financial risk management (9_2636_001)
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FINANCIAL RISK MANAGEMENT
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FINANCIAL RISK
An unplanned event with financial consequences.
Could be profit or loss.
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WHAT IS RISK?
Risk is uncertainty
Risk is volatility of earnings
Risk is deviation of actual outcomefrom expected outcome
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FINANCIAL RISK MANAGEMENT
Controlling sensitivity to any outcome whichwould alter the bottomline of a business
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Risk Management entails management of:
• Commodity Price• Equity Price
• Interest Rates
• Exchange Rates
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What is Likelihood of Happening
Past Volatility creates Future Uncertainty
US$ Interest Rate
11.
0
1 O.O
8.O
5.O
1989 199O 1991
9.OH
7\O -\
6.OH
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Conversely, lack o» past volatility can create false security
3-MONTH FRENCH FRANC RATES
%16
J F M A M J J A S O N D J F M A M J J A S O N D J
^---------------------1991 ~-------------------► <---------------- — 1992—-------- ► 1993
Source: Dalastream
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Interest
Rates
Balance SheetStem
Effect of hate
Movement
Fall
Rise
Fixed rate borrowing
Floating rate borrowing
Fixed rate investment
Floating rate investment
Fixed rate borrowing
Floating rate borrowing
Fixed rate investment
Floating rate investment
Unable to reduce interest cost
Interest cost fallsIncome stream maintained, value of
asset rises
Income stream falls, value of assetlargely unaffected
Borrowing cost maintained
. Borrowing cost rises
Income stream falls in real terms,
value of asset falls
income stream rises, value of asset
largely unaffected
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RISKS CAN BE REDUCED
BUT NOT ELIMINATED
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RISK / REWARD PROFILE
1. PURCHASE CERTAINTY
FX, FORWARD FX, FUTURES, FRAs, LR.S
2. TAKE A VIEW
LEAVE AN EXPOSURE OPEN
3. PARTIAL HEDGE
ELIMINATE UNACCEPTABLE RISKLEAVE SOME EXPOSURE OPEN
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Financial Exposure
Interest Rate Exposure
Arises when financial assets and liabilitieshave a mismatch in maturity or interest ratebasis.
Currency Exposure
Arises when foreign currency receivables andpayables do not match each other in amount
and timing because the future conversionvalue of net inflows into domestic currency of accounting is unknown.
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Example of Financial Exposure
Interest Rate Exposure
A commercial bank extends floating rate U.S.dollar loans to its corporate client base. Thebank itself issues a fixed coupon, dollar-denominated Eurobond to fund its dollar assets. A drop in dollar interest rate will bringthe bank's future profitability in jeopardy.
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Example of Financial Exposure
Currency Exposure
An Indian Company makes a major part of itsexports in U.S. dollars. The current need for working capital is funded through low interestSwiss Franc loans. If U.S. Dollar depreciatesvis-a-vis Swiss Franc, the profitability will besqeezed.
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Foreign Exchange Exposures
Transaction Exposure
Measures the impact of changes in exchangerates on near-term or medium term payables,receivables, or cash-flows.
Translation Exposure
Measures the impact of translation of assets,liabilities, revenues and expenditures from
foreign currency into home currency in whicha firm's financial statements are expressed.
Economic Exposure
Measures the impact of changes in exchangerates on future cash flows.
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RISK PROFILE
v
Decrease O Increase
P = PriceV = Value of the Firm
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RISK PROFILE
0 AP
AP = P - Pe
AV = V - 0
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HEDGING
Hedging creates a position suchthat the gain incurred on thehedge will offset the loss incurredon an underlying position or transaction.
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DERIVATIVE
Derivatives are contracts who value is derived fromthe value of some underlying asset such as
currencies, equities, commodities, or indicators likeinterest rates, stock market index or other indices
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BUILDING BLOCKS FORMANAGING FINANCIAL RISK
FORWARDS
FUTURES
SWAPSOPTIONS
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DERIVATIVE PRODUCTCLASSIFICATION
FORWARD CONTRACTS
(SYMMETRICAL HEDGES)
• Forward FX
• Currency Swap
OPTfONS CONTRACTS
(ASYMMETRICAL HEDGES)
• Currency Option
• Cap/Floor/Collar
Forward Rate Agreement • Interest Rate Guarantee (IRG)
Interest Rate Swap (IRS) Swaptions
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FORWARDS
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F O R W A R D S
A forward contract is an agreement to buy or sell agiven asset at a certain future date at a price agreed
between the two parties at the origination of thecontract
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F O R W A R D S
Payoff Profile
Long Position
Pay Off = ST- K
Short Position
Pay Off = K- ST
K = Delivery price of the assetST = Spot price of the asset at maturity
'■(+)
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HEDGING USING FORWARDCONTRACT
SYMMETRIC HEDGE
Decrease Increase
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HEDGING RISK USING FORWARD CONTRACT
AV
Payoff Profile
Risk Profile
AP
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FORWARDS
Advantages
o Simple instrument
Disadvantages
o Credit instrument and entails counterparty defaultorcredit risk
o Contract is settled only at maturity
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FUTURES
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FUTURES
A financial futures contract is an agreement to buy
or sell a standard quantity of a specific asset at
a fu tu re da te a t a p r i ce agreed be tweenthe two parties at the origination of the contract
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Futures
Characteristics
o Exchange traded contract
o Daily settlement
o Margin requirements
o Clearing House
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FUTURES CONTRACTS
• Precious Metals - Gold, Silver, Platinum
• Industrial Commodities - Aluminium,Copper, Lead, Nickel, Crude Oil, etc.
• Foreign Exchange - Swiss Franc,Deutsche Marks, British Pounds, FrenchFrancs, Japanese Yen, etc.
• Interest Bearing Securities- T-Bills, Gilts,Eurodollar Deposits, Corporate Bonds, etc.
• Stock Indexes - S&P 500 Index, FT Index,Nikkei Index etc.
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FUTURES EXCHANGES
United States Europe Far East
• Chicago Board of • London international • Hong Kong FuturesTrade (CBOT) Financial Futures Exchange
Exchange (LIFFE)• Tok o Stock
• Chicago Mercantile • London Futures and Exchange (TSE)
Exchange (CME) Options Exchange
• Tokyo International• New York • London Metal Financial Futures
Commodity Exchange (LME) Exchange (TIFFE)
Exchange
(COMEX) • MATIF • SingaporeInternational• Philadelphia Stock Monetary Exchange
(SIMEX)Exchange
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Futures
Forward Contract Futures Contract
Customised in terms of size and maturity dates.
Private contract betweentwo parties.
Traded on OTC.
Standardised in termsof size and maturitydates (3rd Wednesdayof March, June, Sept &DeconLIFFE).
Standardised contractbetween a customer and a clearing house.
Traded on the pit of anexchange e.g. CME,LIFFE, etc.
Iliquid secondary market Liquid secondarymarket
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Futures
Forward Contract Futures Contract
Profit or loss position isrealised only on deliverydate.
Performance period isthe same as maturity of the contract
Credit risk depends oncounterparty
Contracts are markedto market; profit andlosses are realisedday to day
Performance periodis reduced to one day
Credit risk practicallyabsent
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Futures
Advantages
o No credit risko Gearing - only small margins required o
Standardised contracts o Large and liquid
market
Disadvantages o Futures contract
does not provide a perfect hedgeo Standardised amounts and dates may not coincide
with actual requirement
o Daily margining is administratively burdensome
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FORWARD RATE AGREEMENT(FRA)
A FRA is an agreement between twoparties to contract an interest rate for aspecific period of time from a specifiedfuture date on an agreed notional
principal amount.
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FRA TERMINOLOGY
Buye
r
Party wishing to protect itself against a future rise
in interest rates
Seller Party wishing to protect itself against a future fall
in interest
Contrac
t Period
Period protected. Quoted as for e.g. 3 X 6
meaning the interest for a 3 month periodcommencing in 3 months time
Forward Date on which contract period begins.
Date
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FRA TERMINOLOGY (CONTD..)
Maturity Date on which contract period ends
Date
Settlement Date when the payment of the interest differential
Date is made. This is usually the same as the forward
date, but may be the maturity date instead
Fixing Date The date when the settlement date is determinedas is usually two business days prior to theForward Date
Trade Date Date on which the deal is struck i.e. the terms of
the FRA are set
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FRA TERMINOLOGY (CONTD..)
Contract The forward rate of interest agreed between the
Rate two parties on the day the deal is struck.
Settlement The floating rate index specified in the contract
Rate e.g. Libor
Settlement Difference calculated between the contract rate
Sum and settlement rate multiplied by the principalamount and the period of the contract.
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FRA TERMINOLOGY (CONTD..)
Fixing DateContract Period
0Trade Date
Forward Date
6
Maturity Date
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Forward Rate Agreements
On settlement date :-
If Libor > FRA rate
If Libor < FRA rate
buyer receives difference from seller
seller receives difference from buyer
Settlement amount
(F - L) * P * D
360 * 100 1 +(360 * 100)
F = FRA rate
L = LIBOR
P = Notional Principal Amount
D = Number of days in contract period
Financial Risk Management
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FRA PAYMENT SCHEME
Fixed Rate
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FRA QUOTATIONS
Start/ End USD(In Months) (%)
1 X7 5.87%
2X8 6.05%
3X9 6.34%
4X10 6.42%
6X12 6.54%
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Forward Rate Agreement
Interest Rate Hedge - 1
Situation Borrower with 3 month borrowingrequirement in 3 months time.
View
Aim
Interest rates will rise
Lock in to interest rate now to minimisefuture borrowing costs
Solution Buy an F.R.A.
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Forward Rate Agreement
Interest Rate Hedge - 2 3-6 month
FRA quoted at 7-6 7/8 Company buys 3-6 F.R.A. for
notional principal at 7%
a) Rate at borrowing date 8%
Company borrows at 8%
- Receives 1 % On settlement of F.R.A.
b) Rate at borrowing date 6%
Company borrows at 6%
- Pays 1 % On settlement of F.R.A.
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Forward Rate Agreements
Example
Customer has a floating rate loan of USD 5 mio that resetsevery 3 or 6 months based on USD Libor. i
The next rollover of the loan is in 4 months time and the
customer anticipates fixing for 3 months. They are
concerned that interest rates may rise, albeit
temporarily.
Solution
Buy a 4 * 7 USD FRA @ 3.26
(Market Price 3.26/3.21)
Financial Risk Management
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Forward Rate Agreements4.5
,Do nothing
3 S t S
B o r r o w i n g c <
3.5
3
2.5-
Buy FRA
^ ^
2
5 3.26 3.5 3.75 4 4.25
Lib or
Financial Risk Management
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Forv\larci Rate Agreenrfent
Market Characteristics
* Developed out of forward/forward depositmarket.
* Market is primarily interbank. Contracts withnon-bank customers are arranged throughbrokers.
* Predominantly (90%) in US Dollars. Other currencies include Pound Sterling, Deutschemarks and Swiss Francs.
* London is the main centre accounting for about 40% of the market. New York is nextwith about 25% of the market.
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Rate
Agreerwent
Advantages
* Simple Documentation - Standard"FRABBA" terms and conditions used.
* Flexible Features - Notional principalamount, contract dates and interest periodsare fixed by agreement between partieswithout margin requirements.
* Direct Settlement - No clearing facility
* Off-Balance Sheet item - principal amountnever exchanged and exposure limited tocompensation payment.
* Enables banks to improve capital ratios andreturn on assets.
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Forward Rate AgreementDisadvantages
Market not liquid over 18 months.