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© 2012 Northern Trust Corporation
Presented by: The Northern Trust CompanyFran Wawrzyniak, CTPJune 7, 2012
Windy City Summit CTP Review
Chapter 9
Service Expertise Integrity
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Chapter 9
Financial Risk Management
Fran Wawrzyniak, CTP
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Studying this Chapter
There are 8-10 questions from this chapter on the exam Know Overview of Financial Risk ManagementKnow Derivatives InstrumentsKnow Different Exposure
Interest Rate
FX
Commodity
Accounting and Tax Issues
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Overview of Risk Management in Treasury
Financial risk is the risk of direct or indirect losses resulting from the uncertainty of the future level of interest rates, FX rates, commodity prices, or from adverse impacts on a company with highly leveraged capital structure
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Overview of Risk Management in Treasury
Techniques to evaluate the impact of risk-reducing eventsValue-At-Risk (VaR)
Developed by traders to estimate the possible loss for the entire trading operation Volatility of an expected average value (such as cash flow) and a standard
deviation of the distribution of future outcomes
Sensitivity Analysis What-If exercise to determine how sensitive cash flow is to changes in variables
Scenario Analysis Similar to Sensitivity Analysis but multiple variables are altered High and low variables are used to find the overall best and worst possible
outcomes
Monte Carlo Simulation An extension of Sensitivity Analysis, but includes a series of probability
distributions to produce an overall probability distribution of some final measure or outcome
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Overview of Risk Management in Treasury
Measuring the exposure of changes of prices of assets which can alter the company’s risk profile. Hedging – Use of financial instruments to reduce or eliminate risk of future
cash flows
Speculation – Betting on the direction of the market - Will the price of an asset will go up (long) or down (short)?
Arbitrage – Buying an asset in one market while simultaneously selling in another. Transaction assumes no risk but attempts to profit from market inefficiencies
The Benefits of Risk Management Reduced financial stress on company
Greater predictability of future cash flows
Enhanced borrowing advantage
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Derivative Instruments Used As Financial Risk Management Tools
A derivative instrument is a financial product that acquires it value by inference through a formulaic connection to another asset.
Companies usually need to sign an International Swap and Derivative Association (ISDA) Agreement
Standard industry contract
Defines terms and conditions of the derivative contract
Types of Derivative Instruments
Forwards
Futures
Swaps
Options
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Derivative Instruments
Forwards
Contracts between two parties that require specific action at a later date at a price agreed upon today
Future Date = Maturity Date
Contract Price = Delivery price
Not traded on an organized exchange
The buyer is in a long position, the seller is in a short position
Long position gains value when the price rises and loses when the price falls
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Derivative Instruments
Forwards - Contracts between two parties that require specific action at a later date at a price agreed upon today
Future Date = Maturity Date
Contract Price = Delivery price
Not traded on an organized exchange
The buyer is in a long position, the seller is in a short position
Long position gains value when the price rises and loses when the price falls
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Derivative Instruments
Futures - Same as Forward, but have standardized contracts and are traded on organized exchanges
Contract size and its maturity date set by exchange
Requires a margin account
Daily mark-to-market and margin calls if necessary
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Derivative Instruments
Swaps - Agreement to exchange (or swap) a set of cash flows at a future point in timeInterest rate swap most common type of swap. One party
swaps its floating interest rate for a fixed rate and vice versaAllows Companies with weaker credit ratings to get better
rates Other types include currency, commodity and basis swapsPrimary risk is counterparty risk
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Derivative Instruments
Options - Contract between two parties where the buyer has the right (not obligation) to buy or sell a fixed amount of underlying asset at a fixed price on or before a specified date Counterparty is the Writer of the option and received the price paid
May be exchange-traded or negotiated between two parties
Call Option: the contract allows the owner to buy the asset at a fixed price
Put Option: the owner has the right to sell the asset at a fixed price
Fixed price is the strike/exercise price of contract
Possible relationships between premium and strike price:
At-the-money→ asset price = strike price
Call Out-of-the-Money →asset price less than strike price
Put Out-of –the-Money → asset price greater than strike price
Call In-the-Money → asset price greater than strike price
Put In-the-Money → asset price less than strike price
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Derivative Instruments
Options (continued)
Strike/exercise price—The fixed or contracted price of the underlying asset
Maturity date (or exercise date)—Specified date after which the option expires
Seller of option receives a premium from the buyer
American Style – you can settle at any time during the option period
European style – you can only settle on the option expiration date
Bermuda style – you can settle at predetermined date or at expiration
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Foreign Exchange (FX) Risk Management in Treasury
FX rates are quoted in several ways, depending on the currency and the markets involved
One U.S. Dollar equivalent to foreign currency
One foreign currency equivalent to U.S. Dollar
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Foreign Exchange (FX) Exposure
Rates are obtained by real-time rate reporting services (Bloomberg, Reuters), through a dealer or free on the internet
FX Markets Spot Market
Current exchange rates
Settled in one or two days – such as Canadian dollars or Mexican pesos in the US
Forward Market Settled in more than two days – such as European and Asian currencies in the US
Current spot rate plus or minus interest rate differential (interest rate parity)
Forward points· Par – interest rates are the same· Discount – currency with higher rate will trade· Premium – currency with lower rate will trade
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Foreign Exchange (FX) Exposure
Change in Foreign Exchange RatesTypes of FX exposure
Economic ExposureGlobal markets and related currencies causes the price of goods
to changeEven if a company does not have a global business perhaps their
competitors doTransaction Exposure
Physically converting one currency for another currencyTranslation Exposure
Consolidating foreign subsidiary's financial statements into the parent company's currency
Accounting exposureLarge amount to hedge, loans in the foreign currency can hedge
this exposure
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Currency Derivatives Used to Hedge FX Exposure
FX Derivatives
Currency or FX Forwards – Commitment to buy foreign currency at a future date.
Currency Futures – Similar to forwards but traded on the exchange and standard contract.
Currency Swaps – Exchange of floating rate cash flow in one currency for fixed in another currency.
Currency Options – Right to buy or sell fixed amount of foreign currency at a fixed exchange rate, on or before specified date.
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Currency Derivatives Used to Hedge FX Exposure
ForwardU.S. company agrees to pay an invoice for 125,000 GBP
in 90 daysBuy GBP and sell USDForward FX exchange rate = 1.6365 (current spot rate
plus or minus forward points)90 days the company must deliver $204,563
(125,000*1.6365) to counterpartyCounterparty will deliver 125,000 GBP wherever the
company needs it to
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Currency Derivatives Used to Hedge FX Exposure
FuturesU.S. company agrees to pay an invoice for 125,000 GBP
in 90 daysBuys future contract at an exchange rate of 1.6365 and
puts up cash marginIn 90 days company buys GBP in spot market to deliver
to supplier and sells USDIf futures contract has a gain then the company can sell
the futures contract for a profitIf futures contract has a loss then cash margin is lost
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Currency Derivatives Used to Hedge FX Exposure
Swaps
U.S. company borrows in the U.S. markets to fund an investment in Japan
Interest expense in USD and interest income in Yen
To reduce FX exposure company swaps Yen interest income for USD at a fixed rate over the term of the debt
Company still owes money to the U.S markets but instead of receiving Yen it will receive USD
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Currency Derivatives Used to Hedge FX Exposure
OptionsU.S. company agrees to pay an invoice for 125,000 GBP
in 90 daysBuy GBP and sell USDBuys option contract at an exchange rate of 1.6365 and
pays an upfront premium
Caps, floors, collarsIn 90 days company has the OPTION to buy GBP in spot
market or at the option price depending on what the then current FX rates are trading at
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Interest Rate Exposure and Risk Management
Companies with variable interest rate investments face lower earnings (interest income) when rates fall
Companies with variable interest rate debt face higher borrowing costs (interest expense) in rising rate environment
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Interest Rate Exposure and Risk Management
ForwardsBuyer can lock in a rate (price) today to be used in the future
Forward Rate Agreement (FRA)
FuturesTraded on the Chicago Mercantile Exchange
SwapsExchange cash flows of two different securities
Fixed-floating swap most common
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OptionsInterest Rate Cap - ensures a floating rate loan receives a
ceiling if interest rates rise
Interest Rate Floor - a hedge against rates dropping below a certain level
Interest Rate Collar - combo of Cap and Floor that effectively locks in a range for its borrowing costs
Interest Rate Exposure and Risk Management
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Commodity Price Exposure
Price Exposure- potential for changes in price of commodity (agriculture and meat products, oil and gas, minerals, and metals)
Two types of exposure
Price – mitigate with derivatives
Delivery – mitigate with long-term contracts
Exposure hedged by Forwards, futures, swaps, and options
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Other Issues Related to Financial Risk Management
Accounting IssuesAddressed by International Accounting Standards Board
(IASB) and Financial Accounting Standard Board (FASB)Valuation and Disclosure of Derivative Instruments
Primary problem is determining accurate value when mark-to-market is applied
Updates made to accounting rules Topic 820-10 (Fair Value Measurement) Topic 815 (Derivatives and Hedging)
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Other Issues Related to Financial Risk Management
Impact on Derivatives from Dodd-Frank ActBrings more transparency and accountability to derivative
markets
Closes regulatory gaps
Requires central clearing and exchange trading
Requires market transparency
Adds financial safeguards
Sets higher standards of conduct
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Other Issues Related to Financial Risk Management
Tax Issues Related to Hedging Very complex tax issues when using hedges
Errors in the accounting treatment can be very costly especially if restatement of earnings is involved
More complex for global companies
Wrongs methods could impact gains and losses
Obtain legal, tax, and accounting experts who specialize in this area
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Other Issues Related to Financial Risk Management
Hedging Policy StatementShould come from the highest level in an organization as
possible (board of directors) Policy statements for FX risks, interest rate risks, and
commodity pricing risk
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Other Issues Related to Financial Risk Management
Emerging Markets – Special challenges companies face:Tightly managed currencies (F/X and availability) Not all hedging instruments are available
Emerging Market CurrenciesFall into one of three baskets
Free floating Capital controls Non-readily tradable in global F/X marketplace
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Other Issues Related to Financial Risk Management
Issues with Exotic CurrenciesLiquidity
Volatility
Transparency
Capital controls
Carrying risk
Pricing distortions
Risk-sharing options
Internal hedging alternatives
Transfer risks
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Other Issues Related to Financial Risk Management
Issues with Exotic Currencies Low level of transaction activity
Dramatic fluctuations
Central bank restrictions
Less developed financial markets
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Hedging Tools Available for Emerging/Exotic Currencies
Non-Deliverable Forward (NDF)
Cash settled in a major base currency and used when exotic currency is not actively traded in the forward market
On settlement, there is no exchange of currencies, only the difference between the NDF rate and the spot rate.
Non-Deliverable Option (NDO)
Same as NDF but buyer has the right (an option) to buy or sell