1. FX Forwards vs. Cross-Currency Swaps: A Fair Comparison?
08 May 2018

2. Agenda
Review of Basic Foreign Currency Hedging Tools Theoretical Constructs: Forwards and Swaps Hedge Accounting Considerations Example 2

3. First Things First: Definitions
FX Forwards
A forward is a contract that locks in the price at which a counterparty can buy or sell a currency on a future date. The exchange rate is today’s rate, adjusted for the interest rate differential in the two currencies (the forward points). If the interest rate in the local currency is higher/ lower than that of the USD (or whatever the reference currency is), the local currency will trade at a discount / premium relative to spot.
A forward can be used to hedge the foreign exchange exposure of a loan or an equity stake when the counterparty only wants to protect the principal repayment.
Cross-currency swaps
In a cross-currency swap, the parties exchange a stream of payments in one currency for a stream of cash flows in another. The typical cross-currency swap involves the exchange of both recurring interest and principal (usually at the end of the swap), and thus can fully cover the currency risk of a loan transaction. The exchange rate used for all cash flows is usually is the spot rate at inception.
Conceptually, cross-currency swaps can be viewed as a series of forward contracts packaged in a single transaction. 3

4. Most Common Hedging Tools: FX Forwards and Options
The company uses “foreign currency forward and option contracts to manage unmatched foreign currency cash inflow and outflow. Our objective is to minimize the risk of exchange rate movements that would reduce the US dollar value of our foreign currency cash flow. Our policy allows for managing anticipated foreign currency cash flow for up to five years”.
Caterpillar Inc. 10-K
“We manage global foreign exchange risk centrally on a portfolio basis to address those risks that are material to NIKE, Inc. We manage these exposures by taking advantage of natural offsets and currency correlations that exist within the portfolio and, where practical and material, by hedging a portion of the remaining exposures using derivative instruments such as forward contracts and options. “
Nike, Inc. 10-K 2016
Cross-currency swaps gaining in popularity and use, yet starting from a low base
Basic building blocks of currency hedging programs: forwards and options 4

5. Foreign Currency Risk Management: Forwards
Description
Indicative Rates: EURUSD Forwards
The forward contract fixes the full value of the future FX revenue or obligation in USD up to the notional amount hedged
The forward rate is based on (A) current spot rate level and (B) the interest rate differential between the two currencies
One of the most common and widely used hedging tools, either with a single future value date, or with window dates
Window forwards provide flexibility by allowing payments to be made between two pre-determined dates (the “window”)
Value Date
Forward Points
All-in Rate
Spot -
1.2400
250
1.2650
460
1.2860
675
1.3075
EURUSD Rate
Pros and Cons of the Strategy
Pay-off Profile: Effective Rate Relative to Unhedged Rate
Certainty over exchange rate for future cash flow conversion
Zero cost upfront
No participation in favorable market movements
Contract may become a liability, in event of an early termination
Accounting Considerations
Recognized and measured at fair value on the balance sheet
Can be designated as an effective hedge of forecasted transactions with changes in value deferred to OCI
Alternatively, changes in value flow through income statement as unrealized gains/losses until maturity; may act as offset to FX gain/loss from on-balance sheet payable/ receivable

6. Foreign Currency Risk Management: Purchased Options
Description
Indicative Costs: EUR Puts / USD Calls
For an upfront premium, option contracts provide protection in case of adverse market movements, while allowing the buyer to benefit should the market move in his/her favor
Strategy is useful for situations of greater degree of uncertainty in timing and amounts of future cash flow
Similar to buying insurance on a property: it protects against a specific undesired future event, while allowing buyer to enjoy upside if market moves in favor
Value Date
Strike
Premium (% of Notional)
1.24
0.5%
1.8%
2.6%
3.4%
EURUSD Rate
Pros and Cons of the Strategy
Pay-off Profile: Effective Rate Relative to Unhedged Rate
Certainty over exchange rate for future cash flow conversion
Carries an upfront cost: the option premium
Flexibility: can be structured for desired level of protection (the “strike” rate)
Longer tenor options increase in cost exponentially due to currency volatility factors
Accounting Considerations
Recognized and measured at fair value on the balance sheet
Can be designated as an effective hedge of forecasted transactions with changes in value deferred to OCI
Once premium is paid, contract can only be an asset and cannot take a non-zero value (it cannot become a liability) 6

7. Forwards vs. Options: Apples and Oranges?
Often the choice between forwards and options is an imperfect one, and in many ways it’s apples to oranges because of the difference in risk profile: options serve particular purpose of allowing upside due to currency movement, whereas forwards lock in a known rate regardless of future rates.
Forwards:
Hedged cash flow certain/ highly probable
Limited/No appetite to spend cash
Presume credit available
Available relatively inexpensively for longer tenors
Options:
Uncertainty in hedged cash flow
Desire to capture positive market movement
Skewed risk reversal
No credit required once premium paid
Prohibitively expensive for longer tenors
Cross-currency swaps:
Presume significant credit available
Similar risk profile and risk management goals 7

8. Foreign Currency Risk Management: Cross Currency Swaps
Description
Alternative Structures
All-in-one transaction coverts a stream of cash flows in one currency in another currency
Payments structured as mirroring loan profiles, with payments based on interest rates and principal amounts in 2 currencies
The exchange rate used for all conversions is the same: the spot rate at time of execution
Structure very flexible and customizable to cash flow needs.
Pay Leg
Receive Leg
Fixed
Floating
Pros and Cons of the Strategy
Cash Flow Profile: Regular Exchanges of Currency
Certainty over exchange rate for future cash flow conversion
No upfront cost
Potential significant savings in interest costs
High credit utilization
Potentially high breakage cost
USD
EUR
EUR
t0…n t0 tn
Accounting Considerations
USD
Recognized and measured at fair value on the balance sheet
Can be designated as an effective hedge of FX-denominated loan or net investment in foreign operation
With favorable hedge accounting treatment, changes in MTM value deferred to OCI; otherwise changes in value to FX G/L
Initial Exchange
Interest and Periodic Exchanges
Final Exchange 8

9. Mechanics of a Cross-Currency Swap: Cash Flow Profile
USD
USD
USD
USD
USD
Bank Pays/ ABC Receives
EUR
EUR
EUR
EUR
EUR
Bank Receives/ ABC Pays
Periodic Exchanges, based on EUR and USD Interest Rates
Key Point:
Same rate (spot) to be used for all cash flows
Can be omitted if USD debt proceeds have already been converted/ invested in EUR assets

10. Mechanics of a Cross-Currency Swap: Sources & Use of Funds
USD
Covering interest costs on USD debt
Used to repay USD debt
USD
USD
USD
USD
CFG Pays/ ABC Receives
EUR
EUR
EUR
EUR
EUR
CFG Receives/ ABC Pays
Lower coupon: funded by incoming EUR revenues
Funded by accumulated EUR revenues or divestment of EUR operations
Can be omitted if USD debt proceeds have already been converted/ invested in EUR assets

11. Credit Risk Profile of a Cross-Currency Swap: Significant
Example: EUR & GBP Xcy Swap: CEE as % of Notional
Potential future exposure (PFE) and therefore CEE (credit-equivalent exposure) increase logarithmically (i.e. at a decreasing rate) as transaction tenor increases
Other parameters driving CEE calculation:
Currency pair
Currency volatility
Transaction size
Simple model: CEE calculated based on credit risk factors relevant for each currency pair at a 95% confidence level.
 Tenor
EUR
GBP 1y
17%
14% 2y
25%
20% 3y
31% 5y
42%
33%
10y
64%
50%
Cross-currency Swap: Potential Future Exposure

12. Accounting for Cross Currency Swaps
Marked-to-market on balance sheet
Through P&L, with no hedge accounting
Through OCI, with cash flow or net investment hedge accounting
Functional currency of entity plays a significant role
Value of swap affected by changes in:
Spot exchange rate,
Interest rates in each of two currencies, and
Cross currency basis
Potential Hedge accounting designations:
Hedged Item
Converted To
Accounting Designation
FX Fixed-rate
Floating-rate, functional ccy
FX and IR Fair value hedge
FX Floating-rate
FX Fair value hedge
Fixed-rate, functional ccy
FX Cash flow hedge
FX and IR Cash flow hedge
Foreign investment
Functional ccy equivalent
Net investment hedge

13. Hedge Accounting: Net Investment in Europe
Cross Currency Swaps qualify for hedge accounting under certain conditions
The swap can be designated as a hedge of ABC’s net investments in its European foreign operation
Cross currency mark to market is recorded through CTA as part of OCI, offsetting changes in value of the EUR-denominated investment
Conditions for Successfully Applying Hedge Accounting
European subsidiary must have EUR functional currency
Starting value of EUR investment value designated as hedged must be no less than Cross Currency Swap notional – EUR leg
ABC must document at inception all key requirements of ASC 815, such as description of hedging instrument, hedged item, method for testing the effectiveness of the hedging relationship
Two methods permitted by ASC 815 (must be consistent among all net investment hedges)
Method based on forward rates
Method based on spot rates

14. OCI-CTA Hedge Accounting: Subsequent Reporting of Accumulated OCI
Account for effective portion of G/L on hedging instrument in same manner as the Cumulative Translation Adjustment (CTA), consistent with ASC 830 (formerly known as FAS 52)
Translation adjustments are reported in CTA, a component of other comprehensive income
CTA removed from equity and reported as part of the G/L on either sale or “substantially complete” liquidation of the foreign investment
OCI-CTA

15. Example: ABC Inc. – Multinational Corporation
Company funded in part by USD debt capital structure
Debt includes fixed rate notes with face value of USD 100 million and 7% coupon due 2021
EUR revenues coming from subsidiaries in Germany, France, Portugal, Italy and Spain from long term customer contracts
Stable, predictable business generates net cash flows in EUR
Historic approach is to hedge EURUSD risk with FX forwards, horizon up to 3 years
No appetite to use cash to purchase currency options
Company considering other zero-cost alternatives, including cross-currency swaps 15

16. Current Market Conditions
EURUSD Forward Market Favorable for EUR Sellers and Long-term Investors in Europe
Negative Cross-currency Basis
Lingering and lasting effect of the financial crisis and 2011 Eurozone crisis : Strong demand for USD spot (and EUR forward) leads to imbalance in the spot/forward market, amplifying effect of interest rate differential.
Positive Forward Points
Mainly as a result of interest rate differential between USA and Eurozone: US rates much higher than Eurozone (ex. 5y UST 2.84% vs. 5y Germany at -0.07%).

17. ABC Inc.: Hedging with FX Forwards
EURUSD Spot Reference: 1.24
Tenor
(Monthly Contracts)
Hedge Notional
Forward Rate (Blended Average)
USD Equivalent
Year 1: 5/1/2018 – 4/30/2019
EUR 800,000/mo.
1.26
$1,008,000 /mo.
Year 2: 5/1/2019 – 4/30/2020
EUR 600,000/ mo.
1.29
$774,000 /mo.
Year 3: 5/1/2020 – 4/30/2021
EUR 400,000 /mo.
1.33
$532,000 /mo.
Total EUR-USD hedge position
EUR 21,600,000
1.2856
USD 27,768,000
Key Features
Individual foreign currency cash flows are locked into USD at preset rates (the forward rate).
Hedging entity benefits from upward sloping forward curve: future EUR more valuable than spot EUR
Advantages
No upfront cost
Individual contracts, highly customizable for each tenor
Disadvantages
Opportunity cost: locking in a rate precludes any future benefit or cost from subsequent exchange rate movements 17

18. ABC Inc. Hedging with Cross-Currency Swap
Fixed-Fixed Cross Currency Swap Transaction
Key Terms:
Effective Date: 4/24/2018
Maturity Date: 4/24/2021
USD Notional Amount: USD 25,000,000
Exchange Rate:
EUR Notional Amount: EUR 20,161,000
Interest Rates: Fixed USD vs Fixed EUR
Payment Periods: Quarterly; Act/ 360
Initial Exchange: None
Periodic Exchanges:
Bank Pays: %
Company Pays: %
Final Exchange:
Bank Pays: USD 25,000,000
Company Pays: EUR 20,161,000
The cross currency swap allows company to effectively reduce its interest costs from 7% to 4.25% on the hedged debt portion of USD 25,000,000. 18

19. Hedging with Cross-Currency Swap (cont.)
Key Features
Initial exchange:
Not needed due to the fact that company’s capital has already been converted from USD and invested in Europe
Periodic cash flows:
ABC pays EUR based on fixed interest rate
Receives fixed/floating USD, to match USD interest leg on debt
Final exchange:
ABC sells EUR
Buys USD – same exchange rate used (initial spot) for all cash flows
Advantages
All-in one transaction with minimal ongoing administration required
Highly customizable, aimed at optimizing currency risk profile of combined capital structure
Potential favorable hedge accounting if designated as net investment hedge
Disadvantages
Can be complex to restructure in the event of a recapitalization or change in risk profile
Credit intensive: far date of (and value embedded in) final exchange carries credit risk for the bank
Adverse mark-to-market value may affect P&L
Periodic Cash flows:
USD 7%
Final Exchange
EUR mm
EUR %
USD 25mm
USD Interest 7%
Principal: USD 25mm
USD Debtholders 19

20. Cross-Currency Swap: Cash Flow Breakdown By Payment Leg
EUR Cash Flows
USD Cash flows
Start
End
Days
Notional
Exchange
Payment
Discount
PV (EUR)
PV (USD)
4/24/18
7/24/18 91
20,161,000
(216,590.74)
(217,175.70)
25,000,000
442,361.11
440,364.91
10/24/18 92
(218,970.86)
(220,072.01)
447,222.22
442,920.36
1/24/19
(220,682.22)
440,482.66
4/24/19 90
(214,210.63)
(216,374.99)
437,500.00
428,460.17
7/24/19
(219,226.57)
430,589.45
10/24/19
(222,057.01)
432,560.65
1/24/20
(222,433.31)
429,766.17
4/24/20
(220,331.17)
422,353.54
7/24/20
(220,587.97)
419,624.09
10/26/20 94
(223,731.10)
(228,071.19)
456,944.44
430,563.76
1/25/21
(220,933.66)
414,129.07
4/26/21
(20,161,000)
(20,377,590.74)
(20,794,492.64)
25,442,361.11
23,664,870.66
(23,149,629.44)
28,705,540.75
at spot
1.24
USD
(28,705,540.75)
NET VALUE
(0.0) 20

21. Cross-Currency Swap Breakdown: Net USD
USD Leg
EUR Leg
Start
End
Days
Payments Rec
Payments Pay
Fwd FX
USD Value
Net Payment (USD)
Discount (USD) PV
(USD)
4/24/18
7/24/18 91
442,361.11
(216,590.74)
1.2410
-268,789.11
173,572.00
172,788.67
10/24/18 92
447,222.22
(218,970.86)
1.2509
-273,916.78
173,305.44
171,638.42
1/24/19
1.2609
-276,108.11
171,114.11
168,535.42
4/24/19 90
437,500.00
(214,210.63)
1.2710
-272,266.62
165,233.38
161,819.33
7/24/19
1.2812
-277,494.13
164,866.98
160,479.71
10/24/19
1.2914
-282,787.86
164,434.36
159,043.54
1/24/20
1.3018
-285,050.17
162,172.05
155,842.15
4/24/20
1.3122
-284,207.41
158,153.70
151,000.57
7/24/20
1.3227
-286,481.07
155,880.04
0.9486
147,867.97
10/26/20 94
456,944.44
(223,731.10)
1.3333
-298,292.91
158,651.53
149,492.10
1/25/21
1.3439
-291,083.10
151,278.01
141,623.30
4/26/21
25,442,361.11
(20,377,590.74)
1.3547
-27,605,172.82
-2,162,811.71
-2,011,711.20
 Total
(0.00)
The large off-market value notional exchange at maturity is recovered through the periodic interest payment differential 21

22. Cross-currency Swaps: Pros and Cons
Advantages
Disadvantages
Elegant approach, with all-in one financial instrument that does not require ongoing administrative work, adjustments and further layering
Complex instruments, requiring a good understanding of interest rate and foreign currency markets and sufficient institutional knowledge for the end-user.
Favorable accounting treatment enables a company to efficiently hedge large balance sheet items such as investments in foreign jurisdictions or debt denominated in foreign currency
Final exchange may lead to an adverse cash event at maturity. This also leads to large swings in value (recorded as unrealized gains/losses) which may affect materially a company’s P&L, especially if special hedge accounting not adopted.
Allows capturing favorable forward points advantage between two currencies through interest rate cost savings. Interest rate cost reduction
Limited flexibility once executed. All-in one feature of the swap can also be its drawback: if something changes in the hedged exposure profile (e.g lower than anticipated foreign currency cash flows), the swap is may be costly to adjust when compared to layer forward contracts, for example.
Companies that execute cross-currency swaps usually weigh the pros and cons and establish net benefits that outweigh complexity factors and other drawbacks from executing a swap 22

23. Strategy Comparison
Criteria
Strip of Forwards
Cross-currency Swap
Delta (FX Sensitivity)
EUR 21.6 million
EUR 20.2 million
Complexity
Minimum
Elevated
Ease of Execution
Yes
May require additional documentation such as ISDA
Credit Charges
Low on front end; proportional for each contract/maturity
High due to large notional exchange at maturity
Exchange Rates Used
Relevant (different) forward rate for each value date
All cash flows exchanged at spot rate
Valuation Drivers
Interest rates, spot rate
Interest rates, spot rate, cross-currency basis
Accounting Treatment
Cash flow hedge accounting or MTM through FX G/L
Cash flow /net investment hedge accounting or MTM through FX G/L
The steeper the forward curve, the more “off-market” the final exchange on the swap will be as a stand-alone forward
Therefore the greater the interest rate differential will have to be to compensate for off-market value of the final exchange 23

24. Q&A. Thank you. Bryan Morales
Global Markets Citizens Commercial Banki​ng
One Logan Square 130 North 18th Street, Suite 1310
Philadelphia, PA 19103
Desk:
Direct: Mobile:

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