Financial risk management Flashcards
Financial risk management Risk management
The focus of this chapter will be on hedging techniques relating to:
Interest rate risk
Foreign exchange rate risk
However, exam questions may also feature other types of financial risk.
The emphasis at advanced level is providing advice to a company
about the risks they face and the course of action they should take to
reduce that risk. Numbers may be needed to support the advice given,
but these are mainly assumed knowledge from the FM paper. Hedge
accounting is tested alongside this advice and is important to include in
your exam file. When analysing risk, statistical techniques may be
needed.
This chapter recaps some of the assumed knowledge for your exam file and
introduces the new calculations in this syllabus. For more details, review the chapter
Appendix 2 – Recap Financial Management and Management Information.
Financial risk management 1.1 To hedge or not 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.
Financial risk management 1.1 To hedge or not to hedge Solutions 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
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
Financial risk management 2.2 Hedging products and methods
1. Forward: An obligation to buy/sell a set amount of an underlying asset on a set
future date at price/rate agreed today.
2. 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.
3. Over-the-counter (OTC) option: The right, but not the obligation, to buy or sell a
specific quantity of an underlying asset on a future date at a price/rate agreed today.
4. Traded option: This is a standardised and thus tradable version of OTC option.
A standardised contract which gives the right, but not the obligation, to buy or sell a
specific quantity of an underlying asset on a future date at a price/rate agreed today.
5. Money market hedge: This 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.
Financial risk management Interest rate risk 3.1 Explanation of interest rate risk
As the diagram below demonstrates, interest rate hedging focuses on the period
before the loan or deposit commences.
Any risk during the actual loan or deposit period can be managed by entering a fixed
rate agreement.
Now
Risk period:
We are taking out a loan in the future and are worried about rates rising before then
Start of fixed rate loan agreement
Loan period:
We take out a loan at a fixed rate – so face no interest rate risk during the loan period
End of loan term
Financial risk management Forward rate agreements (FRAs) 4.1 Definition
A FRA is a cash-settled forward contract on a short-term loan.
Financial risk management Forward rate agreements (FRAs) 4.2 Explanation
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 – Sterling Overnight Interbank Average
Rate) on the transaction date (the date the loan commences) 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 (OTC) product, an FRA can be flexed to the user’s
exact requirements.
Financial risk management Forward rate agreements (FRAs) 4.3 Terminology
Quote terminology:
A 2 v 5 FRA, for example, covers a loan than starts in 2 months
and finishes in 5 months (i.e. it is a 2-month forward rate for a 3-month loan).
Trade date/Spot date: Effectively, both dates reflect when the FRA was initially set
up (i.e. now). Technically, the spot date is 2 working days after the trade date.
Fixing date: The date on which the reference rate used for the settlement is
determined (may be just before the settlement date).
Settlement date: The day the underlying loan starts (i.e. the transaction date). The
FRA is settled with a single cash payment on this date.
Financial risk management Forward rate agreements (FRAs) 4.4 Calculation of settlement amount
Settlement amount =
Loan amount ×
(rREF – rFRA) × (Length of loan (days)/365)
/
1 + rREF × (Length of loan (days)/365)
Where:
rREF = The reference rate (typically SONIA)
rFRA = The forward rate or FRA rate
Some contracts may use 30 day-months and 360 days in the year
Note: The settlement amount is discounted back from the end of the loan period to the settlement date, as the interest on the underlying loan won’t actually be paid until
the end of the loan period.
Financial risk management Interest rate futures
The calculation of the outcome of interest rate futures hedge is assumed knowledge
from FM. Thus, these notes focus on a reminder of the approach and the required
pro-forma.
Scenario: A business has identified the need to borrow (or deposit) funds at some
point in the future and is worried that the rate will rise (or fall) before the borrowing
(deposit) agreement starts.
This is assumed knowledge but is repeated here for clarity.
When using futures there will be two separate elements to the transaction:
1 The underlying transaction at the open market rate
2 The futures transaction
Financial risk management Interest rate futures 5.1 Interest rate futures (IRFs) terminology
Underlying asset: The underlying asset for interest rate futures is either a debt
security (e.g. 90-day T-bills) or an interbank deposit (SONIA).
Futures price: As a convention, short-term interest rate futures are priced at 100
minus the expected annualised reference rate (the market’s expectation of the shortterm interest rate, normally SONIA, at the expiry of the future).
Long-term IRFs prices reflect the market prices of the underlying bonds (hence
prices may exceed 100 if the bond is trading in excess of its par value) but there are
no calculations involving these in the SM.
Expiry dates: Expect the standard expiry dates for interest rate futures to be the last
day of March, June, September and December (unless told otherwise).
Contract size: The contract size is the fixed quantity of the underlying asset,
which can be bought or sold using a futures contract.
Contract length: Expect each contract to cover 3 months’ worth of interest unless
told otherwise.
Basis risk: Basis risk refersto the fact that the hedge may be imperfect due to the
basis.
The 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 but theoretically should be non-zero
at any other time.
Hence closing out a futures position before the expiry date usually results in an
imperfect hedge due to basis risk.
Financial risk management Interest rate futures 5.2 The workings of futures markets
How futures markets work in practice is beyond the scope of the syllabus. However,
there are a few key rules you should be aware of:
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 (we don’t need to buy them first) – If
we sell a future we are simply entering a contract to sell the underlying asset in the
future.
We are not actually 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 not
included in the calculations but you should be aware of them:
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 (on a daily basis if necessary) to cover losses on the futures position
Financial risk management Interest rate futures 5.3 Approach
Buy/sell decision
Borrowers
To set up the futures position (now): Sell
To close out the position on the transaction date: Buy
Savers
To set up the futures position (now): Buy
To close out the position on the transaction date: Sell
What expiry date to pick
Pick the first expiry date on or after the date the borrowing/lending starts – e.g. If you
need to borrow on 31 March, use March contracts. If you need to borrow on
3 August, use September contracts.
How many contracts
No. of contracts =
(Loan or deposit amount)/(Contract size)
X
(Loan or deposit period)/(Contract length)
Futures are only traded in whole contracts, so the no. of contracts needs to be rounded to the nearest whole number.
Calculating the profit or loss on the future
Futures prices are quoted at 100 – interest rate. Therefore, the profit or loss will be a percentage.
Then calculate the total gain or loss as:
% gain/loss × contract size × standard contract length (3/12 for a 3-month future) × no. of contracts.
You should recall a four stage pro forma from FM:
1. Number of contracts
2; Underlying transaction
3. Futures position (buy/sell decision, choice of expiry date)
4. Net position
Financial risk management Foreign exchange rate risk 6.1 Types of foreign currency risk
Firms that trade in different territories face three types of foreign currency 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 – the risk that long-term adverse movements in foreign exchange
rates make the 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 affect
borrowing capacity. Translation risk can be mitigated by financing foreign
investments (assets) with foreign loans (liabilities).
Financial risk management Interest rate futures 5.4 Estimating the futures price on the transaction date
In FM, you were always either:
Given the futures price on the transaction date (as in the above example)
Or
Told that the transaction date was the expiry date, so the futures price equals
the spot price (remember basis always equals zero at expiry)
However, in the SBM exam you may not be given this information and yet still be
expected to estimate the futures price on the transaction date.
We can do this by assuming that the basis (the difference between the futures price
and the spot price) declines evenly over time.
