Risk Management Flashcards
Foreign Currency Exposure
“The volatility of exchange rates, interest rates, and commodity prices, combined with the increasing internationalization of firms, has resulted in a greater interest in the evaluation of firm exposure to financial price risk.” (Moffet & Karlsen, 1994, p.157)
Also referred to as Exchange Rate Exposure. These are risks that arise from changes in the relative valuation of currencies.
It indicates the possibility that currency depreciation will negatively affect the value of an organisation’s assets, investments, and their related interest and dividend payment streams, especially for those securities denominated in foreign currency
This is generally perceived to impact at three levels which are economic, translation and transactional.
Foreign Currency Exposure: Transaction Exposures
Transaction Exposures and transactional risk is an operational, day to day, exposure.
It is the risk that the firm has a commitment in a foreign currency, and that foreign currency will have a variable value because of exchange rate movements
(assuming a floating or simpler currency regime)
This type of exposure is usually associated with imports and exports, particularly when the company is using credit terms (usual practice) which creates a time lag. So, for example if a company buys or sells on the 30 days credit with a foreign currency, there is that amount is subject to the uncertainty between the time the contract is entered into and the time it is completed.
Economic, Translation and Transaction Exposures: Summary
For Economic Exposures it is important to understand what type of goods the company is selling, and the degree of internationalisation of the company as a whole. It is a long term strategic type of exposure which goes to the heart of what markets a company wishes to operate in. It is effectively managed in the long term by strategic investment decision making.
Translation Exposures are an accounting “ on-paper-only” exposure. They are not cash losses or gains, but can be reflected as value gains and losses in the accounts. Despite many (quite solid) arguments from economists and finance academics as to why you should not attempt to hedge this type of exposure, many companies still do according to research.
Transaction Exposure is a day-to-day operational level exposure which can be managed by a variety of strategies. These strategies have increasing levels of cost and sophistication, and so a company must balance the value of the operational risks exposure with the potential costs involved in protecting itself.
Transaction Exposures can also occur with investments aboard in a foreign currency, or even at home if a seller demands to be paid in a specific currency (invoicing in domestic currency, see later).
For example an Australian mining company commits to buying a large new digging machine from a UK company, and the UK company invoices in sterling.
The amounts to be paid are uncertain between the time the contract is entered into and the contract is paid/fulfilled.
Lastly companies can have borrowings in a foreign currency, and therefore could be committed to a constant stream of payments in that foreign currency.
Derivatives: Basic Concepts
A derivative instrument is an asset whose performance is based on (derived from) the behaviour of the value of an underlying asset (usually referred to simply as the ‘underlying’)
It is the legal right that becomes an asset, with its own value, and it is the right that is purchased or sold
Powerful tools, and if employed properly they can be remarkably effective at limiting risk
For unsophisticated investors/users they can be very highly risky (see sidebar), but numerous examples exist of even sophisticated companies losing many millions.
Barings, LTCM, Northern Rock, UBS
Business case: Record business usage of options contracts (2019)
FT.com: Brexit angst spurs record bets on UK interest rates
Investors have taken out a record number of options contracts to bet on or hedge against moves in UK interest rates, amid rising concerns that Britain may leave the EU at the end of October without an agreement on its future relationship with the bloc.
Traders’ open positions in futures and options on UK rates over the next three months surged to 18.4m contracts, worth a notional total of £22.6tn ($28tn), on Tuesday at ICE Futures Europe, the main derivatives exchange in London. The options, if exercised, would allow investors to profit from unexpected rate cuts or protect themselves from the damage stemming from rapid rate rises.
That was up from 14.8m contracts, worth £18.4tn, at the end of August.
The intensity of business has far outstripped the 13m of outstanding futures and options positions open on ICE in the run-up to the original Brexit date of March 29. More than 14m of that total comprises options, which give traders the right but not an obligation to buy or sell a contract on a set date.
The activity reflects the high stakes for investors who fear there may be little time to react to unfolding political developments. “We’ve seen a larger than normal range of market participants expressing a view, or buying protection from the possibility of future interest rate moves,” said Steve Hamilton, global head of financial derivatives at ICE.
Derivatives: Options and Simple Example
An option is a contract giving
one party the right,
but not the obligation,
to buy or sell a financial instrument, commodity or some other underlying asset
at a given price,
at or before a specified date.
Simple Example
A retail company is looking to develop and expand into number of possible retail spaces over the next 3 years. Some retail spaces it is going to immediately move on, but others will happen in year 2 and 3.
The company pays three different owners of three different plots of land a £10,000 premium each (£30,000 cost) to write a contract option to allow it the right to purchase the land on a specified date in three years time for £1m.
Over the next three years the land prices and site valuations the company has calculated greatly vary. It calculated that once planning permission is granted two of the sites may only be worth £500,000 each. However, one of the sites is located in a retail area which has seen large expansion over the three years. If it was purchased it would be worth around £1,500,000.
The company has a number of decisions to now make.
The option to purchase may be exercised.
Options on other plots will be allowed to lapse.
Options can also be traded.
But what is the value of those options? What is its Intrinsic Value.
Class Activity: Intrinsic Values
Three years ago your company spent £30,000 on three options contracts on three different plots of land to enable it to buy them for £1m each. The date has now arrived to exercise those options. Instead of developing the land though, the company has decided to sell the options contracts instead.
Two of those plots of land are only going to be worth, after development, around £500,000 each
One of the plots of land has been estimated to be worth £1,500,000
Consider with the person sitting next to you:
What do you think is the intrinsic value of the options contracts for the two plots of land worth £500,000 is?
What is the intrinsic value of the options contract on the land worth £1.5m?
From that, What percentage return on the initial investment of £30,000 does the sale of the contracts represent to the company?
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Share Options: Call Options
A share call option gives the holder:
a right,
but not the obligation,
to buy
a fixed number of shares
at a specified price
at some time in the future.
London Traded Options Market (ICE Futures Europe), one option contract relates to a quantity of 1,000 shares.
The seller of the option, who receives the premium, is referred to as the writer.
American-style options (exercised at any time up to specified date)
European-style options (exercised on specified date)
An OTC market also exists for Banks and other option writers.
Call Option: Worked Example
On the 1st August 2017 the price of a Unilever share was 2567p
On the London Traded Options Market (ICE Futures Europe), the following prices were being quoted for the purchase of a call option in Unilever shares at exercise prices of 2500p and 2600p.
Key terminology: Exercise price (aka strike price), In-the-money option, Out-of-the-money option, At-the-money option
What do these figures all mean? Assume on August 1st you wanted to have the right to buy 1,000 shares at an exercise price (strike price) of 2600p per share in September (1 month). Then you would have to pay a premium to the writer of £135 (13.5p per share x 1000 shares).
If you wanted a longer option until December (4 months) at that exercise price then you would have to pay a premium to the writer of £365 (36.5p per share x 1000 shares).
The £230 premium difference (£365 - £135) represents an additional time value.
Purchasing a call option with an exercise price of 2600p when the share price is currently 2567p is what is called an out-of-the-money option. It has no intrinsic value.
Purchasing a call option with an exercise price of 2500p when the share price is currently 2567p is what is called an in-the-money option. It has an intrinsic value of 67p per share. We will therefore be charged much higher premiums for these.
An at-the-money option (not shown) would be were we able to persuade an option writer to write an option at the current share price of 2567p.
Let’s look at three possible outcomes for this:
You’re wrong and the share price declines.
You’re wrong and the share price stays at-the-money
You’re right, and the share price does rise to 3000p per share.
Call Option: Worked Example (Cont.)
Let’s look at three possible outcomes for this:
a) You’re wrong and the share price declines.
b) You’re wrong and the share price stays at-the-money
c) You’re right, and the share price does rise to 3000p per share
Class Activity: Why Options?
In the previous example we used options. But why didn’t we just buy the shares themselves? What would have been the outcome had we just done that?
What would be the profit or loss had we just bought 1,000 shares for 2567p and in August and intended to profit in March?
Consider with the person sitting next to you:
Calculate what the profit on 1,000 shares would be if you bought them in August for 2567p (£25.67) each and then sold them in March for 3000p (£30) each. What if your % return?
Calculate what the profit on 1,000 shares would be if you bought them in August for 2567p (£25.67) each and then sold them in March for 2000p (£20) each. What if your % return?
