Currency Risk on Covenants

Stanley Myint and Fabrice Famery

Contents

Foreword

Introduction

1.

Theory and Practice of Corporate Risk Management

2.

Theory and Practice of Optimal Capital Structure

3.

Introduction to Funding and Capital Structure

4.

How to Obtain a Credit Rating

5.

Refinancing Risk and Optimal Debt Maturity

6.

Optimal Cash Position

7.

Optimal Leverage

8.

Introduction to Interest Rate and Inflation Risks

9.

How to Develop an Interest Rate Risk Management Policy

10.

How to Improve Your Fixed-Floating Mix and Duration

11.

Interest Rates: The Most Efficient Hedging Product

12.

Do You Need Inflation-linked Debt?

13.

Prehedging Interest Rate Risk

14.

Pension Fund Asset and Liability Management

15.

Introduction to Currency Risk

16.

How to Develop Currency Risk Management Policy

17.

Translation or Transaction: Netting Currency Risks

18.

Early Warning Signals

19.

How to Hedge High Carry Currencies

20.

Currency Risk on Covenants

21.

Optimal Currency Composition of Debt 1: Protect Book Value

22.

Optimal Currency Composition of Debt 2: Protect Leverage

23.

Cyclicality of Currencies and Use of Options to Manage Credit Utilisation

24.

Managing the Depegging Risk

25.

Currency Risk in Luxury Goods

26.

Introduction to Credit Risk

27.

Counterparty Risk Methodology

28.

Counterparty Risk Protection

29.

Optimal Deposit Composition

30.

Prehedging Credit Risk

31.

xVA Optimisation

32.

Introduction to M&A-related Risks

33.

Risk Management for M&A

34.

Deal-contingent Hedging

35.

Introduction to Commodity Risk

36.

Managing Commodity-linked Revenues and Currency Risk

37.

Managing Commodity-linked Costs and Currency Risk

38.

Commodity Input and Resulting Currency Risk

39.

Offsetting Carbon Emissions

40.

Introduction to Equity Risk

41.

Hedging Dilution Risk

42.

Hedging Deferred Compensation

43.

Stake-building

In this chapter, we return to the subject of financial constraints. One of the most important corporate constraints is financial leverage, commonly defined as total debt/EBITDA or net debt/EBITDA. Leverage is important as it impacts a company’s credit rating, cost of funding and sometimes is also explicitly restricted by loan covenants to not exceed a certain level.

There are three ways that leverage constraints can be endangered. The first is if the denominator, EBITDA, drops as a result of weaker business than originally envisaged. The second is if the debt rises due to higher funding needs. These two cases have to do with business risk, but the third one is the most interesting for us in the context of currency risk. If a significant part of EBITDA is in a foreign currency, EBITDA may fall, even though the underlying business is doing well, purely as a result of depreciation of the foreign currency against the reporting currency of the company. Similarly, if a part of debt is in a foreign currency, the overall debt will be impacted by currency fluctuations.

This kind of risk can be hedged against by matching the debt and assets by currency. For example, if a EUR company

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