lecture 4 - financial risk

Question 1

what is financial risk and what does it cover?

Answer 1

risk to cash flow

covers purchasing raw materials, trading in foreign currency, financing (in use of interest bearing debt), investing overseas and the impact of this on profit

Question 2

what are a financial risk manager’s responsibilities?

Answer 2

quantifying risks, managing day to day risk

Question 3

what is financial hedging?

Answer 3

using derivatives (matching cash flows to protect the balance sheet from downside risks)

using insurance

Question 4

what is speculation?

Answer 4

earnings generation - benefitting from upside risks.

derivatives can be used, but not insurance as it is a pure hedge (NB this means using data on insurance gives pure results on hypotheses about hedging as there are no confounding results from speculation)

Question 5

what are the 4 key financial risk issues?

Answer 5

basis risk - hedge doesn’t completely cover the risk

default/credit risk - counter party fails to honour transaction

moral hazard risk - too big to fail syndrome, GFC. engaging in too much risk because huge companies are aware gov will intervene and bail them out.

systemic or contagion risk - similar to subprime crisis

Question 6

what are the 3 uses of derivatives?

Answer 6

1. hedgingreducing or eliminating financial risk by passing it on to someone else, usually a speculator.
2. speculationjudging where the market will move and attempting to make a profit out of it. speculator is by definition a risk taker.without speculation there would be no liquid markets for hedging to make place, hence speculation is important for ‘deep markets’
3. arbitragemaking risk-free profits by buying and selling the same thing in a different location for profit.arises due to information asymmetries, doesn’t exist under perfect competition

Question 7

what is the treasury?

Answer 7

gov dept, concerned with borrowing, interested in currency and interest rate management

Question 8

what are the responsibilities of the financial risk dept of the treasury?

Answer 8

relationships with banks
liquidity mgment
borrowing activities (debt)
funding arrangements (equity)
currency management

Question 9

what is the treasury function responsible for?

Answer 9

all issues surrounding mgment of risk in major transactions, especially foreign currency and interest rates. treasurer quanitifies risk using forecasting tools (such as regression) and VaR (value at risk).

Question 10

what is VaR? how is it used?

Answer 10

initally developed by JP morgan. allows banks to have control over risk adn allocate risk in relation to the value model indicates.

measures maximum loss acceptable due to normal market movements in a given period for a given level of confidence (usually 95 or 99%).

measures risks associated with portfolios as a result of market fluctuations

also measures value of sum of foreign currency subject to exchange rate fluctuations

used as a capital allocation metric in banks. capital management technique.

Question 11

what are the advantages and disadvantages of VaR?

Answer 11

advantages:

simple, easy to calculate, commonly used

disadvantages:

assumptions of normal distribution may not hold (e.g. for different types of investment normal may not be best), requires regular data which may not be available, attempts to make VaR more ‘realistic’ have increased complexity and brought in new assumptions.

Question 12

what is credit risk?

Answer 12

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

Question 13

what forms can credit risk take?

Answer 13

for banks - arises fundamentally though its lending activities (core business)

nonbank corporations - when providing short-term credit to debtors. even public orgs face credit risk.

investors holding portfolios or corporate bonds or distressed equities need to have handle on default probability of assets in portfolio.

Question 14

what are credit ratings? who are the 4 major rating agencies?

Answer 14

credit ratings are opinions on ability and willingness of an issuer 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.

agencies - AMBest (insurance only), S&Ps, Fiiith and Moodys.

Question 15

what are credit defaults triggered by?

Answer 15

missing or delayed interest/principal payment.

bankruptcy filing

distressed exchange where old debt exchanged for new that represents smaller obligation for borrower (AKA restructuring the debt)

market-specific volatilities (e.g. credit derivatives more risky than loans)

economic and political crises

systemic risks - e.g. GFC - the system cannot cope in some way?

Question 16

how can credit risks be mitigated?

Answer 16

financial guarantee insurance (credit insurance) e.g. through Lloyds.

ex-ante credit vetting, e.g. credit VaR modelling

ex-post monitoring and resolution, through banks

collaterisation

information and intelligence (consultants/analysts)

Question 17

what are the 4 ways currency risks occur?

Answer 17

economic risk

political risk

translation risk

transaction risk

Question 18

how do economic and political currency risks occur?

Answer 18

1. economic risklonger-term cash flows impacted by FX movements. stems from variable international trading activities (e.g., UK now net importer of oil and gas). results of strategic decisions like raw materials being sourced from foreign suppliers
2. political riskgovernment involvement, e.g. tarriffs, exchange controls, quotas etc.

Question 19

what is the main issue with translation and transaction risks?

Answer 19

can impact the balance sheet of a business and therefore share price

Question 20

what is translation risk?

Answer 20

reported financial results in dominant currency, movement in foreign assets or liabilities due to FX movements.

difference between opening and closing amounts can cause accounting loss or addition to balance sheet. important for share price implications.

Question 21

how can translation risk be managed?

Answer 21

immunisation - matching assets and liabilities in relevant currency.

Question 22

what is transaction risk?

Answer 22

risk transaction entered into at one rate is settled at another rate due to timing between entering transaction and receipt of actual cashflows.

i.e. spot rate fluctuations

Question 23

what are the reasons for spot rate fluctuations?

Answer 23

natural resources of country, political stability of country, balance of payments, speculation by currency traders, gov intervention, inflation rates (purchasing power parity), interest rates (interest rate parity).

Question 24

what is purchasing power parity?

Answer 24

FX rates differ between counties due to relative purchasing power of each as a result of local inflation rates.

estimated future (forward) exchange rate under PPP = cogif ÷ cogih, where cogif = cost of good (inflation) in foreign country; cogih = cost of good (inflation) in home country (UK). e.g. if cog = £1 in UK and $1.5 in US, future exchange rate = 1.50/1, due to higher US inflation.

PPP provides reasonable estimate but limitations are: forex rates can be influenced by speculation and gov policies

forex rates can be influenced by currency investment (e.g. investments in financial services) rather than trade in physical goods.

Question 25

what is interest rate parity?

Answer 25

forex rates change due to differing interest rates between countries. domestic price of money set by:

demand and supply, gov intervention, sale and purchase of money in money-markets.

higher interest = stronger currency.

estimates future (forward) exchange rate under IRP = SR x [1+inth] ÷ [1+intf], where inth = interest rate in home country and intf = interest rate in foreign country.

e.g. If UK has IR = 3%, US has IR = 5%, & SR£:$ = £0.75/$1, then £/$ future exchange rate is: 0.75 x [1.03] ÷ [1.05] = £0.736:$1

IRP often judged better than PPP as interest rates shown to be robust estimates of forward rates. however, reliability subject to unexpected gov action - e.g. currency controls or direct gov trading in own currency.

Question 26

how can translation risk be controlled for?

Answer 26

matching (immunising) = match assets with liabilities in foreign currencies to offset movements. removes volatility and risk.

private equity companies very active in this, especially those trading overseas.

Question 27

how can transaction risk be controlled for?

Answer 27

invoicing in stable currency

getting counterparty to pay in your currency (depends on nature of business relationship)

matching receipts and payments - leading or expediting eXport receipts and lagging or deferring iMport payments - e.g. to avoid X default risks reduce M devaluation risks and/or reduce taxes.

use overseas bank account.

netting off inter-company balancing - essentially natural hedging with ERM.

use derivative contracts - forwards, futures or swaps.

Question 28

what is interest rate risk?

Answer 28

more difficult to manage than other financial risks. there are many interest rates for a given currency (treasury rates, interbank rates etc). IR especially important for financial firms as lenders, investors and holders of short and long term liabilities. hence asset-liability maturity matching (A-L structure) important.

Question 29

are long term or short term interest rates higher?

Answer 29

LR interest rates higher than SR interest rates as risks increase with time. hence banks charge higher interest for longterm loans than shortterm.

Question 30

what is a yield curve?

Answer 30

function describing variation of IRs with loan maturity

Question 30

who uses interest rate swaps the most and why?

Answer 30

banks are major IR swap users as they need to manage liquidity. liquidity risk major issue in banks given industry inter-lending.

Question 31

how are short term rates decided?

Answer 31

ST interbank lenging historically pegged to LIBOR (london interbank offered rate) and conditioned by BoE credit worthiness standards.

LIBOR used until 2023 as proxy for risk free rate to estimate price of IR futures traded on the LIFFE & IR forwards dealt over the counter. in view of LIBOR scandal new metric - Sterling Overnight Index Average (SONIA), based on actual market riskfree data now used.

Question 32

what is a forward/exchange contract and what is its main benefit?

Answer 32

private agreement between 2 parties (OTC contract). make a deal at some point in future, fixed commitment (not usually cancellable). can be in any currency, but usually major. forward rate sset by bank, usually calculated using IRP and LIBOR/SONIA.

main benefit is providing certainty.

Question 33

what is a futures contract?

Answer 33

futures traded on an exchange and contracts priced daily. futures mainly quoted in US$. exchange demands initial margin (deposit) from both parties, placed in margin account. daily profit/loss is debit/credited to clients’ accounts - known as variation margin. losses not allowed to build up, and exchange may make a margin call. system protects everyone from counterparty default, but only if properly audited and controlled!!

market is there to protect people from default, but only possible if the people involved are bona fide and controlled

Question 34

what are the advantages of futures contracts?

Answer 34

transaction date flexibility. future doesn’t have to be closed out until states settlement date

exchange regulated market so counterparty risk reduced

ease of buying and selling of contracts through highly liquid market

market provides control and accountability (hopefully)

Question 35

what are the disadvantages of futures?

Answer 35

contracts cannot be tailored to exact requirements

limited number of currencies

need to use a broker, therefore fees

need to deposit and maintain the margin account

Question 36

what are the advantages of options?

Answer 36

available in most developed economies

exchange in regulated market, counterparty risk reduced

provides increased flexibility for option holder

facilitates earnings stability and therefore share price protection; using that link between cash flows — accounting — share price. important strategic link.

Question 37

what are the disadvantages of options contracts?

Answer 37

cost of option premium and broker fees

limited number of currencies

alternatives may be cheaper and more flexibile due to less contractual binding

treasury mgment skills may not exist in-house.

Question 38

what is a swap?

Answer 38

OTC derivative. an agreement between two parties to exchange future interest payments - but not the principal. (i.e. swapping the interest instead of the principal).

banks can either intermediate between parties or be a counterparty. banks can also temporarily ‘warehouse’ the SWAP whilst finding a counterparty. therefore banks can bear ‘holding risk’ until offsetting transaction arranged. this risk is reflected in bank’s fee.

Question 39

what factors affect the SWAP market?

Answer 39

effective contracting and accounting (IFRS 9), low or zero counterparty default risk, political stabililty, efficient and credible information exchange, security of warehousing banks, banks acting as honest brokers, integrity of money market.

Question 40

why do people use SWAPs?

Answer 40

different firms have different comparitive advantages in loan markets. This can arise because firms have different access to and costs of international finance, because default risks differ between firms and firms differ in terms of loan maturity preferences.