EADS is a company in aerospace industry that earns in euro but spends in dollar. This assignment is aimed to analyze its hedge situation and financial results thus make a decision for investment.

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Mo Sun, MSc AF, 2011/12

EADS is a company in aerospace industry that earns in euro but spends in dollar. This assignment is aimed to analyze its hedge situation and financial results thus make a decision for investment. Three sections as follows will illustrate the problem.

  1. Risk exposure

According to the registration document for EADS (2010:95), more than 60% of the revenue is US dollars with half naturally hedged by US dollar-dominated cost. The remainder cost is mainly incurred by euro. A strong US currency will benefit EADS a lot. Thus the main risk it exposed to is exchange rate risk and credit risk.

For the portion that is naturally hedged (nearly 30% of total revenue), the exchange gain or loss from revenue and cost will partially offset one another, there seems no risk.For the portion that is covered by cash flow hedge, it is protected by forward or option to transfer US dollar to euro at a fixed rate. On the one hand, the future price will fluctuate due to different maturity and size of contracts. Take recent two years as the example, revenue was accounted for at 1.35US$/€ in 2010, compared to 1.26 US$/€ in 2009. This led to nearly €1 billion (18.5/1.35-18.5/1.26=-1) decrease in EBIT from 2009 to 2010. An appreciation in euro against US dollar will make the financial result worse since after translation euro revenue will be less with the same amount of US revenue. On the other hand, the credit risk of its hedging counterparties is a problem deserves concerning. The company has witnessed a hedge rate deterioration as the unfavorable appreciation trend in euro against US dollar (registration document 2010:8). The non-performance of these counterparties will pressurize EADS to significant exchange rate risk again.

EADS’s cash flow hedge covers $18.5billion and $16.5billion revenues in 2010 and 2009 respectively. Without this hedge the difference in euro profit will be 0.1 billion (18.5/1.34-18.5/1.35=0.1) and -1.64 billion (16.5/1.44-16.5/1.26=-1.64). Hence the company can earn more without hedge in 2010. It can be concluded that EADS is a risk-averse company even with the sacrifice of earnings.

  1. Accounting for hedges

EADS use cash flow hedge and fair value method is used. When recognition, the one with positive value are recorded as financial asset and negative value recorded in financial liabilities.

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For subsequent measurement, the company needs to account for change in fair value. First of all, the effectiveness of the hedge needs to be determined. The effectiveness is defined as how much percentage change in underlying asset is covered by the change in derivative. According to IAS39, a range from 80% to 125% is regarded as effective. This portion is recorded in other comprehensive income to reflect marked to market price. Accordingly, the negative amount of €2,983 means the fair value of these financial instruments is decreased. Given the €45,442m sales forward contract, a hedge rate from 1.35US$/€ in 2010 to 1.26 US$/€ will result in -3,200 (45,442*1.34/1.35-45,442*1.34/1.26=-3,200) change in fair value of the contracts, which accounts for a large part of €2983. The effective portion is a hiding profit/loss that will be realized when forecasted sales happen. So -€201m net change in fair value of cash flow hedged is transferred to “profit or loss” when hedged transaction occurs in comprehensive income. The ineffective part is recorded in “profit and loss” in IS.

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For more than 60% (assume 65%) dollar-based revenue, half are naturally hedged, $18.5billion are instrument hedged and the rest ($1.5billion) is unhedged. The unhedged part will subject to exchange rate risk when translated at period end rate. Thus exchange gain/ loss will be accounted in “currency translation adjustment for foreign operations” in the comprehensive income. This effect is small for natural hedge since the exchange gain/loss will offset for cost and revenue, asset and liability.

  1. Ratio analysis

Ratio analysis will be carried out in the following two directions: time series analyses (compare 2009 with 2010) and cross ...

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