C. Financial risks Flashcards
1
Q
what is financial risk?
A
a risk of a change in a financial condition such as:
- an exchange rate
- interest rate
- credit rating of a customer
- price of a good
2
Q
what is political risk?
A
risk faced by an overseas investor, that the host country government take adverse action against after the company, has invested
political risk is essentially to do with the wider risks of foreign direct investment
3
Q
is political risk a financial risk?
A
not necessarily a financial risk but included as financial risk is often from the perspective of foreign business activities
4
Q
what are some examples of political risk?
A
- quotas
- tariffs
- import duties
- laws requiring a minimum % of local workers and suppliers
- restrictions on repatriating cash (dividends or capital)
- confiscating overseas assets
5
Q
what are exchange control regulation?
A
generally more restrictive in less developed countries
- rationing the supply of foreign currencies which restricts residents from buying goods abroad
- banning the payment of dividends to foreign shareholders such as holding companies in multinationals, who will then have the problem of blocked funds
6
Q
what are import quotas?
A
limit the quantity of goods that subsidiaries can buy from its holding company to sell in its domestic market
7
Q
what are import tariffs?
A
make imports (from the holding company) more expensive than domestically produced goods
8
Q
what is insisting on a minimum shareholding?
A
some equity in the company is offered to resident investors
9
Q
what is company structure?
A
may be dictated by the host government
requiring all investors to be in the form of joint ventures with host country companies
10
Q
what are some restrictive exchange control regulation?
A
import quotas
import tariffs
insist on a minimum shareholding
company structure
11
Q
what are some discriminatory actions?
A
supertaxes
restricted access to local borrowings
expropriating assets
12
Q
what are supertaxes?
A
imposed on foreign firms, set higher than those imposed on local businesses with the aim of giving local firms an advantage
they may even be deliberately set at such a high level as to prevent the business from being profitable
13
Q
what is expropriating assets?
A
host country government seizes foreign property in the national interest
recognised in international law as the right of sovereign states provided that prompt consideration at fair market value in a convertible currency is given
14
Q
what are the issues with expropriating assets?
A
problems arise over the exact meaning of the terms prompt and fair, the choice of currency, and the action available to a company not happy with the compensation offered
15
Q
what is hedging?
A
a way of using financial instruments to REDUCE THE RISK of adverse price movements of an item (this could be a commodity price, share price, interest rate or currency exchange rate)
can help companies to ‘fix’ the price of something they plan to buy or sell in the future, this reduces the financial risk
16
Q
what are the benefits of hedging?
A
- CERTAINTY of cash flows
- RISK will be reduced
- reduction in probability of FINANCIAL COLLAPSE
- may be perceived to be a MORE ATTRACTIVE employer to risk-averse managers
- may reduce TAXES
17
Q
what are the arguments against hedging?
A
- may harm interest of shareholders with DIVERSIFIED portfolios
- significant transaction costs
- LACK OF EXPERTISE within the business
- COMPLEXITY of accounting within the business
- for some risks, gains and losses may CANCEL OUT INT THE LONG RUN
18
Q
what is a derivative?
A
a financial instrument whose value depends on a the price of some other financial asset or underlying factor (such as oil, gold, interest rates or currencies)
can be used for hedging, speculation and/or arbitrage
19
Q
how can political risk be managed?
A
- RESEARCHING he country’s current and historic political and economic stability
- entering into foreign joint ventures/part-ownership by foreign country’s investors
- obtaining agreements and contracts with overseas government
- using local financing
- making use of local suppliers and the local workforce
20
Q
how can political risk be minimised?
A
- prior negotiation
- structuring investment
- entering into foreign joint ventures
- obtaining agreements and contracts with overseas government
- using local financing
- plans for eventual ownership/part-ownership by foreign country’s investors
21
Q
why does a joint venture reduce risk?
A
- if each partner contributes a share of the funding for the venture, the investment at risk for each partner is restricted to their share of the total investment (although, the upside is reduced because each party has less invested in this potentially lucrative venture)
- if a local company is selected as the JV partner, the likelihood of winning major contracts in the country might be much greater. Some governments have made the involvement of a local company in a JV a condition of awarding contracts to foreign companies
- the local venture partner has a better understanding of the local political risks and can manage them more effectively than a foreigner would be able to. Also the govt might be less inclined to act against the interest of the local venture partner
22
Q
what are pre trading agreements?
A
prior to making the investment, agreements should be secured if possible with the local government regarding rights, remittance of funds and local equity investments and (where appropriate) the award of government contracts to businesses
23
Q
what is the major advantage of local finance?
A
it creates liabilities in the foreign currency and so reduces:
- translation exposures: assets in the foreign currency can be offset against liabilities in the same currency
- transaction exposures: in the sense that interest costs will be payable in the foreign currency and can be paid from income in the same company
24
Q
what is interest rate risk?
A
risk of gains or losses on assets and liabilities due to changes in interest rates
25
what are some examples of interest rate risk?
- floating rate loans - interest rate rises
- floating rate deposits - interest rate falls
- fixed rate loans -interest rates fall
26
how is interest rate risk managed?
- interest rate hedging
| - fixed rate loans/investments
27
what interest is used on bank loans and overdrafts?
variable rate of floating rate, with the interest set at a margin above a benchmark rate such as the base rate or the LIBOR
28
what is the LIBOR?
London Inter Bank Offer Rate
-money market rate at which top-rated banks are able to borrow short-term in the London sterling or eurocurrency markets. There are LIBOR rates for major traded currencies, including the US dollar, euro and yen as well as sterling
29
what is the interest rate on bonds, debentures or loan stock?
fixed rate
30
what reference does the floating rate use?
benchmark interest rate on a specific date
31
what does exposure to interest rate risk depend on?
amount of interest bearing assets or liabilities that it holds and the type that these are (floating or fixed rate)
32
what are the types of interest rate risk exposure?
floating rate loans
fixed rate loans
33
what are floating rate loans?
if the company has floating rate loans, changes in interest rates alter cash flows and profits and the risk is therefore OBVIOUS
34
what are fixed rate loans?
if the company has fixed rate loans interest rate risk still exists
even though interest rate charges themselves will not change, a fixed rate can make a company uncompetitive if its costs are higher than those with a floating rate and interest rates fall.
35
why can fixed rate borrowings also be exposed to interest rate risk?
company runs a risk that:
- if interest rates fall, it will be unable to benefit from the lower rates available in the market, because it is committed to paying fixed rates
- competitor organisations might have floating rate liabilities and so will benefit from lower interest costs, and so improve their profitability and competitive strength
36
how is exposure to interest rate risks measured for floating rate loans?
total amount of floating rate assets and liabilities
the higher the value of loans the greater the exposure to changes in interest rates
37
how is exposure to interest rate risks measured for fixed rate loans?
total amount of fixed rate assets or liabilities together with average time to maturity and average interest rate
longer periods of tie-in at fixed rates could be beneficial, or more costly, to businesses depending on what market rates are and also what the future expectations of interest rate changes are
it is expectations that determine risks
38
what is refinancing risk?
risk that loans will not be renewed when needed, or only renewed at a higher interest rate.
type of interest rate risk
39
what are some examples of refinancing risk?
- bank refuses to renew/refinance a maturing loan
| - bank will only refinance at a higher interest rate than the company currently pays
40
how can refinancing risk be managed?
- longer term loans
- maintaining a high credit rating
- relying more on equity than debt
41
what is currency risk?
risk that arises from possible future movements in an exchange rate
42
what are some examples of currency risk?
- transaction risk
- economic risk
- translation risk
43
what are some ways of managing currency risk?
- hedging
| - diversification-buy and sell in several different currencies
44
who does currency risk affect?
any organisation with:
- assets or liabilities in a foreign currency
- regular income and/or expenditures in a foreign currency
- no assets, liabilities or transactions that are denominated in a foreign currency. Even if a company does not deal in any currencies, it will still face economic risk since its competitors may be faring better due to favourable exchange rates on their transactions
45
what is economic risk?
long term exchange rate movements which impact the competitiveness of the business
any change in the economy, home or abroad which can affect the value of a transaction before the commitment is made
46
does a company have to have foreign currency to be affected by economic risk?
no
still affected by economic risk due to:
- competitive position
- elasticity of demand
- pricing
47
how does elasticity of demand affect economic risk?
can make a company's products more or less expensive
when exchange rate makes the product more expensive the demand will probably fall
if available at a lower price, demand will go up
48
how can economic risk be managed?
diversify globally
49
what is the portfolio theory?
reducing risk by 'not having all your eggs in one basket'
50
how can firms diversify globally this managing economic risk?
- diversification of production and sales
- diversification of suppliers and customers
- diversification of financing
- marketing
51
how can a firm diversify production and sales?
- manufacture in many countries:multiple cash flows
- multiple plants
- source raw materials internationally
52
how can a firm diversify its suppliers and customers?
- international relationships
| - can switch to cheaper one
53
how can financing be diversified?
- borrowing internationally and being aware of foreign exchange risk
- wont help in extreme situations e.g. global recessions
54
how does marketing help manage economic risk?
convinces customers that your product is the one to buy despite it being more expensive
55
what is transaction risk?
risk that the exchange rate moves between the date of the transaction and the date of payment
related to buying or selling on credit in foreign currencies
56
how is transaction risk different from translation risk?
transaction risk affect the cash flows of the business
57
what is translation risk?
risk that the exchange rate moves between the date of the transaction and the date of the payment
only when a company has assets or liabilities denominated in foreign currencies
causes book value to change resulting in currency gains/losses in PL
58
does translation risk affect the conversion of real moey?
no purely paper based exercise, especially during consolidation
59
what is a settled transaction?
transaction must be denominated into functional currency before it is recorded
- initially recorded at spot rate
- then at settlement spot rate
- exchange difference taken to income statement
60
what is an unsettled transaction?
treatment depends on if monetary or non-monetary
monetary:
-re-translated at closing rate
non-monetary:
- spot rate of acquisition
- if loaned, at closing rate
- FX to equity
- unrealised until sold
61
what is the temporal effect?
when currency risk due to assets and liabilities no longer offset eachother
62
what are the 2 strong arguments in favour of the relevance of translation risk?
- may not affect entity as a whole but can affect attribution of that value between the different stakeholders e.g. higher gearing means higher interest
- if accounts are being used 'beyond their design specification' e.g. for calculating bonuses, then theres is a temptation to protect the current year's figures at a long term cost (usually the real reason for managing translation risk)
63
how do venture capitalist often like to invest in unquoted companies via convertible loan stock to skew their risk exposure?
- company that performs moderately then the risk exposure effectively amounts to getting interest paid and the loan redeemed at some future point (usually within 5 years)
- if the investment performs badly then then the downside exposure is limited to getting some interest paid and perhaps their investment back in the event of a winding up
- if the investment performs well, then the company is usually prepared for flotation when the VC will convert the debt into equity to sell a large number of shares at a high point
64
what is VaR?
Value at Risk
assesses the scale of the likely loss in value of a portfolio in a specified time period at a defined level of probability
e.g. there is a 95% change that the value of the portfolio will fall by less than $10m over the next week
65
how is VaR calculated?
standard deviation x Z score
66
who does regulators require to use VaR as a measure of risk?
banks
67
what assumption is VaR based on?
that investors care mainly about the probability of a large loss
also assumed total market value of the portfolio are normally distributed
68
how can VaR help control risk?
-can try to control the risk in its asset portfolio by setting target maximum limits for value at risk over different time periods
69
what are the characteristics of normal distribution?
- mean= centre=mode=median
- 50/50 on either side
- spread is standard deviation
- total area under curve=1
70
what are the % for standard deviations in the normal dist table?
68%=1 SD
95% = 2 SDs
99.7%=3 SDs
71
what are the 2 types of calculations to consider in VaR?
1. the confidence level that the result will be above a particular figure- one tail test
2. the confidence level that a figure will be within a particular range-two tail test
72
if you are asked to calculate the 95% VaR, what type of test is that?
one tail test
95% certain that the outcome will be above a particular value
73
if you about being 95% certain the result is within range?
two tail test
74
what international standards did the Basel committee set?
for banking laws and regulations aimed at protecting the international financial system from the results of the collapse of major banks
75
what is Basel II?
established rigorous risk and capital management requirements to ensure each bank holds reserves sufficient to guard against its risk exposure given its lending and investment practices
regulators require banks to measure their market risk using a risk measurement model which is used to calculate the Value at Risk (VaR)
76
what is the problem with VaR?
based on historical observations
- doesn't allow for extreme events
- e.g. Credit crunch, housing bubbles
77
whats the relationship between VaR and the holding period?
the VaR increases with the holding period
thus the longer the holding period, the greater the VaR
78
what is an exchange rate?
expressed in terms of the quantity of one currency that can be exchanged for one unit of the other currency
i.e. price of the currency
79
what is the sport rate?
given for immediate delivery
i.e. within 2 working days
80
what is a margin/spread?
banks wish to make profit: BANK ALWAYS WINS
sell at lower rate
buy at higher rate
81
what is cross rate?
a foreign currency exchange transaction between two currencies that are both valued against a third currency
e.g. EUR to USD to GBP
82
what are direct quotes?
one unit of foreign currency = its value in home currency
83
what are indirect quotes?
one unit of home currency = its value in foreign currency
84
what are the reasons for forecasting exchange rates?
- foreign debtor and creditor balances:damaging losses
- working capital:overseas funding
- pricing: might need to revise
- investment appraisal:impact on NPV
- consolidation of foreign subsidiaries
85
what is speculation?
trading a financial instrument involving high risk, in expectation of significant returns
causes short-term movements
86
why do exchange rates fluctuate?
- speculation:short selling
- balance of payments:demand for imports and exports
- government policy:devalue/revalue/buying and selling foreign currency
- capital movements between economies
87
how does balance of payments cause exchange rates to fluctuate?
- demand for imports in the US represented a demand for foreign currency or a supply of dollars
- overseas demand for US exports represents a demand for dollars or a supply of the currency
countries with current account deficit (imports > exports) may see its exchange rate depreciate since supply of currency (imports) will exceed the demand for the currency (exports)
88
how do capital movements between economies affect currency?
switching bank deposits from one currency to another
-flows are now more important than the volume of trade in goods and services
factors that lead to inflows/outflows of capital:
- changes in interest rates
- inflation rates
89
what 3 theories give some insight into exchange rate movements?
PPPT
IRPT
International Fisher Effect
90
what is PPPT?
purchasing power parity theory
'law of one price'
rate of exchange will be directly determined by the relative rates of inflation suffered by each currency
RULE:country with higher inflation will suffer a fall in the value of its currency
assumption:rates are quoted in indirect quotes
91
what is the basis of PPPT?
- identical goods must cost the same regardless of the currency in which they are sold
- if not then arbitrage will take place until a single price is charged
92
what is arbitrage?
simultaneously purchasing and selling an identical security, commodity, or currency, across two different markets
- risk-free
- exploit price difference between the two markets
- where a commodity that appears cheap is bought by many traders
- sellers then realise that they can put up their price due to the commodities popularity
- demand will fall at this higher price and profits competed away
93
what are the problems with PPPT?
- is law of one price justified?all markets different
- costs of transporting products mean there is always a premium
- different tax regimes affect costs
- manufacturers may be able to successfully differentiate products in each market to limit the amount of arbitrage that occurs
94
what are the limitations of PPPT as a good predictor?
- future inflation rates may not be accurate
- speculation:market dominated by non-physical asset trades
- government intervention in both direct (management of exchange rates) and indirect ways (tax policies)
95
what is IRPT?
interest rate parity theory
difference between spot and forward exchange rates = differential between interest rates available in the two currencies
RULE: IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation
assumes rates are quoted as indirect quotes
96
what is a forward rate?
future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date
97
what are the limitations on IRPT?
- controls on capital markets:govt limit range
- controls on currency trading:limit on amount of currency taken out
- government intervention:manipulate exchange rate
98
what is the International Fisher Effect?
claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange
99
what is the assumption and theory behind the Fisher equation?
assumes all countries have same real interest rate, although nominal or money rates may differ due to expected inflation rates
thus the interest rates differential between two countries should be equal to the expected inflation differential
therefore, countries with higher expected inflation rates will have higher nominal interest rates and vice versa
100
in what event do the PPPT and the IRPT give identical predicted rates?
International Fisher Effect must hold i.e. real rates of interest are identical in all countries
101
what factors affect the prediction of exchange rates?
- transaction costs of shifting money and making investments
- lack of mobility of capital and goods
- political intervention
- cultural differences between different countries
- central bank action
- trader activity
- key commodity prices
102
who mainly uses arbitrage?
speculators rather than as a hedging tool
| day traders
103
what is pure arbitrage?
risk free
| -rare in recent years due to globalisation
104
what is a day trader?
someone who believes they can spot short term speculative movements and benefit from them
look for 'cheap' currency and then sells it quickly, at a profit, to someone who needs it
105
why is hard to make conclusions on day-trading?
hard to judge whether they are successful because they would lose their advantage if they admitted to being able to spot mispriced assets
106
what are the stages of financial risk management?
1) identify risk exposures
2) quantify exposures
3) decide whether or not to hedge
4) implement and monitor hedging program
107
what are the benefits of hedging?
- provide CERTAINTY of cash flows which will assist in the budgeting process
- risk will be REDUCED and hence management may be more inclined to undertake investment projects
- reduction in the probability of FINANCIAL COLLAPSE
- managers are often risk-averse since their job is at risk. Hedging policy may be perceived as a more ATTRACTIVE employer to risk-averse managers
108
what are the arguments against hedging?
- shareholders have diversified their own portfolio so further hedging by the business may harm interests
- transaction costs associated with hedging can be significant
- lack of expertise within the business, particularly with regards to use of derivative instruments
- complexity of accounting and tax issues associated with the use of derivatives
109
what are the uses of derivatives?
hedging
speculation
arbitrage
110
what are the main functions of the treasury function?
- managing relationship with the banks
- working capital ad liquidity management
- long-term funding management
- currency management
111
what is the organisational structure of the treasury function?
- profit centre or cost centre
| - centralised or decentralised
112
what are the advantages and disadvantages of operating the treasury function as a profit centre instead of a cost centre?
advantages:
- market rate is charged to business unties throughout the entity, making operating costs realistic
- treasurer is motivated to provide services as efficiently and economically as possible
disadvantages:
- the profit concept brings the temptation to speculate and take excessive risk
- management time can be wasted on discussions about internal charges for the treasury activities
- additional administrative costs will be incurred
113
what are the risks associated with operating the treasury function as centralised or decrentralised?
risks with centralised:
- lack of motivation towards managing cash since any cash that is received is swept to HO
- risk that HO commit some error in their treasure operations, the financial health of the whole group could be placed in jeopardy
risks with decentralised:
- one company might pay large overdraft interest costs while another has cash balances in hand earning low interest rates
- the risk of not generating the profits for the group that would be earned if the group funds were actively managed by a treasury operation seeking profits rather than individual executives just seeking to minimise costs
114
what are the principal risks faced by a centralised treasury function?
- liquidity/funding risk
- counterparty risk:fin institutions default
- foreign currency risk
- interest rate risk
115
what internal methods can be used for transaction risk management?
- home currency
- leading/lagging
- matching/netting
- countertrade
116
what external methods can be used for transaction risk management?
- forward contracts
- money market hedges
- currency futures
- currency options
- currency swaps
117
what are the differences between internal and external hedging?
- internal hedging is often more effective for dealing with economic risk
- internal hedging is often cheaper and simpler to understand
- external hedging is more complex, so it is usually undertaken by skilled staff in treasury departments
118
how does invoicing in home currency remove transaction risk?
transfers currency risk to customer or supplier but economic risk not removed
119
what issues does invoicing in home currency give?
- customer/suppliers may not be prepared to accept all the currency risk and therefore they will not trade with the business
- the other parties may not be prepared to accept the same prices and will require discounts on sales or premiums on purchases
- there are other ways of hedging risks that mean that the risk of transacting in foreign currency is acceptable
120
what are the problems with leading and lagging?
- early payment will cost a company in interest foregone on the funds that have been disbursed early
- the payee will not be happy that payment may become overdue, especially if the currency is expected to fall
- it requires the company to take a view on exchange rates i.e. speculate. There is a risk that the company will be wrong
121
what is currency netting?
use of foreign currency bank accounts
reduce exchange risk by using the foreign receipts to cover the foreign payments
net off on dates close together to work best
can be done across subsidiaries
122
what is pooling currencies?
managing cash
multiple account balances swept into a central account at the end of each day, leaving a zero balance on every account except central
overdraft balances and positive cash balances are all swept up into the central account maximising interest earned and minimising any bank charges or interest payable
123
does pooling provide a system for hedging against FX risk?
no but can be an efficient system for cash management
- avoids overdraft costs on individual bank accounts
- enables treasury department to make more efficient use of any cash surpluses
124
what are the requirements for an efficient system of cash pooling?
centralised cash management system
org allows each subsidiary to operate their own cash management system
might be more efficient to share same pooling system hence best operated by a central treasury function
125
what is a countertrade?
involves parties exchanging goods and services of equivalent value
tax authorities don't like this difficult to keep track if no paper trail
-not very common
126
what is multilateral netting?
treasury management technique used by large companies to manage their intercompany payment processes, usually involving many currencies
-can yield significant trading
127
what does a netting centre do?
collated batches of cash flows between a defined set of companies and offsets them against each other so that just a single cash flow to or from each company takes place to settle the net result of all cash flows
128
how often does the netting process take place?
cyclical basis, typically monthly, and is managed by a central entity called the netting centre
129
who usually uses multilateral netting?
MNC that has many production and sales divisions in a number of countries
-direct billing can lead to excessive foreign exchange trading and buying and selling many currencies many times over
130
what is the objective of using a netting centre?
reduce the overall foreign exchange volume traded and thereby cut the amount of foreign exchange spread paid by the company to manage all the currency conversions
131
what issues must successful participants of netting agree on?
- currencies
- credit period
- settlement dates e.g. intervals
- exchange rates: arms length
- conflict resolution:payables vs receivables
- management:bespoke of bank managed?
132
what is a forward contract?
an agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate
133
what is the most popular method of hedging currency transaction risk?
currency forward contracts
- fix in advance an exchange rate at which a transaction will be made
- risk taken by bank who are better at managing exposure
134
at what rate are forward contracts quoted?
at a premium or discount rate
135
what are premium an discount rates?
discount: currency quoted is expected to fall in value in relation to the other currency
- 'dis'
- add discount
premium: expected to rise in value
- prem
- subtract a premium
136
what are the advantages of forward contracts?
- simple and have low transaction costs
- can be purchased from a high street bank
- fix the exchange rate
- are tailored, so are flexible to amount and delivery period
137
what are the disadvantages of a forward contract?
- potential credit risk since the company is contractually bound to sell a currency, which it may not have received from its customer
- no upside potential:inflexible
- some forward markets are banned in some countries e.g. BRIC economies
138
how can we overcome the contractual commitment problem of a forward contract?
arrange an 'option date' forward exchange contract
-allows company to settle a forward contract at an agreed fixed rate of exchange, but at any time between two specified dates
139
what is MMH?
money market hedges
- avoid future (uncertain) exchange rate by making exchange now at known spot rate
- use interest rates to create assets and liabilities that 'mirror' the future assets and liabilities
markets for wholesale (large-scale) lending and borrowing, or trading in short-term financial instruments
many companies are able to borrow or deposit funds through their bank in the money markets
use these markets instead of forward contracts
roughly same result either way
140
what is the rule of MMH?
the money required for the transaction is exchanged at today's spot rate and is then deposited/borrowed on the money market to accrue to the amount required for the transaction in the future
141
what period are money market interest rates available?
any length of borrowing or deposit period, up to about a year
-all rates quoted on annual basis
142
what are the 2 rates quoted for money market interest rates?
higher rate: interest bank will charge on loans
| lower rate:rate bank will charge on deposits
143
what are the characteristics of MMH?
- avoid future exchange rate uncertainty by making the exchange at today's spot rate instead
- achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur
144
what are the steps for future foreign currency payments?
1) borrow in home currency
2) convert to foreign currency at spot
3) deposit foreign currency
4) future deposit to pay supplier
145
what are the steps for future foreign currency receipts?
1) borrow the present value of the future receipt
2) sell today at spot
3) place domestic currency on deposit
4) settle liability with receipt from customer
146
what are the calculations for MMH?
always start with the future foreign cash flow
payment in FX:
- calculate foreign deposit as the PV of the future payment
- then calculate how much home currency you need to borrow
receipt in a foreign currency:
- calculate foreign borrowings as the PV of the future receipt
- then convert into home currency and place on deposit
147
what are the advantages of MMH?
- ensure no currency risk due to taking place now
- have fairly low transaction costs
- offer flexibility (especially if customer delays payment)
- may be of use when forward contracts are not available
148
what are the disadvantages of MMH?
- complex
- difficult to get an overseas loan in the case of a foreign currency receipt-company with large overdraft may struggle to borrow funds now
149
what does IRPT imply about forward contracts and MMH?
forward contracts and MMH should give the same result
150
what is a currency future?
derivative contracts to buy or sell standardised amount of underlying asset at a pre-determined price in the future
very similar form of hedging to forward contract
critical difference is that they are not tailor made and are standardised contracts for fixed amounts of money for a limited range of future dates
151
why can currency futures be traded easily?
traded on future exchanges
| -contract is separated from transaction itself so can be traded
152
what denomination are currency futures traded in?
- small range of currencies
- typically in USD
- less commonly in EUR
153
do futures deliver currency?
usually only gain or net position thus reducing risk
-all buyers/sellers are required to pay an initial margin (deposit) to the exchange when they set up a position
forwards deliver currency
154
what are the standard expiry dates for futures?
last day per quarter
| -can be traded before
155
what are the steps to answering a futures question?
1) set up hedge
- do we initially buy or sell futures?
- which expiry date should be chosen? usually first contract to expire after required conversion date
- how many contracts?
2) contact exchange
- pay initial margin
3) closing out
- position closed out:calculate gain or loss using day's SR
- buy or sell?
- margin refunded by exchange
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what is the concept behind currency futures?
hedging or speculating on the movement of the exchange rate on the future market
-betting on opposite to create no win/no loss position
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how are initial margins used in currency futures?
if losses incurred, could be called on to deposit additional funds (variation margin)
profits are credited to the margin account on a daily basis as the contract is 'marked to market'
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what are ticks in futures contracts?
minimum price movement for a futures contract
0.0001 change in unit = 1 tick of unit
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what is the basis in futures?
difference between the current market price of a currency future and the current spot rate will be different and will only start to converge when the final settlement date for the futures contract approaches
- on final date of contract should be the same otherwise speculators can make instant profit by trading between futures market and the spot 'cash' market
- most contracts are closed out before contract reaches final settlement, leading to a difference between the futures price at close-out and the current spot market price of the underlying item i.e. there will be some basis
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what is basis risk?
risk that when a hedge is constructed, the size of the basis when the futures position is close out is different from the expectation, when the hedge was create, of what the basis ought to be
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what are the advantages of currency futures?
- offer an effective 'fixing' of exchange rate
- have no transaction costs
- are tradeable
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what are the disadvantages of currency futures?
- a foreign futures market must be used for GBP futures
- they require up front margin payments
- they are not usually for the precise tailored amounts that are required
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what are the reasons for imperfect hedges?
- rounding the number of contracts
| - closing before expiry date: leads to basis risk
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what are currency options?
a right, but not an obligation, to buy or sell a currency at an exercise price on a future date
in favourable movement: allow option to lapse to take advantage
only exercise right to protect against adverse movement
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why are premiums charged on currency options?
writer will charge a non-refundable premium for writing the option
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how is the gain/loss calculated on an option?
difference between exercise price and market price- premium paid
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what are the two types of options?
- call option:gives holder the right to BUY the underlying currency
- put option:gives the holder the right to SELL the underlying currency
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what are the calculations for options hedging calculations?
1) set up the hedge
- do we need call or put options?
- which expiry date? first contract to expire after future transaction
- which strike price?
- how many contracts?
2) contact the exchange and pay premium
3) closing out: future transaction date
- compare option price with prevailing spot rate and make decision
4) calculate cash flows
- options may not match exactly with the future transaction so extra exchanges ay be necessary
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what is an in-the-money option?
if the exercise price for an option is more favourable to the option holder
has intrinsic value
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what is the out of money option?
if the exercise price for an option is less favourable to the option holder than the current spot market price
no intrinsic value
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what is at the money?
if the exercise price for the option is exactly the same as the current spot market price
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when would an option holder exercise the option?
if it is in the money
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when are options first purchased?
usually during period before expiry date or when out of the money
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what are the advantages of currency options?
- they offer the perfect hedge (downside risk covered, can participate in upside potential)
- there are many choices of strike price, dates, premiums
- the option can be allowed to lapse if the future transaction does not arise
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what are the disadvantages of currency options?
- traded sterling currency options are only available in foreign markets
- there are high up-front premium costs (non-refundable)
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how do writers of options decide what level of premium to set?
used to calculate the fair value of an option pricing model
| -used to calculate fair value of an option at any given date (useful for financial reporting purposes)
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what is the Black-Scholes model?
market value, or price, of a call option consists of two key elements:
- the intrinsic value of the option
- the time value of the option
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what are the 5 variables that affect the price of a call option?
intrinsic value-for MV of option to rise:
1. CURRENT PRICE of underlying asset must increase
2. STRIKE PRICE must fall (hence making it more likely that the option will be exercised, and so is worth something)
time value-uncertainty surrounding intrinsic value is impacted by 3 variables:
1. SD on the daily value of the underlying asset. The more variability that is demonstrated, the higher the chance that the option will be 'in the money' and so will be exercised
2. TIME PERIOD to expiry of the option. A longer time period will increase the likelihood that the asset value increases and so the option is exercised
3. RISK FREE INTEREST RATES. Having a call option means that the purchase can be deferred so owning a call option becomes more valuable when interest rates are high, since the money left int he bank will be generating a higher return
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what is the intrinsic value?
difference between the current price of the underlying asset and its option strike price
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what are the limitations of the Black-Scholes model?
- assumed risk-free interest rate is known and is constant throughout the option's life
- SD of returns from the underlying security must be accurately estimated and has to be constant throughout the option's life. In practice, SD will vary depending on the period over which it is calculated; unfortunately the model is very sensitive to its value
- assumes that there are no transaction costs or tax effects involved in buying or selling the option or the underlying item
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does a premium on an option mean a commitment to buy?
no, entitles them to first option to buy the asset
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what are swaps?
allows a company to swap a currency it currently holds for a different currency for a fixed period, and then swap back at the same rate at the end of the period
counterparty in a cross currency swap would generally be a bank
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what are the 2 elements of a cross currency swap?
- an exchange of principals in different currencies, which are swapped back at the original spot rate
- an exchange of interest rates-the timing of these depends on the individual contract
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between the lending rate and borrowing rate, which is higher?
the lending rate is higher as the bank wants to make a profit
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what is LIBOR?
London Inter Bank Offer Rate
interest rate at which a major bank can borrow wholesale short-term funds from another bank in the London money markets
- different rates for different lengths of time: overnight to one year
- used in most variable rates
- each bank has own LIBOR rate
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what is the average LIBOR rate?
calculated each day by the British Bankers Association
| -used as benchmark rates for some financial instruments
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why is the LIBOR important?
London is the world's major money market centre
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what is the euribor?
similar to euro LIBOR
- produced by eurozone banks
- different as average rate is calculated daily from data submitted by a completely different panel of banks
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how many basis points is 1%?
100 bonus points
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what is LIBID?
London Interbank Bid Rate
- less important that LIBOR
- rate of interest that a top-rated London bank could obtain on short-term wholesale deposits with another bank in the London money markets
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Between LIBID and LIBOR, which is lower?
LIBID
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which is more volatile between exchange rates and interest rates?
interest rates are less volatile but changed in them can still be substantial
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what is the term structure of interest rates?
provides an implicit forecast (according to market expectations) that is not guaranteed to be correct but is the most accurate forecast available
- relationship between interest rates or bond yields and different terms of maturities
- market expectations about future changes in interest rates and their assessment of monetary policy conditions
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what is the yield curve also known as?
term structure of interest rates
-yields increase in line with maturity, giving rise to upward-sloping yield curve i.e. longer bonds maturity dates = higher yields & interest rates
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what are the types of risk exposure in interest rate risk management on existing loans or deposits?
exposed to changes in interest rates if existing loans and deposits have variable interest rates
can avid by using fixed rates or using swaps
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what are the types of risk exposure in interest rate risk management on future loans or deposits?
even is we want to use fixed rates, we do not know what the rate will be when we need the loan/deposit
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what are internal hedging strategies for managing interest rate risk?
- smoothing
- matching
- netting
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what is smoothing?
maintaining a balance between the fixed rate and the floating rate borrowing
natural hedge against changes in interest rates
less exposure to the adverse effects of each but less exposure to favourable movements in the interest rate
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what is M&S's funding and interest rate hedging policy?
mix of financing methods
-interest rate risk primarily occurs with the movement of sterling interest rated in relation to the Group's floating rate financial assets and liabilities
- maintain mix of fixed and floating rate borrowings
- reviewed on a regular basis against forecast interest costs and covenants
- swaps have been entered into redesignate fixed and floating debt
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what are OTCs?
bespoke, tailored products that fit the companies' needs exactly
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what are exchange traded instruments?
ready made and standardised
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what are 'fixing' instruments?
lock a company into a particular interest rate providing certainty as to the future cash flow
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what are 'insurance' instruments?
allow some upside flexibility in the interest rate i.e. the company can benefit from favourable movements but are protected from adverse movements
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which OTC instruments are used for fixing and insurance instruments?
FRAs for fixing
| IRGs for insurance
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which exchange traded instruments are used for fixing and insurance instruments?
interest rate futures for fixing
| interest rate options for insurance
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what is a forward rate agreement (FRA)?
forward contract on an interest rate for a future short-term loan or deposit
can be used to fix the interest rate on a loan or deposit starting at a date in the future
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how long are FRAs usually for and for what amount?
relate to short term interest rate e.g. 3 month or 6 month LIBOR
normally for amounts greater than GBP 1 million
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what is an important feature of an FRA?
the agreement is independent of the loan or deposit itself
- about the rate of interest on a notional amount of principal (loan or deposit) starting at a future date
- FRA does not replace taking out the loan (deposit) but rather the combination of the loan (deposit) and the FRA result in a fixed effective interest rate
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how are FRAs settled?
- if fixed rate in the agreement is higher than the LIBOR, buyer makes cash payment to the seller. The payment is for the amount by which the FRA result in a fixed effective interest rate
- if fixed rate in the agreement is lower than the LIBOR rate, the seller of the FRA makes a cash payment to the buyer. The payment is for the amount by which the FRA rate is less than the reference rate
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how is a hedge set up in FRA?
if looking to borrow money then you need to buy an FRA
if looking to deposit money, then you need to buy an FRA
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what does 5-8 FRA mean?
3 month loan/deposit starting in five months' time
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what are IRGs?
interest rate guarantees are options on FRAs so the treasurer has the choice whether to exercise or not
-max maturity of one year
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what are IRGs also referred to as?
interest rate options or interest rate caps/floors
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what are the call and put options of IRGs?
borrowing: would buy FRA so need a call
depositing: would sell FRA, so need a put
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what are the decision rules of IRGs?
if there is an adverse movement, exercise the option to protect
if there is a favourable movement, allow the option to lapse
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why are the IRGs more expensive than FRAs?
one has to pay for the flexibility to be able to take advantage of a favourable movement
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what are interest rate caps/floors?
another name for an IRF on a loan/deposit as it caps/creates a floor for the maximum/minimum loan rate received
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what is a collar?
can be created for either a loan or a deposit and sets both a minimum and maximum interest rte
done by entering into both a call and a put option
usually cheaper than a cap or a floor
premiums can be reduced by using a collar
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what are IRFs?
similar principle to forward rate agreements in that they give a commitment to an interest rate for a set period
- tradeable contracts
- terminate end of quarters
- closed out for gash and gain/loss used to offset changed in interest rates
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what are the 2 types of IRFs?
STIRs - short term interest rate futures
| bond futures
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what are the features of IRFs?
operates by the customer making a commitment to effectively deposit or borrow a fixed amount of capital at a fixed interest rate
notional sterling deposit/loan on the LIFFE is GBP 500000
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how are IRFs priced?
price = 100 - interest rate
-as interest rates increase, the value of the future will fall and vice versa if interest rates reduce
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how are gains and losses calculated on STIRs?
reference to the interest rate at the date of close out
difference between the futures price at inception and close will be the gain or loss
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how can companies hedge using futures?
by buying or selling a number of futures contracts that cover a loan period and value
- use futures to hedge borrowing and therefore hedge against an increase in the interest rate
- to do this company sells futures
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whay are IRFs complicated?
- contract sizes and standard contract lengths (3 months)
- margins/deposits payable at the stat of the hedge
- speculators - who dominate the market
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how can companies hedge against the risk of a rise in interest rates with STIRs?
if a company plans to borrow short-term:
- should set up a position with futures that will give it a profit if interest rates go up. Profits from futures trading will offset the higher interest cost on the loan, when it is eventually taken out
- on the other hand, if the interest rate goes down, the effect of the hedge will be to create a loss on the futures position, so that the benefit from borrowing at a lower interest rate on the actual loan, when it is taken out, will be offset by the loss on the futures position
created by SELLING short-term interest rate futures
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what are the causes of an imperfect hedge with IRFs?
- standard sized contract but amount may not be exact multiple
- basis risk:future rate moves approx but not precisely in line with the cash market rate
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how are FRAs and STIRs similar?
- both are binding forward contracts on a short-term interest rate
- both are contracts on a notional amount of principal
- both are cash-settled at the start of the notional interest period
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what advantage do FRAs have?
can be tailored to the company's exact requirements in terms of amount of principal, length of notional interest period and settlement date
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what is the interest rate difference between FRAs and STIRs?
given the efficiency of the financial markets, the difference between the two in terms of effective interest rate is unlikely to be large
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how can you hedge with bond futures?
bond futures fall in value when the interest rates go up
for a bond investor, the required hedge is therefore to sell bond futures
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what are traded interest rate options?
options on STIRS i.e. futures contracts
givers buyer the right to buy or sell an interest rate future at a specified future date at a fixe exercise rate i.e. to effectively have the 'right to bet' on an interest rate increase as shown on the futures market
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why must the options holder pay the writer of the option a premium?
because the exchange traded interest rate options are an option, not a commiment
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what are the characteristics of the exchange traded interest rate options?
- they can fix the interest amount, or can be allowed to lapse to take advantage of a favourable movement in interest rates
- they are for a given interest period (e.g. six months) starting on or before a date in the future
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in exchange traded interest rate options, what is a call option and a put option?
call option: gives the holder the right to buy the futures contract (for depositing)
put option: gives the holder the right to sell the futures contract (for borrowing)
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what is an interest rate swap?
agreement whereby the parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and vice versa
no exchange of principal
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what are the different types of swaps?
interest rate swap
| cross currency swap
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what are the reasons for using a swap?
- way of managing fixed and floating rate debt profiles without having to change underlying borrowing
- take advantage of unexpected increases or decreases in rates
- to hedge against variations in interest rates
- to benefit from comparative advantage
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how do swaps work with intermediaries?
banks offer two rates
- the 'ask rate' at which the bank is willing to receive a fixed interest cash flow stream in exchange for paying LIBOR
- the 'bid rate' that they are willing to pay in exchange for receiving LIBOR
the difference between these gives the bank's profit margin and is usually at least 2 basis points
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why are interest rate swaps the most common form of interest rate hedge ?
they can hedge borrowings of anywhere between a year and 30 years and therefore can be used for long-term borrowings
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what does the swap market look like?
large liquid market in swaps in major currencies and banks will quote bid/offer rates against a reference rate such as 6 month LIBOR or 12 month LIBOR
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what is a forex swap?
2 parties agree to swap equivalent amounts of currency for a period an the re-swap them at the end of the period at an agreed swap rate
the swap rate and amount of currency is agreed between the parties in advance
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whats are the main objectives of a forex swap?
- to hedge agains forex risk, possibly for a longer period than is possible on the forward market
- to access capital markets, in which it may be impossible to borrow directly
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when a re forex swaps particularly useful?
when dealing with countries that have exchange controls and/or volatile exchange rates
245
what are the 2 elements of currency swaps?
- an exchange of principal in difference currencies, which are swapped back at the original spot rate
- an exchange of interest rates-the timing of these depends on the individual contract
246
when is the interest fixing date?
the start date of the swap period
-used as the LIBOR rate will fluctuate daily
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what are the advantages of using interest rate swaps?
- to manage fixed and floating rate debt profiles without having to change underlying borrowing
- to hedge against variations in interest on floating rate debt, or conversely to protect the fair value of fixed rate debt instruments
- a swap can be sued to obtain cheaper finance
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what are the disadvantages of using interest rate swaps?
- interest rates may change int he future and the company might be locked into an unfavourable rate
- creditworthiness of the bank-the company and the bank arrange to make payments to each other for a fixed period. The company must therefore be confident about the creditworthiness of the bank before signing up to the swap
249
what interest rate odes the company entering the cross currency swap end up with?
the type of rate it prefers and the currency it needs
| -could be 'fixed for fixed', 'floating for floating' or 'fixed for floating'
250
what are the advantages of using cross currency swaps?
- useful tool for changing the currency profile of debt
- may help reduce interest costs where debt can be raised more easily or at a competitive rate in a second currency and it proves to be cheaper or easier overall to borrow in one currency and simultaneously enter into a swap to change the currency profile into another currency or several different currencies as required
- cross currency swaps may also be used as part of a broader strategy for managing currency risk. For example, by obtaining foreign currency borrowings to on-lend to foreign subsidiaries denominated in their local currencies
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what are the disadvantages of using cross currency swaps?
there is a risk that the other party to the contract might default on the arrangement. This is an even greater risk for cross currency swaps because:
- the cash flows are in different currencies (and hence there can be no agreement to net them as there could be for interest rate swaps)
- final principals are exchanged (again, unlike interest rate swaps)
