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Capital Markets

Huntington National Bank Currency Risk Management Managing Foreign Exchange Exposure Gabriel Gigliello SVP, Sales Manager Huntington Bank gabriel.gigliello@huntington.com 800-824-5653 May 19, 2011. 1. Capital Markets. Agenda. Market Update Types of Foreign Exchange Risk

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Capital Markets

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  1. Huntington National Bank Currency Risk Management Managing Foreign Exchange Exposure Gabriel Gigliello SVP, Sales Manager Huntington Bank gabriel.gigliello@huntington.com 800-824-5653 May 19, 2011 1 Capital Markets

  2. Agenda • Market Update • Types of Foreign Exchange Risk • Methods of Evaluating Risk • The Risk Management Process • Case Study: Hedging Strategies 2 Capital Markets

  3. Market Update 3 Capital Markets

  4. Market Update • What’s driving Foreign Exchange rates? • Central Bank forecasts • Inflation readings • Commodity Prices • Risk On/Risk Off • The Federal Reserve and a weaker USD • Quantitative Easing and QE2 • FOMC monetary policy and “extended period” language • Debt issues for Europe in a rising rate environment • PIGS and austerity measures • European Central Bank quandary “inflation or growth” 4 Capital Markets

  5. Market Update • China Appreciation, inflation and growth • US China strategic and economic dialogue • No longer the worlds Low Cost Producer • Increasing Domestic Demand • Emerging markets and imported inflation • Energy prices taking a toll on profits • Central Bank actions • Regional concerns over PBOC actions 5 Capital Markets

  6. Forecast 6 Capital Markets

  7. Exchange Rate Volatility 7 Capital Markets

  8. Types of Foreign Exchange Risk 8 Capital Markets

  9. Risk Management • Financial Risk • The chance for a gain or loss due to price changes in the financial markets. • Financial risks are peripheral to the central business in which companies operate. • Differs from Business Risk, or the chance of incurring a gain/loss as a result of operating a business in a certain industry or environment. • In the context of foreign exchange, financial risk management refers to identifying and measuring the currency risk that a business is exposed to and then balancing it against the company’s appetite for that risk and the tools available for managing that risk. • A firm should actively manage its financial risk to its own level of tolerance – a decision to do nothing is a financial risk decision. 9 Capital Markets

  10. Foreign Exchange Risk • Foreign Exchange Risk: The chance for a gain or loss resulting from changes in exchange rates. • Primarily created by import purchases and export sales • Also created by international (foreign currency denominated) assets and liabilities and by international inter-company transactions such as loans, dividends, royalties, franchise & license fees • Accompanies international acquisitions and divestiture • There are two categories of Foreign Exchange Risk: • Transaction Risk • Translation Risk 10 Capital Markets

  11. Transaction Risk • The US dollar equivalent of international transactions denominated in a foreign currency will change as the exchange rate changes • Includes forecasted and booked transactions • Accounts Payable • Accounts Receivable • Foreign Currency Denominated Debt/Inter-company debt • Capital Equipment Purchases • Transactions that may occur in the future, such as being awarded a contract • Declared Dividends • Foreign Interest Payments • A cash flow risk • Gains and losses impact income statement 11 Capital Markets

  12. Translation Risk • The risk that a company’s net assets or income will change in value as a result of exchange rate changes. Sometimes referred to as accounting exposure. • Balance Sheet Exposures occur when consolidating overseas (non-US dollar) net asset position with those of the parent company. • Balance sheet items consolidated at period end rates • Gains and losses impact equity • Income Statement Exposure occurs when consolidating overseas earning (non-US dollar) with the income of the parent company. • Income Statement items consolidated at a period average exchange rate • A non-cash risk 12 Capital Markets

  13. Natural Hedging Strategies • Businesses may create natural hedges of their currency exposure • Location of plants • Geographic sourcing of inputs • Local currency debt • Key Considerations • Effective for long-term foreign currency exposures and cash flows • Less flexible than financial hedges • Economies of scale, distribution costs, costs of changing • Effective when hedging net investment in foreign operations • Foreign currency debt, or a “short position” created with derivatives 13 Capital Markets

  14. Methods of Evaluating Risk 14 Capital Markets

  15. VaR – the Value-At-Risk Model • VaR is one procedure used for estimating the probability of portfolio losses exceeding some specified proportion based on a statistical analysis of historical market price trends and price volatility. • Volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a period of time. Volatility is also a variable in option pricing formulas that denotes the extent to which the return of the underlying asset will fluctuate between now and the expiration of the option. • Key Concept: Historical vs. Implied Volatility • Historical Volatility • The past standard deviation of a security that is used in security analysis. Standard deviation measures the changes in the past price of a security the higher the standard deviation the more volatile the security. • The idea behind looking at historical volatility in security analysis is that it provides a measure of the future volatility of the security. For example, if the historical volatility of a security was high, meaning that the price varied a great deal over a period of time, then it might continue this volatility into the future. • Implied Volatility • The estimated volatility of a security’s price over a given time period. • In addition to known factors such as market price, interested rate movement, expiration date, and strike price, implied volatility is used in calculating an option’s premium. IV can be derived from a model such as the Black-Scholes Model. 15 Capital Markets

  16. Market Risk Factors 16 Capital Markets

  17. Implied Volatility 17 Capital Markets

  18. Risk Management Process 18 Capital Markets

  19. Risk Management Process Step 1 Formulate Risk Management Policy Step 2 Identify Exposures Step 3 Determine Budget Rates Step 4 Formulate Hedging Strategies Step 5 Execute Hedging Strategy Step 6 Evaluate Hedge Performance (back to Step 2) 19 Capital Markets

  20. Case StudyHedging a Foreign Acquisition 20 Capital Markets

  21. Case Study – Situation Overview • ABC Industries, a U.S. leading manufacturer of electrical components, recently agreed to acquire their largest competitor in the U.K. – XYZ Electronics. • Under the terms of the deal, ABC will pay 10 million pound sterling (GBP) in cash to acquire XYZ. ABC has budgeted a purchase price of $17,000,000 million. • The acquisition is expected to close in two months subject to due diligence. 21 Capital Markets

  22. Case Study – ABC’s Objectives • Guaranteed protection. Establish a known worst-case USD cost for acquiring XYZ. • Cost-effective. Minimize up-front costs to hedge acquisition. • Upside potential. Retain ability to benefit if the GBP subsequently weakens against the USD. • Minimize breakage costs. Minimize potential liability in the event acquisition does not go through and hedges must be unwound. • Simplicity. Must be easy to explain to board and senior management. 22 Capital Markets

  23. Case Study – Hedging Strategies • Currency Option Establishes a Known Worst-Case Rate But Retains Upside Potential • ABC can enter into a collar to establish a worst-case (cap) and best-case (floor) exchange rate for purchasing GBP. • Collar can be as wide or as narrow as you wish depending on your risk tolerance. • Collar usually will be centered around current forward rate. • Can be structured with no up-front fee. • Protects against any strengthening of the GBP above the cap rate. • You retain upside potential associated with a weakening of the GBP down to the floor rate. 23 Capital Markets

  24. Case Study – Summary of Hedging Alternatives 24 Capital Markets

  25. Case Study – Indicative Pricing Strategy: Forward 1.6360 1.6348 GBP Call / USD Put $240,000 1.6675 GBP Call / USD Put $107,000 Zero-cost collar 1.6530-1.6110 25 Capital Markets

  26. Case Study - Graph 26 Capital Markets

  27. Case Study - Outcome • ABC entered into a collar option • Limited liability 27 Capital Markets

  28. Foreign Exchange Contracts 28 Capital Markets

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