risk management Flashcards
what’s the difference between risk and uncertainty
risk is quantifiable whereas uncertainty is not
what are some basic ways of risk management
- natural hedge (no active management and has zero cost implications) basically it is borrowing and paying in the foreign currency rather than home
- insurance is always possible but not always affordable
- ‘hedging’ is an approach taken by many companies if the size of the risk and the potential for loss is great enough to justify the time and effort involved setting it up
explain interest rate risk
- arises when there is a time lag between the current date and a future need to borrow or lend a sum of money
- movement in interest rates can be very expensive
- hedging this risk may be worthwhile
what are the big 4 ways IRR can be hedged
- futures
- forwards
- options
- swaps
forward rate agreements (FRAs)
- offered by banks to fix the interest rate
- an example of an over the counter (OTC) instrument
- effectively a forward contract
what does rate, duration, transaction and amount mean in terms of
rate = 5.75-70 means a borrowing rate of 5.75% and a deposit rate of 5.70%
duration = ‘3-9’ FRA starts in 3 months and ends in 9 months therefore has durations of 6 moths
transaction = borrower buys FRA, investor sells FRA
amount = FRA will state the praise amount borrowed usually needs to be at least £500,000
advantages and limitations of FRAs
advantages
- they protect the borrower/lender from adverse interest rate movement
- OTC agreements so they can be tailored to the amount and duration required
limitations
- usually only available for amounts >500,000
- more difficult to obtain for periods >12 months
- remove upside potential
what’s a futures contracts
fulfil a similar role as FRAs, difference is that futures contracts are standardised and exchange traded
futures contract gives the rate of interest for a deposit starting at maturity of the contract for x months
the interest rate quoted on the futures contract is therefore a forward rate
lender is worried about IR falling and so earning less return on the amount loaned what shall they do
we therefore need to buy futures if we want profit when IR fall as the price quote would rose
how do you deal with duration mismatch
adjust the number of contracts, ie if the actual exposure is 6 months and the future contracts are for 3 we could double the number of contracts we buy
what are options
contract giving the right but not the obligation to buy or sell a financial asset on or before a pre determined date in the future at a specified price
- can be used to managed IRR
- BORROWERS can set a max on the interest they have to pay by putting put options
- LENDERS can set a min on the interest they receive by buying call options
-a non refundable premium would have to be paid
- the option does not have to be exercised
for duration mismatch what is the number of contracts needed formula
underlying exposure / size of futures contract x length of underlying exposure/ duration of futures contract
what are swaps
- they involve borrowers swapping obligations
- they are OTC products so can be tailored to precise needs
- arrangement costs are often less than terminating an existing loan and taking out new one with the desired features
- counter party risk exists
what is comparative advantage
is an economy’s ability to produce a particular good or service at a lower opportunity cost than its trading partners.
interest rate savings are possible using this
what are the three types of foreign exchange risks
- transaction risk: profit/loss caused by movements in the exchange rate between date of invoice and date of payment
- economic risk : variations in the value of the business due to unexpected changes in the exchange rates
- translation rate: arises on consolidation - not normal hedged with financial instruments. instead the company will engage in natural or operational hedging
