According to an article published on Bloomberg
, the family-owned Italian company Cimolai, specialised in metallic structures and involved in the Qatar Stadium, is facing heavy losses from FX derivatives positions to the point they may need to raise fresh capital. The FX derivative in question are reported to be a TARF (TArget Redemption Forwards) and is said to be under water due to the fall of the EURUSD. How could that happen ?
For a Euro based company carrying out international operations bringing net cash flows in US dollars, it is a natural decision to hedge that FX exposure, namely to hedge against a fall of USD versus Euro.
For the sake of our analysis, let’s say we are in January 2021 when EURUSD = 1.21 and and the Euro-based company entered into a project that is going to bring USD cash flows of $20mio per month for the next 24 months. A first solution would be to enter into a strip of 24 forwards buyer on EURUSD. That trade would have zero cost upfront and fix an average exchange rate around say 1.20. Each month the company would then receive the $20mio from their operations and convert them at the predetermined fixed rate 1.20, irrespective of the prevailing market exchange rate thanks to the forward contract. The company would then be totally hedged against the variation of FX rates.
But then comes greed…
and someone comes and suggests a “much better deal” : the TARF. Sill at zero cost upfront, the bank will offer a better guaranteed FX rate for the next 24 months, say 1.15 (instead of the previous 1.20). So each month, the company will convert the $20mio at the preferred rate, which will boost profits further ! If the EURUSD rate stays above the preferred rate, the generated extraprofits are capped at a certain level (the Target) and as soon as those pre-agreed extra profits are reached, the trade automatically stops, that is the good scenario for the company. But such a preferred rate does not come for free… if the prevailing FX rate falls under the preferred rate 1.15, then the notional of the forwards increases from $20mio to say $40mio, and that ‘s when the so-called hedge transforms itself into a bet.
What happens if EURUSD falls to 1.10 (March 22) ? For that month the company will get $20mio from their operations, but the TARF will impose them to sell $40mio at the agreed rate of 1.15. How to sell $40million when you only get $20mio from your operations? Well you call your treasury so they wire you 18.2 million euros that you then convert at the market rate (1.10) into 20 million dollars. The TARF imposes you convert those 20millions at 1.15, which gives you back 17.4million euros, which you can give back to your treasury. The treasury just lost 800k for that month… If one month EURUSD falls to 1.05 (May 2022), the loss of the month becomes 1.6 millions …. And on a month where EURUSD falls to 1.00 (August 2022), the loss amounts to 2.4 millions. Very quickly the losses accumulate every month, and a situation that should be favourable to the company (It is “good” for a European company that makes fixed money in USD if EURUSD falls) becomes a catastrophic scenario.
Mutatis mutandis, this is probably what happened to Cimolai. How could they believe that they would enjoy an off market forward rate without taking extra risks ? How could a leveraged TARF be offered to them as a hedging instrument?
TARF are leveraged speculative instruments, there is nothing bad about them but they are not meant to be hedges.
“Greed is bad”