copyright anbirts1 definition of risk variability of possible returns or the chance that the outcome...

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Definition of Risk

Variability of Possible Returns

Or

The Chance That The Outcome

Will Not Be As Expected

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Why Manage Risk?

Objective of the Organisation

Maximise Shareholder Wealth

How? Cash Flow = Value

Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital

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Should We Manage Risk?

• Perfect Markets

• Parity

• Portfolio Theory

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• Risk Management Culture – Focus• Identify• Categorise• Measure• Impact• Manage• Define Accountability• Report• Policy

Risk Management Process

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Why Identify Risks?

• Unidentified risks will not be managed

• Managing risks can improve performance

• Identification provides information about riskiness

• Alerts the Organisation to the importance of risk

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Categorisation

Different Ways

BusinessFinancial

• Avoidable

• Transferable

• Manageable

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Financial Risks

Price/Market Risk

• Foreign Exchange

• Interest Rate

• Equity/Bonds

• Commodity

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Financial Risks

Liquidity

• Cash Flow

• Opportunity Cost

• Cash Concentration

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Financial Risks

Credit

• Default

• Concentration

• Systemic

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Translation Exposure

Translation exposure represents the effects, as reflected in the balance sheet and/or profit and loss account, of a movement in exchange rates between reporting dates on the translation of assets and liabilities denominated in foreign currencies.


Translation Exposure (In Millions)

ASSETS USD @ 1.20

GBP

@ 1.50

GBP

LIABILITIES USD @ 1.20

GBP

@ 1.50

GBP

Cash 15 12 10 Creditors due in one year

95 79 63

Investments 20 17 13 Creditors due over one year

6 5 4

Debtors 65 54 44 Provisions 1 1 1

Fixed Assets 20 17 13 Shareholder Funds

18 15 12

120 100 80 120 100 80


Economic Exposure

The risk that, long term, the relative appreciation in real terms, of the currency in which a company’s major costs are denominated, will adversely affect that company’s competitive position.


Economic Exposure: An Example CoAManufacturer in UK selling to France• Inflation rate 4% p.a.• Current Price GBP 100• Current Exchange Rate EUR/GBP.6503Competitor in France• Inflation Rate 2% p.a.• Current Price EUR 153.7752At Year EndIf PPP held• UK Price GBP 104 (100 x 1.04)• French Price EUR 156.85068 (153.7752 x 1.02)• Therefore Exchange Rate 104 = .6630509

156.85068But if rate has moved to EUR/GBP .6300 then UK Price of GBP 104 = EUR 165.08French price of EUR 156.85

Will they sell any goods?


Transaction ExposureThe risk that arises from exchange rate changes reflected in the day to day trading activities of a company.

TRANSACTION EXPOSURE

EXAMPLE

Receipt due 180 days USD 1,000,000

GBP value @ current spot of 1.44

694,444

GBP value @ current spot of 1.50

666,666

LOSS 27,778


Interest Rate RiskThe risk of loss of interest revenue that occurs when interest rates change, through the mismatch of re-pricing of assets and liabilities.

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0 1 2 3 4 5 6

Lend 6 Months at 5.5Fund Three months at 4.25

Time: Months

Inte

res

t R

ate

s P

A

Yield curve


Approaches To Hedging

1. Foreign Exchange

– Spot

– Forwards

– Money Market Hedge

– Swaps

– Options (not covered)


IllustrationsSpot

Situation: Receipt of USD 10,000,000 in two business days time

Spot Rate GBP/USD 1.6356 – 1.6366

Sell USD to Bank, Buy GBP

Rate 1.6366Receipt GBP 6,110,228.52


IllustrationForward

Situation: Receipt of USD 10,000,000 in 32 days time

Spot Rate GBP/USD 1.6356 – 1.6366

1 month Points 9 7

1 Month Forward Outright 1.6347 – 1.6359

Sell USD to Bank one month forward and Buy GBP rate 1.6359

Receipt GBP 6,112,843.08


Illustration: Money Market Hedge

Spot Rate

GBP/USD 1.6356 – 1.6366

1 Month Points 9 – 7

Forward Outright 1.6347 – 1.6359

Interest Rates

GBP 5 5/8 – 5 13/32

USD 4 31/32 - 4 27/32

Borrowing Spread ½%

Borrow USD @ 431/32 + ½ for 30 days = 5.46875%

Amount Borrowed 10,000,000 = 9,954,634

1 + (.0546875 x 30/360)

Spot USD 9,954,634 to GBP at 1.6366 = GBP 6,082,509

Invest GBP 6,082,509 at 5 13/32 (5.40625) = 6,082,509 x.0540625 x 30/365 = GBP 27,028 = Total GBP at Day 32 = 6,109,537

Situation: Receipt of USD 10,000,000 in 32 days time


Illustration: SwapA Swap is a pure time operation which involves two way flows. In Foreign Exchange terms it is a simultaneous spot and forward. It will be priced off the forward transaction but use the same spot.

Example: Receiving Spot USD 10,000,000

Paying Away in 32 Days USD 10,000,000

Spot GBP/USD 1.6356 – 1.6366

1 Month Points 9 7

1 Month Forward 1.6347 1.6359


Illustration: Swap

Spot

Sell USD 10,000,000 at 1.6356

Buy GBP 6,113,964

In Forward

Buy USD 10,000,000 at 1.6347

Sell GBP 6,117,330


Foreign Exchange Policy Issues

Define Exposures to Be Managed– Economic– Translation– Transaction

Objective:Minimise FX losses and Maximise FX Gains Commensurate with a defined level of Risk



• Which exposures are important• Time Period

– Start Date• Price List, Forecast, Order Date

– End Date• Year end or beyond, invoiced or expected date

• Policy Alternatives• Cover Everything• Leave Open• Selective Cover• Hybrid



• Instruments– Define proportions in each– Options – write covered or uncovered, buy

• Set Limits– Overall limits– Individual limits

• Treasury Procedures


Value at Risk (VAR)

VAR estimates the potential pre-tax loss resulting from an adverse movement in market prices over a defined holding period.

• Equities• Commodities• FX• Interest Rates


VAR Correlation Approach

• Historic Data• Normal Distribution• 68% of changes

within one Standard Deviation (SD)

• 95% of changes within two SD’s

• 99% of changes within three SD’s

10 million (GBP equivalent)

long position in USD

SD .15%

Want 95% confidence

Max loss =

10,000,000 x .0015 x 2 = 30,000

Example: Single Asset


VAR Two Assets

[(VAR1)2 + (VAR2)2]

Example: Two Unrelated Assets10,000,000 (GBP equivalent) long in USD SD .15%10,000,000,Long (GBP equivalent) long in Euro SD.20%95% Confidence

VAR = [(10,000,000 x .0015 x 2)2 + (10,000,000 x .002 x 2)2]

VAR = (30,000)2 + (40,000)2

VAR = 900,000,000 + 1,600,000,000 = 2,500,000,000

= 50,000


VAR Correlation (Related Movements)

VAR = [(VAR1)2 + (VAR2)2 + 2 x VAR1 x VAR2 x R]

ExampleSame as above but Correlation Coefficient .6

VAR = (30,000)2 + (40,000)2 + 2 x 30,000 x 40,000 x .6]

VAR = 62,769


VARAdvantages

– Reasonably simple concept to communicate– Used to aggregate risks– Can correlate Profits to Risk (Performance Measurement)

Disadvantages– Based on major assumptions (normal distribution, history

repeats itself)– Complex mathematics– Sudden shifts of volatility– Appears scientific


Setting Limits: An ApproachCo Net Worth GBP 10,000,000

Prepared to Lose 2,000,000

Currency Exposure USD

Annual Volatility 20% and Monthly Volatility 20 x

Maximum Exposure Period: 6 months12

M

Month 1 2 3 4 5 6

Volatility 5.77 8.16 10.00 11.55 12.90 14.14

Position 3,198,976

Possible Loss

184,581 261,036 319,898 369,482 412,668 452,335

Maximum Loss 2,000,000


Interest Rate Risk - Gap Analysis

(1) At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit

Months 0-6 6-12 12-18 18-24 24-30 30-36 36-42 42-48

Principal 9000 7875 6750 5625 4500 3375 2250 1125

i @ 8% 365 319 273 228 182 137 91 46

+ Principal 1490 1444 1398 1353 1307 1262 1216 1171

Op profit 1598 1597 1598 1597 1598 1598 1597 1598

I @ 10% 456 399 342 285 228 171 114 57

+ Principal 1581 1524 1467 1410 1353 1296 1239 1182

i @ 12% 547 479 411 342 273 205 137 68

+ Principal 1672 1604 1536 1467 1398 1330 1262 1193

Op profit 1598 1597 1598 1597 1598 1597 1598 1597

Short Fall (78) (7) 62 130 200 267 336 404

(1) Op Profit 1279 1278 1279 1278 1279 1278 1278 1278

Short Fall (393) (326) (257) (189) (119) (52) 16 86

(2) Op Profit

Short Fall (302) (246) (188) (132) (74) (18) 39 97


Interest Rate Risk

Instruments

• Forward Forward Money

• Forward Rate Agreement

• Interest Rate Swap

• Interest Rate Options


Forward Forward MoneySituation: Need to borrow GBP 1,000,000 from 30 days time for 30 days

Current Interest Rate1 month 3-3½2 month 3¾-4Borrowing Spread ¼%Action: Borrow for 2 months at 4¼%, Deposit for 1 month at 3%

Borrow today GBP 997,540.31 and Deposit for 1 month997,540.31 x .03 x 30/365 = 2,459.69 = 1,000,000 in total at T30Cost of Borrowing: 997,540.31 x .0425 x 60/365 = 6969.12Total to Repay at 60 days = 1,004,509.43Effective Cost of Borrowing = 4,509.43 x 365/30 = 5.4865 from T30-T60

1,000,000


Forward Rate Agreements (FRA’s)

An agreement between two parties to compensate one another, in cash, on a certain date for the effect of any subsequent movement in market rates in respect of a future interest period.


FRA ExampleNeed to borrow GBP 1,000,000 in 30 days time for 30 days. Worried rates will rise.

Rate Agreed 51/8 (5.125)Actual Rate On Day T30 51/4

Compensation amount paid by Bank to Company1,000,000 x .05125 x 30/365 = 4,212.331,000,000 x .0525 x 30/365 = 4,315.07

= 102.74

= 102.74 = 102.30 1 + (.0525 x 30/365)

Quote Period Rate

1-2 5-51/8

1-4 51/8-51/4

3-12 51/4-53/8


Test

1,000,000, - 102.30 = 999,897.70

999,897.70 x .0525 x30/365 = 4,314.63

Less Compensation Amount = 102.30

Total Net Interest Paid 4,212.33


Interest Rate SwapComparative Advantage

Fixed Floating

AAA 8 Libor + 1/4

BBB 10 Libor + 1/2

Difference 2 1/4

Benefit 13/4


81/2

L

-(L + ½)

+(L)

-81/2

Net –9.0

AAA

-(8)

+ 8.1/2

-L

Net – (L –1/2)Benefit

¾ + 1

13/4

BBB81/2

L

-(L + ½)

+(L)

-81/2

Net –9.0


Interest Rate Swap

AAA

-(8)

+ 8.51/2

-L

Net – (L –1/2) 1/4

¾ ¾

13/4 Benefit

Bank81/2

L

-(L + ½)

+(L)

-83/4

–91/4

BBB

L

83/4

+ 1/4


Interest Rate Cap or Ceiling Agreement

An interest rate cap is an agreement between the seller or provider of the cap and the borrower to limit the borrower’s floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above.


Interest Rate Cap

Unhedged Rate

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0 1 2 3 4 5 6 7 8 9Market Interest

Rate

Hedged Rate

Eff

ectiv

e In

tere

st R

ate

Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million


Interest Rate Collar Agreements

An interest rate collar is an agreement whereby the seller or provider of the collar agrees to limit the borrower/investors floating interest rate to a band limited by a specified ceiling rate and floor rate.


Interest Rate Collar

Unhedged Rate

0

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Unhedged Rate

Hedged Rate

Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%


Duration

You have a bond, life 5 years with annual interest payments of 8%, face value GBP 1,000

What is your problem?

• Market Price Risk

• Re-Investment Rate Risk


DurationDuration gives an ‘average life’ of the cash flows of an instrument by weighting the Net Present Values of the cash flows by their timing.

Cash Flow Year NPV NPV x Y

80 1 74.07 74.07

80 2 68.59 137.18

80 3 63.51 190.53

80 4 58.80 235.20

1080 5 735.03 3675.15

1,000 4,312.13


Duration

Duration = 4,312.13 = 4.31 years

1,000

Known as Macauley Duration


Uses of Duration

Immunisation

Wish to fix yield on a portfolio of bonds regardless of whether interest rates go up or down.

Done by creating a portfolio of bonds with a Duration equal to the required period.


Uses of Duration

Price Sensitivity

Modified Duration which is Macauley Duration

(1 + y/n)

Where y = yield

n = number of discounting periods

4.31 = 3.99

(1.08)

Or increase in the market interest rate of 1% will lead to a drop in the value of the bond of approximately 3.99%.

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