Prof. Ian Giddy New York University Structured Finance: Fixed Income.
Prof. Ian Giddy New York University Managing Financial Risk.
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Transcript of Prof. Ian Giddy New York University Managing Financial Risk.
Prof. Ian GiddyNew York University
Managing Financial Risk
Copyright ©1998 Ian H. Giddy Managing Financial Risk 2
First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics. Manage corporate financial risk
Copyright ©1998 Ian H. Giddy Managing Financial Risk 3
Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©1998 Ian H. Giddy Managing Financial Risk 8
Tools for Hedging
Pacasmayo has to pay for equipment from Japan, in Japanese yen, in 3 monthsBorrow soles and pay now?Use a forward contract/FX swap?Hedge with options?
Copyright ©1998 Ian H. Giddy Managing Financial Risk 11
A Typical Forward Contract
We agree today to pay a certain price for a currency in the future
BackusBackus SAN-
TANDER
SAN-
TANDER
Soles
Copyright ©1998 Ian H. Giddy Managing Financial Risk 12
Customization, Performance Riskand Liquidity
Customization implies bilateral contracts, which carry performance risk
Liquidity implies standardization and freedom from counterparty risk, through exchange-traded contracts
Copyright ©1998 Ian H. Giddy Managing Financial Risk 13
How Does the Bank Hedge a Forward Contract?
Hedging approaches:OpenForwardSpot plus swapRolloverMoney market
Copyright ©1998 Ian H. Giddy Managing Financial Risk 14
The FX Swap Hedge
3-month Forward Contract
3-month Swap
Dealers often hedge a long-term foreign-exchange commitment with a spot plus (FX Swap”: spot sale plus forward purchase of a foreign currency
The FX swap rate is determined by the interest differential
Copyright ©1998 Ian H. Giddy Managing Financial Risk 15
The Roll-Over Swap Hedge
6-month Forward Contract
3-month Swap 3-month Swap
Dealers often hedge a long-term foreign-exchange commitment with shorter-term contracts, which are “rolled over” as they come due
Corporations themselves do this too.
Copyright ©1998 Ian H. Giddy Managing Financial Risk 16
110
115
120
125
130
135
140
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
EXCHANGERATE, YENPER US$
FORWARDPREMUIM,PERCENTPER ANNUM
FORWARD(LEFT SCALE)
SPOT (LEFT SCALE)
FORWARD PREMIUM(RIGHT SCALE)
MONTHLY DATA, 1987-1989
FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100
The Forward Rate Tracks the Spot Rate
Marking-to-Market of aForward Contract
0.625
0.63
0.635
0.64
0.645
0.65
-25 -20 -15 -10 -5 -1
SHORT POSITION
LONG POSITION
DAILY GAINS AND LOSSES
DAILY DMFUTURES PRICEMOVEMENTS
FUTURES
SPOT
FUTURES PRICES,US$ PER MARK
DAYS BEFORE SETTLEMENT DATE
Copyright ©1998 Ian H. Giddy Managing Financial Risk 19
Forwards vs Futures vs Options
Good credit: Forward usually best Sometimes, Money Market Hedge better
Perfect market: same (covered int. arb.) Imperfect market: MMH may be better
Credit problem: Futures But: limited and standardized Requires margin and daily settlement
Uncertain future cash flows: Liquid instrument (futures/forwards to assure
flexibility Options sometimes advisable
Copyright ©1998 Ian H. Giddy Managing Financial Risk 23
Option Hedge
CALL
OPTION
ON YEN
FORWARD
CONTRACT
Copyright ©1998 Ian H. Giddy Managing Financial Risk 24
Option Hedge
Questions about options: When should companies use them? Which options? How much do they cost, Are they worth paying for? What is the risk to the bank?
Copyright ©1998 Ian H. Giddy Managing Financial Risk 26
Measuring Market Exposure
Defining corporate exposure:
“How will my company’s value be affected by market price fluctuations?”
Types of exposureTransactionsBalance sheet/portfolioEconomic
A risk management framework
Copyright ©1998 Ian H. Giddy Managing Financial Risk 27
How Effective is My Company’s Risk Management?
Don’t measure risk No linkage of risk to
value No effort to anticipate Lack of business risk
policy
Fragmented effort Narrow focus Poor risk
communications Lack of an
integrated risk assessment framework
Warning Signs:
Copyright ©1998 Ian H. Giddy Managing Financial Risk 28
Risk Management is a Process
Corporate Risk Management
DefineDefine MeasureMeasure ManageManage MonitorMonitor
Copyright ©1998 Ian H. Giddy Managing Financial Risk 29
Risk Management is a Process
Corporate Risk Management
DefineDefine MeasureMeasure ManageManage MonitorMonitor
Copyright ©1998 Ian H. Giddy Managing Financial Risk 30
Risk Management is a Process
Corporate Risk Management
DefineDefine MeasureMeasure ManageManage MonitorMonitor
Copyright ©1998 Ian H. Giddy Managing Financial Risk 31
Risk Management is a Process
Corporate Risk Management
DefineDefine MeasureMeasure ManageManage MonitorMonitor
Copyright ©1998 Ian H. Giddy Managing Financial Risk 32
Formalize Risk Management Policy and Control Framework
Corporate Risk Management
DefineDefine MeasureMeasure ManageManage MonitorMonitor
• Develop an outline of a policy statement, or recommend improvements to existing document
• Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices
• Assess centralization issues related to financial risk management and treasury design
Copyright ©1998 Ian H. Giddy Managing Financial Risk 33
Identification and Definition of Financial Exposures
Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile.
Translation Exposure, Transaction Exposure, and
Economic Exposure
• Long-term versus short-term exposure
• Intracompany versus third party exposure
• Cross currency exposure
• Competitive exposures
Absolute Rate Risk, Convexity, Basis or
Correlation Risk
Currency Interest Rate
• Short-term liquidity portfolio
• Investment portfolio
• Capital markets borrowing
• Leasing portfolio
Price Risk, Basis or Correlation Risk
Commodity
• Procurement
• Inventory
• Sales elasticity
Copyright ©1998 Ian H. Giddy Managing Financial Risk 34
Market Risks: Definitions
Three Views of
Market Price Risk:TransactionsBalance Sheet/PortfolioEconomic risk.
Copyright ©1998 Ian H. Giddy Managing Financial Risk 35
Market Risks: Definitions
Three Views of
Market Price Risk:TransactionsBalance Sheet/PortfolioEconomic risk.
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 36
Transactions Exposure
Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain dateExample: If Nokia invoices a NTT of Japan in
Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen.
This kind of exposure is readily hedgable using forwards, futures or debt
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 37
But Transactions Exposure Can be Misleading...
Austin Computer purchases notebook computers in Taiwan for sale in the US.
Austin must pay in NT$. Should it hedge its anticipated
payments for 1996?
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 38
Austin Computer
NT$
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 39
Interest Rate Risk:Portfolio
Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio
Bond price fluctuations will affect the balance sheet
Can be hedged, using duration as a risk/sensitivity measurement tool
Can be hedged with futures, bond options, and swaps.
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 40
Pepsico Pension
Assets (each $10m):1-year E$ deposit5-year, 6% T-note
D=4.610-year Strip
Pension liabilities:$10m 3 years$10m 5 years$10m 7 years
What is Pepsico pension fund’s risk? Duration of the assets (+ve)Duration of the liabilities (-ve)Net duration is the risk to be hedged!
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 41
Value at Risk: SantosBank
Asset and liability positions for a Brazilian bank’s New York branch.
What risk does it face?
INSTRUMENTSANTOSBANK
POSITIONS
30 day ($1,250,000)
90 day ($100,000)
180 day $450,000
1 yr $120,000
2 yr $120,000
3 yr $120,000
4 yr $1,120,000
5 yr $0
7 yr $0
9 yr $0
10 yr ($420,000)
15 yr $0
NET $160,000
TOTAL $3,700,000
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 42
BIS: Minimize Value at Risk
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Mean
Value-at-RiskValue-at-Risk
INSTRUMENTSANTOSBANK
POSITIONS
30 day ($1,250,000)
90 day ($100,000)
180 day $450,000
1 yr $120,000
2 yr $120,000
3 yr $120,000
4 yr $1,120,000
5 yr $0
7 yr $0
9 yr $0
10 yr ($420,000)
15 yr $0
NET $160,000
TOTAL $3,700,000
+
=
Copyright ©1998 Ian H. Giddy Managing Financial Risk 43
Market Price Risk: Economic
Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates, FX, commodity prices
It affects the shareholder value, but may be difficult to quantify
Hedging may require tailored solutions
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 44
Inmet Mining Corp.
In 1994 Canadian mining company Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds?
Answer: Business exposure is to lead & zinc prices (mine shutdown in Oct 96 because of low zinc prices)
Hedge with digital option linking cost of funds to lead & zinc prices
Copyright ©1998 Ian H. Giddy Managing Financial Risk 45
Market Price Risks: Summary
Three Views of
Market Price Risk:Transactions - lock in
forward ratePortfolios
Avoid duration mismatchingMinimize Value at Risk
Economic risk - business sensitivity to market prices.
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Copyright ©1998 Ian H. Giddy Managing Financial Risk 48
Heineken Hedges
Heineken plans to borrow DM15 million in 3 months to expand its Heineken Ice advertising campaign.
The Treasurer wishes to lock in a cost of funds.
One way is with a Forward Rate Agreement (FRA): Vereinsbank agrees to pay Heineken if 3-mo DMLibor>6%, and vice-versa.
Copyright ©1998 Ian H. Giddy Managing Financial Risk 49
Let’s Quote an FRA rate
MaturityDM Libor Implied Forward
3 mo 3.28 n.a.6 mo 3.41 3 to 612 mo 3.41 6 to 12
Monday, February 12, 1996
Copyright ©1998 Ian H. Giddy Managing Financial Risk 50
Borrow for 6 months at 5%Borrow for 6 months at 5%
FRA Mechanics
Invest for 3 months at 4%Invest for 3 months at 4% Lock in cost at 6%Lock in cost at 6%
SET RATE AT 6%
IF LIBOR > 6%, V PAYS H
IF LIBOR < 6%, H PAYS V
HOW MUCH?
PV[(LIBOR-6%)/4]
Copyright ©1998 Ian H. Giddy Managing Financial Risk 53
Borrow for 6 months at 5%Borrow for 6 months at 5%
The Law of One Price
FRA (forward rate agreement)FRA (forward rate agreement)
Invest for 3 months at 4%Invest for 3 months at 4% Lock in cost at 6%Lock in cost at 6%
Lock in 6%Lock in 6%
Futures contractFutures contract Lock in 6%Lock in 6%
Interest rate swapInterest rate swap Lock in 6%Lock in 6%
Copyright ©1998 Ian H. Giddy Managing Financial Risk 54
Interest Rate Swaps
An interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time.
Effectively, it involves paying the difference between a fixed rate and Libor:
JALJAL BVBSwaps
BVBSwaps
10% Fixed
3-mo Libor,
floating
Copyright ©1998 Ian H. Giddy Managing Financial Risk 55
Caps and Floors
An interest-rate collar involves buying a cap and selling a floor:
RATE
TIME
5%
7%
Copyright ©1998 Ian H. Giddy Managing Financial Risk 56
Borrow for 6 months at 5%Borrow for 6 months at 5%
The Law of One Price
FRA (forward rate agreement)FRA (forward rate agreement)
Invest for 3 months at 4%Invest for 3 months at 4% Lock in cost at 6%Lock in cost at 6%
Lock in 6%Lock in 6%
Futures contractFutures contract Lock in 6%Lock in 6%
Interest Rate SwapInterest Rate Swap Lock in 6%Lock in 6%
Cap & Floor at 6%Cap & Floor at 6% Lock in 6%Lock in 6%
Copyright ©1998 Ian H. Giddy Managing Financial Risk 57
Borrow for 6 months at 5%Borrow for 6 months at 5%
Linkages Between Instruments
FRA (forward rate agreement)FRA (forward rate agreement)
Invest for 3 months at 4%Invest for 3 months at 4% Lock in cost at 6%Lock in cost at 6%
Lock in 6%Lock in 6%
Futures contractFutures contract Lock in 6%Lock in 6%
Commodity spreadCommodity spread Lock in 6%Lock in 6%
Interest rate swapInterest rate swap Lock in 6%Lock in 6%
Copyright ©1998 Ian H. Giddy Managing Financial Risk 58
Positions
FRAsAssets & Liabilities
Futures Swaps
Hybrids
Factors
Reducing Positions to Factors
Copyright ©1998 Ian H. Giddy Managing Financial Risk 59
Three Views of Interest Rate Risk
Transactions
Exposure
Transactions
Exposure
Portfolio
Exposure
Portfolio
ExposureEconomic
Exposure
Economic
Exposure
Assignment
Copyright ©1998 Ian H. Giddy Managing Financial Risk 61
Aero Lloyd
Aero Lloyd is wants to benefit from lower rates but is afraid of a higher cost of funds in the future. Should it:Convert the Vereinsbank line into a 3-year fixed rate
term loan at 8.85%Fix Aero Lloyd's short-term cost of funds by means of
a 3-month FRA , starting in three months.Hedge against rising interest rates using interest rate
futures.Renegotiate the leases at a floating rate.Convert Aero Lloyd's cost of funds into floating by
means of an interest rate swap. The 3-year swap rate was 6.97%.
Do nothing at present?
Copyright ©1998 Ian H. Giddy Managing Financial Risk 62
Aero LloydExhibit 1. Current Interest Rates
EuroD M Interest Rates
1 month 3 months 6 months 1 year
5 1/4 - 5 7/16 5 7/16 - 5 5/8 5 11/16 - 5 7/8 6 - 6 3/16
3-Month EuroD M Futures Contracts (IMM) $1m points of 100%
Open Settle Change High Low Volume Open Interest
MarJunSep
94.1493.8293.67
94.2193.9393.80
+ 0.07+ 0.11+ 0.13
94.2794.0294.00
94.1193.7993.62
76,85986,70679,942
411,868440,381293,293
Bunds and S waps
Bund Yields (annual) Interest Rate SwapsSpreads over Bunds(basis points)
3 month6 month1 year2 year3 year5 year
5.265.505.746.216.406.59
45-4846-5052-5753-58
Exhibit 1. Current Interest Rates
Copyright ©1998 Ian H. Giddy Managing Financial Risk 63
Interest Rate Risks: Summary
Three Views of Interest Rate Risk:Transactions - lock in a ratePortfolios - avoid duration
mismatchingEconomic risk - evaluate the
business sensitivity to interest rates.
Copyright ©1998 Ian H. Giddy Managing Financial Risk 67
www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
http://www.giddy.org