8 Chapter Financial risk - PowerPoint Presentation

1. 8ChapterFinancial risk

2. Overview

3. Types of Financial Risk

4. Credit Risk ManagementStrong credit control proceduresInsuranceDebt factoring without recourse

5. Political Risk ManagementEntering into foreign joint venturesObtaining agreements and contracts with overseas governmentUsing local financingEventual ownership / part-ownership by foreign country’s investors

6. Interest Rate RiskTypes of interest risk exposure:Floating rate loansFixed rate loansMeasuring interest risk exposure:Floating rateFixed rateRefinancing

7. Currency Risk TypesTranslation riskTransaction riskEconomic risk

8. 9ChapterCurrency risk management

9. Overview

10. Exchange ratesAn exchange rate is expressed in terms of the quantity of one currency that can be exchanged for one unit of the other currency it can be thought of as the price of a currency. For example: 1 USD = 0.6667 GBPThis means that 0.6667 GBP will buy 1 USD, i.e. the price of a USD is 0.6667 GBP.The notation adopted by most financial institutions and reporters is for example: 1USD/ZAR = 13.5673. this means that 1USD is worth 13.5673 Rands.

11. Exchange rates…Spot rate: This is the rate given for a transaction with immediate delivery. In practice this means it will be settled within two working days.Spread: banks will quote two rates to customers, a buy rate (bid) and an ask rate (ask). The difference between the two is known as the spread. E.g. 1GBP/USD = 1.2504 – 1.2510The bank buys the counter-currency HIGH and sells the counter currency LOW. In this case the counter currency is the USD and the base currency is the GBP.

12. Exchange Rate TheoryPurchasing power parity theory (PPPT)Interest rate parity theory (IRPT)International Fisher Effect

13. PPPTThis theory suggests the rate of exchange will be directly determined by the relative rates of inflation suffered by each currency. If one country suffers a greater rate of inflation than another its currency should be worth less in comparative terms.The basis of PPPT is the 'Law of One Price':• identical goods must cost the same regardless of the currency in which they are sold.if this is not the case then arbitrage (buying at the lower price, selling at the higher price) will take place until a single price is charged.

14. PPPT

15. PPPT ExampleThe USD and GBP are currently trading at GBP1/USD1.7200.Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.Predict the future spot rate in a year’s time.

16. Does PPPT work in practice?PPPT certainly does explain the reasoning behind much of the movements in exchange rates but is not a very good predictor of exchange rates in the short to medium term because:Future inflation rates are only an estimate and often cannot be relied upon to be accurate.The market is dominated by speculation and currency investment rather than trade in physical goods.Government intervention in both direct (e.g. management of exchange rates) and indirect ways (e.g. taxation policies) can nullify the impact of PPPT.

17. IRPTThe IRPT claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the two currencies.The forward rate is a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future dateRule: IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation

18. IRPTWhere intsf money risk-free rate of interest for the foreign currencyintsh money risk-free rate of interest for the home currencyspot rate in terms of 1 unit of home currency / foreign currency (e.g. GBP1/USD)

19. IRPT exampleA treasurer can borrow in Swiss francs (CHF) at a rate of 3% pa or in the UK at a rate of 7% p.a. The current rate of exchange is GBP1/10CHF.What is the likely rate of exchange in a year’s time?

20. IRPT in practiceThe only limitation on the universal applicability of this relationship will be due to government intervention. These may arise in a number of ways including the following:Controls on capital markets – The government may limit the range and type of markets within their financial services system.Controls on currency trading – These may be in the form of a limit on the amount of currency that may be taken out of a country or the use of an 'official' exchange rate that does not bear any relation to the 'effective' rate at which the markets wish to trade.Government intervention in the market – The government may attempt to control or manipulate the exchange rate by buying or selling their own currency.

21. International Fisher EffectThe International Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange.The International Fisher Effect assumes that all countries will have the same real interest rate, although nominal or money rates may differ due to expected inflation rates.Thus the interest rate differential between two countries should be equal to the expected inflation differential.Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa.

22. IFEThe IFE theory states that 1 + m = (1 + r)(1 + h)Wherer = the real rate of interesth = the inflation ratem = the money/nominal interest rate

23. Currency Risk Management

24. External Hedging TechniquesForwardFixed dateFixed rateTailor madeContractual obligationMoney Market HedgeBring forward conversion of currency to todayCreate matching asset/ liabilityFutureStandardised contractTradableRange of future datesEffectively fixes the rateOptionsStandardised contractTradableInsuranceDownside risk covered by option

25. Forward rate agreements FRAsA forward contract is an agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate.This is the most popular method of hedging exchange rate risk. The company is able to fix in advance an exchange rate at which a transaction will be made.The risk is taken by the bank who are better able to manage their exposure. A proportion of their exposure will normally be avoided by writing forward contracts for opposite trades on the same day.

26. FRAsForward contracts are a commitment, and as a result they have to be honoured even if the rate in the contract is worse than the rate in the market. Forward contract rates are often quoted at a premium or discount to the current spot rate.A discount means that the currency being quoted is expected to fall in value in relation to the other currency. If a currency falls in value then you need more of that currency to buy a single unit of the other. A discount is often to referred to as ‘dis’, a premium as ‘prem’.add a forward discount to the spot rate ('add:dis')subtract a forward premium from the spot rate.

27. FRA exampleEEFS Ltd (a UK company) sold goods to the value of USD2.0 million. Receipt is due in 90 days.The current spot rate is GBP1 = USD 1.5430 – 1.5150.There is a three month discount forward of 2.5 cents – 1.5 cents.Required:Calculate the amount of sterling that EEFS Ltd will receive under the forward contract.

28. Money market hedgesThe money markets are markets for wholesale lending and borrowing, or trading in short term financial instruments. Many companies are able to borrow or deposit funds through their bank in the money markets.Instead of hedging a currency exposure with a forward contract, a company could use the money markets to lend or borrow, and achieve a similar result.Since forward exchange rates are derived from spot rates and money market interest rates, the end result from hedging should be roughly the same by either method.

29. MMH..The basic idea of an MMH is to create assets and liabilities that 'mirror' the future assets and liabilities.Rule: The money required for the transaction is exchanged at today's spot rate, and is then deposited / borrowed on the money market to accrue to the amount required for the transaction in the future.The basic idea is to avoid future exchange rate uncertainty by making the exchange at today’s spot rate instead.• This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur:

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31. MMH exampleA UK company is due to receive USD12,000 in 6 months time from a customer.The USD/GBP forward rate is 1.9550 – 1.9600 and the spot rate is 1.9960 – 1.9990.Interest rates in the US to borrow are 12% and to lend are 11%. In the UK interest rate to borrow are 11% and to lend are 10%.If the company chooses to use a money market hedge, how much will they receive in GBPs in 6 months time?

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33. Currency FuturesCurrency futures, also called forex futures, are exchange-traded futures contracts to buy or sell a specified amount of a particular currency at a set price and date in the future. Currency futures were introduced at the Chicago Mercantile Exchange (now the CME Group) in 1972 soon after the fixed exchange rate system and gold standard were discarded. Similar to other futures products, they are traded in terms of contract months with standard maturity dates typically falling in March, June, September and December.Futures operate much like forward rate agreements except that futures contracts are standardised and they can be traded

34. Setting up a futures hedgeTo buy or sell futures?Identify the futures contract currency denomination and do to the futures what you want to do to that currency, i.e. if you want to buy GBP and the futures are denominated in GBP then buy futureschoose the first contract to expiry after the required conversion date.How many contracts? Convert the amount to be hedged to the futures currency using the futures price then divide by contract size.

35. Setting up futures hedge…2. Pay the initial margin and wait for settlement date3. On expiry of the contract the trading position is automatically reversed. Any profit or loss is computed and cleared, and the underlying commodity is retained by the trader.The value of the transaction is calculated using the spot rate on the transaction date.

36. Futures example

37. Futures exampleImagine it is 10 July 2014. A UK company has a US$6.65m invoice to pay on 26 August 2014. They are concerned that exchange rate fluctuations could increase the £ cost and, hence, seek to effectively fix the £ cost using exchange traded futures. The current spot rate is $/£1.71110. Research shows that £/$ futures, where the contract size is denominated in £, are available on the CME Europe exchange at the following prices: September expiry – 1.71035 December expiry – 1.70865The contract size is £100,000 and the futures are quoted in US$ per £1.On 26 August the following was true:Spot rate – $/£ 1.65770September futures price – $/£1.65750Show how the futures hedge would work and effective forex rate

38. Ticks and Basis riskA tick size is the minimum price movement of a trading instrument. The price movements of different trading instruments vary with the tick size representing the minimum incremental price movement that can be experienced on an exchange. Basis risk is the risk that the value of a futures contract (or an over-the-counter hedge) will not move in line with that of the underlying exposure. In other words, it is the risk that the loss caused by adverse movements in currency rates will not be completely offset by the gain made in the futures trade.

39. Currency optionsA currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future dateIf there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement.Options provide protection against downside while offering unlimited upside opportunityFor this reason option contracts are very expensive.The premium paid for an option is non refundable regardless of whether the option was exercised or not.

40. Calls and Puts..A call option is an option to buy a particular currency at a particular exchange rate.A put option is an option to sell a currency at a certain rate**you need to be careful when deciding whether to buy calls or puts

41. Operation of options..On the day of the transaction the holder must ascertain whether gains will be made by exercising the option or by letting it lapse.The total gain is the difference between the exercise price (option strike price) and the market price of the underlying item LESS the premium paid.Gain on exercise xPremium paid (x)Net gain/(loss) x

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43. Example..A company is due to receive USD 3 million in 3 months time. The spot rate is USD 1.9500/GBP but the company is worried that the USD will weaken. They have been offered a three month put option on USD at USD 1.9700/GBP, costing USD 0.02 per GBP. If the company chooses to buy and then exercise the option, what is its net receipt in GBP?

44. In- vs out-of-the-money optionsIn the money means that a call option's strike price is below the market price of the underlying asset or that the strike price of a put option is above the market price of the underlying asset. Being in the money does not mean you will profit, it just means the option is worth exercising.Out of the money (OTM) is term used to describe a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.

45. Black and Scholes Option Pricing model

46. the value of the underlying asset - Paits volatility (Standard deviation) - sthe exercise price - Pethe time to settlement - tthe risk free rate of interest. - r

47. The intrinsic value of an option is the difference between the Exercise price and the value of he underlying, i.e Intrinsic value in options is the in-the-money portion of the option's premium. For the intrinsic value of a call option to increase one of the following must occur1) Current price of the underlying asset must increase.(2) Strike price must fall (hence making it more likely that the option will be exercised, and so is worth something).The opposite is true for put optionsIntrinsic value of an option

48. Example..

49. Currency swapsIn a forex swap, the parties agree to swap equivalent amounts of currency for a period and then reswap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a ‘fixed rate/fixed rate’ swap.

50. The main objectives of a forex swap are:Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.• To hedge against forex risk, possibly for a longer period than is possible on the forward market.• To access capital markets, in which it may be impossible to borrow directly.Illustration…UK construction company in Argentina

51. Currency swapA currency swap allows the two counterparties to swap interest rate commitments on borrowings in different currencies. In effect a currency swap has two elements:An exchange of principal in different currencies, which are swapped back at the original spot rate – just like a forex swap.An exchange of interest rates – the timing of these depends on the individual contractThe swap of interest rates could be ‘fixed for fixed’ or ‘fixed for variable’.Illustration, Warne Co..

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53. 10ChapterInterest rate risk management

54. Chapter Summary

55. Interest RatesInterest ratesLending vs Deposit Rates – A bank will quote two rates, a lending rate and a deposit rate. The lending rate is always higher than the deposit rate (the bank always wins!)LIBOR – London InterBank Offer Rate: this is the rate at which a major bank can borrow wholesale short term funds from other banks. It is used as the minimum rate when banks set their own ratesLIBID

56. Interest Rate RiskTypes of interest risk exposure:Floating rate loansFixed rate loansMeasuring interest risk exposure:Floating rateFixed rateRefinancing risk is associated with interest risk because it looks at the risk that loans will not be refinanced at the same rates. This could be:Lenders are unwilling to lend or only prepared to lend at higher rates.The credit rating of the company has reduced making them a more unattractive lending optionsInterest rate risk is the risk of gains or losses on assets and liabilities due to changes in interest rates.

57. Interest Rate RiskInterest rate risk is the risk of gains or losses on assets and liabilities due to changes in interest rates.Interest rate risk takes two formsReinvestment riskImpact of a change in interest rates on a firm’s future cash flowsPrice riskImpact of a change in interest rates on the value of a firm’s assets and liabilitiesAn inverse relationship exists between interest rates and security prices i.e. a rise in interest rates results in a fall in the value of an asset or liability, or vice versa

58. Interest Rate Risk Management

59. Summary of External Hedging TechniquesInterest rate optionsInterest rate guarantees (IRG’s), (sometimes called caps/floors or options)‘Insurance’instrumentsInterest ratefuturesForward rate agreements (FRAs)‘Fixing’ instrumentsExchange Traded InstrumentsOTC Instruments

60. Forward rate agreement (FRAs)A customized contract between two parties that guarantees a certain interest rate on an investment or a loan for a specified time interval in the future, i.e. begins on one forward date and ends later.Features and Operations is about the rate of interest on a notional amount of principal result in a fixed effective interest rateSettlement of FRAs Net amount is settled (difference between the current LIBOR and the agreed FRA rate) i.e. If the fixed rate in the agreement is higher than the reference rate (LIBOR), the buyer of the FRA makes a cash payment to the seller. The reverse is true.

61. Forward rate agreement (FRAs)A customized contract between two parties that guarantees a certain interest rate on an investment or a loan for a specified time interval in the future, i.e. begins on one forward date and ends later.TYU 1 & 2 on Pg - 772Pricing is based on future expectations of interest rate movement on the reputation of the company they are lending to

62. Forward rate agreement (FRAs)– TYU 2It is 31 October and Cooper plc is arranging a six month £5 million loan commencing on 1 July, based on Libor. Cooper wants to hedge against an interest rate rise using an FRA. The current LIBOR is 8%.If LIBOR turned out to be 9% on 1 July, evaluate the use of the FRA?If LIBOR on 1 July was 5%, re-evaluate the FRA.

63. Interest rate guarantee (IRGs)is an option on a forward rate agreement (FRA) that is handled over-the-counter (OTC). A call IRG is called a borrower's IRG. A put IRG is called a lender's IRG.Often referred to as interest rate options or interest rate caps/floors.Features and Operations is an OTC instrument arranged directly with a bank & have a minimum of one year A borrower hedge by buying a FRA would need an IRG that provides a call option on FRAs A depositor could hedge by selling a FRA so would need an IRG that provides a put option on FRAs

64. Interest rate guarantee (IRGs)is an option on a forward rate agreement (FRA) that is handled over-the-counter (OTC). A call IRG is called a borrower's IRG. A put IRG is called a lender's IRG.Often referred to as interest rate options or interest rate caps/floors.Features and Operations A company will only exercise the option to protect against an adverse interest movementDecision rules:If there is an adverse movement = exercise the option to protectIf there is a favourable movement = allow the option to lapsePremium is paid for the flexibility

65. Interest rate guarantee (IRGs) – TYU 3It is 31 October and Cooper plc is arranging a six month £5 million loan commencing on 1 July, based on Libor. Cooper wants to hedge against an interest rate rise using an IRG. The current LIBOR is 8%.The IRG fee is 0.25% p.a. of the loan.If LIBOR turned out to be 9% on 1 July, evaluate the use of the IRG?If LIBOR on 1 July was 5%, re-evaluate the IRG.

66. Interest rate futures (IRFs)They are similar to a FRA in that they give a similar commitment to an interest rate for a set period.They are tradeable contracts & operates for set periods of three months, and terminates in March, June, September and December.The futures position will be closed out for cash and gains or losses be used to offset changes in interest rates.Two types of IRF – Short Term Interest Rate Futures (STIRS) and Bond Futures

67. Interest rate futures (IRFs)Features and OperationsThey are for a notional size of 500,000GBP To hedge borrowings, you sell futures Pricing - the future is priced by deducting the interest rate from 100If the interest rate is 5% the future will be priced at 95.00The reason for this is that if interest rates increase, the value of the future will fall and vice versa if interest rates reduce.Gains and losses on STIRS are calculated by reference to the interest rate at the date of close out. The difference between the futures price at inception & close will be the gain and loss.

68. Exchange traded interest rate optionsThe market provides a product that can cap interest rates for borrowers like an IRG.Often referred to as interest rate options or interest rate caps/floors.It gives the buyer the right to buy or sell an interest rate future, at a specified date at a fixed exercise rate.Because they are an option, a premium will be required.Features and Operations They fix an interest on a notional amount of capital, for a given period, starting on or before a date in the future.Because these are options to buy or sell futures, all the futures information is till valid: standardised size (500k GBP); 3 months period, maturity dates.

69. Exchange traded interest rate optionsFeatures and Operations They fix an interest on a notional amount of capital, for a given period, starting on or before a date in the future. Because these are options to buy or sell futures, all the futures information is till valid: standardised size (500k GBP); 3 months period, maturity dates. A call option gives the holder the right to buy the futures contract. A put option gives the holder the right to sell the futures contract What should happen:Depositor: Buy futures in the futures market and buy calls in the options marketBorrower: Sell futures in the futures market and buy puts in the options market

70. Complications with IRFsBasis risk: difference between the expected futures price and the actual price on date of closingStandardised contracts: Because the contracts are for standardized amounts it may be impossible to organize a perfect hedge. Some amount will have to be left unhedged. The unhedged amounts are usually insignificant compared to the hedged amounts.

71. Collars

72. Interest Rate SwapsD plc Fixed rate loanE plc Floating rate loanFloating interest rateFixed interest rateOriginal lendersFixed interest paymentsOriginal lendersFloating interest payments

73. Vanilla swap exampleCompany A wishes to raise $10 million and to pay interest at a floating rate, as it would like to be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above LIBOR. Company B also wishes to raise $10 million. They would prefer to issue fixed rate debt because they want certainty about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR + 2% floating, as it has a lower credit rating than company A.Calculate the effective swap rate for each company – assume savings are split equally.

74. Swap with intermediary

75. Intermediary example