In today's increasingly globalized world, the propensity of firms to generate cash flows streams internationally has grown. Implicit to international cash flows are certain risks which can be managed via an array of financial instruments. What types of risk? What are the specific benefits of risk management? Which financial instruments are appropriate? What alternatives exist? These questions will be answered for two firms with international operations, Billabong International and Wesfarmers, subsequently.
2 Introduction
As a result of international operations and cash flows, Billabong and Wesfarmers naturally incur transaction, interest rate, & debt repayment risks in regards to foreign denominated currencies. In the presence of these risks, the two firms are obliged to formulate mitigating strategies to avoid unnecessary losses. Firstly, in order to better comprehend the dynamics of each company, an overview & history and business model will be presented upon the introduction of each firm. Secondly, an assessment of and hedging strategies for foreign exchange risks will be discussed. Next will follow a comparison of the two firm's foreign exchange risks; followed then by further risk analysis and alternatives. In conclusion, other foreign exchange risks recommendations will be presented.
3 Company overview and history
3.1 Wesfarmers
Wesfarmers started operations in June 1914. The company's main focus was the provision of services and merchandise to Western Australia's rural community (Wesfarmers Company Website, 2009).
Founded in 1914, Wesfarmers began as a cooperative arrangement between farmers in Australia's west. In the 1950's, the company ventured into diversified business by establishing Kleenheat Gas, a distributor of liquefied petroleum gas and gas appliances to Western Australia Rural Areas . In 1984 the company was listed on the Australian Stock Exchange. In the 1990s, the company invested in the Bengalla mine in the Hunter Valley in New South Wales. In the beginning of 2003, Wesfarmers gained the privilege to establish a close by deposit. September 2006 saw Wesfarmers change its energy division with the construction of a unique coal division in charge of the wholly-owned Curragh and Premier mines. In November 2007 Wesfarmers acquired Coles Group Limited. In January 2009, non-renouncable rights issue and equity placement raised A$4.6b (Wesfarmers Company Website, 2010).
3.2 Billabong
Billabong was founded in 1973 by Gordon and Rena Merchant in Queensland as a small scale producer of goods for extreme sport retailers. The firm expanded operations in Australia for the duration of the decade.
In the early 1980's, the firm reached the A$1 million sales mark. Shortly after this milestone, Billabong broadened operations to the US, Japan, and New Zealand via licensing arrangements where the firm steadily grew its revenues. The licensed operations grew over A$25 million in sales by the mid 1980's. In 1988 the firm began operations in Europe through a licensing agreement in the United Kingdom. One year later, Billabong was available in South Africa (Billabong International Ltd. References for Business, n.d.).
The 1990's saw Billabong take direct control of its sales operations in the UK, France, and Spain. Also during the decade, the firm started operations in Indonesia, Singapore, Brazil, Peru, and Chile. During this time, the firm also began diversifying product offerings into the different board sports, such as snowboarding and skateboarding via alternatively named subsidiaries. In 1997, Billabong recorded sales of A$47.7 Million (Billabong International Ltd. References for Business, n.d.).
In 2000, professional management was solicited and Billabong was floated on the Australian Stock Exchange. One year later, the firm acquired the brand Element, and expanded heavily into skateboard product offerings. Additionally, Billabong entered the footwear industry through the purchase of the Australian company Kustom surf shoes. Furthermore, Billabong opened a retail store in Times Square in New York (Datamonitor, 2009).
4 Company Business Model and its Strengths and Weaknesses
4.1 Wesfarmers
Business Model
Multi-brand, Multi-region Business Mode
Strengths on Risks
Diversified Business
Portfolio
A strong portfolio of diversified business;
Including retail operations covering supermarkets, general merchandise and specialty department stores, fuel and liquor outlets and etc.
Acquisition of Coles:
Acquired Coles in November 2007;
Becoming one of the Australia's largest retailer and listed company;
Coles business has added a new business dimension to diversify risks.
Leading Market Position:
A competitive advantage to the company;
Adopting flexible pricing strategy to eliminate the foreign exchange risk.
Weaknesses on Risks
Lax quality control:
Diversified regions and industries pose threat on products quality
Source: Datamonitor, 2009.
4.2 Billabong
Business Model
Multi-brand, Multi-region Business Mode
Strengths on Risks
Multi-channel Diverse Operations &
Multi-brands
A large product base with multi-brands;
Offering it to the customers through multiple channels.
Large Geographical Base & Global Demands
multi-regions;
Presence directly or indirectly in about 100 regions across the world;
Diversified revenues across regions reduce the vulnerability of Billabong to vagaries of specific economies
Acquisitions in North America
A strong contribution from the acquisitions;
indicating Billabong's strong strategic backbone
Weaknesses on Risks
Increase of interest burden: Billabong has taken a large debt to finance its acquisitions and organic retail growth. This led to an increase of interest expense
Pricing strategy in North America: Billabong maintained closely managed pricing strategy in North America to protect its brand equity. This led to decline in sales of certain Billabong brands in North America.
Source: Datamonitor, 2009.
5 Exposed Risks
5.1 Foreign Exchange Risk and Hedging
5.1.1 Wesfarmers
Based on the introduction from its annual reports, the main foreign exchange
transaction risk comes from the contracts of selling the export coal and purchasing
import inventory denominated in US dollars and current US-denominated debt.
Thus the main foreign exposure, for the Wesfarmers, is the volatility of USD
exchange rates relative to AUD, which will be illustrated in details in the later part.
As a result of operation in New Zealand, the movements in the AUD/NZD exchange rates affect the financial data in the annual reports, and the Group mitigates the effect of its structural currency exposure by borrowing in NZ dollars in New Zealand (Wesfarmers Limited Annual Report, 2009, 2008, 2007, 2006).
Strategically, most companies apply forward contracts to hedge such risks. Wesfarmers aims to "hedge approximately 45 per cent to 55 per cent (2009, 2008, 2007) of its foreign currency sales and to hedge approximately 70 per cent to 100 per cent (up to 12 months) of its foreign currency purchases (2009, 2008, 2007, 2006)" (Wesfarmers Limited Annual Report, 2009, 2008, 2007, 2006).
From the chart, Wesfarmers uses forward contracts to hedge expected future sales by selling USD for AUD. In 2006, Wesfarmers sold USD 1,066.8 million at foreign exchange rate AUD/USD = 0.7009. In 2007, it sold USD 1,103.6 million at foreign exchange rate AUD/USD = 0.7375. Meanwhile, it sold NZD for USD to hedge expected future purchases by getting USD 3.2 million at NZD/USD = 0.7271 in 2007 and USD 1.1 million at NZD/USD = 0.6248 in 2006.
Also, Wesfarmers purchases forward contracts to hedge expected future procurements by selling AUD for USD. In 2006, it bought USD 81.5 million at AUD/USD = 0.7434, GBP 0.3 million at AUD/GBP = 0.3994, EUR 12.5 million at AUD/EUR = 0.6086 and JPY 141.3 million at AUD/JPY = 84.10. In 2007, it purchased USD 116.3 million at AUD/USD = 0.8184, GBP 0.1 million at AUD/GBP = 0.4184, EUR 21.9 million at AUD/EUR = 0.5858 and DKK 0.5 million at AUD/DKK = 4.51.
5.1.2 Billabong
Most of Billabong's revenue originates from foreign markets, and international expansion has allowed Billabong to reduce risks through diversification of different markets and products; but it must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. Hence, Billabong is exposed to foreign exchange risk arising from various currency exposures over sixty countries, primarily with respect to United States Dollars. So, forward contracts are used to purchase US dollars, Euro and Australian dollars to manage foreign exchange risk. The Group's Risk Management Policy is to hedge greater than 80% in 2009 of forecast foreign denominated inventory purchases for the upcoming season (2008: 74%; 2007, and 2006: 90%). Also, Billabong faces risk on exchange rate movement on scheduled repayment of drawn segments under its syndicated facility. Forward contracts are used to hedge this risk (Billabong International Limited Annual Report, 2008 - 09/2007-2008/2006-2007/2005-2006).
Billabong's choices of different foreign currency forwards and different volumes of forwards are all based on its trading situation. The following charts discovered this changing strategy. Like the ratios of "Sell Euro"/ "Buy USD" and "Sell AUD" / "Buy USD" are always changing from year to year since the company made different transactions every year. And also in the financial year of 2008, Billabong commenced distribution from South Africa (Billabong International Limited Annual Report, 2008). This is why Billabong started to use "ZAR"/ "USD" forwards to hedge foreign currency risk since 2008.
5.2 Interest Rate Risk and Hedging
5.2.1 Wesfarmers
Due to the complex corporate structure, Wesfarmers confronts interest rate risk across multiple countries. Generally, the Group tended to apply interest rate and cross currency interest rate swaps to reduce the exposure which may have dramatic influences on the Group's profitability and value. The interest risk management (IRRM) plan specified in its annual report is designed to hedge unnecessary interest costs related to corresponding debt liabilities. Take FY 2004 for instance, nearly half of the borrowings were exposed to interest rate volatility, yet there is a decreasing trend in this proportion. Until FY 2009 the percentage slumped to 18 percent, partly because of the Group cut part of foreign trade and imports after the Global Financial Crisis (Wesfarmers Limited Annual Report, 2009, 2004).
More specifically, interest rate swap contracts are listed below and the AUD and NZD dominate the notional currency. Three out of five interest rate swaps consist of changing floating rates to fixed rates, and these three swaps are denominated in AUD.
Source: Wesfarmers Limited Annual Report 2009 pg130.
Although Wesfarmers has issued US bonds, cross currency swaps are put in place, which removes most exposure to US interest rates. According to its cross currency interest rate swap contracts, the only instrument in this regard is fixed for floating rate swaps denominated in USD.
Source: Wesfarmers Limited Annual Report 2009 pg131.
5.2.2 Billabong
Billabong borrows money from overseas to make use of lower interest rates or more generous payment conditions. But, Billabong faces interest rate payment risk when it is obliged to receive and pay interest in foreign currency and is uncertain with the change of interest rate fluctuations. The Group has entered into interest rate swap contracts under which it is obliged to receive interest at variable rates and to pay interest at fixed rates. "At the balance date, the notional principal amount of the interest rate swap contracts covered 51% (2008: 74%, 2007: 9.3%, 2006: 12.6) of outstanding USD denominated cash advances "(Billabong International Limited, 2008 - 09/2007-2008/2006-2007/2005-2006). Details of the interest rate swap contracts will be analysed in part 7.2 and 7.3.
6 Comparison of Hedging Strategies
6.1 Introduction
Overall, both companies face significant exposure from foreign exchange risk and interest rate risk. The major difference being that Wesfarmers' overall exposure is much larger than Billabong's exposure due to the larger size of the operations. Although Billabong's overall foreign exchange risk exposure is smaller, it is derived from a number of different currencies. This is due to the fact that Billabong's revenues originate from multiple countries.
6.2 Foreign Exchange Risk Management
Billabong manages its foreign exchange risks via forward contracts. Its strategy is to hedge greater than 80% of forecasted foreign denominated inventory purchases for the upcoming season. Special considerations are being given to further hedging strategies following receipt of customer orders (Billabong International Limited Annual Report, 2009).
Wesfarmers' currency exposure mitigating strategy is localized borrowings - it requires all its divisions to hedge foreign exchange exposures for firm commitments relating to sales or purchases or when highly probable transactions have been identified. Before hedging, it takes into account its competitive position and its hedging instrument is always in the same currency as the hedged item. Its divisions are not permitted to speculate on future currency movements. The firm's policy is to hedge approximately 45% to 55% (over five years) of its foreign currency sales. For foreign currency purchases the aim is to hedge 70% to 100% (up to 12 months) of the exposure (Wesfarmers Limited Annual Report, 2009).
6.3 Interest Rate Risk Management
Billabong has no significant interest-bearing assets. Hence, its income and operating cash flows are largely independent of changes in market interest rates. As mentioned earlier, its interest rate risk arises from floating interest-based long-term borrowings. Therefore, the company applies floating-to-fixed interest rate swaps as its mitigating tool. The swap contracts convert interest on borrowings from floating rates to fixed rates. Overall, Billabong's exposure to interest rate risk was $355 million in 2009 (Billabong International Limited Annual Report, 2009).
Wesfarmers, on the other hand, has some significant interest-bearing financial assets which include, among others, investing activities in insurance and cash market. Furthermore, Wesfarmers issues US bonds, but cross currency swaps are still in place, which remove any exposure to US interest rates. These cross currency swaps ensure that the effective interest rate to Wesfarmers is referenced to Australian interest rates. Overall, Wesfarmers was exposed to interest rate risk from interest bearing loans and borrowings amounting to $831 million. At 30 June 2009, after taking into account the effect of interest rate swaps and other factors, approximately 18% (35% in 2008) of the firm's borrowings were exposed to movements in variable interest rates. In 2009 the value of Wesfarmers' outstanding interest rate swaps was $263 million (Wesfarmers Limited Annual Report, 2009).
6.4 Cost Associated With Hedging Strategies
Billabong's hedging costs mainly arise from entering into forward contracts and floating-to-fixed interest rate swaps. On the other hand, Wesfarmers' engages in local currency based borrowings to hedge. For this reason, the cost associated with this strategy is mainly subject to the higher lending interest rate fluctuations in the respective countries where it has operational bases. Wesfarmers also has costs associated with floating-to-fixed interest rate swaps.
6.5 Results in Terms of Profit
For Billabong, if the interest rates had changed by plus or minus 50 basis points - as at 30 June 2009 - from the year-end rates with all other variables held constant, post-tax profit for the year would have been $1.5 million lower or higher. The effect would have been insignificant on 2008 profit. Also, 2009 equity would have been $2.6 million lower or higher while 2008 would be $1.4 million lower or higher mainly as a result of a rise or fall in the fair value of the cash flow hedges as at 30 June 2009 (Billabong International Limited Annual Report, 2009). In opposition, for Wesfarmers, if the interest rates had changed by plus or minus 50 basis points - as at 30 June 2009 - with all the other conditions applicable as in the case of Billabong mentioned above, post-tax profit as well as equity for the year would have been drastically affected (Wesfarmers Limited Annual Report, 2009).
7 Current Hedging Strategy Analysis and Alternatives
7.1 Wesfarmers Hedging Strategy Analysis
In terms of hedging the transaction risk, the fluctuation in the exchange rate of US Dollar against the Australian Dollar is the treasury manager's main concern. Indeed, the sensitivity analysis included in the 2009 annual report suggested its profound impact on the Group's economic performance and prospects:
Source from: Wesfarmers 2009 Annual Report pg. 126
If the USD is going to appreciate relative the AUD, the Group's profit would shrink by AUD $6million and the equity would rise by two times as the percentage of the appreciation. On the contrary, profit would increase while the equity would decrease by AUD $55million.
It is not surprising to find out that Wesfarmers preferred forward contracts to futures and nearly all of big cross-board companies tend to stick to forwards as their hedging tool, although the payoff and rationale of these two derivatives are similar, and generally the standardisation stemming from futures contracts is the main reason for this phenomenon. As unpractical as futures contracts are in certain circumstances, its unique advantage of zero-default risk is worth mentioning. The margin call is put in place to ensure certain counterparty's capability to fulfil contracts, which can effectively reduce credit risk.
Another derivative playing an important role in hedging foreign exchange risks is options. It is mainly about taking a position in contingent events relative to foreign currency payables or receivables, which may affect the company's profit in the future. The flexibility that the options offer is the reason why multinational companies consider putting this instrument in place to hedge foreign exchange risk, although some believe that they are overpriced.
However, in the Wesfarmers context, the forward contracts have empirically outperformed options; therefore, the firm discarded option strategies after 2004. In order to compare the outcome from forward and option and illustrate the benefits and costs from these two derivatives, we firstly choose the USD-denominated receivables due on January 2013:
If we sell the foreign currency forward contracts, the agreed exchange rate would be AUD/USD=1.3639;
If we buy a European put option at July/02/2009, the strike price is determined at AUD/USD=1.5, spot rate is 1.2436, ius=0.25% (World Interest Table,2010), iaus=3% (Reserve Bank of Australia, 2010) and expired date is 31/Dec/2012, then the option premium is A$221,244,106.39 (OzForex Pty Ltd, 2010);
Thus, the result would be:
Table 1
Notwithstanding the high payoff of options, after deducting the premium, the ultimate value of foreign receivables by using options to hedge is obviously lower than that by using forward contracts. However, according to the previous analysis, the next question is: what if the inappropriate strike price or the option premium is the real cause of the low value? Hence, the following step is to change the strike price from 1.2 to 1.6, thereby changing the option premium, and the results also reveal Wesfarmers should be inclined to forward contracts.
Table 2
Most of the results are lower than A$1,274,837,330, which means that the forward contracts are better than the options. Nevertheless, in this analysis, the costs associated with forward contracts are ignored since the amount may be not material enough to influence the results.
In reality, it is impossible to expect the market remain the certain pattern for an extremely long time. Choosing the most appropriate derivative depends on the manager's personal skills, the ordinary course of business of the company engages in, the type of the risks and how severe the adverse impact would be if the risk is managed poorly, etc. However, application of the foreign exchange derivatives cannot ensure the company stay in the risk-free zone for the long-term horizon, simply because the market keeps changing (Huffman and Makar, 2003).
7.2 Billabong Hedging Strategy Analysis
Back to Financial Year (FY) 2005, Billabong used interest swap contracts and forward exchange contracts to hedge "exposure to fluctuations in interest and foreign exchange rates". (Billabong International Limited, 2005).
Overall the fair value of interest rate swap contracts increased gradually with time. Under the damages of the global finance crisis, Billabong was bound to spend more money on self protection. And the entity "covered 74% of outstanding USD denominated cash advances" by "notional principal amount of the interest rate swap contracts" successfully with using $1.5 million USD on swap (Billabong International Limited, 2008).
2005
2006
2007
2008
2009
2006
2007
2008
2009
Swap contracts are a costless strategy compared with other hedges but less liquid as well. These contracts could be suitable for long term hedging strategies. On the other hand, it leads to another risk - default risk (MightyStudents.com, 2010). Compare with FY 2003 and FY 2004, Billabong entered into forward contracts to purchase US Dollars, Euro and Australian Dollars but not only US Dollars since FY 2005. However, the hedging result is not always optimistic compared with swap contract results:
2005
2006
2007
2008
2009
Using forward contracts are a better way to avoid the standardization issue. In the OTC market, forwards are much more flexible than future contracts or option contracts.
However, when Billabong chose forward contracts to hedge, it gave up the potential profit in the future (Business link, 2010).
7.3 Alternative Recommendations for Billabong
Instead of using forwards to hedge foreign exchange risk, Billabong may consider currency options to hedge open risk exposures. Option contracts often provide full coverage against foreign currency risk (NASDAQ, 2010).
As a large multinational company, revenue for Billabong is denominated in various currencies, like AUD, USD, CAD, and NZD (Billabong International Limited, 2006). From the annual report we can clearly see that USD constitutes the largest proportion of total revenue (Billabong International Limited, 2007). Thus, to best hedge most exposures to the AUD, Billabong could purchase USD/CAD, USD/NZD, and USD/EUR options to hedge these risks first and then long USD/AUD option to hedge the outstanding amount after the first step hedge. This pattern of hedging will save a large number of costs.
Saving cost
8. Recommendations on Other Foreign Exchange Risk Strategies
8.1 Leading and Lagging
Firstly, the "leading and lagging" strategy provides an important rule of thumb for multinational entities: lead the payment and lag the receivables if the denominated currency is expected to appreciate relative to the domestic currency. The Wesfarmers Group is a big corporation with dozens of foreign currency denominated payables and receivables, thus this strategy may assist the risk manager in coping with unpredictable foreign exchange fluctuations. In comparison, as a single product retail company, Billabong may not choose this way of hedging.
8.2 Exposure Netting
Within the multinational corporations with a number of subsidiaries across the world, such as the Wesfarmers, exposure netting is a good way to reduce the risk as well because the reducing types of foreign currencies means reducing the exposure of the entire foreign exchange volatility. Moreover, the decentralized model is also applied by Wesfarmers Group, requiring the individual subsidiary to hedge its specific transaction risk in the division level. Billabong could also consider this hedging strategy.
8.3 Basket Options
Last but not least, similar to the traditional options, the basket options provide another perspective to the hedging strategies, which need to be taken into consideration by the treasury manager in the large companies. Furthermore, the Wesfarmers can shift, share or diversify its foreign exchange risk by negotiating the contract with specific currency of invoicing. This is a high-cost and complex method which does not match Billabong Group.
9 Conclusion
In conclusion, Billabong and Wesfarmers incur foreign exchange risks as a result of international cash flows such as transaction risk, interest rate risk, and debt repayment risk. The two firms have chosen to hedge these risks through a mixture of various financial instruments, mainly forwards and swaps. As demonstrated these hedging strategies are significantly beneficial for the firm in protecting profits and staying competitive. Also, recommended in this report is suggested consideration of options, exposure netting, leading and lagging, and basket options.
