Chapter 6 Financial risk management Flashcards
1.1 Risk management – deciding to hedge
Materiality: if the cost of hedging outweighs the potential loss on a transaction then it is better to take the potential loss.
Time: if the time between today and the transaction date is short, then it is unlikely that the markets will move considerably.
Volatility: if the underlying security is not prone to significant fluctuations, then it is less likely the company will suffer huge losses.
2.1 Practical solutions
For interest rate risk: pooling of assets and liabilities
For foreign exchange rate risk: seller invoices in home currency, matching receipts and payments, foreign currency bank account and automated foreign exchange conversions (allows a company to make payments in a foreign supplier’s local currency, using a bank’s automated service. This reduces the need to operate multiple foreign currency accounts).
2.2 Hedging products and methods
- Forward: obligation to buy/sell a set amount of an underlying asset on a set future date at price/rate agreed today
- Future: a standardised and thus tradable version of a forward contract. An agreement to buy or sell a standard quantity of a specified underlying asset on a fixed future date at a price/rate agreed today
- Over-the-counter option: the right, but not obligation to buy or sell a specific quantity of an underlying asset on a future date at a price/rate agreed today
- Traded option: standardised and thus tradable version of OTC option
- Money market hedge: involves the use of the money markets, to create a transaction today at today’s exchange rate, hence removing the risk
- Interest rate swap: an agreement whereby two parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and vice versa.
3.1 Forward rate agreements
A FRA is a cash-settled forward contract on a short-term loan. It is typically an agreement with an investment bank, which is separate from the underlying loan. It effectively fixes the interest suffered on a future loan agreement, as:
- If the reference rate (typically SONIA) on the transaction date is greater than the FRA rate, the investment bank pays the difference to the FRA holder
- If the reference rate on the transaction date is less than the FRA rate, the holder pays the difference to the investment bank
As a bespoke over-the-counter product, an FRA can be flexed to the user’s exact requirements.
3.2 Terminology
Quote terminology: a 2 v 5 FRA covers a loan that starts in 2 months and finishes in 5 months.
Trade date/spot date: both dates reflect when the FRA was initially set up. The spot date is technically 2 working days after the trade date.
Fixing date: date on which the reference rate used for the settlement is determined.
Settlement date: the day the underlying loan starts. The FRA is settled with a single cash payment on this date.
3.3 Calculation of settlement amount
Settlement amount = loan amount x (Rref – Rfra) x length of loan/365) /(1+Rref x length of loan/365)
- Rref is the reference rate (typically SONIA)
- Rfra is the forward rate of FRA rate
4.1 Interest rate futures – terminology
Underlying asset: for interest rate futures this is either debt security or an interbank deposit
Futures price: short-term interest rate futures are priced at 100 minus the expected annualised reference rate. Long-term IRFs price reflect the market prices of the underlying bonds.
Expiry dates: expect the standard expiry dates for interest rate futures to be the last day of March, June, September and December.
Contract size and length: the contract size if the fixed quantity of the underlying asset, which can be bought or sold using a futures contract. The length is normally 3 months.
Basis risk: refers to the fact the hedge may be imperfect. Basis is the difference between futures price and the spot price of the underlying asset. It will be zero at the expiry of the contract. Hence closing out a futures price position before the expiry date results in an imperfect hedge.
4.2 The workings of futures markets
The futures market is highly liquid: so we will always be able to enter a contract when we want and we will always be able to close out our position when we need to.
We can always sell futures when we need to: if we sell a future we are simply entering a contract to sell the underlying asset in the future. We are not selling anything when we enter the contract, we are simply promising to sell something in the future.
There are cash flow implications associated with futures. These are:
- Initial margin: this is the initial deposit required to be posted with a broker to set up a futures position
- Variation margin: additional payments that are required to be made to the broker to cover losses on the futures position
4.3 Approach
Buy/sell decision:
- To set up the futures position (now): borrowers will sell, savers will buy
- To close out the position on transaction date: borrowers will buy, savers will sell
Expiry date: pick the first expiry date on or after the date the borrowing/lending starts
Contracts: number of contracts is (loan amount / contract size) x (loan amount / contract length)
Calculating the profit or loss on the future: futures price are quoted at 100 – interest rate. Therefore the profit or loss will be a percentage. Then calculate the total gain or loss as: % x contract size x standard contract length x (3/12) x number of contracts.
4.4 Estimating the futures price on the transaction date
We can do this by assuming that the basis (difference between the futures price and spot price) declines evenly over time.
5.1 Foreign exchange rate risk
Transaction risk: the risk of exchange rates changing before the settlement date of a transaction. This risk can be reduced or eliminated using hedging methods
Economic risk: risk that long-term adverse movements in foreign exchange rates make company less competitive internationally. Over-reliance on a particular currency increases a firm’s exposure to economic risk. Diversifying internationally enables a firm to reduce its exposure.
Translation risk: the risk of exchange rate movements between one year and the next causing fluctuations in values of foreign currency assets and liabilities in consolidated accounts. Beware that unrealised translation losses can impact borrowing capacity. Translation risk can be mitigated by financing foreign investments with foreign loans.
5.2 Forecasting exchange rates
Purchasing power parity: this can be used to estimate future spot rates, as follows:
Future spot rate = spot rate x (1 + inflation(foreign)) / (1+ inflation(home))
Interest rate parity: can be used to calculate exchange rates, as follows:
Forward rate = spot rate x (1 + interest(foreign)) / (1+ interest(home))
6.1 Currency forward contracts: quoted exchange rates
Exchange rates may be quoted in the direct method (domestic currency/foreign currency) or the indirect method.
Banks will quote a spread of exchange rates (the bid-offer spread). The bank will make its profit on the difference between these two prices. A company will:
- Buy the variable currency at the low rate
- Sell the variable currency at the high rate,
Or
- Buy the base currency at the high rate
- Sell the base currency at the low rate
6.2 Quoted forward rates
Forward rates are often not quoted directly but as a premium or discount to the spot rate. A premium means that the variable currency is expected to strengthen in the future. A discount means the variable currency is expected to weaken in the future. Thus to convert a VC/BC spot rate to a forward rate, we need to add a discount or deduct a premium.
6.3 Approach to forward rates
- Take the forward rate from the question (or calculate it by adjusting the spot rate for the discount/premium given)
- Convert the future payment or receipt at the forward rate, if
o The hedging company’s home currency is the variable currency, multiple the foreign currency amount by the forward rate
o The hedging company’s home currency is the base currency, divide foreign currency amount by the forward rate
