CH17-Financial Risk Management Flashcards
define Implicit Risk
type of Transaction Risk - Cash flow exposure
define Explicit Risk
type of Transaction Risk - Balance sheet exposure
define Translation Risk
AKA Accounting Exposure.
When a company holds assets or liabilities in a currency other than its functional currency. Must be converted (translated) into Reporting currency. Exchange rate.
Natural hedging
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used to address FX risk.
Company holds assets and liabilities in same currency; they offset each other when market fluctuates: borrow/invest, fixed/floating, balance sheet matching, fixed-price supply
Active hedging
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Similar to buying insurance to insure asset’s value (or liability’s risk) when market fluctuates
Arbitrage
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no-risk attempt to profit from market inefficiencies: buy asset in one market and simultaneously sell in another
Speculation
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Betting on market direction to profit: not a normal treasury objective unless part of strategy
Forwards Contracts
agreement between two parties to buy or sell a fixed amount of an asset at a future date at an agreed upon price today
- underlying asset
- Future date (maturity of contract)
- price is delivery price of contact
- Buying party is LONG on a forward contract
- Selling party (counter party) (bank/FX dealer) is SHORT on a forward contract
Forwards Contract - who is long / short
Fwd Contract
LONG=Buyer
SHORT=Seller/Bank/FX Dealer
Futures Contracts
standardized contract traded on an organized exchange, which serves as the counterparty to all trades
Attributes of a Futures Contract
- Organized on an Exchange
- virtually eliminates counterparty risk
- LONG=Buyer
- SHORT=Seller
- Size and maturity date set by Exchange (standardized)
- Requires Margin Account which is covered at EOD
- Marked to market
- Rarely settled; closed out prior to maturity
- Government regulated (CFTC / FCA)
Attributes of a Forwards Contract
-customized contract between two parties (not on an exchange)
- underlying asset
- Negotiable expiration date=Future date (maturity of contract)
- price is delivery price of contact
- LONG=Buyer
- SHORT=Seller
Options
contract giving buyer right (not obligation) to buy or sell fixed amount of underlying asset at a fixed price on or before specified date
Call Option
Right to Buy an asset
Put Option
Right to Sell an asset
Strike/Exercise Price
Fixed price of underlying asset on an Option
3 Styles of Options, ranked by Size of Premium
Highest premium: American Option
Middle premium: Bermudan Option
Lowest premium: European Option
When is American Option date of exercise?
Any time on or before delivery date. Most likely to be exercised.
When is Bermudan Option date of exercise?
At specified dates over the option’s life
When is European Option date of exercise?
On delivery date ONLY. Least likely to be exercised.
When an option is In The Money, is it profitable?
Not necessarily. Must consider Premium
What general approach do “IAS 21: The Effects of Changes in Foreign Exchange Rates” and “ASC Topic 830: Foreign Currency Matters” both follow regarding translation risk?
Helps firms to assess the specific impact that changing FX rates have when translating financial statements
define Interest Rate Collar
CAP + FLOOR = COLLAR
an interest rate CAP + an interest rate FLOOR = interest rate COLLAR.
Cap = maximum borrowing rate, thereby protecting the company against higher interest rates
Floor = minimum borrowing rate.
An investor who wants to hedge the possibility of a fall in the price of an asset could perform which of the following actions?
Buy a put option
A put option gives the contract owner the right, but not the obligation, to sell (put) the underlying asset to the contract writer at a fixed price through the delivery date.
Four basic types of derivative securities
forwards, futures, swaps and options.
Define Window Forward
variation of a standard forward contract.
allows settlement during a given “window” period
Economic Risk
AKA Operating Risk: LT effect of changes in exchange rates on the PV of future CFs
Transaction Risk
a company creates receivables, payables denominated in a currency other than its functional currency. Ultimate value of collected AR / paid AP is a different value than when created
2 parts of Transaction Risk
- CF exposure (implicit risk) - time between when sale is made and price is set vs cash collected
- BS exposure (explicit risk) - time between when transaction occurs vs finally settled
Translation Risk (accounting exposure) guidance
In the US: ASC 830 - Foreign Currency Matters
Global: IAS 21 - The Effects of Changes in Foreign Exhange Rates
Both helps firms assess the specific impact that changing FX rates have when translating financial statements
Less variability in expected future cash flows increases a firm’s value in 4 ways:
- greater predictability of CFs
- lenders view the company as less risky, which enhances borrowing advantage in credit markets
- company can assess costs and revenues more accurately, which decreases financial distress
- can prepare more accurate budgets b/c doesn’t need to make allowances for price volatility, which sets more competitive pricing
T/F: Using hedging to reduce the variability in expected future cash flows creates an advantage in the credit markets
True
__________ is the most common method companies use to lower the volatility of future cash flows and consequently lower their perceived investment risk
Hedging
On a Forwards Contract, the LONG makes money when…
Long=Buyer
Long makes money when ASSET PRICE RISES
On a Forward Contract, the SHORT makes money when…
Short=Seller = make money when asset SINKS
Short makes money when ASSET PRICE SINKS (falls)
Call Option = Buy
make money when asset price rises
Put Option = Sell
make money when asset price Sinks
What does it mean when an option is At-The-Money
Asset price = Strike price
formula to calc profit/(loss) on an option contract
(Current Asset Price - Strike Price - Premium) = P/L
formula to calc break even or profit/(loss) on a Put option contract
(Strike - Premium) = Put Option B/Even
(Strike - Premium -1) = Put Option become Profitable
Which ASC topic helps determine the real market price of an asset?
ASC 820-10: Fair Value Measurement-Overall
3 greater challenges in global treasury over domestic
Increased risk of:
FX risk,
Cash Flow Complexity,
Tax issues
Which currency can be managed using mainstream risk management instruments and techniques?
Euro = A currency that has externally controlled monetary policy and single-currency, cross-border pooling
A currency that has externally controlled monetary policy and single-currency, cross-border pooling =
Euro
T/F: When an advantage to investing in another country’s money market exists, it will be eliminated quickly because exchange rates adjust to the cross-border money flows created by investors as they attempt to capture the advantage
True
What was a downside of the mark-to-market valuation approach for derivatives that required updated guidance within ASC Topics 815 and 820 and similar updates to IFRS guidelines?
If one asset class rapidly deteriorates in value it can cause illiquidity in other markets
2 Primary issues addressed by FASB and IASB regarding derivatives
Valuation and Disclosure
