15: Financial Risk Management

Question 1

Market Risks

Answer 1

Interest rate changes
Exchange rate changes
Commodity price changes
Equity price changes

Question 2

Financial Risk management

Answer 2

Having a mix of equity (lower risk) and debt (cheaper) finance
Having a mix of long term (lower risk) and short-term (cheaper) debt
Having a mix of fixed (lower risk) and variable (potentially cheaper) debt
Having a diverse portfolio of investments in different industries and different countries

Question 3

International portfolio diversification can be very effective for what five reasons

Answer 3

Different countries at different stages of trade cycle at any one time
Monetary, fiscal and exchange rate policies differ internationally
Different countries have different endowments of natural resources and different industrial bases
Potentially risky political events are likely to be localised within particular national or regional boundaries
Securities markets in different countries differ considerably in the combination of risk and return they offer

Question 4

Credit risk management

Answer 4

Vetting prospective customers before offering credit
Setting credit limits in terms of time and amounts
Sending regular statements to customers
Credit triggers terminating an arrangement if customer’s credit limit becomes critical

Question 5

Corporate reporting requirements (risk) - qualitative disclosures

Answer 5

For each type of risk:
- the exposures to risk and how they arose
- its objectives, policies and processes for managing the risk and the methods used to measure risk
- any changes in the above from the previous period

Question 6

Corporate reporting requirements (risk) - quantititve disclosures

Answer 6

In relation to credit risk

• maximum exposure at the year end
• the amount by which related credit derivatives or similar instruments mitigate the maximum exposure to credit risk
• the amount of change during the period and cumulatively in fair value that is attributable to changes in credit risk
• any collateral pledged as security
• information about the credit quality of financial assets

Question 7

For liquidity risk entities must disclose

Answer 7

maturity analysis of financial liablities
description of the way risk is managed

Question 8

Interest rate risks - Forward rate agreements - what is it?

Answer 8

A bespoke contract between two parties which exactly fixes the rate of interest on a future loan or investment.

Question 9

A 2 v 5 or 2 - 5 FRA would fix the rate of interest on a loan or investment …..

Answer 9

beginning in 2 months and ending in 5 months

Question 10

How do FRAs settle?

Answer 10

With a single cash payment or receipt made on the first day of the underlying loan or investment - this date is the settlement date.

Question 11

How is the settlement amount for an interest FRA calculated?

Answer 11

it’s in your book.

it’s the notional amount of the loan multiplied by the difference between the two rates over the reference rate but you have to time apportion it

Question 12

Advantages of an interest rate Forward Rate Agreement

Disadvantages of an interest Forward Rate Agreement

Answer 12

Advantages
- an FRA protects borrower from adverse movements away from the rate negotiated
- FRAs are flexible. They can be arranged for any amount and any duration (normally over $1m)
- FRAs may well be free (at any rate will cost very little)

Disadvantages
- if interest rates are expected to rise the bank may set the FRA higher than current spot rate
- the borrower will not be able to take advantage if rates fall unexpectedly
- the FRA will terminate on a fixed date (cashflow)
- FRAs are binding agreements

Question 13

Interest rate Futures - what are they?

Answer 13

Similar to forwards in that they attempt to fix interest rate for a future loan or investment.

Standardised traded contracts - often leads to imperfect hedging

Futures contracts require an initial margin deposit and also subsequent maintenance margin deposits

Question 14

Futures - Borrowers will wish to hedge against an interest rate rise by:

Answer 14

• selling futures now
• buying futures on the date that borrowing starts

You do to the underlying what you do to the hedge - if you are a borrower you are selling the right to receive your interest payments for cash now - therefore you sell futures

Question 15

Futures - Lenders will wish to hedge against an interest rate fall by:

Answer 15

• buying futures now
• selling futures on the date that borrowing starts

You do to the underlying what you do to the hedge - if you are a lender you are buying the right to receive future interest payments - therefore you buy futures

Question 16

How do we set up a futures hedge (interest rate)

Answer 16

• we decide which contract to pick - this will be the next available expiry date on or after the date of borrowing
• We decide if we are buying or selling - borrowers are selling their interest, lenders are buying their interest
• We decide the number of contracts - loan or investment size over contract size multiplied by loan length over contract length

Outcome
Sell today X
Buy later X
Difference x £contract amount x no. contracts x contract length (3/12)

= futures market outcome

so you deduct futures market outcome from what actually happened and you have the net cost of your loan

Then you can work out an effective interest rate

Question 17

Advantages and disadvantages of interest rate futures

Answer 17

Advantages
- costs are reasonably low (but not as cheap as forwards)
- company can hedge relatively large exposures of cash with a relatively small initial employment of cash

Disadvantages
- inflexibility of terms (standardised contracts)
- basis risk
- daily settlement (when losses arise on a futures position the company must make margin payments to cover the loss).

Question 18

What is basis risk?

Answer 18

We make the assumption that the difference between spot price and futures price (known as the basis) falls linearly over time.

Basis risk is the risk that the difference will not move in this predictable way and the hedge is less effective than expected.

Question 19

Interest options - what are they?

Answer 19

An instrument sold by an option writer to an option purchaser for a price known as a premium.

The specified rate of interest for borrowing or lending is the strike price for an option.

The option holder has the right but not the obligation to exercise the option on or before a specified expiry date.

Question 20

Interest options

A call option is:

A put option is:

Answer 20

A call option gives the holder the right to buy an underlying instrument at the strike price and obligates the writer to sell the instrument at that price if and when the option is exercised.

A put option gives the holder the right to sell an underlying instrument at the strike price and obliges the option writer to buy the instrument at that price if and when the option is exercised.

Question 21

What are the two types of interest options?

Answer 21

• Tailor made over the counter options - can be purchased from major banks with bespoke values, periods of maturity, denominated currencies and rates of agreed interest.
• Exchange traded options have standardised amounts, standardised periods and they give the holder the right, but not he obligation, to enter into interest rate futures contracts at a specified price on or before a specified date.
• If a company needs to hedge borrowing at a future date it should purchase put options to sell futures
• If a company needs to hedge lending money it should purchase call options to buy futures

Question 22

Interest rate options pros & cons

Answer 22

Pros
- upside risk - the company has the choice not to exercise the option and will therefore be able to take advantage of falling interest rates
- over the counter options - these are tailored to the specific needs of the company and are therefore more flexible than exchange traded options for a more exact hedge
- useful for uncertain transactions - for example you may be unsure if a loan will actually be needed. If it becomes evident that the option is not required it can be sold.

Cons
- premium - options are expensive compared with other hedging instruments
- maturity - the maturity of exchange rated options may be limited to one year
- potential for an imperfect hedge due to basis or rounded number of contracts

Question 23

Caps, floors and collars - what are they?

Answer 23

Cap - option that sets an upper limit on an interest rate
Floor - option that sets a lower limit on an interest rate
Collar - using a collar arrangement a borrower can buy an interest rate cap and sell an interest rate floor. This ensures interest paid will be somewhere between the two strike prices on the options. The premia on the cap and the floor will largely cancel out, reducing the cost for the company.

Question 24

Interest rate swaps

Answer 24

Can be used to turn a fixed interest rate loan into a floating rate loan or vice versa

Question 25

Swaptions

Answer 25

Give the holder the right but not the obligation to enter into a swap with the seller.

Question 26

Advantages of interest rate swaps & disadvantages

Answer 26

Advantages
- fixed rate loan can be swapped to floating if interest rates are expected to fall
- floating can be swapped to fixed if interest rates are expected to rise
- swaps can be arranged for any size and reversed if necessary
- low transaction costs
- both companies should pay less interest with a swap than without if their credit ratings differ
-swaps can change the nature of interest commitments with no need to renegotiate with lenders
- swaps are relatively easy to arrange

Disadvantages
- counter party risk - the risk that the other party will default leaving the first company to bear its obligations. This risk can be avoided by using an intermediary.
- if a company rakes on floating rate commitment it may be vulnerable to adverse movements in interest rates. If it takes on a fixed commitment it won’t be able to take advantage of favourable movements in rates.
- the lack of a secondary market in swaps makes it difficult to liquidate a swap contract.

Question 27

Summary of interest rate hedges

Answer 27

• Forward rate agreements
• futures
• options (OTC / traded)
• caps and collars (types of option)
• swaps / swaptions

Question 28

Foreign exchange rate risks

Answer 28

Transaction risk - the risk that exchange rate will change between the date that a price is agreed in a foreign currency and the date that cash changes hands

Translation risk - the danger of a business generating accounting losses when translating the results of overseas subsidiaries (cannot be hedged)

• Economic risk - the long term version of transaction risk - refers to the effect of exchange rate movements on international competitiveness

Question 29

If we are exporting to the US and the dollar weakens - what happens?

Answer 29

If the dollar weakens that means there are more dollars to the pound. That means that we need to make more dollars to get £s back. That means we lose competitive advantage.

Question 30

If we are exporting to the US and the dollar strengthens what happens?

Answer 30

If the dollar strengthens that means there are fewer dollars to the pound. That means that we need to make fewer dollars to get £s. That increases our competitive advantage.

Question 31

If we are buying from the US and the dollar weakens - what happens?

Answer 31

If the dollar weakens there are more dollars to the pound. That means that we can buy more dollars worth of stuff for fewer pounds. That is good for us.

Question 32

If we are buying from the US and the dollar strengthens - what happens?

Answer 32

If the dollar strengthens there are fewer dollars to the pound. This means that our pound won’t buy as many dollars worth of goods. That is bad for us.

Question 33

Exchange rates - the bank quotes two rates. Which one do we use?

Answer 33

The bank buys (the foreign currency) high and sells low

Question 34

FX exchange risk management - non hedging techniques

Answer 34

• invoice in home currency (the dream, but they won’t like it)
• match receipts and payments
• leading and lagging
• netting off inter company balances before payment takes place

Question 35

Forward contracts for FX - what are they

Answer 35

A binding agreement which fixes the exchange rate for the purchase or sale of a specified quantity of currency on or before a specified date.

A forward rate might be higher or lower than the current spot rate depending on the market’s current expectations for future exchange rates.

The forward rate can be determined using interest rate parity theory.

If a forward rate is quoted at a discounted you add this to the spot rate, and if at a premium you subtract it from the spot rate.

Question 36

Advantages of FX forwards

Disadvantages of FX forwards

Answer 36

Advantages
- fix a definite amount for a future inflow or outflow
- can be for any amount
- length of the contract can be flexible - usually less than 2 years

Disadvantages
- can be difficult to cancel as they are contractual obligations
- possible to be re-exposed to transaction risk if underlying transaction falls through

Question 37

Interest rate parity theory

Answer 37

IRPT states that wherever in the world we invest our money we should be equally wealthy in 1 year.

The formula is in the book with FX stuff and basically the forward rate = the current spot rate multiplied by the counter currency interest over the base currency interest

Question 38

Purchasing power parity (PPPT)

Answer 38

Not as good.

States that goods purchased anywhere in the world should cost the same amount. known as the law of one price. It predicts the expected spot rate by multiplying current spot rate with inflation in counter currency over inflation in base currency.

Question 39

Money market hedge

Answer 39

DIY hedge

Can be set up to cover future foreign currency payments of future foreign currency receipts. Used instead of forwards and have exactly the same effects.

Hedging a receipt involves borrowing the present value of the foreign receivable today in order to sell it at the spot rate.

Hedging a payment involves borrowing in the home currency today to fund the purchase of the present value of the foreign payable at the spot rate.

Both of the above serve to bring the FX purchase / sale forward to the present time so that a known exchange rate can be used.

Question 40

Currency futures - what are they?

Answer 40

Currency futures are similar to forward in that they attempt to fix an exchange rate for a future foreign payment or receivable.

However futures are traded and standardised which often leads to imperfect hedging.

Futures contracts require an initial margin deposit and also subsequent maintenance margin deposits.

Question 41

Currency futures - are we selling or are we buying?

Answer 41

Assuming that futures are denominated in sterling:

A UK company with a foreign receivable will need to sell the foreign currency. Therefore we are buying sterling.

Buy futures now
Sell futures on the day the receipt is due.

A UK company with a foreign payable will need to buy the foreign currency. Therefore we are selling sterling.

Sell future now
Buy futures on the day the payment is due.

In theory futures could be denominated in a different currency in which case the buying and selling above would be reversed.

Question 42

FX futures - what are the contract dates?

Answer 42

31st March
30th June
30th September
31st December

(and you pick the next available expiry date)