Northwind Chemical: Sizing an FX Hedge When the Bank Behind It Gets Downgraded
Northwind Chemical sells EUR 60 million annually into the Eurozone and incurs EUR 22 million of euro-denominated operating costs. The budget rate is 1.08; spot has moved to 1.12. EBITDA is $12 million. In Q3 the company will pay EUR 15 million for a machine from an Italian supplier under a signed, non-cancellable contract. A EUR 10 million intercompany loan to the German subsidiary matures in three years. Policy: hedge 50-80% of forecast net exposure on a rolling 12-month basis using forwards; no naked options; minimum counterparty rating A- at inception. The relationship bank was downgraded to BBB+ last week and holds forwards with $4 million of positive mark-to-market exposure to Northwind.
1. Compute the net exposure and recommend a hedge ratio and instrument set. What does a move to 1.02 cost?
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Exposure ladder - do not add the items blindly.
| Item | Amount | Treatment |
|---|---|---|
| Euro revenue | EUR 60M | Forecast exposure, 12 months rolling |
| Euro operating cost | (EUR 22M) | Natural hedge |
| Net operating | EUR 38M | Hedgeable under policy |
| Capex commitment | EUR 15M | Firm commitment, Q3 - hedgeable, likely cash flow hedge candidate |
| Intercompany loan | EUR 10M | Balance sheet / net investment exposure - different instrument and designation |
Sensitivity: EUR 38M at 1.12 = $42.56M; at 1.02 = $38.76M. A 10-cent move costs $3.8M, or 32% of EBITDA. That magnitude justifies hedging at the top of the policy band, not the bottom.
Recommendation: hedge 70-80% of the EUR 38M net operating exposure (EUR 26.6-30.4M) using layered monthly forwards so no single execution date sets the rate; hedge the EUR 15M capex near 100% with a forward matched to the payment date and designate it as a cash flow hedge with documentation at inception; treat the EUR 10M intercompany loan separately - either a net investment hedge (if the subsidiary's functional currency is EUR and the loan is long-term in substance) or leave it unhedged as accounting exposure. At 70%, the program protects ~$2.66M of the $3.8M move.
2. What do you do about the downgraded counterparty, and what governance follows?
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First, read the policy precisely. Most policies say "A- at inception," which grandfathers existing trades; some say "A- at all times," which forces action. That distinction determines whether this is a documentation exercise or a live unwind.
Then quantify the actual exposure. The relevant number is notional for credit-limit monitoring but positive mark-to-market for loss-given-default. With $4M of positive MTM, an uncollateralized default scenario is a real but bounded loss; the cost of novating four to eight months of forwards early may exceed the credit risk.
Options, in order of preference:
- Confirm whether the ISDA has a Credit Support Annex - if so, the downgrade may trigger a collateral threshold change that already mitigates the exposure.
- Stop adding new trades with the bank; direct new flow to A- or better counterparties.
- Split the forward book so no single bank exceeds a stated percentage of notional.
- Novate or compress offsetting trades to reduce gross notional.
- If unwinding, cost the bid-offer and breakage explicitly and compare to expected loss.
Governance: any deviation from policy requires a documented, time-limited exception approved by the treasury risk committee, with the rationale, the mitigating actions, and a review date. This is exactly the situation where the process is being tested - approving an exception informally because the bank is a long-standing relationship is the failure mode. Report to the audit committee at the next meeting and update the policy to specify "at inception" vs. "ongoing" and collateral requirements.
3. Sales proposes passing the FX move to customers through price increases instead of hedging. How do you evaluate that?
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It is a complement, not a substitute - and it is slower and less complete than the numbers suggest.
Test it against three realities:
- Timing. Contract cycles and customer notice periods mean price changes land 6-12 months after the FX move. In the interim the exposure is unhedged and the full $3.8M hits EBITDA.
- Pass-through rate. Unless the company has pricing power, only part of the move sticks. Ask sales for the realized pass-through from the last 10% currency move; assume 40-60% unless evidence says otherwise.
- Competitive position. European competitors priced in euros are unaffected by the USD/EUR rate; a price increase may simply hand them volume. Local competitors may be the binding constraint, not the customer's willingness.
The decision: hedge the near-term exposure (0-12 months) regardless, because pricing cannot respond fast enough; use price increases over the medium term to reset the structural rate. The two are not alternatives on the same timeline.
Also flag the accounting and behavioural trap: if price increases are counted as "the hedge," treasury loses the discipline of a measured hedge ratio, and FX losses get re-labelled as margin problems. Track realized pass-through as a KPI and review the hedge ratio quarterly against it.