Global firms sharpen currency hedging on euro concern DAVOS, Switzerland (Reuters) - International firms are spending more time at the highest levels discussing how to hedge currency risk, particularly euro-denominated earnings and transactions, in readiness for a worst case scenario of a euro zone breakup. Companies are scrutinizing the inbuilt protections in their hedge contracts and robustness of the settlement process if the euro were to collapse, bankers and executives said in interviews leading up to and during the World Economic Forum in Davos. "Any CFO or any CEO of a company today, much like in the late 70s, is spending more time thinking about alternate outcomes," said Vasant Prabhu, chief financial officer of U.S. hotel operator Starwood Hotels & Resorts Worldwide Inc (HOT.N). And currencies clearly are an element of that right now. The implied volatility on 1-year euro/dollar contracts, a guide to future price direction in the spot currency market, has come down from the highs of October/November. But companies remain worried about future swings and the impact on earnings and acquisitions. Firms are increasingly turning to tools such as currency options -- which give them the right but not the obligation to buy or sell a currency at a particular exchange rate - to protect against extreme volatility. They are also trying to maximize ways of naturally hedging their exposure by trying to match assets and liabilities in a particular currency. "There are more questions that are raised now -- questions that were never raised before are now coming to the surface," said Marc Zenner, co-head of Corporate Finance Advisory at JPMorgan Investment Banking (JPM.N), speaking in New York. If you had any of these contracts or agreements a couple of years ago you would probably not even have dared to ask the question, 'OK, what would it mean if countries X, Y, Z leave the euro.' That would not have been even part of the discussion. Tech giant Hewlett-Packard (HPQ.N), for example, has added the possibility of a country exiting the euro and currency volatility due to the European debt crisis to the list of disclosures about risks to its business. HP gets about 65 percent of its sales from countries outside the United States. "In the event that one or more European countries were to replace the euro with another currency, HP sales into such countries, or into Europe generally, would likely be adversely affected until stable exchange rates are established," HP said in a filing with the U.S. Securities and Exchange Commission last month. Discussions about managing currency risk are taking place at the highest levels of management because of the sheer scale of the potential impact of a euro zone break up. Once the purview of the treasurer, the topic now exercises the CEO and the CFO, often prompted by questions from the board. Jacques Brand, Global Co-Head of Investment Banking Coverage and Advisory at Deutsche Bank (DBKGn.DE), recounted a November conversation with a CEO of a large company based in the U.S. Midwest, which sees a significant portion of its revenue base come from outside the United States. "He had never hedged foreign exchange, but it was now a topic of conversation he was personally involved in," Brand said in an interview in New York. Risk management on a global basis is now the topic at the CEO and board level and we are in active dialogue around hedging strategies. Historically, the CEO, the board, the CFO and the head of M&A have relegated risk management activities. In this volatile environment, the treasurer is working more closely than ever with senior management," Brand said. With the euro zone crisis dragging on, companies are increasingly trying to understand what would happen if the euro were to break up and the various scenarios under which something like that could happen, and how to plan for them. One piece of advice that bankers say they are giving clients is to get the paperwork in order and narrow the number of jurisdictions that hedge contracts are subject to. "Our advice to clients is to make documentation as consistent and uniform as possible," said Jackie Morriss, a managing director in Foreign Exchange Sales at Deutsche Bank in New York. Restricting business to counterparty banks in a single jurisdiction was another smart move because they would use many of the same terms. Hedge contracts are typically governed by the International Swaps and Derivatives Association but there isn't anything explicit in the definitions put together by the derivatives industry body about how to settle those contracts should the euro fall apart, according to a lawyer at a major investment bank, who was not authorized to speak publicly. There would need to be a market protocol to settle contracts. One method could be to have a fixed ratio of component new currencies, the weighted average of which could then determine the payout, according to the lawyer. Several bankers said they expected the euro to depreciate if a country left the currency. They forecast volatility will continue in the coming months, keeping the cost of hedging high. One proxy for the cost is the implied volatility on 1-year euro/dollar contracts. That was around 13.7 percent this month, after touching about 16 percent in October. It compares with about 8 percent in January 2008, before the financial crisis fully took hold. Volatility tends to fall when the market expects a currency to trade in a range. "The market's expectation is that we will see continued volatility, which means that even at that 13 percent level it might be inexpensive -- and hedging the tail risk is really a very efficient and effective process to consider," Deutsche Bank's Morriss said. Switzerland-based Adecco Group, which provides HR services such as temporary staffing and permanent placement, gets most of its business in Europe, but also has as much as 20 percent coming from the United States and 7 percent from Japan. Chief Financial Officer Dominik De Daniel said the company provides services in the same currency as its clients and has short-term -- weekly or monthly -- billing cycles, which hedge its currency risks automatically. Hotel operator Starwood typically hedges about half of its euro exposure -- its second-largest after the U.S. dollar -- at a fixed level through tools such as forward contracts, which allow the company to buy the currency at a specific price. "It really does a great job of reducing the volatility without us really speculating," Prabhu said. We do not view ourselves as currency experts. We do not view ourselves as currency speculators. Hedging for currency risk is also becoming a more important conversation in cross-border deals. The costs can add up in large transactions. HP, for example, recorded $276 million of charges in connection with the acquisition of Autonomy Corp, with $265 million coming from the net cost of British pound options it bought to limit foreign exchange rate risk. "It is becoming far more important and a much larger portion of our discussion is revolving around, 'How do you take that risk off the table?'" said Peter Tague, a managing director in Citigroup Inc's (C.N) Global M&A group, in New York. Not that it means that deals aren't getting done. It simply means that clients are prepared to pay for insurance in a way that perhaps they haven't in the past. Citigroup has bankers in New York and London who are technically part of the forex group but cross the 'Chinese wall' to work alongside M&A teams advising clients on cross-border deals. Sometimes, the banks take the risk of the hedge through a product called a deal contingent contract. In such a contract, the bank would agree to sell currency to a client at a premium to where it is currently trading but at a lower price than a similar currency option. "One of the interesting aspects of 2011 was the number of smaller corporate companies that dipped their toe in the deal contingent pool," Deutsche Bank's Morriss said. For the most part, prior to that, deal contingent capital was really the realm of private equity sponsors. Reporting By Paritosh Bansal; editing by Janet McBride