Hedging Foreign Exchange Risk Case Study

Increasing the Effectiveness of Hedging Interest Rate and Foreign Exchange Risks


McDonald's Corporation (McDonald's) is the world's leading and best known global food-service retailer, with nearly 29,000 restaurants in more than 120 countries. In 1967, McDonald's opened its first foreign country franchise in Canada. Today, more than 65% of total revenue is derived internationally, as more and more restaurants are opened in countries outside the United States, increasing McDonald's foreign exchange and interest rate risks. McDonald's Treasury is challenged with managing these risks. This is no small task, as hedging the interest rate and foreign exchange risks for operations based in foreign countries is complex.

McDonald's Treasury is divided into four areas – Cash Management, Financial Markets, Domestic Finance, and International Finance. The Cash Management team takes care of the administration and back office duties of the treasury, while the Domestic Finance and International Finance areas manage the banking relationships for McDonald's Corporation, franchisees, and suppliers.

The Financial Markets group is responsible for hedging the balance sheet and income statement against foreign exchange and interest rate risks, while funding the growth of global operations They often fund assets locally, but in many markets this is challenging. The assets are funded by more than $8 billion in debt, with over 50% of the debt denominated in a foreign currency. McDonald's uses swaps and options in managing their financial risks.


Brian Moore, Manager of Financial Markets at McDonald's, identified a need to further increase the effectiveness of the interest rate and foreign exchange hedging programs. He and his team wanted to implement a leading-edge solution that would help achieve this goal while containing costs. They also needed to maintain consistency with the long-standing risk management policy requiring Treasury to be able to price and manage every derivative they transact. To maximize the hedge coverage while minimizing the hedge cost, Brian Moore and Darin Aprati, Foreign Exchange Manager at McDonald's, used basket option strategies to hedge their interest rate and foreign exchange risks. A basket option is an option whose payoff depends on the value of a portfolio (or basket) of assets.

McDonald's was looking for an upgrade in technology to help the Treasury build the currency basket option, so the search began...


McDonald's hedges their interest rate and foreign exchange exposures, which are made up of foreign income and assets and their domestic and foreign debt portfolio, by using the following approaches:

  • Qualitative Analysis – uses the underlying economic fundamentals for each country, and the currency is analyzed to determine when it is necessary to hedge.
  • Quantitative Analysis – relies on mathematical models to analyze assets vs. liabilities implies using different weightings of different baskets. Much of this is done using random scenario simulations, however, McDonald's needed tools to measure hedge effectiveness.

McDonald's evaluated several system-based software solutions to evaluate hedge effectiveness, but they lacked the flexibility and the analytical coverage needed to price many of the complex derivatives. "Big systems lack flexibility and functionality, plus they are harder to link to market data," stated Aprati. "The technology just didn't exist to do what we needed," he added.

In 1996, Moore and Aprati chose FINCAD's Microsoft® Excel based financial engineering software as a pricing tool. FINCAD Analytics Suite for Excel allows McDonald's to price their derivatives portfolio, enabling them to work more efficiently with instruments such as basket, average rate and double average rate options. These exotic currency options allow them to hedge their exposures in a more cost-effective manner.

McDonald's can now run simulations in Microsoft Excel to test the effectiveness of their hedges. When they are dealing with exotic option models, they can easily confirm that they match the risks that are being hedged.

McDonald's also uses FINCAD Analytics to analyze their portfolio of interest rate swaps, currency swaps, and swaptions. "Being able to work with both foreign exchange and interest rates in the same software environment has reduced the learning curve it takes to value instruments," Moore states. "FINCAD Analytics works with just about everything we do," Moore added.

Moore and Aprati built spreadsheet templates for these instruments and linked them to live market data from Reuters® and Bloomberg®. This enables them to calculate mark-to-market values in real time.

"In implementing the solution, the FINCAD support staff was very responsive in meeting McDonald's needs for financial instrument valuation," stated Aprati. "FINCAD proactively incorporated an option function into their software before we even requested it, which saved us a lot of time," Aprati adds. FINCAD listens to its customers and continues to improve its product based on user feedback and industry trends.


As part of their hedging technology solution, the Financial Markets Group uses Reuters and Bloomberg live data feeds to retrieve current & historical interest rates and foreign exchange data. They use the curve building, swap, and option pricing tools in FINCAD Analytics. The team uses PC based solutions generally, though they also have a deal capture system to handle the fixed income portfolio. At trade time they use FINCAD to confirm pricing using real-time data.

Pharmaceutical giant Pfizer makes most of its money abroad these days, so its operations are exposed to significant currency risk. Such exposure has taken some other multinationals by surprise, as evidenced in sizable hits to earnings.

Yet Pfizer's results suggest that it is effective at actively hedging its currency risk.

In this year's first quarter, ended March 30, 2014, Pfizer CFO Frank D'Amelio told analysts that foreign currency had a 3 percent negative impact on the company's revenues, reducing them by US$364 million.

"We don't hedge currency risk because we can; when we hedge, we do it because it's a conscious decision within a properly designed program."

But FX had a net positive impact of US$195 million on the aggregate of the company's adjusted cost of sales, overhead and R&D expenses. As a result, foreign exchange negatively impacted first-quarter adjusted diluted EPS by approximately US$0.01, compared with the same quarter a year ago.

That’s not bad at all. The consultancy FiREapps says a penny or less impact of FX on EPS is the benchmark for best practices in managing currency risk, based on a recent survey of corporate treasurers.

No tweaking

How exactly Pfizer goes about managing its FX exposure isn't easy to tell. FiREapps declined to comment on that, citing its confidentiality agreement with the company.

But in a webinar FiREapps held in March in the US, the pharmaceutical company's assistant treasurer, Amit Singh, said that Pfizer managed its currency risk by netting all its exposures.

Said Singh: “Given increased globalization, increased currency volatility and increased corporate complexity, we have to look at currency exposure on a portfolio basis.”

Singh noted that the company doesn't care how deeply it is exposed to any particular currency. "Our approach is risk mitigation. We're agnostic to currency levels; we have programs in place that we try not to tweak in response to the most recent swing."

Scenario analysis

What that means in practice is that Pfizer uses financial instruments, mainly currency swaps and forward contracts, to hedge risk that isn't offset by operational, or "natural," means.

Tellingly, given the recent increase in value of the dollar against other currencies, especially the euro, Japanese yen, Australian dollar and Brazilian real, the hit from FX to Pfizer's net income before allocation to non-controlling interests fell to US$535 million in 2013, down from US$811 million in 2012.

Meanwhile, the value of Pfizer's foreign currency swaps in a receivable position soared to US$871 million in 2013 from $US194 million the year before, while the value of its FX swap liabilities fell from US$428 million to US$110 million. (Its forward contracts showed much smaller changes in value.)

That suggests that the company either saw huge moves by its underlying currency exposures or that it took big speculative positions last year.

Yet none of the company's hedging activities in 2013 were deemed "ineffective" for purposes of the accounting rule known as FAS 133, which means none of the changes in the value of its derivatives showed up in earnings.

Too, the company noted in its most recent 10K filing with the US Securities and Exchange Commission that, according to a scenario analysis it had run, if the dollar had appreciated by 10% against all other currencies by the end of 2013, it would have had no significant impact on its financial results.

Effective hedging

None of this surprises Charles Mulford, an accounting professor at the Georgia Institute of Technology. After examining Pfizer's 10K, Mulford communicated his observation in an email to FierceCFO: "Either they have few such FX gains and losses, or the ones they have are being hedged effectively."

As Singh put it during the FiREapps seminar: "We don't hedge currency risk because we can; when we hedge, we do it because it's a conscious decision within a properly designed program."

Food for thought for other CFOs and treasurers grappling with the unsettled state of today’s foreign exchange markets.

About the Author

Ronald Fink is Editor of FierceCFOin the US, a sister publication of CFO Innovation. Click here to sign up for the FierceCFOnewsletter.

Photo credit: Shutterstock

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