The Baggins Co. Page 1 of 5.

Dick Sweeney

The Baggins Co.

The Baggins Co. was acquired several years ago by Mordor Inc. Mordor has adopted a hands-off policy towards Baggins, as towards a number of its wholly owned subsidiaries. Mordor provides Baggins with a target cost of capital and evaluates performance based on this target rate. Recently, however, Baggins executives have perceived disturbing signs that Mordor is unhappy with how Baggins manages its foreign-exchange exposure.

Mordor has major international interests, and it sees itself as continually looking for ways to improve its international performance. Mordor’s CFO, John Gandalf, has asked a staff team to look into foreign-exchange management practices in all its operations. Bob Smith heads the team. Mr. Smith has found a wide range of practices across Mordor itself, its subs and some businesses it owns, including Baggins. Mordor and Baggins offer two ends of the spectrum. Mordor does not hedge much of its transaction risk, but Baggins hedges all of its transaction risk. Managers at both Mordor and Baggins argue vehemently that they are making the right risk-management decisions. Mr. Gandalf is perplexed: How can both Mordor and Baggins be doing the right thing, when they do such different things? And, after all, Mordor owns Baggins.

Mr. Smith is to provide a report in seven days that makes concrete suggestions about how to change FX risk-management. Mr. Smith is currently unable to give convincing reasons why both Mordor and Baggins should persist in their different policies; worse, he cannot decide which if either paradigm should be adopted. He has some data that Baggins and Mordor have provided, feels that these are not enough data or perhaps not the right data, but does not know what more to ask for. He finds the issues complex and worries that he has become bogged down in details and is missing key issues, “not seeing the woods for the trees,” as he puts it.

Baggins produces specialized recording devices and typically sells to relatively small firms. It had sales last year of $100m. Last year, and in a typical year, one-third of its sales are foreign, mainly to European Union members, and largely to EU members that use the Euro. These sales typically imply three-month exposure to exchange risk. Before formation of the European Monetary Union and introduction of the Euro, Baggins thought of its currency exposure mainly in terms of the Deutsche Mark (DEM). Baggins had long been on its own before being acquired by Mordor, and had hedged all its transaction exposure. This practice was based on a few disastrous years when it had not hedged and as a result lost substantial amounts from exchange-rate fluctuations, amounts that were large relative to profits. Baggins executives are worried that they will be forced to change their current practice, and forced to leave much of the exchange risk unhedged.

In its investment decisions, Baggins uses the 10 percent real cost of capital that Mordor uses in evaluating Baggins’ performance. Baggins executives understand and accept this rate. In the past, they had used a quite similar rate. Further, they understand The Baggins Co. Page 2 of 5. the risk-measurement system that Mordor uses in arriving at this rate and the rates Mordor uses in evaluating its own and its subsidiaries’ operations.

Mordor uses a tailored cost of capital for each class of its operations. Mordor pays a good deal of attention to developing and updating these tailored discount rates. A major concern is finding and estimating risk premia for the systematic risk factors, and the beta sensitivities to risk factors. For these risk premia and betas, Mordor relies on asset pricing models. Mordor’s rationale is that it is a large company, held predominantly by large, well diversified share holders: These share holders have diversified away, or cheaply can diversify away, all non-systematic risk, so Mordor should not take this risk into account in discounting expected cash flows. For many purposes, Mordor uses the CAPM, but it is willing on occasion to use more complicated asset-pricing models if it feels that the operation in question is subject to systematic risk that “the” market does not capture. (See “A Review of Asset-Pricing Models and The CAPM.”)

Mordor is diversified across several lines of business. The percentage of its revenue that comes from foreign sales varies across business lines, but averages approximately 15 percent, with some ups and downs across years. Its treasury operation goes by the rule of thumb that it should not hedge transaction exposure. Its rationale is that currency risk is diversifiable and hence shareholders can best deal with this risk. On occasion, however, the treasury people see situations where the risk of exchange losses appears so large that they override their rule of thumb and hedge. This happens on average in one-fifth of all transactions across years.

Mordor’s real discount rates vary across operations, from 3 percent to 25 percent. Thus, in situations where the expected rate of inflation is 3 percent, Modor’s nominal discount rates vary from 6 percent to 28 percent. In evaluating the performance of Mordor’s treasury, the hurdle rate used is the USD inter-bank rate. Mordor is large enough and a good enough credit risk that it borrows and lends at inter-bank rates.

Mr. Smith has some data on the performance of FX risk management for both Baggins and Mordor for 1999. These data are in brief memos sent in response to his request for information. Baggins hedges all transactions exposure with forward contracts. Baggins hedged $30m worth of sales last year. Baggins’ financial people make several points. First, they are very proud that these $30m in sales turned into actual revenues received of $30.056203m, and they attribute this to their hedging operations. Second, they report that the Euro fell two percent last year, and calculate that Baggins would have lost $600,000 had it not hedged. Baggins people argue that a penny saved is a penny earned. In their view, making (saving) $600,000 for no investment is a good deal at any discount rate, let alone the 10 percent real rate that Baggins and Mordor apply to Baggins’ operations. Third, the bid-ask spread on the three-month forward contracts averages only one-eighth of one percent; hedging is dirt-cheap (for comparison, the spread on spot trades averages one-sixteenth of one percent).

Mordor had $200m worth of sales that were exposed to exchange risk last year. It hedged $40m of these. Mordor’s treasury reports that on the $40m it hedged, it calculates The Baggins Co. Page 3 of 5. it received payments of $40.075m. Had it not hedged, it calculates it would have received $39.288m. Thus, argue Mordor’s treasury people, they made a profit of $0.787m or $787,000.

In their brief memo, the Mordor people note that the mid-rate on inter-bank 90- day USD averaged 5 percent last year, with no trend up or down (and for comparison, the Euro averaged 4 percent, with no trend up or down). Mr. Smith made a brief follow-up phone call after reading the Mordor memo. Mr. Smith asked the Mordor people why they did not compare this profit to the 5 percent inter-bank rate to judge whether they actually made profits—after all, the USD inter-bank rate is supposed to be the hurdle rate for treasury operations. Their response was that they put up no money for the forward contracts, unlike futures contracts, and hence in a sense they made an infinite rate of profit compared to the 5 percent benchmark.

Mr. Smith also asked the Mordor people how much they made or lost on the part of their exposure that they did not hedge. They responded that this was irrelevant. Their base position was not to hedge, because exchange risk is diversifiable.

Mr. Smith is exasperated and even confused. He does not fully understand how Baggins and Mordor arrived at their profit figures. Further, Mr. Smith knows that Mordor’s risk-management team believes that the USD appreciation rate relative to the Euro has a beta of - 0.10 (so the EUR appreciation rate relative to the USD has a beta of + 0.10), and estimate that the risk premium on the market is 6%/year. He also knows that the rate of return on the market was 10 percent last year. He is puzzled by what these financial-market numbers imply for the issue of hedging. He wonders why no one considers these numbers; he wonders why neither the Baggins nor Mordor memos talk about the risk involved. He is determined to understand the meaning of the data he currently has, and to use the resulting knowledge to decide what other data to demand.

Mr. Smith has just received a memo on these issues from Ms. Robin Scott, a project analyst whom he asked to review the material from Baggins and Mordor. He hopes that this memo will clear up some of the issues. The Baggins Co. Page 4 of 5.

$$$ Semper Mordor $$$

Memo

To: Mr. Bob Smith

From: Ms. Robin Scott, Project Analyst

Subject: FX Risk Management Review

I have reviewed the documents you sent me, and am giving you my reactions in the short time frame you specified.

1. We need more data to really understand what the treasury people are doing at Baggins and here at Mordor. I would like to see the day-by-day records of foreign sales for each, and also I want to see what the FX bid-ask quotes are at the time each transaction was made. We need this to find out how much was gained or lost by the hedging strategy.

2. I have some preliminary calculations for Baggins’ saving from its FX strategy. They say they “saved” $600k last year with their “hedge everything” strategy. I think they simply multiplied their $30m in foreign sales by the 2% Euro depreciation to get this figure. This is misleading in two ways.

A. They appear to assume that the full $30m was exposed for the entire year, and would have suffered the 2% FX loss. In fact, they typically have only 90 days of exposure. So only about ¼ of the $30m was exposed at any one time, or about $7.5m. (This is rough, of course. I’m assuming dollar sales were pretty much even over the year. This probably is not right, but it is the best I can do until we get the data.) They would have lost the 2% on the base of $7.5m, meaning a loss of about $150k.

B. Mordor treasury compares actual depreciation with what could be locked in with a forward hedge. It is interesting to apply Mordor’s methodology to what Baggins did. From the interest-rate data in the memos—4% for Euro deposits and 5% for USD deposits—the forward premium on the Euro was about 1%. On typical exposure of $7.5m, Baggins locked in a 1% premium by hedging their Euro receivables, or got an extra $75k above the spot rate. If we put this extra $75k together with the $150k they saved by not having Euro exposure, they are ahead by about $225k.

C. These rough calculations leave out the transaction costs of the FX transactions. For us and for Baggins, these costs are just the bid-ask spread—no brokerage fees. My calculations are based on the mid-point of the spot and forward rates. But on any transaction, using the mid-point of the rate in the calculation overstates the amount received by one-half of the spread. I agree with Baggins, the spread is only about 1/8 of 1% for forward transactions and only about 1/16 of 1% for spot transactions. But of course these are spreads that hold in normal times, not in crises when they can widen a good deal. Baggins would not have got the full $75k by locking in the forward premium, but less than that by half of the 1/8% spread applied to the sum of the whole $30m base plus the extra $75k. They would have got less by $18,797. And Baggins would have had to pay one-half of the 1/16% spot spread if it had not hedged, on the whole $30m base less the FX loss of $150k. This would give costs of $9,328. The net of these two transaction costs is $9,469, so Baggins paid an extra $9,469 in transactions costs by using forward rather than spot FX sales. So the saving for hedging is not the full $225k but $215.5k.

As an aside, those bid-ask spreads nickel-and-dime us to death. They are not so bad for FX deals, but I wonder if we pay enough attention to how much the company pays in spreads on all the transactions it makes. In addition, it is pretty obvious that the spreads on different types of FX transactions can be pretty The Baggins Co. Page 5 of 5. different, even though it is all FX. I wonder if the company overlooks how much larger the costs are for one type of instrument rather than another, even if they are both in the same general category.

3. I have some hypothetical calculations about Baggins based on what happened the year before. That year, the DEM went up by 2%. If the premium is 1% but the Euro goes up by 2%, the numbers change for Baggins’ hedging profits. Baggins still locks in an extra 1% on $7.5m, or $75k. But with 2% appreciation, they would have made $150k. So, using the Mordor treasury method, Baggins would have lost $75k.

This makes me think: if the Euro had gone up 4% last year, instead of losing 2%, Baggins would have lost $225k. Baggins is making a lot of noise about saving money by their “hedge everything” strategy, but some years there is a lot more appreciation than the premium. Of course, some years the premium is negative, and so Baggins locks in a loss by hedging. I do not see how they can justify their strategy by citing their profits from hedging.

4. I have looked at the Mordor treasury numbers for the transactions they did not hedge. They lost a lot. They had foreign sales of $200m, or average exposure of $50m because the average exposure was only for 90 days, just like Baggins. They could have locked in a 1% gain on this $50m from the forward premium, or $500k. By not hedging, the FX losses from Euro depreciation would have been 2%, or $1m. So the “hedge nothing” strategy would cost $1.5m on a base of $200m in sales. (Again, these calculations are rough, but they give a feel.)

5. Mordor treasury deviated from their typical strategy by hedging $40m in sales. They state they would have received only $39.288m if they had not hedged. I have done the numbers on this. They would have lost $712k on the $40m. This means the Euro had to go down by 1.78 percent over the 90 days the $40m was exposed. Checking back with databases at hand, it looks like the Euro did have a lot of ups and downs last year, though the trend was down by 2%. What happened is, when Mordor treasury hedged, the Euro went down a lot more than average, in fact, at an annual rate of 7.12%. An excellent period to be hedged!

6. I do not understand why Mordor treasury didn’t hedge all the time. They would have locked in the 1% premium on a base of $50m, and saved FX loses that averaged 2%, or would have been ahead by 3%, and this comes to $1.5m on the base of $50m. On the other hand, if the Euro had gone through the roof, I guess I’d be saying they lost money by hedging. This is a little like my comments above on Baggins.

7. Mordor treasury justifies its base-case position of not hedging by claiming that FX risk is diversifiable. But I don’t see this argument.

A. Our risk management system says that Euro risk has a systematic component. The estimate we use is that the beta for Euro appreciation is 0.10. And put the other way around, the beta for dollar appreciation is -0.10. This systematic risk for Euro exposure may be small, but it is still important. Given our estimate of the risk premium on the market of 6% per annum, our risk models require us to earn a risk premium of 0.6% per annum on our risky FX positions. So just ignoring FX risk will not fly.

B. It’s pretty clear that Mordor is not diversified enough to get rid of FX risk. Some of the FX losses from last year fed right through to our bottom line. Not all the losses, but some did. This raises two issues. If we are not diversified, maybe we ought to diversify and gain the advantages in reduced risk that are touted for diversification. I know this is an old argument around here, and a lot of people say we ought to focus on what we are really good at, but I want to raise it again in the context of FX risk. Also, if we are not going to diversify, maybe we ought to go more in the direction of Baggins’ strategy. Maybe Mordor ought to hedge.

Sorry I cannot give you more definitive answers now. With the new data I requested, I can give you better answers as to what actually happened last year with foreign exchange losses and savings. But we will still have to face the strategic issues in managing FX risk. How can Baggins and Mordor treasury both be right? How can Mordor treasury say FX risk is diversifiable when it isn’t? and we aren’t diversified, anyway? Should Mordor diversify to get rid of FX risk? Or should Mordor treasury hedge more like Baggins does?