Risk management Flashcards
Economic risk
Economic risk refers to the longer term risk a business is exposed to by trading in a particular foreign country – e.g. a UK exporter (whose costs are in Pounds) making sales to the US
If the Dollar weakens vs. the Pound, then the value of Dollar denominated sales to the US will reduce, but costs in Pounds will not, leading to the exporter becoming less competitive than US rivals (whose costs and revenues are both denominated in Dollars).
Translation risk
Translation risk refers to the danger of a business generating accounting losses when translating the results of overseas subsidiaries (denominated in a foreign currency) into their group reporting currency
E.g. a UK parent company may generate paper losses when translating accumulated Dollar profits from a US subsidiary into Pounds if the Dollar weakens against the Pound.
Basic / traditional methods of foreign currency risk management
Currency of invoice
Netting and matching
Leading and lagging
Asset and liability management
Forward exchange contracts
Netting and matching
Netting and matching can be used where foreign currency is both being earned and spent so that receipts and payments can be netted (just leaving the risk on the net balance). This approach is facilitated by having a bank account denoted in relevant currency.
However this only works where there is a two way flow in the currency concerned and so unless the organisation is both earning and spending the currency in question, this approach will not be available.
Leading and lagging
Leading: e.g. bringing forward a foreign currency payment if you think that the foreign currency will
strengthen before the payment due date
Remember that if you lead on a payment, then you will incur borrowing costs in making the payment early!
Lagging: e.g. trying to push back a foreign currency payment if you think that the foreign currency will weaken after the current expected payment date
This is not strictly hedging, rather speculation – if you lag on a payment then you remain exposed to FX movements.
Asset and liability management
Asset and liability management involves matching the assets and liabilities held in a particular currency. In this way any change in value is automatically off set between the asset and liability. This technique also eliminates the translation risk.
However, in practice, it will not always be economical to raise funds in the same currency as they are to be invested.
However, the foreign bank may view overseas mcompany as higher risk and charge higher interest which could more than offset the benefit of this method
Forward exchange contracts
A forward exchange contract is a contract, normally with a bank, which fixes the exchange rate that will be used on the future transaction today, thus the transaction risk is being taken, for a fee, by the bank (the fee is usually factored into the rate offered).
Advantages of forward exchange contracts
They fix an exchange rate, hedging away any downside risk
They are tailored to the company’s requirements (so the company won’t be under/over hedged)
Disadvantages of forward exchange contracts
They remove any upside potential (e.g. in the example below if the Dollar strengthens against the Pound)
They cannot be cancelled, which is problematic if the future receipt / payment date changes (delivery will still be expected).
Premium =
Discount =
Deduct
Add on
A derivative is something which
derives its value from something else; in this context it will be foreign exchange rates.
FX Futures
These are similar to forward contracts, but FX futures are of a standardised contract size, standardised maturity date and are traded on organised exchanges.
Settlements take place in three-monthly cycles ending in March, June, September and December.
E.g. a US company expecting to receive Euros in 3 months’ time will sell Euro futures now (to lock in a Dollar price at which they can sell the Euros).
They will then buy the same number of Euro futures contracts when on the date they receive the Euros.
This will lead to a net cash payment or receipt in Dollars based on the difference between the price sold at and the price purchased at.
However, the futures do not facilitate the sale of the Euros – we will still have to sell our Euros at the spot rate to a buyer.
Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and opposite investment in the same underlying currency, prior to maturity. This makes futures more flexible than forward contracts.
The futures price will change as the spot price changes and this allows any gain or loss on the actual business transaction to be offset by losses or gains on the futures.
Causes of exchange rate fluctuations
Balance of payments
Interest rate parity theory (IRPT)
Interest rate parity theory (IRPT)
Interest rate parity theory states that the difference between the current spot exchange rate (S0) and current forward rate (F0) reflects the difference between nominal interest rates in each country.
This needs to hold for there to be no arbitrage (risk-free profits) available
I.e. an investor should be indifferent between buying Dollars using a forward contract OR
borrowing Pounds to buy Dollars at spot and investing Dollars in a deposit account. Assumptions: spot price represents equilibrium price (demand = supply)
Balance of payments
The balance of payments is the difference between a country’s overseas earnings and spending. If a country earns more than it spends it will have a surplus and if it spends more than it earns it will have a deficit.
A surplus implies the country is doing well and so its exchange rate will strengthen and a deficit implies it is doing badly and so the exchange rate will weaken.
Causes of interest rate risk
Interest rate risk refers to the sensitivity of a company’s profits and cashflows to changes in interest rates.
For example, a company with variable rate debt will face increases in interest payments if interest rates rise.
Gap risk / exposure
Gap exposure arises where the principle of matching the maturity of funding to maturity of assets (discussed in Chapter 3) has not been followed.
For example, a company may have initially secured an interest rate on 5-year borrowing and used this borrowing to fund the purchase of a 10-year income generating asset (we can assume that the income from the asset exceeded the interest rate on the borrowing at the start).
When the debt matures after 5 years, the company will have to refinance and will be exposed to any increases in interest rates over the course of the 5-year period – i.e. the ‘spot’ rate (current interest rate) in 5 years’ time may be higher than today.
This may mean that interest rate secured on the funding for the second 5-year period may exceed the income from the asset.
In other words there is a gap between the earnings and the required interest payments. The earnings and interest rate risks can vary over time and so the gap exposure will not necessarily be constant.
Liquidity preference theory
Liquidity preference theory states that as investors prefer instant access to their funds, the longer the funds are borrowed for, the higher the cost will be.
Expectations theory
Expectations theory states that the shape of the yield curve reflects investors’ expectations of
future interest rates.
Hence, if lenders expected interest rates to fall in the future, then they would be prepared to accept lower interest rates on borrowing spanning future periods. This would result in short term interest rates being higher than long term interest rates, resulting in the inverted yield curve shown above.
Market segmentation
Market segmentation explains that the yield curve may not in fact be a perfect curve as is it is made up of different segments of investors, some investing for the short term, some the medium term and some the long term.
Hence the shape of the yield curve would be based on the supply of money to lend and the demand to borrow at each maturity date, leading to ‘humps’ at maturity dates where there is greater demand to borrow.
Techniques for hedging interest rate risk
Matching
Smoothing
Asset and liability management
Forward rate agreements (FRAs)
Matching
This is where a company has investments and loans of the same value earning and paying the same rate of interest at the same dates. Thus, if interest rates change the effects self-cancel. This technique is most commonly used by financial institutions and for the majority of institutions is a noble long-term goal that is practically very difficult to achieve.
Smoothing
This is where a company maintains a balance between fixed rate and variable rate borrowing to reduce the impact of any interest rate rises.
Asset and liability management
This involves matching the term of assets and liabilities (i.e. the matching approach from Chapter 3), in order to avoid gap exposure.
Forward rate agreements (FRAs)
FRAs are contracts that help companies to fix the rate of interest to pay on borrowing that will start at a future date:
Terminology:
A spot interest rate of 5.65-5.61 means that you can borrow at 5.65% and deposit at 5.61% (remember, you always get the worst rate!).
A 3-6 FRA starts in 3 months’ time and lasts for 3 months
A FRA fixed rate of 5.75-5.70 means you can fix a rate to borrow at 5.75%, and to deposit at
5.70%
Hedging interest rate risk with derivatives - Interest Rate Futures
These are similar to forward rate agreements, but futures are of a standardised contract size, standardised maturity date and are traded on organised exchanges.
Settlements take place in three-monthly cycles ending in March, June, September and December.
Borrowers will sell futures now and buy the same number of futures contracts when their borrowing starts. This will lead to a net cash payment or receipt based on the difference between the price sold at and the price purchased at.
However, the futures do not facilitate the borrowing – we will still have to borrow at spot.
Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and opposite investment in the same underlying currency, prior to maturity. This makes futures more flexible than forward contracts.
The futures price will change as the spot price changes and this allows any gain or loss on the actual borrowing (due to interest rate movements) to be offset by losses/gains on the futures.
Advantages of futures
They fix an interest rate, hedging away any downside risk
They may be closed out early (and are hence more flexible than FRAs)
Disadvantages of futures
They are standardised and hence may lead to over / under hedging (if maturity dates and contract sizes don’t fit with borrowing requirements)
They remove any upside potential (i.e. if interest rates were to fall)
Futures prices will differ to the spot rate until you reach the maturity date of the future and this will lead to the hedge not being 100% effective if the borrowing date doesn’t equal the futures maturity date (this is known as ‘basis risk’)
Hedging interest rate risk with derivatives - Options
Over the counter (OTC) interest rate options can be purchased from major banks and allow the borrower to have the right, but not the obligation to borrow at a set fixed rate (strike price) in the future.
The borrower would have to pay a premium now to buy the option contract and would then wait to see how interest rates move before deciding whether to exercise the option or not.
If interest rate rise between now and the borrowing date, the borrower would exercise the option and borrow at the pre-determined fixed rate specified in the option
If interest rates fall between now and the borrowing date, the borrower would let the option lapse and borrow at the spot rate.
Advantages of options
They only hedge away the downside risk, leaving the borrower the ability to benefit from the upside (rates falling) – this is in contrast to FRAs and futures.
Disadvantage of options
They are expensive and the premium must be paid up front.
An interest rate cap is where
an option is used by a borrower to set a maximum rate they would pay
An interest rate floor is where an option is
used by a lender/depositor to set a minimum rate they would receive (the strike price of the option)
An interest rate collar is where a
borrower combines buying a cap and selling a floor, to set both a maximum and minimum rate that they would be subject to. This is less beneficial than just using either a cap or a floor, but it is also cheaper (as a premium is received on the floor)
Swaps
Interest rate swaps involve two counterparties swapping interest rate payments on a set notional borrowing amount for a set period of time.
The swap would be based on one party having fixed rate debt, but actually desiring variable rate interest payments and another party wanting fixed rate interest payments but having variable rate debt.
By swapping interest payments, the two parties get the type of interest rate exposure that they desire, without having to renegotiate the terms of their debt / refinance.
