Financial Risk Management (9_2636_001)

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FINANCIAL RISK MANAGEMENT



FINANCIAL RISK

An unplanned event with financial consequences.

Could be profit or loss.



WHAT IS RISK?

Risk is uncertainty

Risk is volatility of earnings

Risk is deviation of actual outcomefrom expected outcome



FINANCIAL RISK MANAGEMENT

Controlling sensitivity to any outcome whichwould alter the bottomline of a business



Risk Management entails management of:

• Commodity Price• Equity Price

• Interest Rates

• Exchange Rates



What is Likelihood of Happening

Past Volatility creates Future Uncertainty

US$ Interest Rate

11.

0

1 O.O

8.O

5.O

1989 199O 1991

9.OH

7\O -\

6.OH



Conversely, lack o» past volatility can create false security

3-MONTH FRENCH FRANC RATES

%16

J F M A M J J A S O N D J F M A M J J A S O N D J

^---------------------1991 ~-------------------► <---------------- — 1992—-------- ► 1993

Source: Dalastream



Interest

Rates

Balance SheetStem

Effect of hate

Movement

Fall

Rise

Fixed rate borrowing

Floating rate borrowing

Fixed rate investment

Floating rate investment

Fixed rate borrowing

Floating rate borrowing

Fixed rate investment

Floating rate investment

Unable to reduce interest cost

Interest cost fallsIncome stream maintained, value of

asset rises

Income stream falls, value of assetlargely unaffected

Borrowing cost maintained

. Borrowing cost rises

Income stream falls in real terms,

value of asset falls

income stream rises, value of asset

largely unaffected



RISKS CAN BE REDUCED

BUT NOT ELIMINATED



RISK / REWARD PROFILE

1. PURCHASE CERTAINTY

FX, FORWARD FX, FUTURES, FRAs, LR.S

2. TAKE A VIEW

LEAVE AN EXPOSURE OPEN

3. PARTIAL HEDGE

ELIMINATE UNACCEPTABLE RISKLEAVE SOME EXPOSURE OPEN



Financial Exposure

Interest Rate Exposure

Arises when financial assets and liabilitieshave a mismatch in maturity or interest ratebasis.

Currency Exposure

Arises when foreign currency receivables andpayables do not match each other in amount

and timing because the future conversionvalue of net inflows into domestic currency of accounting is unknown.



Example of Financial Exposure

Interest Rate Exposure

A commercial bank extends floating rate U.S.dollar loans to its corporate client base. Thebank itself issues a fixed coupon, dollar-denominated Eurobond to fund its dollar assets. A drop in dollar interest rate will bringthe bank's future profitability in jeopardy.



Example of Financial Exposure

Currency Exposure

An Indian Company makes a major part of itsexports in U.S. dollars. The current need for working capital is funded through low interestSwiss Franc loans. If U.S. Dollar depreciatesvis-a-vis Swiss Franc, the profitability will besqeezed.



Foreign Exchange Exposures

Transaction Exposure

Measures the impact of changes in exchangerates on near-term or medium term payables,receivables, or cash-flows.

Translation Exposure

Measures the impact of translation of assets,liabilities, revenues and expenditures from

foreign currency into home currency in whicha firm's financial statements are expressed.

Economic Exposure

Measures the impact of changes in exchangerates on future cash flows.



RISK PROFILE

v

Decrease O Increase

P = PriceV = Value of the Firm



RISK PROFILE

0 AP

AP = P - Pe

AV = V - 0



HEDGING

Hedging creates a position suchthat the gain incurred on thehedge will offset the loss incurredon an underlying position or transaction.



DERIVATIVE

Derivatives are contracts who value is derived fromthe value of some underlying asset such as

currencies, equities, commodities, or indicators likeinterest rates, stock market index or other indices



BUILDING BLOCKS FORMANAGING FINANCIAL RISK

FORWARDS

FUTURES

SWAPSOPTIONS



DERIVATIVE PRODUCTCLASSIFICATION

FORWARD CONTRACTS

(SYMMETRICAL HEDGES)

• Forward FX

• Currency Swap

OPTfONS CONTRACTS

(ASYMMETRICAL HEDGES)

• Currency Option

• Cap/Floor/Collar

Forward Rate Agreement • Interest Rate Guarantee (IRG)

Interest Rate Swap (IRS) Swaptions



FORWARDS



F O R W A R D S

A forward contract is an agreement to buy or sell agiven asset at a certain future date at a price agreed

between the two parties at the origination of thecontract



F O R W A R D S

Payoff Profile

Long Position

Pay Off = ST- K

Short Position

Pay Off = K- ST

K = Delivery price of the assetST = Spot price of the asset at maturity

'■(+)



HEDGING USING FORWARDCONTRACT

SYMMETRIC HEDGE

Decrease Increase



HEDGING RISK USING FORWARD CONTRACT

AV

Payoff Profile

Risk Profile

AP



FORWARDS

Advantages

o Simple instrument

Disadvantages

o Credit instrument and entails counterparty defaultorcredit risk

o Contract is settled only at maturity



FUTURES



FUTURES

A financial futures contract is an agreement to buy

or sell a standard quantity of a specific asset at

a fu tu re da te a t a p r i ce agreed be tweenthe two parties at the origination of the contract



Futures

Characteristics

o Exchange traded contract

o Daily settlement

o Margin requirements

o Clearing House



FUTURES CONTRACTS

• Precious Metals - Gold, Silver, Platinum

• Industrial Commodities - Aluminium,Copper, Lead, Nickel, Crude Oil, etc.

• Foreign Exchange - Swiss Franc,Deutsche Marks, British Pounds, FrenchFrancs, Japanese Yen, etc.

• Interest Bearing Securities- T-Bills, Gilts,Eurodollar Deposits, Corporate Bonds, etc.

• Stock Indexes - S&P 500 Index, FT Index,Nikkei Index etc.



FUTURES EXCHANGES

United States Europe Far East

• Chicago Board of • London international • Hong Kong FuturesTrade (CBOT) Financial Futures Exchange

Exchange (LIFFE)• Tok o Stock

• Chicago Mercantile • London Futures and Exchange (TSE)

Exchange (CME) Options Exchange

• Tokyo International• New York • London Metal Financial Futures

Commodity Exchange (LME) Exchange (TIFFE)

Exchange

(COMEX) • MATIF • SingaporeInternational• Philadelphia Stock Monetary Exchange

(SIMEX)Exchange



Futures

Forward Contract Futures Contract

Customised in terms of size and maturity dates.

Private contract betweentwo parties.

Traded on OTC.

Standardised in termsof size and maturitydates (3rd Wednesdayof March, June, Sept &DeconLIFFE).

Standardised contractbetween a customer and a clearing house.

Traded on the pit of anexchange e.g. CME,LIFFE, etc.

Iliquid secondary market Liquid secondarymarket



Futures

Forward Contract Futures Contract

Profit or loss position isrealised only on deliverydate.

Performance period isthe same as maturity of the contract

Credit risk depends oncounterparty

Contracts are markedto market; profit andlosses are realisedday to day

Performance periodis reduced to one day

Credit risk practicallyabsent



Futures

Advantages

o No credit risko Gearing - only small margins required o

Standardised contracts o Large and liquid

market

Disadvantages o Futures contract

does not provide a perfect hedgeo Standardised amounts and dates may not coincide

with actual requirement

o Daily margining is administratively burdensome



FORWARD RATE AGREEMENT(FRA)

A FRA is an agreement between twoparties to contract an interest rate for aspecific period of time from a specifiedfuture date on an agreed notional

principal amount.



FRA TERMINOLOGY

Buye

r

Party wishing to protect itself against a future rise

in interest rates

Seller Party wishing to protect itself against a future fall

in interest

Contrac

t Period

Period protected. Quoted as for e.g. 3 X 6

meaning the interest for a 3 month periodcommencing in 3 months time

Forward Date on which contract period begins.

Date



FRA TERMINOLOGY (CONTD..)

Maturity Date on which contract period ends

Date

Settlement Date when the payment of the interest differential

Date is made. This is usually the same as the forward

date, but may be the maturity date instead

Fixing Date The date when the settlement date is determinedas is usually two business days prior to theForward Date

Trade Date Date on which the deal is struck i.e. the terms of

the FRA are set




Contract The forward rate of interest agreed between the

Rate two parties on the day the deal is struck.

Settlement The floating rate index specified in the contract

Rate e.g. Libor

Settlement Difference calculated between the contract rate

Sum and settlement rate multiplied by the principalamount and the period of the contract.




Fixing DateContract Period

0Trade Date

Forward Date

6

Maturity Date



Forward Rate Agreements

On settlement date :-

If Libor > FRA rate

If Libor < FRA rate

buyer receives difference from seller

seller receives difference from buyer

Settlement amount

(F - L) * P * D

360 * 100 1 +(360 * 100)

F = FRA rate

L = LIBOR

P = Notional Principal Amount

D = Number of days in contract period

Financial Risk Management



FRA PAYMENT SCHEME

Fixed Rate



FRA QUOTATIONS

Start/ End USD(In Months) (%)

1 X7 5.87%

2X8 6.05%

3X9 6.34%

4X10 6.42%

6X12 6.54%



Forward Rate Agreement

Interest Rate Hedge - 1

Situation Borrower with 3 month borrowingrequirement in 3 months time.

View

Aim

Interest rates will rise

Lock in to interest rate now to minimisefuture borrowing costs

Solution Buy an F.R.A.



Forward Rate Agreement

Interest Rate Hedge - 2 3-6 month

FRA quoted at 7-6 7/8 Company buys 3-6 F.R.A. for

notional principal at 7%

a) Rate at borrowing date 8%

Company borrows at 8%

- Receives 1 % On settlement of F.R.A.

b) Rate at borrowing date 6%

Company borrows at 6%

- Pays 1 % On settlement of F.R.A.



Forward Rate Agreements

Example

Customer has a floating rate loan of USD 5 mio that resetsevery 3 or 6 months based on USD Libor. i

The next rollover of the loan is in 4 months time and the

customer anticipates fixing for 3 months. They are

concerned that interest rates may rise, albeit

temporarily.

Solution

Buy a 4 * 7 USD FRA @ 3.26

(Market Price 3.26/3.21)




Forward Rate Agreements4.5

,Do nothing

3 S t S

B o r r o w i n g c <

3.5

3

2.5-

Buy FRA

^ ^

2

5 3.26 3.5 3.75 4 4.25

Lib or




Forv\larci Rate Agreenrfent

Market Characteristics

* Developed out of forward/forward depositmarket.

* Market is primarily interbank. Contracts withnon-bank customers are arranged throughbrokers.

* Predominantly (90%) in US Dollars. Other currencies include Pound Sterling, Deutschemarks and Swiss Francs.

* London is the main centre accounting for about 40% of the market. New York is nextwith about 25% of the market.



Rate

Agreerwent

Advantages

* Simple Documentation - Standard"FRABBA" terms and conditions used.

* Flexible Features - Notional principalamount, contract dates and interest periodsare fixed by agreement between partieswithout margin requirements.

* Direct Settlement - No clearing facility

* Off-Balance Sheet item - principal amountnever exchanged and exposure limited tocompensation payment.

* Enables banks to improve capital ratios andreturn on assets.



Forward Rate AgreementDisadvantages

Market not liquid over 18 months.

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Financial Risk Management (9_2636_001)

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