Synthetic credit rating model

FX risk hedging at EADS 1

Reasons for EADS FX risk management policy2

Mismatch between dollar denominated revenues and euro, pounds

denominated cost base (50 % of aircraft’s order)

Significant time lapse between payment commitment and cash receipt

( about 8 years)

Loss of competitiveness (Prime rival is a US-

based manufacturer)

Loss of competitiveness as prime rival (Boeing) is a US-based

manufacturer

Large amount of eligible exposure with highly instable exchange rates have a

dramatic impact on company’s EBIT

1

2

3

4

Reasons for EADS FX risk management policy

Double - pronged approach 3

Double-

pronged

approach

Risk transfer

Risk

mitigation

(natural

hedge)Using off-

shores

Restructuring

Programs

(e.g. Power8)

Hedging with

forward

contracts

Hedging

with

options

Double – pronged approach

4What is the Speed Grid ?

Speed grid is a mechanical hedging approach that is

aimed to determine the weekly amounts of FX forward

contracts to purchase in order to execute EADS’

hedging policy.

What is the Speed Grid ?

5Factors affecting speed of hedging 5

Year to hedgethe further ahead, the less is

hedged per week

Dollar to euro forward

exchange rate,the stronger the forward

exchange rate for the dollar

against the euro, the higher

weekly amounts of forward

contracts that traders had to

purchase and vice versa.

Hedging SpeedThe weekly amounts of FX

forward contracts to

purchase

ResultExecution EADS’ hedging

policy

Factors affecting speed of hedging

6

The pros and cons of Speed Grid

In extreme cases the Speed Grid’s

functioning is not appropriate to EADS’

FX hedging policy.

The pros and cons of Speed Grid

7

At a crossroads

Resetting Speed Grid:

Increasing the amount hedged per week

Hedging with a large single forward contract:

All the eligible exposure will be hedged within a month by

using forward contracts

Using FX options:

EADS Front Office can decide is it worth to be exercised or not

At a crossroads

Current Business EnvironmentCurrent Business Environment

8

Current Business Environment

2

1 1

2

Increase in

Number of

Aircrafts Orders

Drop in Exchange Rate

from $1.20/€ to $1.47/€ two

years later

Growth of Euro

denominated cost base

Growth of delivery years

ahead up to 8 years

Surge in Overall dollar

exposure up to $94.2

billion

Decrease in earnings

Growth of credit

spread volatility risk

Decline in the share

price from € 21.8 to

€15 per share

9

FX Options

Flexibility

Risk mitigation in volatile

market

Elimination of default risk

Gaining counterparty’s

loyalty

Option for reselling

Requirement of

mark-to-market through P&L

Rumors on the market

Forward Contracts

Relatively cheap instrument Strict obligation

Comparison of options and forward contracts

Huge expenses on option premium,

especially in volatile market (2-8% of the

contract)

Comparison of options and forward contracts

Data

10

weekly spot and forward

EURO/USD exchange rates

weekly central strike prices of

EURO/USD options

weekly premiums of

EURO/USD options

The aim of the analysis:

to find out which alternative’s

exchange rate could be the most

beneficial

Source: Bloomberg

Time period

2000 March of 2008

From To

Alternatives EvaluationAlternatives Evaluation

11

PeriodFX exposure,

bln. $

Share in total

FX exposure

Current year 0 0,0%

In 1 year 326 0,7%

In 2 years 661 1,3%

In 3 years 2 531 5,1%

In 4 years 3 264 6,6%

In 5 years 3 930 8,0%

In 6 years 10 445 21,2%

In 7 years 12 050 24,5%

In 8 years 15 960 32,5%

Cumulative 49 167 100%


Source: Company data

Time FX exposure distribution

1 year

2 years

3 years

4 years

5 years

6 years

7 years

8 years

32,5%

24,5%

21,2%

8,0%

6,6%

5,1%

1,3%0,7%

12

Time

period

Period of

hedging

Strike

price

Spot price at

expiration date

FX rate of

conversion

(minimum of

spot and strike

prices)

Option Premium

Final FX rate (sum

of price of FX deal

and option

premium)

1 week

1 year 1,065 0,887 0,887 0,0160 0,903

2 years 1,079 0,895 0,895 0,0162 0,911

3 years 1,098 0,985 0,985 0,0165 1,002

4 years 1,115 1,120 1,115 0,0167 1,132

5 years 1,133 1,227 1,133 0,0170 1,150

6 years 1,151 1,211 1,151 0,0173 1,168

7 years 1,168 1,260 1,168 0,0175 1,186

8 years 1,186 1,353 1,186 0,0178 1,204

The aggregate FX rate (at which all the FX gap was closed, if we start hedging on the 1st week) = 0,903 * 0,7% + 0,911 *

1,3% + 1,002 * 5,1% + 1,132 * 6,6% + 1,150 * 8% + 1,168 * 21,2% + 1,186 * 24,5% + 1,204 * 32,5% = 1,165

Source: Bloomberg, Team Estimates


13Solution

StrategySpeed

Grid

Single

forward

FX

options

No

hedging

Exchange

rate $/€1.149 1.008 1.023 1.355

0

0,2

0,4

0,6

0,8

1

1,2

1,4

1,6

1,8

120

39

58

77

96

11

513

415

317

219

121

022

924

826

728

630

532

434

336

238

140

041

9

Spot rates

spot

$/€

ratio

Source: Bloomberg

Source: Bloomberg, Team Estimates

weeks

Solution

14Alternative approachesAlternative approaches

Continuous futures

“Double hedge”

“SPOT-swap combo”

It allows to mitigate significant negative movements of FX rate and

to be close to current FX rate. Although, this contract requires

cautious approach to rolling position.

This approach includes two levels of hedging. The first level is a

typical hedge contracts (forwards or options). The second level

allows mitigating risk of volatility.

This approach gives the opportunity to operate in the market for

all hedging time. The technique is to buy foreign currency by

SPOT FX rate.

Counter-party default riskCounter-party default risk

15

Monitoring hedge counterparty risk arising from changes in the market

value of EADS’ derivatives. To mitigate the credit default risk we need to

carefully estimate creditworthiness of the banks we deal with.

Synthetic credit rating modelSynthetic credit rating model

16

Data

334 banks, which had long-

term credit ratings of S&P,

Moody’s or Fitch and whose

financial statements were

disclosed

banks credit ratings

financial statements

The aim of the analysis:

Possibility to determine banks’ credit

ratings in every period of time;

Possibility to determine banks’ credit

ratings of those banks, which do not

have in order to minimize option

premium

Source: Bloomberg

sovereign credit ratings of the countries, in which

banks operated

Sample

17

Credit rating Score

AAA 6

AA 5

A 4

BBB 3

BB 2

B 1

CCC / C 0

Where

w(i) – weight of financial factor i (sum of all the weights is equal to 1)

Factor score(i) –score of financial factor i (varies from 0 to 1)


18

Tier 1 capital ratio, %

ROA, %Cash / Demand

depositsTotal assets,

bln. $Factor score

<12.51 <0.32 <0.07 <4.7 012.51 - 13.87 0.32 - 0.60 0.07 - 0.21 4.7 - 10.3 0.213.87 - 14.86 0.60 - 0.87 0.21 - 0.39 10.3 - 22.7 0.414.86 - 16.10 0.87 - 1.13 0.39 - 0.61 22.7 - 42.4 0.616.10 - 18.0 1.13 - 1.62 0.61 - 0.98 42.4 - 121.7 0.8

>18.0 >1.62 >0.98 >121.7 1

Factor WeightTier 1 capital ratio 6,2%ROA 26,3%Cash / Demand deposits 25,7%Total assets, bln. $ 41,8%


Credit risk mitigation: default probabilitiesCredit risk mitigation: default probabilities

19

Credit risk mitigation: limitsCredit risk mitigation: limits

20

Criteria:

PD > 2% -> Lim=0%

PD < 0.5% -> Lim=100%

Lim = 0.5% / PD

Credit risk mitigation: limitsCredit risk mitigation: limits

21

Criteria:

PD > 1% -> Lim=0%

PD < 0.1% -> Lim=100%

Lim = 0.1% / PD

Risk mitigating with downgrade trigger approach 22

Stating Downgrade Trigger Covenant in the Forward

Contract

Bank has an option to

close out the contract at

current market price

EADS has an option to close out

the contract at current market

price

EADS’s credit rating

falls

Bank’s credit

rating falls

Risk mitigating with downgrade trigger approach

Risk mitigating with collateralization approach23

Specifying Forward Exchange Rate and Calculating

Threshold

Subjecting to mark-to-market

Exchange Rate

moves in Bank’s

favor

Exchange Rate

moves in EADS’s

favor

EADS posts

collateral to

equalize a

threshold

EADS refuses to

post collateral

Bank refuses to

post collateral

Bank posts

collateral to

equalize threshold

Bank has an option

to close out the

contract at current

market price

EADS has an option

to close out the

contract at current

market price

Risk mitigating with collateralization approach

Thanks for your attention

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Synthetic credit rating model