Chapter 9: Financial Risk Management Outline: Overview of Risk Management in Treasury Derivative...

Chapter 9: Financial Risk ManagementOutline: Overview of Risk Management in Treasury Derivative Instruments Used as Financial Risk

Management Tools 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

v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 6: Module 4, Chapter 9 - 1

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:

The speed of business through advances in technology and communications

The scope of business through trends toward globalization


1

2

Match the following terms with the clues provided.

Value at risk Sensitivity analysis Scenario analysis Monte Carlo

simulation

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

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: Supply information to assist in analysis

to determine an organization’s riskappetite and profile.

Implement an overall risk management strategy.


Hedging, Speculation and Arbitrage


HedgingReducing or eliminating risks associated with the uncertain future cash flows

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

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 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 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).

Primary uses: Managing FX Managing interest

rates

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

Four basic types of derivative instruments: Forwards Futures Swaps Options


Forward Contracts

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.


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

Futures Contracts

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.


A standardized contract between two parties traded onan organized exchange

Swaps

Types of swaps include: Interest rate swap—an agreement to exchange

interest payments (e.g., a fixed-rate loan for a floating-rate loan)

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

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


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

Options

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.


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

Discussion QuestionWhich of the following is true of options?a) American option: exercise only on delivery

dateb) European option: exercise any time

through delivery datec) Bermuda option: exercise only on

specific dates that are evenly spacedover option’s life

Answer: c


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 Out-of-the-money If the asset price exceeds the strike price of the option

Call option In-the-money If the asset price is greater than the strike price of the option

Put option In-the-money If the asset price is less than the strike price of the option

Discussion Question


Answers:

Price of Underlying Asset ($)

$50 Call Option Value ($)

Profit (+) or Loss () ($)

46

50

54

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.

OUT

AT

IN

0

0

4

− 1

−1

+3

Discussion Question


Answers:

Price of Underlying Asset ($)

$50 Call Option Value ($)

Profit (+) or Loss () ($)

54

50

46

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.

OUT

AT

IN

0

0

4

− 1

−1

+3

Managing FX Rate Fluctuations


Foreign exchange (FX) risk

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.

Cash flow complexity

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

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

Sample Foreign Currency Quotation Formats

Currency USD Equivalent Currency per USD

GBP-British Pound GBP/USD 1.4870 USD/GBP 0.6725

CAD-Canadian Dollar CAD/USD 0.9742 USD/CAD 1.0265

EUR-Euro EUR/USD 1.3383 USD/EUR 0.7472

JPY-Japanese Yen JPY/USD 0.010804 USD/JPY 92.56

Given USD USD/rate = FC USD x rate = FC

Given foreign currency (FC) FC x rate = USD FC/rate = USD


Foreign Exchange (FX) Rates

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

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


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

1.3383

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

1.4870

Foreign Exchange (FX) Rates

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

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


$2,000,000 92.56 = JPY185,120,000

CAN250,000 = $243,546 (USD)

1.0265

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

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 Delivers

Dealer Buys

Dealer Sells

Company Receives

Company wants to buy Japanese yen (JPY)

USD USD at bid rate (JPY90.57)

JPY JPY

Company wants to sell JPY for USD

JPY JPY USD at offer rate (JPY90.63)

USD


Foreign Exchange (FX) Markets

Spot market (spot rate)

Forward market (forward rate) 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.SOURCE: PRICEWATERHOUSECOOPERS LLP, 2007

FX Rate Exposure

Types of FX exposure Economic Transaction Translation

Types of derivatives Currency or FX

forwards Currency futures Currency swaps Currency options


Currency or FX Forward

Three factors: Current spot rate Term of forward

contract Current interest

rates in two countries during term


EXAMPLE:

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

Traded on organized exchanges

Standardizedin amountsand maturity dates

70% of daily volume onthe CME

Contracts generallyoffered for six-month maturities

Currency Pair Contract Size Margin Required

EUR/USD EUR125,000 $2,205

USD/JPY JPY12,500,000 $2,700

GBP/USD GBP62,500 $1,485

USD/CHF CHF125,000 $1,350

USD/CAD CAD100,000 $1,755


Common Contracts

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

Contract settle price: GBP/USD 1.6521Change in contract value = (1.6521 – 1.6369) x 125,000 = $1,900New margin account value = $2,970 + $1,900 = $4,870

Futures contract decreases to GBP/USD 1.6472Change in contract value = (1.6472 – 1.6521) x 125,000 = –$612.50New margin account value = $4,870 – $612.50 = $4,257.50

If exchange rate rises to GBP/USD 1.7245Profit on contract = $1.7245 – $1.6369 = $0.0876 per GBP

If exchange rate drops to GBP/USD1.5681Loss on contract = $0.0688 per GBP; however, next cost still GBP/USD 1.6369


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 ExampleU.S.-based firm wishes to borrow JPY100 million for 10 years at exchange rate of USD/JPY 90.9091.Borrows $1,100,000 (USD equivalent to JPY100 million) for 10 years at 6% fixed interest rate.Currency swap to yen-denominated funding:

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%

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)

Every six months for 10 years, counterparty pays firm $29,700.0.054 x $1,100,000 x (180/360) = $29,700

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

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:

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

Examples 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.

Interest rate forwards Forward rate

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

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.

Futures rate is 1.5%. Contract price = Predetermined price of 98.5 (100 – 1.5).

If actual rate is 2.1% at end of year, realized value is only 97.9.100 – 2.1 = 97.9

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: 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:

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

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 Results from

changes in the price of a commodity used or sold: Rising prices for a

commodity used creates exposure.

Declining prices for a commodity sold creates exposure.

Delivery exposure 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 Requires central clearing and

exchange trading Requires market transparency Adds financial safeguards Sets higher standards of conduct


Emerging Markets Emerging market

currencies: Free floating with

partial pricing transparency and liquidity

Capital controls impacting bilateral availability at any point in time

Non-readily tradable in the worldwide FX marketplace

Exotic currency characteristics Illiquidity Volatility Reduced transparency Limited derivative availability Capital controls Heightened carrying risk Pricing distortions Limited risk-sharing options Minimal internal heading

alternatives Transfer risks


Chapter 9: Financial Risk Management Outline: Overview of Risk Management in Treasury Derivative...

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