presented by: the northern trust company fran wawrzyniak, ctp june 7, 2012

© 2012 Northern Trust Corporation

Presented by: The Northern Trust CompanyFran Wawrzyniak, CTPJune 7, 2012

Windy City Summit CTP Review

Chapter 9

Service Expertise Integrity

IntegrityExpertiseService2 Windy City Summit CTP Review

Chapter 9

Financial Risk Management

Fran Wawrzyniak, CTP

IntegrityExpertiseService3 Windy City Summit CTP Review 3

Studying this Chapter

There are 8-10 questions from this chapter on the exam Know Overview of Financial Risk ManagementKnow Derivatives InstrumentsKnow Different Exposure

Interest Rate

FX

Commodity

Accounting and Tax Issues


Overview of Risk Management in Treasury

Financial risk is the risk of direct or indirect losses resulting from the uncertainty of the future level of interest rates, FX rates, commodity prices, or from adverse impacts on a company with highly leveraged capital structure



Techniques to evaluate the impact of risk-reducing eventsValue-At-Risk (VaR)

Developed by traders to estimate the possible loss for the entire trading operation Volatility of an expected average value (such as cash flow) and a standard

deviation of the distribution of future outcomes

Sensitivity Analysis What-If exercise to determine how sensitive cash flow is to changes in variables

Scenario Analysis Similar to Sensitivity Analysis but multiple variables are altered High and low variables are used to find the overall best and worst possible

outcomes

Monte Carlo Simulation An extension of Sensitivity Analysis, but includes a series of probability

distributions to produce an overall probability distribution of some final measure or outcome



Measuring the exposure of changes of prices of assets which can alter the company’s risk profile. Hedging – Use of financial instruments to reduce or eliminate risk of future

cash flows

Speculation – Betting on the direction of the market - Will the price of an asset will go up (long) or down (short)?

Arbitrage – Buying an asset in one market while simultaneously selling in another. Transaction assumes no risk but attempts to profit from market inefficiencies

The Benefits of Risk Management Reduced financial stress on company

Greater predictability of future cash flows

Enhanced borrowing advantage


Derivative Instruments Used As Financial Risk Management Tools

A derivative instrument is a financial product that acquires it value by inference through a formulaic connection to another asset.

Companies usually need to sign an International Swap and Derivative Association (ISDA) Agreement

Standard industry contract

Defines terms and conditions of the derivative contract

Types of Derivative Instruments

Forwards

Futures

Swaps

Options


Derivative Instruments

Forwards

Contracts between two parties that require specific action at a later date at a price agreed upon today

Future Date = Maturity Date

Contract Price = Delivery price

Not traded on an organized exchange

The buyer is in a long position, the seller is in a short position

Long position gains value when the price rises and loses when the price falls



Forwards - Contracts between two parties that require specific action at a later date at a price agreed upon today

Future Date = Maturity Date

Contract Price = Delivery price

Not traded on an organized exchange

The buyer is in a long position, the seller is in a short position

Long position gains value when the price rises and loses when the price falls



Futures - Same as Forward, but have standardized contracts and are traded on organized exchanges

Contract size and its maturity date set by exchange

Requires a margin account

Daily mark-to-market and margin calls if necessary



Swaps - Agreement to exchange (or swap) a set of cash flows at a future point in timeInterest rate swap most common type of swap. One party

swaps its floating interest rate for a fixed rate and vice versaAllows Companies with weaker credit ratings to get better

rates Other types include currency, commodity and basis swapsPrimary risk is counterparty risk



Options - Contract between two parties where the buyer has the right (not obligation) to buy or sell a fixed amount of underlying asset at a fixed price on or before a specified date Counterparty is the Writer of the option and received the price paid

May be exchange-traded or negotiated between two parties

Call Option: the contract allows the owner to buy the asset at a fixed price

Put Option: the owner has the right to sell the asset at a fixed price

Fixed price is the strike/exercise price of contract

Possible relationships between premium and strike price:

At-the-money→ asset price = strike price

Call Out-of-the-Money →asset price less than strike price

Put Out-of –the-Money → asset price greater than strike price

Call In-the-Money → asset price greater than strike price

Put In-the-Money → asset price less than strike price



Options (continued)

Strike/exercise price—The fixed or contracted price of the underlying asset

Maturity date (or exercise date)—Specified date after which the option expires

Seller of option receives a premium from the buyer

American Style – you can settle at any time during the option period

European style – you can only settle on the option expiration date

Bermuda style – you can settle at predetermined date or at expiration


Foreign Exchange (FX) Risk Management in Treasury

FX rates are quoted in several ways, depending on the currency and the markets involved

One U.S. Dollar equivalent to foreign currency

One foreign currency equivalent to U.S. Dollar


Foreign Exchange (FX) Exposure

Rates are obtained by real-time rate reporting services (Bloomberg, Reuters), through a dealer or free on the internet

FX Markets Spot Market

Current exchange rates

Settled in one or two days – such as Canadian dollars or Mexican pesos in the US

Forward Market Settled in more than two days – such as European and Asian currencies in the US

Current spot rate plus or minus interest rate differential (interest rate parity)

Forward points· Par – interest rates are the same· Discount – currency with higher rate will trade· Premium – currency with lower rate will trade


Foreign Exchange (FX) Exposure

Change in Foreign Exchange RatesTypes of FX exposure

Economic ExposureGlobal markets and related currencies causes the price of goods

to changeEven if a company does not have a global business perhaps their

competitors doTransaction Exposure

Physically converting one currency for another currencyTranslation Exposure

Consolidating foreign subsidiary's financial statements into the parent company's currency

Accounting exposureLarge amount to hedge, loans in the foreign currency can hedge

this exposure


Currency Derivatives Used to Hedge FX Exposure

FX Derivatives

Currency or FX Forwards – Commitment to buy foreign currency at a future date.

Currency Futures – Similar to forwards but traded on the exchange and standard contract.

Currency Swaps – Exchange of floating rate cash flow in one currency for fixed in another currency.

Currency Options – Right to buy or sell fixed amount of foreign currency at a fixed exchange rate, on or before specified date.



ForwardU.S. company agrees to pay an invoice for 125,000 GBP

in 90 daysBuy GBP and sell USDForward FX exchange rate = 1.6365 (current spot rate

plus or minus forward points)90 days the company must deliver $204,563

(125,000*1.6365) to counterpartyCounterparty will deliver 125,000 GBP wherever the

company needs it to



FuturesU.S. company agrees to pay an invoice for 125,000 GBP

in 90 daysBuys future contract at an exchange rate of 1.6365 and

puts up cash marginIn 90 days company buys GBP in spot market to deliver

to supplier and sells USDIf futures contract has a gain then the company can sell

the futures contract for a profitIf futures contract has a loss then cash margin is lost



Swaps

U.S. company borrows in the U.S. markets to fund an investment in Japan

Interest expense in USD and interest income in Yen

To reduce FX exposure company swaps Yen interest income for USD at a fixed rate over the term of the debt

Company still owes money to the U.S markets but instead of receiving Yen it will receive USD



OptionsU.S. company agrees to pay an invoice for 125,000 GBP

in 90 daysBuy GBP and sell USDBuys option contract at an exchange rate of 1.6365 and

pays an upfront premium

Caps, floors, collarsIn 90 days company has the OPTION to buy GBP in spot

market or at the option price depending on what the then current FX rates are trading at


Interest Rate Exposure and Risk Management

Companies with variable interest rate investments face lower earnings (interest income) when rates fall

Companies with variable interest rate debt face higher borrowing costs (interest expense) in rising rate environment



ForwardsBuyer can lock in a rate (price) today to be used in the future

Forward Rate Agreement (FRA)

FuturesTraded on the Chicago Mercantile Exchange

SwapsExchange cash flows of two different securities

Fixed-floating swap most common


OptionsInterest Rate Cap - ensures a floating rate loan receives a

ceiling if interest rates rise

Interest Rate Floor - a hedge against rates dropping below a certain level

Interest Rate Collar - combo of Cap and Floor that effectively locks in a range for its borrowing costs



Commodity Price Exposure

Price Exposure- potential for changes in price of commodity (agriculture and meat products, oil and gas, minerals, and metals)

Two types of exposure

Price – mitigate with derivatives

Delivery – mitigate with long-term contracts

Exposure hedged by Forwards, futures, swaps, and options


Other Issues Related to Financial Risk Management

Accounting IssuesAddressed by International Accounting Standards Board

(IASB) and Financial Accounting Standard Board (FASB)Valuation and Disclosure of Derivative Instruments

Primary problem is determining accurate value when mark-to-market is applied

Updates made to accounting rules Topic 820-10 (Fair Value Measurement) Topic 815 (Derivatives and Hedging)



Impact on Derivatives from Dodd-Frank ActBrings more transparency and accountability to derivative

markets

Closes regulatory gaps

Requires central clearing and exchange trading

Requires market transparency

Adds financial safeguards

Sets higher standards of conduct



Tax Issues Related to Hedging Very complex tax issues when using hedges

Errors in the accounting treatment can be very costly especially if restatement of earnings is involved

More complex for global companies

Wrongs methods could impact gains and losses

Obtain legal, tax, and accounting experts who specialize in this area



Hedging Policy StatementShould come from the highest level in an organization as

possible (board of directors) Policy statements for FX risks, interest rate risks, and

commodity pricing risk



Emerging Markets – Special challenges companies face:Tightly managed currencies (F/X and availability) Not all hedging instruments are available

Emerging Market CurrenciesFall into one of three baskets

Free floating Capital controls Non-readily tradable in global F/X marketplace



Issues with Exotic CurrenciesLiquidity

Volatility

Transparency

Capital controls

Carrying risk

Pricing distortions

Risk-sharing options

Internal hedging alternatives

Transfer risks



Issues with Exotic Currencies Low level of transaction activity

Dramatic fluctuations

Central bank restrictions

Less developed financial markets


Hedging Tools Available for Emerging/Exotic Currencies

Non-Deliverable Forward (NDF)

Cash settled in a major base currency and used when exotic currency is not actively traded in the forward market

On settlement, there is no exchange of currencies, only the difference between the NDF rate and the spot rate.

Non-Deliverable Option (NDO)

Same as NDF but buyer has the right (an option) to buy or sell

presented by: the northern trust company fran wawrzyniak, ctp june 7, 2012

Documents

treasuryfinancial risk

risk of direct

risk vardeveloped

impact of risk

companys risk profile

financial product

use of financial instruments

cash concentration