Published: October 01, 2010
As the world’s largest package delivery company, distributing 15 million parcels and serving almost 8 million customers in more than 200 countries every day, UPS’ two most significant financial exposures are foreign exchange risk and commodity risk. As the business continues to expand overseas, our non-USD revenues continue to grow, so our foreign exchange hedging requirements also increase. Meanwhile, the nature of our business makes us a major user of fuel for both our aircraft fleet and our road vehicles, so we have a substantial and ongoing commodity exposure. Although we do hedge our interest rate to some degree, we have relatively little debt. As our business is closely tied to the economy, it is generally preferable for interest payments to be floating rate, so interest payments are highest when revenues are strongest.
Our risk management approach at UPS is conservative, so we aim to hedge 100% of our risk, although this is not always feasible in practice. On occasion, we seek to lower our premium expense, but we will not compromise our risk management objectives.
Our policy is to use options almost exclusively, as we value the flexibility they offer.
Consequently, we adopt a fairly conventional approach to our FX hedging. When hedging foreign exchange, for example, our International F&A Group first sets a budget rate based on the forward curve, from which it derives its P&L for the year. The exposure and budget rate information are passed to treasury to recommend hedges and advise on the cost of them, the aim being to protect the budget rate. At that point treasury works with International F&A and the CFO to determine the best course of action. Once a decision is made treasury is responsible for executing the hedges.
Our policy is to use options almost exclusively, as we value the flexibility they offer. We put in place collars, buying puts and selling out-of-the-money calls to finance the position. Ordinarily we purchase options at, or slightly out of the money, with the aim of achieving the budget rate as closely as possible. The call is then set based on the level of premium that we want to spend.
The global financial crisis has resulted in significantly higher levels of volatility than we saw in previous years. Our strategy for hedging the budget rate has been a challenge and we have needed to adapt our approach to risk management in the face of increased market uncertainty.
The scale of UPS’ hedging requirements and the scale of the financial risks involved, mean that an appropriate risk management tool is essential. We use a legacy treasury management system for our US treasury activities, which we are currently seeking to replace. However, this system does not cater either to our risk modelling requirements in treasury or our hedge accounting needs in our accounting group. In the past, we used spreadsheets to achieve both of these functions, but neither treasury nor accounting considered this a sufficiently robust solution in the light of Sarbanes-Oxley and the problems with retaining consistency and control of our spreadsheets, particularly as staffing changes over time. Therefore, we made the joint decision to implement Reval for FX hedging, which allows treasury to manage current debt and hedge exposures in a controlled environment, whilst also enabling the accounting group to automate the accounting process for our hedging transactions.
Typically, risks are considered in silos, but we have recognised that there are clear benefits to taking a combined view of risk across foreign exchange, commodities, interest rates and more. By doing so, we will be able to identify negative and positive correlations and assess how each impact the organisation, which is likely to result in a different approach to hedging. [[[PAGE]]]
There are three stages to achieving this. The first is to establish a clear understanding of our exposures. Given the scale of UPS’ operations and our long history of acquisitions, this is not a trivial exercise.
The second stage is to establish how to manage these exposures, which will involve combining our risks and performing Monte Carlo simulations to identify correlations.
The third stage is to use this information to determine how much risk we are willing to tolerate, which represents a significant change from our current approach of hedging against a budget rate. This will be a considerable undertaking for us, and of course, in the interim, as we transition towards that new approach, we will need to continue to operate our current hedging model. While this involves a lot of work in the short term, we believe that a move towards a new model is essential, and indeed we have seen at close hand examples of other corporates which have reaped the benefits of an integrated approach to risk, particularly during one of the toughest periods we have seen. By truly understanding risk, and the outcomes, in financial terms, the approach to hedging can be significantly different.
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