6_AFPLST_Slides_Chapters_9_10

Transcript 6_AFPLST_Slides_Chapters_9_10

Chapter 9: Financial Risk Management

Outline:

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Overview of Risk Management in Treasury Derivative Instruments Used as Financial Risk Management Tools

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FX Risk Management in Treasury FX Exposure Currency Derivatives Used to Hedge FX Exposure Interest Rate Exposure and Risk Management Commodity Price Exposure Other Issues Related to Financial Risk Management

Basics of Financial Risk Management

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Financial risk is the risk of direct or indirect losses resulting from uncertainties in the future levels of interest and FX rates and commodity prices.

Financial risk has increased significantly recently for two reasons:

1 The speed of business through advances in technology and communications 2 The scope of business through trends toward globalization

Discussion Question

Match the following terms with the clues provided.

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Value at risk Sensitivity analysis Scenario analysis Monte Carlo simulation

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What-if exercises that alter a single variable; can identify most influential variables.

Developed in trading rooms to estimate possible losses in a day.

Computer uses a series of probability distributions to set multiple variables.

Changes more than one variable at a time; experts supply range of values.

Discussion Question

What is the role of the treasury area?

Answer:

The treasury department is a clearinghouse for daily functional information. Treasury professionals are asked to:

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Supply information to assist in analysis to determine an organization’s risk appetite and profile.

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Implement an overall risk management strategy.

Hedging, Speculation and Arbitrage

Hedging Speculation Assuming risk and betting on the direction of the market and whether the price of an asset will go up (long) or down (short) Arbitrage Reducing or eliminating risks associated with the uncertain future cash flows Assuming no risk but attempting to profit from market inefficiencies by buying an asset in one market and simultaneously selling in another

Benefits of Financial Risk Management

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The company’s probability of financial distress decreases because the firm can assess costs and revenues more accurately.

Greater predictability in future cash flows makes the company more attractive to shareholders.

The company gains an enhanced borrowing advantage in credit markets because lenders view the firm as being less risky.

Derivative Instruments Used as Financial Risk Management Tools

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Derivative instrument is a financial product that acquires its value by inference through a formulaic connection to another asset (such as another financial instrument, currency or commodity).

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Primary uses:

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Managing FX Managing interest rates

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Use of derivatives may have immediate favorable/unfavorable impact on cash flow.

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Four basic types of derivative instruments:

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Forwards Futures Swaps Options

Forward Contracts

A customized agreement between two parties to buy

or sell a fixed amount of an asset at a future date at a price agreed upon today

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Asset involved is referred to as the underlying asset.

Future date (maturity date of the contract).

Price is delivery price of contract.

Company buying asset is one party; the other is called the counterparty (bank or FX dealer).

Buying party is long a forward contract; counterparty is short a forward contract.

Futures Contracts

A standardized contract between two parties traded on

an organized exchange

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Similar to forwards in intent (payoff profiles from long and short positions are the same) but differ in execution (e.g., counterparty is the exchange itself).

Size of contract and its maturity date set by exchange.

Trading requires a margin account.

Futures contracts are rarely settled by actual delivery and are usually closed out prior to maturity.

Swaps

An agreement between two parties to exchange (swap) a set of cash flows at a future point in time

Types of swaps include:

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Interest rate swap —an agreement to exchange interest payments (e.g., a fixed rate loan for a floating-rate loan)

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Currency swap —an agreement to convert an obligation in one currency to an obligation in another currency

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Commodity swap a fixed price —an agreement to exchange a floating price for a commodity at

Options

A contract where one party has the right (but not the obligation) to buy or sell a fixed amount of an underlying asset at a fixed price on or before a specified date

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Counterparty (writer of the option) selling the option receives a premium from the buyer.

May be exchange-traded or negotiated with a counterparty.

Call option: Contract giving the owner the right to buy an asset.

Put option: Contract giving the owner the right to sell an asset.

Strike/exercise price: The fixed or contracted price of the underlying asset.

Discussion Question

Which of the following is true of options?

a) b) c) American option: exercise only on delivery date European option: exercise any time through delivery date Bermuda option: exercise only on specific dates that are evenly spaced over option’s life

Relationship Between an Option Premium and Strike (Exercise) Price

Call or put option At-the-money If the underlying asset price is equal to the strike price of the option Call option Out-of-the-money If the asset price is less than the strike price of the option Put option Call option Put option Out-of-the-money In-the-money In-the-money If the asset price exceeds the strike price of the option If the asset price is greater than the strike price of the option If the asset price is less than the strike price of the option

Discussion Question

A call option with a $50 strike price is purchased when the underlying asset is selling for $46 per unit. The premium paid is $1. Identify if the following put options are in-, at-, or out-of-the-money.

Answers:

OUT AT IN Price of Underlying Asset ($) 46 50 54 $50 Call Option Value ($) 0 0 4 Profit (+) or Loss (

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) ($) − 1 − 1 + 3

Discussion Question

A put option with a $50 strike price is purchased when the underlying asset is selling for $54 per unit. The premium paid is $1. Identify if the following put options are in-, at-, or out-of-the-money.

Answers:

OUT AT IN Price of Underlying Asset ($) 54 50 46 $50 Call Option Value ($) 0 0 4 Profit (+) or Loss (

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) ($) − 1 − 1 + 3

Managing FX Rate Fluctuations

Foreign exchange (FX) risk Cash flow complexity Tax issues International companies with cash flows in various foreign currencies must assess the volatility of the types and levels of FX rate fluctuations for each currency.

Global companies must manage cash flows from subsidiaries, suppliers and customers in each country in which they operate.

Global treasury operations must interpret the rules and regulations of different tax authorities.

Sample Foreign Currency Quotation Formats

Currency

GBP-British Pound CAD-Canadian Dollar EUR-Euro JPY-Japanese Yen

Given USD Given foreign currency (FC) USD Equivalent

GBP/USD 1.4870

CAD/USD 0.9742

EUR/USD 1.3383

JPY/USD 0.010804

USD/rate = FC FC x rate = USD Currency per USD

USD/GBP 0.6725

USD/CAD 1.0265

USD/EUR 0.7472

USD/JPY 92.56

USD x rate = FC FC/rate = USD

Foreign Exchange (FX) Rates

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Example: The quoted rate for the USD equivalent is EUR 1.3383. How many euros would $2 million buy?

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$2,000,000 = EUR1,494,433 1.3383

Example: The quoted rate for the USD equivalent is GBP 1.4870. How many pounds would $2 million buy?

$2,000,000 = GBP1,344,990 1.4870

Foreign Exchange (FX) Rates

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Example: The quoted rate for the Japanese yen is USD/JPY 92.56. How many yen would $2 million purchase?

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Example: The quoted rate for the Canadian dollar is USD/CAN 1.0265. CAN250,000 would be equivalent to how many USD?

CAN250,000 = $243,546 (USD) 1.0265

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Foreign Exchange (FX) Rates: Bid-Offer Spreads and Dealer Profit

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Bid rate: Dealer buys currency.

Offer rate: Dealer sells currency.

Bid/offer spread or bid/ask spread: Difference between rates (dealer’s profit).

Dealer bid-offer quote; e.g., USD/JPY 90.57-63.

Scenario Company wants to buy Japanese yen (JPY) Company wants to sell JPY for USD Company Delivers USD JPY Dealer Buys USD at bid rate (JPY90.57) JPY Dealer Sells JPY USD at offer rate (JPY90.63) Company Receives JPY USD

Foreign Exchange (FX) Markets

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Spot market (spot rate) Forward market (forward rate)

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Par Discount Premium

Interest rate parity

FX Rate Exposure

Implicit and explicit transaction exposures are two pieces of a single transaction. Implicit is the piece from exposure initiation to balance sheet realization; explicit is the piece from balance sheet realization through cash flow.

FX Rate Exposure

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Types of FX exposure

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Economic Transaction Translation

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Types of derivatives

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Currency or FX forwards Currency futures Currency swaps Currency options

Currency or FX Forward

Three factors:

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Current spot rate

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Term of forward contract Current interest rates in two countries during term EXAMPLE:

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A U.S. company (importer) has agreed to pay an invoice for GBP125,000 in 90 days.

The importer purchases a forward contract today at $1.6365 in USD per GBP, deliverable in 90 days.

At the end of the 90 days, the importer pays: USD1.6365 x GBP125,000 = USD204,563

Currency Futures

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Traded on organized exchanges Standardized in amounts and maturity dates 70% of daily volume on the CME Contracts generally offered for six month maturities Common Contracts Currency Pair

EUR/USD USD/JPY GBP/USD USD/CHF USD/CAD

Contract Size

EUR125,000 JPY12,500,000 GBP62,500 CHF125,000 CAD100,000

Margin Required

Currency Futures Example

U.S. importer must pay invoice for GBP125,000 in 90 days. Company purchases futures contract for GBP/USD 1.6369. Margin requirement = $2,970.

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Contract settle price: GBP/USD 1.6521

Change in contract value = (1.6521 – 1.6369) x 125,000 = $1,900 New margin account value = $2,970 + $1,900 = $4,870

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Futures contract decreases to GBP/USD 1.6472

Change in contract value = (1.6472 – 1.6521) x 125,000 = –$612.50

New margin account value = $4,870 – $612.50 = $4,257.50

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If exchange rate rises to GBP/USD 1.7245

Profit on contract = $1.7245 – $1.6369 = $0.0876 per GBP

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If exchange rate drops to GBP/USD1.5681

Loss on contract = $0.0688 per GBP; however, next cost still GBP/USD 1.6369

Currency Swaps

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The exchange of a floating-rate cash flow denominated in one currency with a fixed-rate cash flow denominated in another currency, as well as exchange of principal

Currency Swaps Example

U.S.-based firm wishes to borrow JPY100 million for 10 years at exchange rate of USD/JPY 90.9091.

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Borrows $1,100,000 (USD equivalent to JPY100 million) for 10 years at 6% fixed interest rate.

Currency swap to yen-denominated funding:

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Semiannual payments in yen to counterparty at fixed rate of 5.2% Counterparty makes semiannual payments in USD to firm at fixed rate of 5.4%

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Every six months for 10 years, firm pays counterparty JPY2,600,000 from local yen currency.

0.052 x JPY100,000,000 x (180/360)

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Every six months for 10 years, counterparty pays firm $29,700.

0.054 x $1,100,000 x (180/360) = $29,700

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End of 10 years, investment matures, returning JPY100 million principal, which firm pays counterparty; counterparty pays firm $1,100,000.

6% interest rate = semiannual payment to creditors of $33,000 (0.06) x (1,100,000) x (180/360) = $33,000

Currency Options

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Give the buyer the right to buy (call) or sell (put) a fixed amount of foreign currency at a fixed exchange rate (strike price) on or before a specific future date EXAMPLE:

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Foreign-currency call option sets ceiling price to buy foreign currency in terms of the domestic currency.

Ceiling price is strike price plus premium paid for call.

Call option on EUR has strike price of $1.30 with premium of $0.10.

Maximum ceiling = ($1.30 + $0.10) = $1.40 per euro

Interest Rate Exposure

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Examples

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Falling rates with variable interest rate investments may mean lower earnings.

Rising rates with debt tied to variable interest rates may mean higher borrowing costs.

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Interest rate forwards

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Forward rate agreement (FRA) Interest rate futures Interest rate swaps Interest rate options

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Interest rate cap Interest rate floor Interest rate collar

Interest Rate Futures Contract Example

Futures contract pricing on one-year T-bill is 100 minus the promised interest rate.

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Futures rate is 1.5%.

Contract price = Predetermined price of 98.5 (100 – 1.5).

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If actual rate is 2.1% at end of year, realized value is only 97.9.

100 – 2.1 = 97.9

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The holder of the long position will be paid by the seller of the contract the difference.

98.5 – 97.9 = 0.6 per unit of the contract

Example: Interest Rate Swap

Parties A and B enter into a five-year swap with a notional value of $100M. A takes fixed side (exchanging floating rate exposure for fixed rate), B takes floating side (vice versa). A pays fixed rate (5.5%) to B, and B pays floating rate to A (LIBOR+3.5%). At the end of each year:

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Party A will owe Party B $100M x 5.5%.

Party B will owe Party A $100M x (LIBOR + 3.5%).

In practice, there is a netting procedure and only the difference is settled. If LIBOR is < 2%, then A pays B, and if LIBOR > 2%, then B pays A. For example:

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If LIBOR is 1.25%, then Party A pays Party B as follows: [0.0550 – (0.0125 + 0.0350)] x $100M = $750,000

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If LIBOR is 2.50%, then Party B pays Party A as follows: [(0.0250 + 0.0350) – 0.0550] x $100M = $500,000

Commodity Price Exposure

Price exposure

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Results from changes in the price of a commodity used or sold:

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Rising prices for a commodity used creates exposure.

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Declining prices for a commodity sold creates exposure.

Delivery exposure

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Occurs when regular supply of a commodity is crucial Can be mitigated by entering into a long-term agreement with a producer

Discussion Question

What is one of the primary problems in the valuation of, and subsequent accounting for, derivatives?

Answer: 

Determining their accurate value. As a general guideline, Topic 820-10: Fair Value Measurements offers some guidance on this issue.

Discussion Question

How does the Dodd-Frank Act bring more transparency and accountability to the derivatives market?

Answer: 

Closes regulatory gaps

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Requires central clearing and exchange trading Requires market transparency

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Adds financial safeguards Sets higher standards of conduct

Emerging Markets

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Emerging market currencies:

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Free floating with partial pricing transparency and liquidity

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Capital controls impacting bilateral availability at any point in time Non-readily tradable in the worldwide FX marketplace

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Exotic currency characteristics

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Illiquidity Volatility Reduced transparency Limited derivative availability Capital controls Heightened carrying risk Pricing distortions Limited risk-sharing options Minimal internal heading alternatives Transfer risks

6_AFPLST_Slides_Chapters_9_10

Transcript 6_AFPLST_Slides_Chapters_9_10

Chapter 9: Financial Risk Management

Basics of Financial Risk Management

Financial risk is the risk of direct or indirect losses resulting from uncertainties in the future levels of interest and FX rates and commodity prices.

Financial risk has increased significantly recently for two reasons:

Discussion Question

Discussion Question

Hedging, Speculation and Arbitrage

Benefits of Financial Risk Management

Derivative Instruments Used as Financial Risk Management Tools

Forward Contracts

Futures Contracts

Swaps

Options

Discussion Question

Relationship Between an Option Premium and Strike (Exercise) Price

Discussion Question

Discussion Question

Managing FX Rate Fluctuations

Sample Foreign Currency Quotation Formats

Foreign Exchange (FX) Rates

$2,000,000 = EUR1,494,433 1.3383

$2,000,000 = GBP1,344,990 1.4870

Foreign Exchange (FX) Rates

CAN250,000 = $243,546 (USD) 1.0265

Foreign Exchange (FX) Rates: Bid-Offer Spreads and Dealer Profit

Foreign Exchange (FX) Markets

Spot market (spot rate) Forward market (forward rate)

Interest rate parity

FX Rate Exposure

FX Rate Exposure

Types of FX exposure

Types of derivatives

Currency or FX Forward

Currency Futures

Currency Futures Example

Currency Swaps

The exchange of a floating-rate cash flow denominated in one currency with a fixed-rate cash flow denominated in another currency, as well as exchange of principal

Currency Swaps Example

Currency Options

Interest Rate Exposure

Examples

Interest Rate Futures Contract Example

Example: Interest Rate Swap

Commodity Price Exposure

Discussion Question

Discussion Question

Emerging Markets

Directory