Topic 4: Managing Market RIsk

Question 1

Interest Rate Instruments:
FRA
Interest Rate Options

Answer 1

FRA

• OTC
• Pay / rec fixed for a period starting at some point in the future for agreed rate now.
• Cash settled, bilateral, credit risk

Interest Rate Options
- call is referred to as cap, put referred to as floor

Question 2

Interest Rate Instruments

FUTURES (6)

Answer 2

Futures

1. ETD
2. Buy / Sell fixed rate for 1 period at defined point in future for agreed rate now.
3. Underlying = cash deposit (30 days), bank bill (90 days) GB (3 or 10 year)
4. Not flexible (dates, amounts)
5. Deposits & margin calls
6. Cash settlement (BABs physical)

Question 3

Interest Rate Instruments

INTEREST RATE SWAPS

Answer 3

Interest rate swaps

1. Convert series of fixed obligations to floating
2. Notional principal exchanged at agreed fixed rate for term of deal. Floating leg based on index (BBSW, LIBOR)
3. OTC; tailor
4. Credit exposure (mutual / mandatory breaks may be required for long dated deals. RTB not required if collateral is swept)
5. LT. Liquid up to 10 years, possible to trade to 30.

Question 4

Interest Rate Instruments

CROSS CURRENCY INTEREST RATE SWAP

Answer 4

Cross Currency Interest Rate Swap

1. convert fixed / floating payments in one currency into fixed / floating payments in another currency
2. Physical exchange of principal at beginning and end; payments in intervening period
3. Manages both exchange risk and interest rate risk
4. Fully tailor
5. Credit exposure
6. Can be longer tenor

Question 5

Interest Rate Instruments

SWAPTIONS

Answer 5

Swaptions

1. Option to enter into swap
2. Buy or sell a swaption
3. Payer = right to pay fixed. Receiver = right to receive fixed
4. Premium paid in advance
5. Cash settled, or trigger a physical swap
6. European or American

Question 6

Commodity Instruments

Types

Answer 6

1. Forward Freight Agreements (as per FRA but for freight)
2. Futures (hard / soft commodities)
3. Forwards (physical sale or purchase for agreed grade and quantity of commodity at a committed price for settlement at future date
4. Swaps: location swaps and grade swaps
5. Options

Question 7

Hedging
FX Instruments:
1. Settlement terms for Spot, Tom, Today
2. Other Instruments: Outright forward, Futures, FX Swap

Answer 7

1. Settlement terms
   Spot: Settles value in 2 days
   Tom: Settles value in 1 day
   Today: Settles value today
2. Other Instruments:
   Outright forward: settles value a future date at agreed rate
   Futures:
   FX Swap: Buy 1 currency spot (or tom or today); sell currency back at future date at agreed rate. Points driven by interest rate differential between the 2 currencies.

Question 8

Managing Price Risk

3 alternatives

Answer 8

1. Floating (fully exposed to +ve and -ve price movements)
2. Fixed (lock in price, remove exposure whether +ve or -ve)
3. Option (lock in worst case price to protect, but leave open to benefit from +ve price movements)

Question 9

Options
1. TYPES (2)
2, AMERICAN vs EUROPEAN
3. PARTIES
4. RIGHT vs OBLIGATION 
5. Term

Answer 9

1. TYPES (Call / Put)
2. AMERICAN (anytime) vs EUROPEAN (end)
3. PARTIES (seller - granter, short, receives premium upfront / buyer - holder, long), pays premium up front
4. RIGHT vs OBLIGATION: Option holder has the right but not the obligation to settle the option. The seller MUST settle if the buyer chooses.
5. Term: Option only protects for one period, unless you do a strip of them. Consider swaptions.

Question 10

Basis Risk

1. Define
2. Futures implications
3. Accounting implications
4. Key areas that may not align

Answer 10

1. Define: underlying and the hedge contract are not perfectly aligned/correlated therefore gains / losses do not fully offset each other
2. Futures implications - cannot customise, therefore basis risk likely
3. Accounting implications - physical cashflow associated with hedging transaction, but no physical cashflow associated with the underlying. Will need to close out rather than settle a hedge contract. Credit lines etc.
4. Key areas:
   - contract size
   - dates
   - quality / grade
   - location (commodity issue)
5. Key areas that may not align

Question 11

6 step process for risk management

1. Risk identification
2. Risk quantification
3. Risk assessment
4. Solution identification
5. Execution
6. Monitoring & reporting

Answer 11

1. Risk identification (what underlying txn / activity causes risk / components of risk)
2. Risk quantification (market conditions or triggers; when is it ‘real’; size; impact of standard price mmt; what size price mmt to make an impact; how likely)
3. Risk assessment (material to co, project or txn?; what if make wrong decision; should action be taken)
4. Solution identification (products available; logical/what makes sense; preferred solution; who needs to approve)
5. Execution (monitor mkts; timing; how to execute; complete/record txn)
6. Monitoring & reporting (not set&forget; report outcome (one-off/ongoing); monitor effectiveness over time; any changes required?)

Question 12

FX Risk Management

3 types of risk, define

Answer 12

1. Economic Risk: change in value of company due to change in exchange rate (impact on business activity). Result of structure of company and where it operates. not normally hedged
2. Translation risk: change in value of balance sheet due to exchange rates. ie restates for accounting purposes. not normally hedged.
3. Transaction risk: change to value of payment or receipt due to change in exchange rate

Question 13

FX Risk Management

2 types of hedges

Answer 13

1. Balance sheet hedge
   offset assets with liabilities (reduce net exposure)
2. Market hedge
   offset accounting exposure with a financial transaction (accounting loss hedged with a physical gain or vice versa)

Question 14

Hedging FX risk

1. Is there a difference between opex and capex.

Answer 14

Opex vs Capex
1. Some companies treat capex and opex separately.
- Large projects; impact of adverse exchange rates is obvious, but can (sometimes) be excused
- Opex often hedged on a systematic basis
- Capex often hedged on case-by-case basis
- Most companies have hedging guidelines to dictate how much to hedge, when, approved list of instruments
eg, hedge on rolling basis; hedge cover increases as exposures are known with greater certainty; cover is topped up over time

Question 15

Interest Rate Risk management - hedging strategy

Fixed / Floating mix, generally have a set target or a range for hedging

Answer 15

Most companies have hedging guidelines to dictate how much, when, approved group of instruments
- hedge on rolling basis
- hedge cover decreases over time
- cover is topped up as time to maturity runs off.
key measure is the fixed / floating mix of the portfolio.
- if you are taking a view that rates are to increase, hedging will be at the higher end of the range. (& vice versa)

Question 16

Interest Rate risk
Hedging

How to shift exposure if too much fixed?
How to shift exposure if too much repricing risk (on one day)?

Answer 16

1. too much fixed:
   - Structure a swap (pay floating receive fixed) with notional exactly matching overhedged amount)
   - Enter several discrete forward start swaps to cover each period
   - swaps are very flexible, consider cost
   - Consider the cost or benefit of a decision to deviate from strategy - eg cost of carry, time to break even.
2. Repricing risk
   - could manage by FRAs (eg 3/6 FRA (pay) for amount of maturity/reset)

Question 17

Interest Rate Risk Management

3 Charges added to mid swap rate

Answer 17

1. Credit Value Adjustment (CVA)
   - reflects c/ps creditworthiness
   - incorporates probability of default; loss given default; deal size, tenor, type etc
2. Funding Value Adjustment
   - adjustment made to reflect funding costs inherent in swap (+ve or -ve) ; if the swap is MtM +ve, this is the same as a loan to the counterparty. NPV of fixed and floating rate. If there was a shortfall swap desk would need to borrow to fund the adjustment. If in your favour, ensure it is paid.
3. Capital
   - banks hold capital against potential losses on derivatives. Includes components for expected and unexpected loss.

Could also be an execution charge.

Question 18

Commodities

5 differences between commodities and currencies/interest rates

Answer 18

1. fungibility (all commodities unique - chemical composition. Can only be substituted if have exactly the same composition)
2. physical vs financial (cannot be transferred into a bank account, but can be held in warehouse and change hands electronically, have to be physically transported)
3. transport (transport is a discrete traded market itself: ship size; time charter vs voyage charter; bunkers (ie fuel to run ship); insurance; free on board vs CIF; pipeline mgmt; pipeline capacity
4. chemical composition (goods assayed before loading to ensure alignment with contract specs; any deviation requires price adj; details are specified in contract)
5. spreads (understand how they are created and traded - are they an outright commodity or created from another commodity? All refined products are tradable in own right: buy jet fuel or crude oil plus the (crude/jet) crack spread)

Question 19

Commodities

6 classes

Answer 19

1. Energy
2. Metals (hards)
3. Agricultural (softs)
4. Livestock
5. Transport - freight, bunkers etc
6. Environmental - carbon emissions, heating degree days, cooling degree days, rainfall, snowfall…

Question 20

Commodities

Pricing (6)

Answer 20

1. More futures focussed than FX or rates
2. index linked products are generally linked to futures prices (or industry published price)
3. Published prices are adjusted for grade (eg WTI + 50 cents, API4 -120
4. Also TCs and RCs (treatment costs, refining charges)
5. Majority of futures contracts closed out prior to delivery. But for right grade of product can be delivered to exchange’s warehouse.
6. Goods can be slow to get into and out of warehouses.

Question 21

COmmodities
Price Risk Management
1. 2 perspectives
2. Implications of producers being consumers of commodities as well
3. How to manage commodity price risk

Answer 21

2 perspectives

1. producer of commodities
2. consumer of commodities

Implications

• Producers as consumers - eg buy crude oil / sell diesel; buy fertiliser / sell coffee
• consider net exposures when hedging

Manage risk

• reduce exposure through contracting (passing risk on to seller or buyer)
• hedge the exposure

Question 22

Commodity producers as margin businesses

1. example
2. QP

Answer 22

Example
- oil refinery buys crude oil linked to price of crude; sells refined products (petrol, diesel) linked to price of crude

Quotation Period (QP)

• Try to ensure the purchase and sale of crude are linked to the same commodity index and same pricing month
• this is a margin business. Need both sides linked to the same pricing point / contract
• Could agree on price at M+3. Would need to make a Provisional Payment based on an earlier contract to ensure the seller is paid; then adjust at M3. ie mitigate credit risk.

Question 23

Be wary of direct commodity futures:

Answer 23

1. pay transfer costs, brokerage, margin calls (do you have enough cashflow/experience to do this)

Question 24

Commodity risk management
SPREADS
1. Examples
2. Four alternatives to hedging jet fuel position for airline

Answer 24

Examples

• Crack spread (crude oil vs jet fuel/other refined products)
• spark spread (gas vs electricity)
• dark spread (coal vs electricity)

Four alternatives

1. hedge jet fuel outright
2. hedge crude oil exposure only (run the crack spread risk)
3. Hedge the crack spread only (run the crude oil risk)
4. Hedge crude oil and hedge crack spread separately

Question 25

Credit Risk Management Two core areas where credit risk arises Transactions where credit risk occurs

Answer 25

Two core areas: - sales to customers (AR) - financial and derivative transactions completed by TSY Transactions where credit risk occurs - bank account balances - Deposits with banks - Owned securities (bank bills, bonds etc) - Other investments (MM funds) - Unsettled txns - Derivatives (eg P/L positions)

Question 26

Credit Risk Management | - Issues to consider (6)

Answer 26

Issues 1. quantum of risk which is acceptable(?) 2. Max amt for bank 3. How to incorporate sovereign risk (eg Italian banks can't be ranked higher than sovereign) 4. How heavily a credit rating is weighed on as measure of creditworthiness 5. Potential exposures included(?) 6. Credit support required 7. HOw to treat limit breaches

Question 27

Credit Risk Management - Banks use... - Corporates...

Answer 27

- Banks use sophisticated VaR and Monte Carlo - Corporates do not have credit assessment skills / data generally available to banks. May use S&P / Moodys with limits (eg $ limit and tenor limit per rating)

Question 28

Credit Risk Management - Future Potential Exposure (FPE) - Basel Capital Accord

Answer 28

Future Potential Exposure - an add-on, over the life of the derivative, as the MtM can change by a dramatic amount between initiation & maturity. Basel Capital Accord - add on factor (FPE) for derivatives, driven by instrument, tenor, notional principal -

Question 29

Managing the Risk of Bond Issue | 5 RISKS

Answer 29

FIVE risks 1. Market Risk - rising rates in lead up to issue 2. Credit Risk - re-offer spread 3. Execution Risk - volume & tenor achieved at reasonable price 4. Govt bond risk - mismatch between bond used to price issue vs bnd used to price IRS 5. Swap spread risk - worsening swap spreads in lead up to issue

Question 30

Managing Risk of Bond Issue | Factors to align for the underlying and hedge when swapping fixed to floating (8)

Answer 30

Factors 1. STart date 2. Maturity date 3. Currency 4. Principal / notional principal 5. Coupon rate / fixed rate 6. Interest rate frequency and dates 7. Day count basis 8. Govt bond benchmark

Question 31

Managing the Risk of a Bond Issue 1. Components of Fixed Rate Bond (2) 2. Components of IRS (6)

Answer 31

Fixed Rate Bond 1. Underlying benchmark (government) bond 2. Reoffer (credit) spread ``` Interest Rate Swap 1. Corporate Bond Rate 2. Bond Swap Spread 3. Credit Spread 4. Capital Charge 5. Funding Charge 6. Execution Charge These components are the spread to go from bond to swap ```

Question 32

Managing the Risk of a Bond Issue | - what can be hedged in advance?

Answer 32

1. Govt Bond rate can be locked in 2. Bond / swap spread can be locked in 3. Usually these are not locked in advance - normally done on the day.

Question 33

Managing the Risk of a Bond Issue | Two methods to manage IRS execution risk on day of issue

Answer 33

Two methods to manage IRS execution risk: 1. Tender with a number of banks (messy / time consuming) 2. Execute with holding bank (hold up to 7 days) then auction swap to ultimate c/ps - This locks in bond/swap spread (with small holding charge). The credit, capital & funding charges are what you effectively auction off a few days later. - Auction process via term sheet with all relationship banks having chance to quote, best rate wins.

Question 34

Scenario: Hedge Guidelines suggest target is 75%. Underhedged in 3 months time (ie need to increased fixed rate portion). How?

Answer 34

Need to use short dated derivative Could use bank bill futures (1m, Mar, Jun, Sep, Dec). But deposits and margin calls would be required. Could also enter 2/5 FRA paying fixed.

Question 35

Scenario: Hedge Guidelines suggest target is 75%. Overhedged in all maturities (long term). (ie need to decrease fixed rate portion). How?

Answer 35

Option 1: Swap - depends on impact at each tenor. May be under hedged year 1 and overhedged for the rest.. Option 2: Structured Swap - Pay floating / receive fixed, with notional principle exactly matching over hedged amount. Cleanest for hedging, nightmare to record and could be costly Option 3: Enter 9 year swap; starting in year 2. (fairly good proxy) Option 4: Series of discrete forward start swaps.

Question 36

Exposure to BBSW movements on particular day of month - how to hedge

Answer 36

``` Could use FRAs to hedge out exposure eg in march, use 3/6 FRA in April; use 2/5 FRA May; 1/4 FRA June; 0/3 FRA ```