copyright anbirts 1
Definition of Risk
Variability of Possible Returns
Or
The Chance That The Outcome
Will Not Be As Expected
copyright anbirts 2
Why Manage Risk?
Objective of the Organisation
Maximise Shareholder Wealth
How? Cash Flow = Value
Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital
copyright anbirts 3
Should We Manage Risk?
• Perfect Markets
• Parity
• Portfolio Theory
copyright anbirts 4
• Risk Management Culture – Focus• Identify• Categorise• Measure• Impact• Manage• Define Accountability• Report• Policy
Risk Management Process
copyright anbirts 5
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
copyright anbirts 6
Categorisation
Different Ways
BusinessFinancial
• Avoidable
• Transferable
• Manageable
copyright anbirts 7
Financial Risks
Price/Market Risk
• Foreign Exchange
• Interest Rate
• Equity/Bonds
• Commodity
copyright anbirts 8
Financial Risks
Liquidity
• Cash Flow
• Opportunity Cost
• Cash Concentration
copyright anbirts 9
Financial Risks
Credit
• Default
• Concentration
• Systemic
copyright anbirts 10
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.
copyright anbirts 11
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
copyright anbirts 12
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.
copyright anbirts 13
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?
copyright anbirts 14
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
copyright anbirts 15
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.
1
2
3
4
5
6
7
8
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
copyright anbirts 16
Approaches To Hedging
1. Foreign Exchange
– Spot
– Forwards
– Money Market Hedge
– Swaps
– Options (not covered)
copyright anbirts 17
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
copyright anbirts 18
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
copyright anbirts 19
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
copyright anbirts 20
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
copyright anbirts 21
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
copyright anbirts 22
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
copyright anbirts 23
Foreign Exchange Policy Issues
• 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
copyright anbirts 24
Foreign Exchange Policy Issues
• Instruments– Define proportions in each– Options – write covered or uncovered, buy
• Set Limits– Overall limits– Individual limits
• Treasury Procedures
copyright anbirts 25
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
copyright anbirts 26
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
copyright anbirts 27
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
copyright anbirts 28
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
copyright anbirts 29
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
copyright anbirts 30
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
copyright anbirts 31
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
copyright anbirts 32
Interest Rate Risk
Instruments
• Forward Forward Money
• Forward Rate Agreement
• Interest Rate Swap
• Interest Rate Options
copyright anbirts 33
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
copyright anbirts 34
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.
copyright anbirts 35
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
copyright anbirts 36
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
copyright anbirts 37
Interest Rate SwapComparative Advantage
Fixed Floating
AAA 8 Libor + 1/4
BBB 10 Libor + 1/2
Difference 2 1/4
Benefit 13/4
copyright anbirts 38
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
copyright anbirts 39
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
copyright anbirts 40
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.
copyright anbirts 41
Interest Rate Cap
Unhedged Rate
0
1
2
3
4
5
6
7
8
9
10
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
copyright anbirts 42
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.
copyright anbirts 43
Interest Rate Collar
Unhedged Rate
0
1
2
3
4
5
6
7
8
9
10
Unhedged Rate
Hedged Rate
Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%
copyright anbirts 44
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
copyright anbirts 45
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
copyright anbirts 46
Duration
Duration = 4,312.13 = 4.31 years
1,000
Known as Macauley Duration
copyright anbirts 47
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.
copyright anbirts 48
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%.