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F3 > C. Financial risks > Flashcards

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
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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

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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

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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
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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
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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

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7
Q

what are import tariffs?

A

make imports (from the holding company) more expensive than domestically produced goods

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8
Q

what is insisting on a minimum shareholding?

A

some equity in the company is offered to resident investors

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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

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10
Q

what are some restrictive exchange control regulation?

A

import quotas
import tariffs
insist on a minimum shareholding
company structure

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11
Q

what are some discriminatory actions?

A

supertaxes
restricted access to local borrowings
expropriating assets

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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

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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

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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

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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

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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
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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
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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

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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
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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
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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
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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

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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
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24
Q

what is interest rate risk?

A

risk of gains or losses on assets and liabilities due to changes in interest rates

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25
Q

what are some examples of interest rate risk?

A
  • floating rate loans - interest rate rises
  • floating rate deposits - interest rate falls
  • fixed rate loans -interest rates fall
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26
Q

how is interest rate risk managed?

A
  • interest rate hedging

- fixed rate loans/investments

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27
Q

what interest is used on bank loans and overdrafts?

A

variable rate of floating rate, with the interest set at a margin above a benchmark rate such as the base rate or the LIBOR

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28
Q

what is the LIBOR?

A

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

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29
Q

what is the interest rate on bonds, debentures or loan stock?

A

fixed rate

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30
Q

what reference does the floating rate use?

A

benchmark interest rate on a specific date

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31
Q

what does exposure to interest rate risk depend on?

A

amount of interest bearing assets or liabilities that it holds and the type that these are (floating or fixed rate)

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32
Q

what are the types of interest rate risk exposure?

A

floating rate loans

fixed rate loans

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33
Q

what are floating rate loans?

A

if the company has floating rate loans, changes in interest rates alter cash flows and profits and the risk is therefore OBVIOUS

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34
Q

what are fixed rate loans?

A

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.

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35
Q

why can fixed rate borrowings also be exposed to interest rate risk?

A

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
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36
Q

how is exposure to interest rate risks measured for floating rate loans?

A

total amount of floating rate assets and liabilities

the higher the value of loans the greater the exposure to changes in interest rates

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37
Q

how is exposure to interest rate risks measured for fixed rate loans?

A

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

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38
Q

what is refinancing risk?

A

risk that loans will not be renewed when needed, or only renewed at a higher interest rate.

type of interest rate risk

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39
Q

what are some examples of refinancing risk?

A
  • bank refuses to renew/refinance a maturing loan

- bank will only refinance at a higher interest rate than the company currently pays

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40
Q

how can refinancing risk be managed?

A
  • longer term loans
  • maintaining a high credit rating
  • relying more on equity than debt
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41
Q

what is currency risk?

A

risk that arises from possible future movements in an exchange rate

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42
Q

what are some examples of currency risk?

A
  • transaction risk
  • economic risk
  • translation risk
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43
Q

what are some ways of managing currency risk?

A
  • hedging

- diversification-buy and sell in several different currencies

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44
Q

who does currency risk affect?

A

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
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45
Q

what is economic risk?

A

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

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46
Q

does a company have to have foreign currency to be affected by economic risk?

A

no

still affected by economic risk due to:

  • competitive position
  • elasticity of demand
  • pricing
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47
Q

how does elasticity of demand affect economic risk?

A

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

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48
Q

how can economic risk be managed?

A

diversify globally

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49
Q

what is the portfolio theory?

A

reducing risk by ‘not having all your eggs in one basket’

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50
Q

how can firms diversify globally this managing economic risk?

A
  • diversification of production and sales
  • diversification of suppliers and customers
  • diversification of financing
  • marketing
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51
Q

how can a firm diversify production and sales?

A
  • manufacture in many countries:multiple cash flows
  • multiple plants
  • source raw materials internationally
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52
Q

how can a firm diversify its suppliers and customers?

A
  • international relationships

- can switch to cheaper one

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53
Q

how can financing be diversified?

A
  • borrowing internationally and being aware of foreign exchange risk
  • wont help in extreme situations e.g. global recessions
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54
Q

how does marketing help manage economic risk?

A

convinces customers that your product is the one to buy despite it being more expensive

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55
Q

what is transaction risk?

A

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

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56
Q

how is transaction risk different from translation risk?

A

transaction risk affect the cash flows of the business

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57
Q

what is translation risk?

A

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

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58
Q

does translation risk affect the conversion of real moey?

A

no purely paper based exercise, especially during consolidation

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59
Q

what is a settled transaction?

A

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
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60
Q

what is an unsettled transaction?

A

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
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61
Q

what is the temporal effect?

A

when currency risk due to assets and liabilities no longer offset eachother

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62
Q

what are the 2 strong arguments in favour of the relevance of translation risk?

A
  • 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)
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63
Q

how do venture capitalist often like to invest in unquoted companies via convertible loan stock to skew their risk exposure?

A
  • 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
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64
Q

what is VaR?

A

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

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65
Q

how is VaR calculated?

A

standard deviation x Z score

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66
Q

who does regulators require to use VaR as a measure of risk?

A

banks

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67
Q

what assumption is VaR based on?

A

that investors care mainly about the probability of a large loss

also assumed total market value of the portfolio are normally distributed

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68
Q

how can VaR help control risk?

A

-can try to control the risk in its asset portfolio by setting target maximum limits for value at risk over different time periods

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69
Q

what are the characteristics of normal distribution?

A
  • mean= centre=mode=median
  • 50/50 on either side
  • spread is standard deviation
  • total area under curve=1
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70
Q

what are the % for standard deviations in the normal dist table?

A

68%=1 SD
95% = 2 SDs
99.7%=3 SDs

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71
Q

what are the 2 types of calculations to consider in VaR?

A
  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
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72
Q

if you are asked to calculate the 95% VaR, what type of test is that?

A

one tail test

95% certain that the outcome will be above a particular value

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73
Q

if you about being 95% certain the result is within range?

A

two tail test

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74
Q

what international standards did the Basel committee set?

A

for banking laws and regulations aimed at protecting the international financial system from the results of the collapse of major banks

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75
Q

what is Basel II?

A

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)

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76
Q

what is the problem with VaR?

A

based on historical observations

  • doesn’t allow for extreme events
  • e.g. Credit crunch, housing bubbles
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77
Q

whats the relationship between VaR and the holding period?

A

the VaR increases with the holding period

thus the longer the holding period, the greater the VaR

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78
Q

what is an exchange rate?

A

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

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79
Q

what is the sport rate?

A

given for immediate delivery

i.e. within 2 working days

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80
Q

what is a margin/spread?

A

banks wish to make profit: BANK ALWAYS WINS

sell at lower rate
buy at higher rate

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81
Q

what is cross rate?

A

a foreign currency exchange transaction between two currencies that are both valued against a third currency

e.g. EUR to USD to GBP

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82
Q

what are direct quotes?

A

one unit of foreign currency = its value in home currency

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83
Q

what are indirect quotes?

A

one unit of home currency = its value in foreign currency

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84
Q

what are the reasons for forecasting exchange rates?

A
  • 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
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85
Q

what is speculation?

A

trading a financial instrument involving high risk, in expectation of significant returns

causes short-term movements

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86
Q

why do exchange rates fluctuate?

A
  • speculation:short selling
  • balance of payments:demand for imports and exports
  • government policy:devalue/revalue/buying and selling foreign currency
  • capital movements between economies
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87
Q

how does balance of payments cause exchange rates to fluctuate?

A
  • 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)

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88
Q

how do capital movements between economies affect currency?

A

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
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89
Q

what 3 theories give some insight into exchange rate movements?

A

PPPT
IRPT
International Fisher Effect

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90
Q

what is PPPT?

A

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

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91
Q

what is the basis of PPPT?

A
  • 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
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92
Q

what is arbitrage?

A

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
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93
Q

what are the problems with PPPT?

A
  • 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
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94
Q

what are the limitations of PPPT as a good predictor?

A
  • 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)
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95
Q

what is IRPT?

A

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

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96
Q

what is a forward rate?

A

future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date

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97
Q

what are the limitations on IRPT?

A
  • controls on capital markets:govt limit range
  • controls on currency trading:limit on amount of currency taken out
  • government intervention:manipulate exchange rate
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98
Q

what is the International Fisher Effect?

A

claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange

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99
Q

what is the assumption and theory behind the Fisher equation?

A

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

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100
Q

in what event do the PPPT and the IRPT give identical predicted rates?

A

International Fisher Effect must hold i.e. real rates of interest are identical in all countries

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101
Q

what factors affect the prediction of exchange rates?

A
  • 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
Q

who mainly uses arbitrage?

A

speculators rather than as a hedging tool

day traders

103
Q

what is pure arbitrage?

A

risk free

-rare in recent years due to globalisation

104
Q

what is a day trader?

A

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
Q

why is hard to make conclusions on day-trading?

A

hard to judge whether they are successful because they would lose their advantage if they admitted to being able to spot mispriced assets

106
Q

what are the stages of financial risk management?

A

1) identify risk exposures
2) quantify exposures
3) decide whether or not to hedge
4) implement and monitor hedging program

107
Q

what are the benefits of hedging?

A
  • 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
Q

what are the arguments against hedging?

A
  • 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
Q

what are the uses of derivatives?

A

hedging
speculation
arbitrage

110
Q

what are the main functions of the treasury function?

A
  • managing relationship with the banks
  • working capital ad liquidity management
  • long-term funding management
  • currency management
111
Q

what is the organisational structure of the treasury function?

A
  • profit centre or cost centre

- centralised or decentralised

112
Q

what are the advantages and disadvantages of operating the treasury function as a profit centre instead of a cost centre?

A

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
Q

what are the risks associated with operating the treasury function as centralised or decrentralised?

A

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
Q

what are the principal risks faced by a centralised treasury function?

A
  • liquidity/funding risk
  • counterparty risk:fin institutions default
  • foreign currency risk
  • interest rate risk
115
Q

what internal methods can be used for transaction risk management?

A
  • home currency
  • leading/lagging
  • matching/netting
  • countertrade
116
Q

what external methods can be used for transaction risk management?

A
  • forward contracts
  • money market hedges
  • currency futures
  • currency options
  • currency swaps
117
Q

what are the differences between internal and external hedging?

A
  • 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
Q

how does invoicing in home currency remove transaction risk?

A

transfers currency risk to customer or supplier but economic risk not removed

119
Q

what issues does invoicing in home currency give?

A
  • 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
Q

what are the problems with leading and lagging?

A
  • 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
Q

what is currency netting?

A

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
Q

what is pooling currencies?

A

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
Q

does pooling provide a system for hedging against FX risk?

A

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
Q

what are the requirements for an efficient system of cash pooling?

A

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
Q

what is a countertrade?

A

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
Q

what is multilateral netting?

A

treasury management technique used by large companies to manage their intercompany payment processes, usually involving many currencies
-can yield significant trading

127
Q

what does a netting centre do?

A

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
Q

how often does the netting process take place?

A

cyclical basis, typically monthly, and is managed by a central entity called the netting centre

129
Q

who usually uses multilateral netting?

A

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
Q

what is the objective of using a netting centre?

A

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
Q

what issues must successful participants of netting agree on?

A
  • currencies
  • credit period
  • settlement dates e.g. intervals
  • exchange rates: arms length
  • conflict resolution:payables vs receivables
  • management:bespoke of bank managed?
132
Q

what is a forward contract?

A

an agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate

133
Q

what is the most popular method of hedging currency transaction risk?

A

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
Q

at what rate are forward contracts quoted?

A

at a premium or discount rate

135
Q

what are premium an discount rates?

A

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
Q

what are the advantages of forward contracts?

A
  • 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
Q

what are the disadvantages of a forward contract?

A
  • 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
Q

how can we overcome the contractual commitment problem of a forward contract?

A

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
Q

what is MMH?

A

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
Q

what is the rule of MMH?

A

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
Q

what period are money market interest rates available?

A

any length of borrowing or deposit period, up to about a year
-all rates quoted on annual basis

142
Q

what are the 2 rates quoted for money market interest rates?

A

higher rate: interest bank will charge on loans

lower rate:rate bank will charge on deposits

143
Q

what are the characteristics of MMH?

A
  • 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
Q

what are the steps for future foreign currency payments?

A

1) borrow in home currency
2) convert to foreign currency at spot
3) deposit foreign currency
4) future deposit to pay supplier

145
Q

what are the steps for future foreign currency receipts?

A

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
Q

what are the calculations for MMH?

A

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
Q

what are the advantages of MMH?

A
  • 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
Q

what are the disadvantages of MMH?

A
  • 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
Q

what does IRPT imply about forward contracts and MMH?

A

forward contracts and MMH should give the same result

150
Q

what is a currency future?

A

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
Q

why can currency futures be traded easily?

A

traded on future exchanges

-contract is separated from transaction itself so can be traded

152
Q

what denomination are currency futures traded in?

A
  • small range of currencies
  • typically in USD
  • less commonly in EUR
153
Q

do futures deliver currency?

A

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
Q

what are the standard expiry dates for futures?

A

last day per quarter

-can be traded before

155
Q

what are the steps to answering a futures question?

A

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

156
Q

what is the concept behind currency futures?

A

hedging or speculating on the movement of the exchange rate on the future market

-betting on opposite to create no win/no loss position

157
Q

how are initial margins used in currency futures?

A

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’

158
Q

what are ticks in futures contracts?

A

minimum price movement for a futures contract

0.0001 change in unit = 1 tick of unit

159
Q

what is the basis in futures?

A

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
160
Q

what is basis risk?

A

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

161
Q

what are the advantages of currency futures?

A
  • offer an effective ‘fixing’ of exchange rate
  • have no transaction costs
  • are tradeable
162
Q

what are the disadvantages of currency futures?

A
  • 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
163
Q

what are the reasons for imperfect hedges?

A
  • rounding the number of contracts

- closing before expiry date: leads to basis risk

164
Q

what are currency options?

A

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

165
Q

why are premiums charged on currency options?

A

writer will charge a non-refundable premium for writing the option

166
Q

how is the gain/loss calculated on an option?

A

difference between exercise price and market price- premium paid

167
Q

what are the two types of options?

A
  • call option:gives holder the right to BUY the underlying currency
  • put option:gives the holder the right to SELL the underlying currency
168
Q

what are the calculations for options hedging calculations?

A

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

169
Q

what is an in-the-money option?

A

if the exercise price for an option is more favourable to the option holder

has intrinsic value

170
Q

what is the out of money option?

A

if the exercise price for an option is less favourable to the option holder than the current spot market price

no intrinsic value

171
Q

what is at the money?

A

if the exercise price for the option is exactly the same as the current spot market price

172
Q

when would an option holder exercise the option?

A

if it is in the money

173
Q

when are options first purchased?

A

usually during period before expiry date or when out of the money

174
Q

what are the advantages of currency options?

A
  • 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
175
Q

what are the disadvantages of currency options?

A
  • traded sterling currency options are only available in foreign markets
  • there are high up-front premium costs (non-refundable)
176
Q

how do writers of options decide what level of premium to set?

A

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)

177
Q

what is the Black-Scholes model?

A

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
178
Q

what are the 5 variables that affect the price of a call option?

A

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
179
Q

what is the intrinsic value?

A

difference between the current price of the underlying asset and its option strike price

180
Q

what are the limitations of the Black-Scholes model?

A
  • 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
181
Q

does a premium on an option mean a commitment to buy?

A

no, entitles them to first option to buy the asset

182
Q

what are swaps?

A

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

183
Q

what are the 2 elements of a cross currency swap?

A
  • 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
184
Q

between the lending rate and borrowing rate, which is higher?

A

the lending rate is higher as the bank wants to make a profit

185
Q

what is LIBOR?

A

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
186
Q

what is the average LIBOR rate?

A

calculated each day by the British Bankers Association

-used as benchmark rates for some financial instruments

187
Q

why is the LIBOR important?

A

London is the world’s major money market centre

188
Q

what is the euribor?

A

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
189
Q

how many basis points is 1%?

A

100 bonus points

190
Q

what is LIBID?

A

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
191
Q

Between LIBID and LIBOR, which is lower?

A

LIBID

192
Q

which is more volatile between exchange rates and interest rates?

A

interest rates are less volatile but changed in them can still be substantial

193
Q

what is the term structure of interest rates?

A

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
194
Q

what is the yield curve also known as?

A

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

195
Q

what are the types of risk exposure in interest rate risk management on existing loans or deposits?

A

exposed to changes in interest rates if existing loans and deposits have variable interest rates

can avid by using fixed rates or using swaps

196
Q

what are the types of risk exposure in interest rate risk management on future loans or deposits?

A

even is we want to use fixed rates, we do not know what the rate will be when we need the loan/deposit

197
Q

what are internal hedging strategies for managing interest rate risk?

A
  • smoothing
  • matching
  • netting
198
Q

what is smoothing?

A

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

199
Q

what is M&S’s funding and interest rate hedging policy?

A

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
200
Q

what are OTCs?

A

bespoke, tailored products that fit the companies’ needs exactly

201
Q

what are exchange traded instruments?

A

ready made and standardised

202
Q

what are ‘fixing’ instruments?

A

lock a company into a particular interest rate providing certainty as to the future cash flow

203
Q

what are ‘insurance’ instruments?

A

allow some upside flexibility in the interest rate i.e. the company can benefit from favourable movements but are protected from adverse movements

204
Q

which OTC instruments are used for fixing and insurance instruments?

A

FRAs for fixing

IRGs for insurance

205
Q

which exchange traded instruments are used for fixing and insurance instruments?

A

interest rate futures for fixing

interest rate options for insurance

206
Q

what is a forward rate agreement (FRA)?

A

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

207
Q

how long are FRAs usually for and for what amount?

A

relate to short term interest rate e.g. 3 month or 6 month LIBOR

normally for amounts greater than GBP 1 million

208
Q

what is an important feature of an FRA?

A

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
209
Q

how are FRAs settled?

A
  • 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
210
Q

how is a hedge set up in FRA?

A

if looking to borrow money then you need to buy an FRA

if looking to deposit money, then you need to buy an FRA

211
Q

what does 5-8 FRA mean?

A

3 month loan/deposit starting in five months’ time

212
Q

what are IRGs?

A

interest rate guarantees are options on FRAs so the treasurer has the choice whether to exercise or not

-max maturity of one year

213
Q

what are IRGs also referred to as?

A

interest rate options or interest rate caps/floors

214
Q

what are the call and put options of IRGs?

A

borrowing: would buy FRA so need a call
depositing: would sell FRA, so need a put

215
Q

what are the decision rules of IRGs?

A

if there is an adverse movement, exercise the option to protect

if there is a favourable movement, allow the option to lapse

216
Q

why are the IRGs more expensive than FRAs?

A

one has to pay for the flexibility to be able to take advantage of a favourable movement

217
Q

what are interest rate caps/floors?

A

another name for an IRF on a loan/deposit as it caps/creates a floor for the maximum/minimum loan rate received

218
Q

what is a collar?

A

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

219
Q

what are IRFs?

A

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
220
Q

what are the 2 types of IRFs?

A

STIRs - short term interest rate futures

bond futures

221
Q

what are the features of IRFs?

A

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

222
Q

how are IRFs priced?

A

price = 100 - interest rate

-as interest rates increase, the value of the future will fall and vice versa if interest rates reduce

223
Q

how are gains and losses calculated on STIRs?

A

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

224
Q

how can companies hedge using futures?

A

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
225
Q

whay are IRFs complicated?

A
  • contract sizes and standard contract lengths (3 months)
  • margins/deposits payable at the stat of the hedge
  • speculators - who dominate the market
226
Q

how can companies hedge against the risk of a rise in interest rates with STIRs?

A

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

227
Q

what are the causes of an imperfect hedge with IRFs?

A
  • 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
228
Q

how are FRAs and STIRs similar?

A
  • 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
229
Q

what advantage do FRAs have?

A

can be tailored to the company’s exact requirements in terms of amount of principal, length of notional interest period and settlement date

230
Q

what is the interest rate difference between FRAs and STIRs?

A

given the efficiency of the financial markets, the difference between the two in terms of effective interest rate is unlikely to be large

231
Q

how can you hedge with bond futures?

A

bond futures fall in value when the interest rates go up

for a bond investor, the required hedge is therefore to sell bond futures

232
Q

what are traded interest rate options?

A

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

233
Q

why must the options holder pay the writer of the option a premium?

A

because the exchange traded interest rate options are an option, not a commiment

234
Q

what are the characteristics of the exchange traded interest rate options?

A
  • 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
235
Q

in exchange traded interest rate options, what is a call option and a put option?

A

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)

236
Q

what is an interest rate swap?

A

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

237
Q

what are the different types of swaps?

A

interest rate swap

cross currency swap

238
Q

what are the reasons for using a swap?

A
  • 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
239
Q

how do swaps work with intermediaries?

A

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

240
Q

why are interest rate swaps the most common form of interest rate hedge ?

A

they can hedge borrowings of anywhere between a year and 30 years and therefore can be used for long-term borrowings

241
Q

what does the swap market look like?

A

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

242
Q

what is a forex swap?

A

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

243
Q

whats are the main objectives of a forex swap?

A
  • 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
244
Q

when a re forex swaps particularly useful?

A

when dealing with countries that have exchange controls and/or volatile exchange rates

245
Q

what are the 2 elements of currency swaps?

A
  • 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
Q

when is the interest fixing date?

A

the start date of the swap period

-used as the LIBOR rate will fluctuate daily

247
Q

what are the advantages of using interest rate swaps?

A
  • 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
248
Q

what are the disadvantages of using interest rate swaps?

A
  • 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
Q

what interest rate odes the company entering the cross currency swap end up with?

A

the type of rate it prefers and the currency it needs

-could be ‘fixed for fixed’, ‘floating for floating’ or ‘fixed for floating’

250
Q

what are the advantages of using cross currency swaps?

A
  • 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
251
Q

what are the disadvantages of using cross currency swaps?

A

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)

F3 (4 decks)

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