goal included reaching €80 billion in turnover by 2020, half of which would come from Airbus; targeting a 10% EBIT
margin by 2015; and lifting non-European sourcing from 23% to 40% by 2020. To achieve this, the firm planned to open an
assembly line in China in September of 2008.
FX Risk Management at EADS

 Airbus’ ability to compete against U.S.-based manufacturers in the U.S. dollar-priced

aircraft market was affected by the euro’s and the pound’s exchange rate to the dollar.
 Sustained decline in the value of the dollar relative to the euro would cause Airbus’ cost
base to grow relative to Boeing’s, undermining Airbus’ profitability and market
competitiveness.
 Airbus also faced foreign exchange transactional exposures resulting from time lags
between payment commitments and actual cash settlement of those commitments.
Measuring Airbus’ FX Exposures

 Airbus represented over 80% of EADS’ foreign currency risk exposure and was central to
the group’s overall FX risk.
 If the delivery of a firmly ordered aircraft was scheduled within the next eight years
would a foreign exchange exposure be recognized by Airbus and become eligible for
hedging in line with EADS’ hedging policies.
 A hedge able FX risk exposure represented a full aircraft payment (including the 20%
down payment and the 80% delivery payment) minus the remaining dollar-sourced cost of
an aircraft (around 50% of the order price).
FX Risk Management Strategy

 FX risk mitigation- EADS took advantage of so-called “natural hedges” that could be achieved through
operating decisions that minimized their expected net dollar inflows.
 It was estimated that without natural hedges, EADS’ hedgeable exposure would have been twice as high.
 EADS trimmed its euro-denominated cost base or converted it into dollars via restructuring initiatives
such as its “Power8 Program,” which was launched in 2007.
 Through this program, the company planned to reduce manufacturing headcount and to divest and re-
price selected European production sites into U.S. dollars.
 FX risk transfer- With a portfolio of derivatives, mainly FX forward contracts, EADS locked in exchange
rates at which its future dollar receivables could be converted into euros.
 The overall aim of FX hedging at EADS using derivatives was to protect the firm’s EBIT against the
dollar’s decline and to meet shareholder expectations of stable future euro-denominated earnings.
Hedge accounting & Counterparty risk

 Being listed in Europe, EADS had to report under International Financial Reporting
Standards (IFRS) and comply with respective hedge accounting principles.
 IFRS required that financial instruments be marked to their market value at the end of
each reporting period.
 The treasury believed that in early 2008 EADS’ hedge portfolio, in which Airbus
represented over 80% of the aggregate hedging positions’ value, was slowly approaching
the limits of banks’ hedge risk tolerance.
 This could present difficulties in raising annual purchases of forward contracts beyond
current levels.
Hedging strategies Being Considered by
EADS

 Reset the Speed Grid- A clear advantage for the Speed Grid is that it enables the company to
employ a layered hedging strategy where they hedge in the shorter term and less in the longer
term, thus this gives some flexibility, which complements the usage of pre-determined forward
rates.
 Enter into a single large forward contract- Entering into a single large contract reduces and even
closes the currency cap. The main advantage with this method is that it is efficient and easily
provides a solution to EADS’ risk problem, giving management more time to focus on strategy
and the business rather than currency risk.
 Buy FX options- The authors see this alternative as most suitable, as it introduces more flexibility
in the hedge portfolio. A combination of forwards and call options on euros from dollars, allows
the company to secure the currency rates while still benefiting from appreciations of the dollar.
On the other hand, this, of course, comes with a price, as options are quite expensive.
Considerations in the Purchase of FX Options
 Proposal of buying options was never gained traction due to its cost.
 $/€ exchange rate’s volatility was one of the main drivers of an option’s price given the prevailing spot
exchange rate, the option’s exercise price, and its maturity
 1 percentage point rise in the $/€ volatility could increase the premium for an option by 13.3%
 The Middle Office pointed out, from a hedge accounting perspective:
 Forward are more advantageous, because all changes in its intrinsic value will be recorded in “other comprehensive
income” equity account.
 Whereas, options had both intrinsic and time value components. Any changes in the latter requires marking-to-
market through the P/L account, i.e., when the market is highly volatile, options will skew the earning.
 According to Treasury team:
 Buying an option will be more advantageous for EADS’ banks from a credit counterparty risk perspective. Contrary
to a forward, an option could, but didn’t have to be executed at maturity, which will minimize risk on potential
default.
 Despite options being expensive, it can be traded depending on currency market’s development. Eg. If the dollar
suddenly appreciates, EADS can resell options and get a part of option premium back.