You are here

Contingent Currency Risk in Tenders at ABB

Professor: 
Type: 
Master's Thesis
Corporate Partner: 
ABB Asea Brown Boveri Ltd
Date Published: 
October 1, 2013

Contingent currency risk arises when a company faces a potential future transaction in foreign currency of which is unknown whether it will happen or not. The typical example of a transaction with contingent currency risk is bidding for a tender in foreign currency. Compared to the transaction exposure, which arises from contracted transactions in foreign currency, the contingent exposure is much more difficult to hedge because the materialization of cash flows is uncertain. The standard approach proposed in the management literature and in business school textbooks to hedge contingent exposures is the use of options.
ABB as a multinational corporation with operations in approximately 100 countries submits many offers in foreign currency and as a result is confronted with contingent currency risk on a regular basis. However, this currency risk during the tender phases is not systematically monitored and managed. Whereas the transaction exposure is consistently hedged at the financial market, the hedging policy at ABB only allows the hedging of currency risk inherent to tenders in certain circumstances and requires special approval. In many cases, the business unit submitting a tender in foreign currency manages the currency risk during the tender phase with the inclusion of a currency fluctuation reserve. Yet, none of the guidelines at ABB specifies how such a fluctuation reserve must be calculated. As a result, a vast number of more or less sophisticated measures are used to calculate such currency fluctuation reserves.

The aim of this thesis is to analyze and quantify the currency risk during the tender phase at ABB for the period of 2011 – mid 2013. Data on submitted tenders from a risk review tool is used to estimate the foreign exchange exposure of tenders. Once the size of the exposure and the impacts from currency fluctuations is estimated, the most commonly suggested approach on how to handle it, the use of options, is simulated using a standard Black-Scholes option price model. Based on the option prices an alternative approach is derived: the calculation of currency fluctuation reserves based on option prices. The major advantage of a fluctuation reserve based on option prices is the fact that it includes all relevant information on the currency pair available to the financial market.

A multinational corporation of the size and scope of ABB faces a much diversified currency portfolio. As a result, on the group level, many positive and negative currency effects cancel each other out and the overall currency effect is not substantial. However, an individual project or business unit can experience significant currency moves with considerable impact on the profitability. Most exchange rate moves are around +/-2% but strong moves of up to -16% and +18% happen with statistical frequency. A business unit should therefore be interested in an approach to manage such currency risk. Purchasing put options for every submitted tender proves highly inefficient. First of all, the option strategy results in substantial cash outflow for the premiums. Second, the option strategy results in the purchase of many options without any underlying transaction and exposure. Because on average the option premiums are higher than the payout from the option, these option positions destroy value. Contingent currency risk can be managed much more efficiently with a consistent calculation of fluctuation reserves in combination with currency clauses. Calculating fluctuation reserves based on option prices protects the project value from the frequent but small changes in exchange rates. To protect against the less frequent but stronger moves currency clauses are required that allow for adjustments when the exchange rate moves outside a predefined range.

Due to the available data the study is limited by the fact that only the sales side exposure can be analyzed and all foreign exchange exposure on the purchase side has to be ignored. Further, no information on currency fluctuation reserves and currency clauses that are included in submitted offers is available. Analyzing the offsetting effects of the purchase side on the contingent currency risk during tenders, and a comparison of option price based fluctuation reserves with other approaches that were used, can be the basis for further studies.Contingent currency risk arises when a company faces a potential future transaction in foreign currency of which is unknown whether it will happen or not. The typical example of a transaction with contingent currency risk is bidding for a tender in foreign currency. Compared to the transaction exposure, which arises from contracted transactions in foreign currency, the contingent exposure is much more difficult to hedge because the materialization of cash flows is uncertain. The standard approach proposed in the management literature and in business school textbooks to hedge contingent exposures is the use of options.
ABB as a multinational corporation with operations in approximately 100 countries submits many offers in foreign currency and as a result is confronted with contingent currency risk on a regular basis. However, this currency risk during the tender phases is not systematically monitored and managed. Whereas the transaction exposure is consistently hedged at the financial market, the hedging policy at ABB only allows the hedging of currency risk inherent to tenders in certain circumstances and requires special approval. In many cases, the business unit submitting a tender in foreign currency manages the currency risk during the tender phase with the inclusion of a currency fluctuation reserve. Yet, none of the guidelines at ABB specifies how such a fluctuation reserve must be calculated. As a result, a vast number of more or less sophisticated measures are used to calculate such currency fluctuation reserves.

The aim of this thesis is to analyze and quantify the currency risk during the tender phase at ABB for the period of 2011 – mid 2013. Data on submitted tenders from a risk review tool is used to estimate the foreign exchange exposure of tenders. Once the size of the exposure and the impacts from currency fluctuations is estimated, the most commonly suggested approach on how to handle it, the use of options, is simulated using a standard Black-Scholes option price model. Based on the option prices an alternative approach is derived: the calculation of currency fluctuation reserves based on option prices. The major advantage of a fluctuation reserve based on option prices is the fact that it includes all relevant information on the currency pair available to the financial market.

A multinational corporation of the size and scope of ABB faces a much diversified currency portfolio. As a result, on the group level, many positive and negative currency effects cancel each other out and the overall currency effect is not substantial. However, an individual project or business unit can experience significant currency moves with considerable impact on the profitability. Most exchange rate moves are around +/-2% but strong moves of up to -16% and +18% happen with statistical frequency. A business unit should therefore be interested in an approach to manage such currency risk. Purchasing put options for every submitted tender proves highly inefficient. First of all, the option strategy results in substantial cash outflow for the premiums. Second, the option strategy results in the purchase of many options without any underlying transaction and exposure. Because on average the option premiums are higher than the payout from the option, these option positions destroy value. Contingent currency risk can be managed much more efficiently with a consistent calculation of fluctuation reserves in combination with currency clauses. Calculating fluctuation reserves based on option prices protects the project value from the frequent but small changes in exchange rates. To protect against the less frequent but stronger moves currency clauses are required that allow for adjustments when the exchange rate moves outside a predefined range.

Due to the available data the study is limited by the fact that only the sales side exposure can be analyzed and all foreign exchange exposure on the purchase side has to be ignored. Further, no information on currency fluctuation reserves and currency clauses that are included in submitted offers is available. Analyzing the offsetting effects of the purchase side on the contingent currency risk during tenders, and a comparison of option price based fluctuation reserves with other approaches that were used, can be the basis for further studies.Contingent currency risk arises when a company faces a potential future transaction in foreign currency of which is unknown whether it will happen or not. The typical example of a transaction with contingent currency risk is bidding for a tender in foreign currency. Compared to the transaction exposure, which arises from contracted transactions in foreign currency, the contingent exposure is much more difficult to hedge because the materialization of cash flows is uncertain. The standard approach proposed in the management literature and in business school textbooks to hedge contingent exposures is the use of options.
ABB as a multinational corporation with operations in approximately 100 countries submits many offers in foreign currency and as a result is confronted with contingent currency risk on a regular basis. However, this currency risk during the tender phases is not systematically monitored and managed. Whereas the transaction exposure is consistently hedged at the financial market, the hedging policy at ABB only allows the hedging of currency risk inherent to tenders in certain circumstances and requires special approval. In many cases, the business unit submitting a tender in foreign currency manages the currency risk during the tender phase with the inclusion of a currency fluctuation reserve. Yet, none of the guidelines at ABB specifies how such a fluctuation reserve must be calculated. As a result, a vast number of more or less sophisticated measures are used to calculate such currency fluctuation reserves.

The aim of this thesis is to analyze and quantify the currency risk during the tender phase at ABB for the period of 2011 – mid 2013. Data on submitted tenders from a risk review tool is used to estimate the foreign exchange exposure of tenders. Once the size of the exposure and the impacts from currency fluctuations is estimated, the most commonly suggested approach on how to handle it, the use of options, is simulated using a standard Black-Scholes option price model. Based on the option prices an alternative approach is derived: the calculation of currency fluctuation reserves based on option prices. The major advantage of a fluctuation reserve based on option prices is the fact that it includes all relevant information on the currency pair available to the financial market.

A multinational corporation of the size and scope of ABB faces a much diversified currency portfolio. As a result, on the group level, many positive and negative currency effects cancel each other out and the overall currency effect is not substantial. However, an individual project or business unit can experience significant currency moves with considerable impact on the profitability. Most exchange rate moves are around +/-2% but strong moves of up to -16% and +18% happen with statistical frequency. A business unit should therefore be interested in an approach to manage such currency risk. Purchasing put options for every submitted tender proves highly inefficient. First of all, the option strategy results in substantial cash outflow for the premiums. Second, the option strategy results in the purchase of many options without any underlying transaction and exposure. Because on average the option premiums are higher than the payout from the option, these option positions destroy value. Contingent currency risk can be managed much more efficiently with a consistent calculation of fluctuation reserves in combination with currency clauses. Calculating fluctuation reserves based on option prices protects the project value from the frequent but small changes in exchange rates. To protect against the less frequent but stronger moves currency clauses are required that allow for adjustments when the exchange rate moves outside a predefined range.

Due to the available data the study is limited by the fact that only the sales side exposure can be analyzed and all foreign exchange exposure on the purchase side has to be ignored. Further, no information on currency fluctuation reserves and currency clauses that are included in submitted offers is available. Analyzing the offsetting effects of the purchase side on the contingent currency risk during tenders, and a comparison of option price based fluctuation reserves with other approaches that were used, can be the basis for further studies.Contingent currency risk arises when a company faces a potential future transaction in foreign currency of which is unknown whether it will happen or not. The typical example of a transaction with contingent currency risk is bidding for a tender in foreign currency. Compared to the transaction exposure, which arises from contracted transactions in foreign currency, the contingent exposure is much more difficult to hedge because the materialization of cash flows is uncertain. The standard approach proposed in the management literature and in business school textbooks to hedge contingent exposures is the use of options.
ABB as a multinational corporation with operations in approximately 100 countries submits many offers in foreign currency and as a result is confronted with contingent currency risk on a regular basis. However, this currency risk during the tender phases is not systematically monitored and managed. Whereas the transaction exposure is consistently hedged at the financial market, the hedging policy at ABB only allows the hedging of currency risk inherent to tenders in certain circumstances and requires special approval. In many cases, the business unit submitting a tender in foreign currency manages the currency risk during the tender phase with the inclusion of a currency fluctuation reserve. Yet, none of the guidelines at ABB specifies how such a fluctuation reserve must be calculated. As a result, a vast number of more or less sophisticated measures are used to calculate such currency fluctuation reserves.

The aim of this thesis is to analyze and quantify the currency risk during the tender phase at ABB for the period of 2011 – mid 2013. Data on submitted tenders from a risk review tool is used to estimate the foreign exchange exposure of tenders. Once the size of the exposure and the impacts from currency fluctuations is estimated, the most commonly suggested approach on how to handle it, the use of options, is simulated using a standard Black-Scholes option price model. Based on the option prices an alternative approach is derived: the calculation of currency fluctuation reserves based on option prices. The major advantage of a fluctuation reserve based on option prices is the fact that it includes all relevant information on the currency pair available to the financial market.

A multinational corporation of the size and scope of ABB faces a much diversified currency portfolio. As a result, on the group level, many positive and negative currency effects cancel each other out and the overall currency effect is not substantial. However, an individual project or business unit can experience significant currency moves with considerable impact on the profitability. Most exchange rate moves are around +/-2% but strong moves of up to -16% and +18% happen with statistical frequency. A business unit should therefore be interested in an approach to manage such currency risk. Purchasing put options for every submitted tender proves highly inefficient. First of all, the option strategy results in substantial cash outflow for the premiums. Second, the option strategy results in the purchase of many options without any underlying transaction and exposure. Because on average the option premiums are higher than the payout from the option, these option positions destroy value. Contingent currency risk can be managed much more efficiently with a consistent calculation of fluctuation reserves in combination with currency clauses. Calculating fluctuation reserves based on option prices protects the project value from the frequent but small changes in exchange rates. To protect against the less frequent but stronger moves currency clauses are required that allow for adjustments when the exchange rate moves outside a predefined range.

Due to the available data the study is limited by the fact that only the sales side exposure can be analyzed and all foreign exchange exposure on the purchase side has to be ignored. Further, no information on currency fluctuation reserves and currency clauses that are included in submitted offers is available. Analyzing the offsetting effects of the purchase side on the contingent currency risk during tenders, and a comparison of option price based fluctuation reserves with other approaches that were used, can be the basis for further studies.