ARACRUZ Brazilian company that lost over U$2 billion due to exchange rate movements resulting from the

financial crisis of 2008

Aracruz used 6 types of derivatives during 1999-2008 to hedge its position :

Standardized derivatives : 1) Standard future contracts 2) Currency couponsOTC derivatives :3) Non deliverable forwards (NDF)4) Conventional swaps5) An exotic swap with monthly

settlements 6) A structured derivative : sell target

forward

Aracruz was the major Brazilian manufacturer of pulp and paper with steady growth in revenue, output and profits throughout 1999-2007.• the biggest world producer of bleached eucalyptus pulp• net revenue : U$1.42B & 26% of world market • market capitalization of U$7.1B (July 8th, 2008) & BBB flat rating by Moody’s ,

S&P

• Losses of U$2.13B in derivatives posted

• ~ 3.7 times of 2007 EBIT

• ~ 30% of Aracruz’s market capitalization

• Stock plunge > 90% in 3 months,

• Acquired by another cellulose producer in 2009.

1999 2001 2003 2005 2007 20092008

Aracruz (1999-2009)

2007 2008 2009 2010 2011

80

60

40

20

6M

4M

2M

Share Price

Volume

Share prices take a nose dive

Optimal & Effective Hedge

Aracruz Optimal and Real Hedge (US$ million) – 1999-2008

Aracruz Foreign Currency Liabilities and Assets, and Derivatives Short position (US$ million) – 1999-2008

Expectation (1,6,12 months) and Effective Exchange Rate – US$/R$ – 2003-2008

Effective Exchange Rate – US$/Real and S&P500 – 08/28/2008 to 10/02/2008

SOURCE: Report-The Failure of Risk Management for Non-Financial Companies in the Context of the Financial Crisis

Shifting Focus toSell Target Forwards Aracruz started to invest in Sell Target Forwards in

2008 Sell Target Forwards allowed Aracruz to “double

hedge” the exchange rate risk:1. Traditional dollar forward sale – the standard hedging

for currency risk2. Then sold the same dollar again via a “call option” –

where the speculation and the scandal starts Sell the same dollar again Taking the same short position on the $ The problem is that the second position has a strike price

where the bank will call the option which constitutes a ceiling. But there is no floor…

…continuedThe contract is valid for a year with

monthly settlements => is equivalent, for Aracruz, of selling 12 calls with successive monthly strike dates, and also 12 NDFs.

P/L = 2nt *( X – S ) P/L % = 2*12 *( X- 1.5X ) *100/1.5X = 800%n: notional amount , t: time left in the contract,

X: strike price ; S: actual price.

Scandal ???Far greater exposure to the derivatives than was

necessary to hedge against the USD riskMolding its hedging activities towards creating risk

rather than minimizing it

Severe violations of the company’s hedging policyStrategy deviated from share-holder protection

towards making money from betting….Agency problem – poor corporate governance

because too much discretion given to CFO