S2 - risk management Flashcards
what is foreign currency exposure
exchange rate exposure
Risks that arise from changes in the relative valuation of currencies
Possibility that currency depreciation will negatively effect the value if an organisations assets, investments, interest bd dividends
Impact at three levels - economic, translation, transactional
what are economic exposures
long term and strategic
Goes to the heart of what markets a company wishes to operate in
Investment decision making
Understand type of goods and degree of internationalisation
what are translation exposures
not cash losses or gains but can be reflected as value gains and losses in the accounts
Companies attempt to hedge this type of exposure but shouldn’t
what are transaction exposures
day to day exposure
Can be managed by a variety of strategies
Company must balance value of operational risks exposure with the potential costs involved
Risk that the firm has a commitment in a foreign currency that has a variable value because of exchange rate movements
Imports and exports
Can occur with investments aboard in a foreign currency or even at home if a seller demands to be paid in a specific currency
Can have borrowings in a foreign currency and could be committed to a constant stream of payments
what are derivatives - instruments
an asset whose performance is based on the behaviour of the value of an underlying asset
Legal right becomes an asset with its own value - can be purchased or sold
Can be effective at limiting risk if employed properly
Can be highly risky for unsophisticated users, but sophisticated companies can also lose millions
what are derivatives - options
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
what is intrinsic value
the price a rational investor is willing to pay for an investment, given its level of risk
what are 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
the seller of the option (the writer) receives the premium
American style - exercised up to the date
European style - exercised on date
OTC market exists for banks and other option writers
what is terminology for call options
In the money - when the securities price is above the strike price
Out of the money - when the securities price is below the strike price
At the money - options contract with strike price identical to the underlying market price
Exercise price - the price at which an underlying security can be purchased or sold when trading a call or put option
why use options and not just buy shares
could have made a bigger loss if we got it wrong
Higher rates of return
buy and hold equity strategy has a lower breakeven point and profit point
BUT options
limit downside risk
ties up less capital
higher return on capital employed
what are put options
a share call gives the a holder a right but not an obligation to sell a fixed number of shares at a specified price at some time in the future
The opposite of call options
what is option pricing
Revolves around several elements
C = value of call option
S = current market price of share
X = future exercise price
Rf = risk free interest rate
T = time to expiry
Theta = standard deviation of the share price
what is option pricing for call options
options have a minimum value of zero because you have the right not to use it
Market value of an option will be greater than the intrinsic value at any time prior to expiry
Market value = intrinsic value + time value
The higher the risk free rate of return, the higher the intrinsic value
Maximum value is the price of the share
Volatility of the underlying share price boosts the time value
what are derivatives - forward contract
a forward contract is:
Agreement between two parties
To undertake an exchange
At an agreed future date
At a price agreed now
Long position – The party buying the contract to exchange at a future date is said to be taking the long position.
Short position – The counterparty which is delivering at the future date is taking the short position.
Tailor made contracts and can be difficult to sell
Can be for a range of commodities, currencies or assets with a readily marketable trading price
Famers would agree price before harvest - locking in the price is central to usage
what are forward rate agreements
locking in interest rates
agreements between two parties about the future level of interest rates
Rate of interest at some point in the future is compared with the level agreed when the FRA was established and compensation is paid by one party
Generally agreed for 3 months period
Sale of a FRA by a company protects it against a fall in interest rates
