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Risk > Financial Risk > Flashcards

Financial Risk Flashcards

1
Q

Financial Risk Types

A

Risk to cash flows:
- Purchasing raw materials (commodities/inputs)
- Trading in foreign currency (receipts and payments)
- Financing - e.g. interest rates
- Investing overseas and the impact of this on profits by foreign exchange rate fluctuations

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2
Q

Risk managers have

A

Responsibility of managing day-to-day risks
Quantification of risks

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3
Q

Financial Hedging and Speculation

A

Speculation: taking calculated risks in the hope of generating profits.

Speculation and hedging
- using derivatives (i.e. matching cash flows to protect balance sheet from downside risks)

Hedge technique only
- using insurance (e.g. financial guarantee / credit insurance)

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4
Q

Key financial risks issues

A
  • Basis risk (hedge doesn’t completely cover the risk)
  • Default (credit) risk (counterparty fails to honour transaction)
  • Moral Hazard Risk (Too big to fail syndrome - global financial crisis) - careless and risky action as they assume government will back them up.
  • Systemic (Contagion) Risk (e.g. sub-prime crisis in America 2007-2009), where risk spread across industries and countries
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5
Q

Derivatives

A

Hedging
- Involves reducing or eliminating financial risk by passing it on to someone else; usually a speculator.
Speculation
- Judging where the market will move and attempting to make a profit out of it (risk taker). Without speculation there would be no liquid markets in which hedging could take place.
Arbitrage
- Making risk-free profits by buying and selling the same thing in different location for a profit. Due to information asymmetries.

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6
Q

Treasury Function

A

Responsible for all issues surrounding management of risk in major transactions - especially foreign currency and interest rates.

Treasurer quantifies risk using forecasting (e.g. regression) tools and VaR

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7
Q

Treasury specialist department responsibility

A
  • Relationship with banks
  • Liquidity management
  • Borrowing activities (debt)
  • Funding arrangements (equity)
  • Currency management
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8
Q

VaR

A

Capital management technique developed by JP Morgan

Measures the maximum loss acceptable.
- due to normal market movements
- in a given period
- for a given level of probability (95% or 99% confidence)
- also measures foreign currency subject to exchange rate fluctuations.
- used as a capital allocation metric in banks

Advantages
- Simplicity (understood by non-finance managers)
- Easy to calculate
- Commonly used (esp in the banking sector)

Disadvantages
- Assumes normal distribution and may not hold
- Requires regular data, which may not be available
- Attempts to make VaR more ‘realistic’ have increased complexity

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9
Q

Credit risk

A

Risk of loss due to counterparty’s failure to honour an obligation in part or in full

Forms of credit risk:
- Bank arises through its lending activities
- Non bank corporations - provide short-term credit for their debtors face credit risk as well.
- Investors who own a mix of corporate bonds and distressed equities (stocks of companies facing financial difficulties) to understand the probability that these assets will fail to meet their financial obligations, i.e. default.

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10
Q

Credit default triggers and mitigation

A

Triggers
- Missed / Delayed interest or principal payment
- Bankruptcy
- Distressed exchange where old debt is exchanged for new debt that represents a smaller obligation for the borrower
- Market-specific volatilities (e.g. credit derivative more risky than loans)
- Economic and political crisis
- Systematic risks

Mitigation
- Credit insurance e.g. through Lloyds
- Ex-ante credit vetting e.g. VaR modelling (evaluating the creditworthiness of potential borrowers)
- Ex-post monitoring and resolution (of borrowers)
- Collaterisation (obtaining assets from borrowers or)
- Utilising external sources (consultants and analysts)

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11
Q

Currency risk occurs in…

A
  1. Economic Risk
    - Longer-term cash flows impacted by FX movements
    - Variable international trading activities (e.g. UK now net importer of oil and gas from being an exporter)
    - Results of strategic decisions (e.g. source raw materials from foreign suppliers)
  2. Political Risk
    - Government involvement (tariffs, exchange controls (regulation preventing currency being moved out of the country, and quotas)
  3. Translation Risk
    - Report financial results in dominant currency
    - Movement in foreign assets/liabilities due to FX movements
    E.g. 31/12/12 – Loan (in US) = $1m
    FX rate £1:$2
    Repatriate to UK and purchase an Asset =£500k
    Consolidated results in UK: Debt of £500k
    31/12/13 – Loan = $1m
    FX rate £1:$1
    Results in UK: Debt of £1m but Asset = £500k
    - Difference between opening and closing amounts can cause an accounting loss or addition to the balance sheet - “accounting numbers have share price implications” (Ball and Brown, 1968)
    - Managed by matching assets and liabilities in relevant currency (immunisation)
  4. Transaction Risk
    - Risk transaction entered into at one rate, is settled at another rate
    Due to timing in entering transaction and receipt of actual cash flows
    E.g. UK Co sells goods that cost £400k to US customer for £500k ($1m) on 12/12/14 with a payment terms of 3 months. But when fund received, on 12/03/15, exchange rate has increased and therefore the fund received was £333k making a loss of £67k
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12
Q

Spot rate fluctuation

A

Reflects today’s price of one currency against another - thus a reliable measure of value

Reasons for the fluctuations:
- Natural resources
- Political stability
- Balance of payments
- Speculation by currency traders
- Government intervention
- Inflation rates (purchasing power parity)
- Interest rate (interest rate parity)

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13
Q

FX estimation - PPP

A

Differ between countries..
due to relative purchasing power of each as a result of a local interest rate

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14
Q

PPP

A

provides a reasonable estimate but limitations are:
FOREX rates can be influenced by
- speculations and government policies
- currency investment rather than trade in physical goods

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15
Q

FX Estimation - IRP

A

due to differing interest rates between countries
Domestic price of money is set by
- Demand and Supply
- Government intervention
- Sale and purchase of money occurs in the money-markets

Investing in economies with higher interest rates may seem more appealing. The higher income received initially is attractive, and there’s potential to sell the currency later. However, heightened demand drives up the currency’s price. Subsequently, when selling the currency, decreased demand can lead to a drop in its price once more.

The higher your interest rate, the stronger your currency

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16
Q

IRP

A

often judged to be better than PPP as interest rates can be seen as robust estimates of forward rates.

However, their reliability is subject to unexpected government action (e.g. currency controls or direct govt trading in its own currency)

17
Q

Controls over FX risks

A

Translation Risk:
- Matching (Immunisation): Matching assets with liabilities in foreign currencies to offset fluctuations, reducing volatility and risk.

Transaction Risk:
- Invoicing in Stable Currencies: e.g. Sterling, Dollar, and Euro for invoicing.
- Encouraging counterparties to pay in your currency
- Matching Receipts and Payments: Employing strategies like leading export receipts and lagging import payments to mitigate default and devaluation risks and reduce taxes.
- Leveraging Overseas Bank Accounts.
- Offsetting Inter-company Balances: using natural hedging through ERM
- Use Derivative Contracts: Using privately traded OTC forwards, traded futures, options, or OTC swaps.

18
Q

Interest rate risk

A
  • More difficult to manage than other risk e.g. there are many IR for a given currency - treasury rates, interbank rates
  • Important for financial firms (esp. banks) - as lenders, investors and holders of short and long term liabilities
    Hence asset-liability maturity matching is important
  • LT IR rates are higher than ST IR as risks increases with time
  • Liquidity risk is a major issue in banks
  • ST IR historically tied to LIBOR it is conditioned by the bank of England to provide credit worthiness - LIBOR served as a benchmark for determining IT but since a scandal in 2008, revealed that banks were manipulating LIBOR rates for their benefit.
    • LIBOR was used until 2023 as a proxy for the risk–free rate when estimating the pricing of IR
    • SONIA was introduced in response to this scandal and was based on transactions in the overnight unsecured funding market and reflects risk-free interest rae
19
Q

Credit Rating

A

To mitigate credit risk

Four major credit rating agencies: AM Best (insurance-specific), S&Ps, Fitch and Moody’s

Credit ratings are opinions on the ability and willingness of an issuer – e.g., company or government - to meet its financial obligations

Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation

20
Q

Forward exchange contract

A
  • Private agreements between two parties (OTC contracts)
  • Agreement to exchange a specified amount of one currency for another at a predetermined future date
  • Typically not cancellable, representing a fixed commitment
  • Can involve any currency, but major currencies like the US dollar are common
  • Forward exchange rate set by a bank
    • Rate calculation often involves factors like Interest Rate Parity (IRP) and benchmark rates like LIBOR or SONIA
21
Q

Futures contracts

A
  • Futures traded on exchange
  • Daily pricing
  • Mainly in US$
  • Initial margin required and held in margin account
  • Daily profit/loss settled (variation margin)
  • Margin call possible
  • Exchange protects from default (if audited & controlled)
22
Q

Pros and cons of futures

A

Pros
- Flexibility
- Regulated
- Ease of buying and selling (through a liquid market)
- Well control and accounted for

Cons
- Cannot be tailored to requirement (standardised)
- Limited number of currencies
- Broker (meaning extra fees)
- Deposit and maintain a marginal account

23
Q

Pros and Cons of Options

A

Pros
- Available
- Regulated
- Increased flexibility
- Earnings stability and share price protection

Cons:
- Premium / Broker (Fees)
- Limited number of currencies
- Alternatives may be cheaper and more flexible (less contractually binding)
- Treasury management skills may not exist in-house

24
Q

SWAPS

A

Over counter derivatives
- an agreement between two parties to exchange future interest payments
- Banks are intermediate between the corporate players
- Banks can warehouse SWAP (e.g. swap interest rates a UK company with a variable rate with a Japanese company with a fixed rate [Japan has - interest rate])
- Thus they can bear ‘holding risk’ (reflected in the bank fee)

25
Q

SWAP market depends on

A
  • effective contracting & accounting (IFRS 9)
    • low / zero counterparty default risk
    • political stability (low Sovereign risk)
    • efficient & credible information exchange
    • security of ‘warehousing’ banks
    • banks act as ‘honest brokers’
    • integrity of the money market – note: the 2008 LIBOR rate fixing scandal!
26
Q

Why SWAP

A

Different firms have different comparative advantages in loan markets. This can arise because, for example:
- firms have different access to, & costs of, international finance
- default risks differ between firms (hence firms with volatile cash flows likely to prefer fixed loan rates)
- firms differ in terms of loan term maturity preferences

Risk (10 decks)

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