Zanders goes back to school
Appropriate FX management strategy considering the new risk environment
Bertold Walther: “Liam and Sebastian had a very fast understanding of our problem. Within a few sessions, we have been able to set up a hedging policy. Which was the goal of our collaboration”.
The École Polytechnique Fédérale de Lausanne (EPFL) is one of two Swiss Federal Institutes of Technology. The university is ranked Europe’s number one and the world’s 20th in the field of Engineering, Technology and Computer Sciences in the academic ranking of universities.
Bertold Walther, head of finance at EPFL, and treasurer Nicolas Shelton are responsible for finance and treasury, which includes the managing of FX exposure of all the research projects conducted by the university’s researchers and principal investigators. This exposure principally materializes from receiving funds from the European Commission in euros, yet having to distribute Swiss francs to the researchers.
Over the past couple of years, the number of research projects EPFL has undertaken has increased twofold, foreign exchange volatility has risen dramatically (especially in EUR/CHF) and EPFL’s internal budgeting structure has changed significantly. All these factors affected EPFL’s underlying FX exposure a great deal and were the stimuli for the university to seek some support and guidance from Zanders with regard to devising a more suitable FX management strategy considering the new risk environment EPFL found itself in. From a policy and governance standpoint there also now needed to be an alignment with the new risks and the new environment.
Enhancing existing policy
Considering EPFL’s existing financial policy, a specific FX policy framework was devised which would easily supplement it. We incorporated typical components such as the risk appetite of the university, the various roles and responsibilities, risk descriptions, approved derivatives list and a delegation of authority matrix. A key point discussed at length was that of limits and how to calculate appropriate levels.
Universities such as EPFL have neither the treasury resources nor the risks which necessitate round-the-clock, detailed risk analyses such as VaR models. Sensitivity analysis on the other hand is easily set-up (see Fig. 1 ) and can be reproduced quickly and without too much reliance on systems and data input. At a later stage, it might make sense to introduce measures such as VaR or Expected Shortfall.
Additionally, Zanders supported EPFL in drafting an addendum for the Credit Risk Policy, encompassing financial counter party limits, diversification rules, netting agreements and other risk mitigating tools.
“The discussion of options has been traditionally a sensitive discussion.”
Developing a suitable Fx strategy
EPFL receive funding from two main sources, a US source and the European Commission. The US dollar funding is about 15% of total funding and is relatively straightforward. The euro funding on the other hand is slightly more complex.
EPFL is regularly granted funding from the European Commission for research projects. The funding of these grants are made over the whole life of the project, typically up to five years and mostly in euro, whereas direct and indirect costs typically occur in Swiss francs, resulting in an FX risk for EPFL. Although this is a standard risk for many of Zanders’ clients, this FX exposure was slightly more complex due to the settlement conditions of such grants enforced by the EC.
Universities applying for these types of grants are obliged to submit a budget forecast outlining the expenditure plans for the funds. These budget plans are the basis of selection by the EC of where to distribute the available funds. Therefore, if successful in obtaining funding, the university lives in hope of a stable FX rate! Upon payment of the grant tranches, the spot rate after the reporting date is used to calculate the amount paid rather than any prearranged budget rate. This means that while a project may be to budget in Swiss franc, the benefit of aggregate under-spend in euro terms due to a weakening franc does not benefit the university, whereas aggregate over-spend because of a strengthening franc is not reimbursable by the EC. A Catch-22 situation!
For the common symmetrical exposures such as EPFL’s US dollar exposure, forward contracts are a viable hedging instrument to use and these traditionally compare well with options. However, for the asymmetrical exposures such as EPFL’s euro exposure (outlined above), forward contracts are useless after a point. With FX options, however, EPFL are able to hedge their asymmetric euro exposure more effectively. The discussion of options in the corporate (and university) environment has been traditionally a sensitive discussion. However, with due care and an appropriate structured and controlled process, options might be a perfect and effective way to hedge FX exposure.