SBM Chapter-15
Financial risks 1
Interest
rate risk 2
Foreign
exchange risk 3
Hedge accounting 4
1 Financial risks:
- Financing risk: The risk that a certain type of finance becomes unavailable in the future.
- Liquidity risk: The risk that firm will be unable to pay
its debts as they fall due.
- Cash flow risk:
- Credit risk: The risk of customer (or counterparty) default
- Market risk: The risk of losses due to changes in market prices or rates.
1.6
Financial risk management :
- Diversification
- Hedging
- Macro hedging: Also known as portfolio hedging, is a technique
where financial instruments with similar risks are grouped together and
the risks of the portfolio are hedged together.
- Transfer: One method of transferring risk is securitisation. Securitization is the peocess of transforming illiquid assets into security through financial
engineering.
2 Interest rate risk:
2.1 Future:
· PSRB
· Prices interest rate futures are quoted as 100 minus interest rate
expressed in annual terms.
· Future contract price move in tick 1 tick = 0.01%
· One million 3 month deposit on tick is 1000000 x .0001 x
3/12 = 25
· Sell – Buy = Gain (Loss)
Worked
example: Interest rate futures: Yew has taken a three-month $1,000,000 loan
with interest payable of 8%, the loan being due for rollover on 4 March. At 1
January, the company treasurer considers that interest rates are likely to rise
in the near future. The futures price is 91.00 representing a three-month
interest rate of 9%. A eurodollar future is a contract for a notional
three-month deposit of $1,000,000.
Yew wants to hedge against the risk of a rise
in the three-month interest rate before 4 March. It therefore sells one March
contract at a price of 91.00.
Suppose that at 4 March, the spot three-month
interest rate is 11%. Yew closes the futures position by purchasing a March
futures contract, but the price for buying the contract might be, say, 89.05.
Requirement: Calculate the effect of the futures hedge.
Worked
example: Setting up a futures contract: Panda has taken a six-month $10,000,000
loan at a variable rate of interest, with the interest rate due for rollover on
8 September. At 25 June, the company treasurer considers that interest rates
are likely to rise in the near future. The current futures price is 91.00
representing an interest rate of 9%. The futures contract size is a notional
three-month deposit of $1,000,000: to hedge against a rise in the six-month
interest rate, the company sells September contracts.
At 8 September, suppose the
six-month LIBOR rate is 11% and the futures price is 88.50.
Requirement: Demonstrate how futures can be used
to hedge against interest rate movements.
2.1.1 Basis risk: Risk that the futures price might not move steady correlation
with the price of the underlying asset. The basis will be zero only at the maturity date of the contract.
Worked example Basis Risk: Page 963 new book
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Advantages of interest rate futures
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Disadvantages of interest rate
futures
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Cost:
Costs of arranging are reasonably low.
Amount
hedged: Can hedge large exposures with a small
initial employment of cash.
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Inflexibility
of terms: Fixed deposit
periods, standard settlement dates and fixed amounts.
Basis
risk:
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Interactive
question 2: Interest rate futures- see
page 962 new book
2.2
Interest rate options- OTC interest rate options; Exchange-traded: PS (Put) RB (call)
Interactive
question 3: Exchange-traded options- Rumble(see Interactive question 2)
is considering using options to hedge against interest rate movements on its $4
million loan. It is now 1 March and LIBOR remains at 3.5%. Rumble Inc will be
able to borrow on 1 June at LIBOR + 1%. Options on three-month futures
($1,000,000 contract size, premium cost in %) are as follows.
Rumble chooses to trade in options
on futures with an exercise price of 96.25.
Requirement- Illustrate the effect
of using options to hedge against the risk of a rise in interest rates with an
option hedge at 3.75% and assuming that on 1 June
(a) three-month LIBOR is 4% and the
June futures price is 95.90
(b) three-month LIBOR is 2% and the
June futures price is 97.95.
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Advantages of interest rate options
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Disadvantages of interest rate
options
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a) Upside
risk
(b) Over-the-counter
options – More flexible than exchange-traded options.
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(a) Premium
(b) Expiry date
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2.3
Caps, floors and collars
Cap: Option that sets an interest rate
ceiling. It is an interest rate
derivative
in which the buyer receives payments at the end of each period in which the
interest rate exceeds the agreed strike
price.
Floor: Option that sets a lower limit to
interest rated. An interest
rate floor is a derivative contract in which the buyer receives payments at
the end of each period in which the interest rate is below the agreed strike
price.
Collar: Using a callar arrangement, the
borrower can buy an interest rate cap and at the same times sell an interest
rate floor whcih reduce the cost for the compnay.
Worked
example: Caps and collars: A company has a three-year loan at a variable interest rate (LIBOR +
1%) with interest payable every six months, and wants to hedge against the risk
of a rise in the LIBOR rate. At the same time it wants to benefit from falls in
the interest rate. The current six-month LIBOR rate is 8% and the company does
not want to pay interest at more than 11%. It could create a hedge by
purchasing a cap from its bank. This would consist of a series of call options with
expiry dates every six months. As the company is paying LIBOR plus 1% and does
not want to pay more than 11%, it may buy a cap with an exercise rate of 10%.
At the expiry date for each option, if the
LIBOR rate is above 10%, the company will exercise the option and receive a
cash payment from the bank for the difference between the LIBOR spot rate and
the exercise rate of 10%. This will offset the higher cost of interest on the
loan.
At the expiry date for each option, if the
LIBOR rate is below 10%, the company will let the option lapse and will pay
interest on the loan at LIBOR plus 1%.
The cap will therefore restrict the cost of
borrowing to no more than 11% (the exercise rate of 10% plus 1%) for the full
term of the loan. However the cost of the premium for the cap could be very
high.
An alternative arrangement might be to arrange
a collar rather than a cap. A collar might consist of buying a series of call
options with an exercise rate of 10% and selling a series of put options with
an exercise rate of, say, 7%. As a result, the collar would fix the effective
LIBOR rate within a range 7% to 10%. The company would exercise a call option
if the LIBOR rate is higher than 10% at expiry, but would have to settle a put
option if the LIBOR rate is below 7%. However the net cost of the collar – the cost
of the call options minus the income from selling the put options, would be
less than the cost of a cap.
2.4
Forward rate agreements (FRAs): A forward rate agreement (FRA) is a
cash-settled forward contract. FRAs are over-the-counter instruments. A 2 v 5
FRA, for example, is a two-month forward agreement on a three month loan. The
settlement amount for an FRA is calculated using the following formula:
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Where:
L = the notional
amount of the loan
S = settlement
amount
rREF =
the reference rate, typically a LIBOR rate or EURIBOR
rFRA =
the rate in the FRA
ND = the number of
days the loan is for
DY = the day count
basis applicable to money market transactions in the currency
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Advantages of forward rate agreement
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Disadvantages of forward
rate agreements
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a) Protect adverse movements
c) Cost of agreements is free/very little.
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a) Upside risk
c) Binding agreement
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Interactive
question 4: FRA settlement value-
Suppose a 4 v 10 US$10 million FRA is transacted with an FRA rate of 3.5%. The
four-month forward period starts on the spot date and extends to the settlement
date. For this FRA, the reference rate is sixmonth US$ LIBOR. Suppose the
reference rate is 3.8% on the fixing date. What is the settlement amount? (The
US$ money market uses a 360-day basis for calculating interest, not a 365-day
basis.)
2.5
Swaps: An interest rate swap is a contract between two parties. The two
parties agree to exchange a stream of payments at one interest rate for a
stream of payments at a different rate.
There are two main types of interest rate swaps
– coupon swaps and basis swaps.
In a coupon swap= Swap fixed rate with floating rate.
In a basis swap = floating rate (three-month LIBOR) with another
floating rate (six-month LIBOR).
Most interest rate swaps are coupon swaps.
Swaptions : Options on swaps, giving the holder
the right but not the obligation to enter into a swap with the seller.
Worked
example: Swaption: It is now 1 January
20X6. Towyn plc pays a variable rate of interest on a $1,000,000 eurodollar
loan which is due to mature on 30 June 20X9. The interest rate currently
payable on this loan is 6.75% per annum. The company treasurer is now concerned
about the possibility of interest rate rises over the near future. The
company's bank has indicated that an American-style dollar swaption is
available with the following features.
Interest rate 7.5%
Exercise period July 20X6 to 31 December 20X6
Maturity date 30
June 20X9
Premium $20,000
Requirement: Assess under what
circumstances Towyn plc will gain from exercising the swaption. Ignore the time
value of money.
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Advantages of swaps
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Disadvantages of swaps
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a) Flexibility and costs
b) Swaps
allow capital
restructuring
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a) Additional risk: counterparty risk
b) Lack of liquidity: The lack of a secondary market in swaps makes it
very difficult to liquidate a swap
contract.
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Interactive
question 5: Interest rate swap : Seeler Muller, a German company, wishes to
borrow US$300 million for five years at a floating rate to finance an
investment project in California. The cheapest rate at which it can raise such
a loan is US dollar LIBOR + 0.75%. Seeler Muller can issue a fixed interest
five-year bond at 9% per annum interest.
Another German company, Overath Maier, needs a
five-year fixed interest loan at $300 million. The cheapest rate at which it
can arrange the loan is 10.5% per annum. It could, however, borrow in US dollars
at the floating rate of US dollar LIBOR + 1.5%.
Both companies have approached the same bank
that deals in interest rate swaps. The bank is currently offering the following
five-year swap rates against US dollar LIBOR:
8.78% – 8.48%.
Seeler Muller can issue a fixed interest
five-year dollar bond at 9% per annum interest. The bank would charge a swap
arrangement fee of 0.15% per year to both parties. You are required to devise a
swap by which both parties can benefit.
You are also required to explain why the
companies would prefer to arrange a swap through their bank rather than
directly with each other.
2.6
Devising (planing) an interest rate hedging strategy: Different hedging instruments offer
alternative ways of managing risk in a specific situation. The choice of
instrument or method of hedging should consider a number of factors, such as cost,
flexibility, expectations and ability to benefit from favourable interest rate
movements.
3 Foreign exchange risk
Causes
of exchange rate fluctuations
Currency supply and demand:
Interest rate parity theory
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Purchasing power parity:
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3.1.4 International Fisher effect: The International Fisher effect states that
currencies with high interest rates are expected to depreciate relative to
currencies with low interest rates. For the UK, the Fisher equation can be
expressed as:
Countries with relatively high rates of
inflation will generally have high rates of interest. According to the
International Fisher effect, interest rate differentials between countries
provide of future changes in spot exchange rates. The International Fisher
effect can be expressed as:
3.2 Foreign exchange risk management : In addition of hedging risk can be manage:-
Currency of invoice
Matching receipts and payments
Leading (advance) and lagging
Netting
3.7
Forward contracts:
Forward
rate adjustment to spot rated
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Forward rate for overseas
currency is weaker than spot
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Quoted at discount
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Add with foreign currency
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Mnemonic
ADDIS
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Forward rate for overseas
currency is stronger than spot
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Quoted at premium
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Subtracted with foreign currency
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Advantages of forward exchange
contracts
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Disadvantages of forward exchange
contracts
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They are
transacted over the counter
They
can, in theory, be for any amount.
The length of the contract can be flexible
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The
contracts are difficult to cancel
There is
a risk of default by the
counterparty
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3.7.3 Synthetic foreign exchange agreements : In order to reduce the volatility of exchange rates,
some governments have banned foreign currency trading.
In such markets, synthetic
foreign exchange agreements (SAFEs), also known as non-deliverable
forwards, are used. These
instruments resemble forward contracts but no currency is actually delivered. Instead
the two counterparties settle the profit or loss (calculated as the difference
between the agreed SAFE rate and the prevailing spot rate)
Worked
example: Settlement of synthetic agreements
Interactive
question 10: Forward contract
3.8
Money market hedge
Worked
example: Hedging payments
Worked
example: Hedging receipts
Interactive
question 11: Money market hedging
3.9
Currency futures : A currency future is a contract to buy or sell a standard amount of
one currency in exchange for another, for notional delivery at a set date in
the future
RSPB
Worked example : Currency Future:
Worked
example: Currency futures
Interactive
question 12: Currency futures
Worked
example: Basis risk
3.9.4 Hedge efficiency
Worked
example: Hedge efficiency
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Advantages of currency futures
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Disadvantages of currency futures
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Transaction costs should be lower
No counterparty risk
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The contracts cannot be tailored
Basis risk.
Only certain currencies
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3.10
Currency options: A currency option is an agreement involving a right, but
not an obligation, to buy or sell a certain amount of currency at a stated rate
of exchange (exercise price) on or before some specified time in
the future.
Step
1 Set up the hedge
(a) Choose contract date (b) Decide whether put or call option (c) Decide which exercise or strike price
applies (d) How many contracts (e)
Calculate premium
Step
2 Ascertain closing price: You should be given this.
Step
3 Calculate outcome of hedge: May calculate the outcome more than
one closing spot rate.
(a) Outcome in options market. This
will include:
(i) Exercising the option
(ii) Cash flows on exercise
(iii) Converting amount uncovered/over-covered at spot
rate
(b) Net outcome
Worked example: Currency options
Interactive question 13: OTC option
Interactive question 14: Traded option
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Advantages of currency options
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Disadvantages of currency options
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Protection
against adverse currency movements
Upside
risk
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Cost
Traded options are not available in every currency.
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3.10.6 FX collars: Interest rate collars have already
been described. An FX collar is similar. It is a form of option that may be
attractive because it reduces the net cost of the option.
A collar is a derivative instrument
that combines:
buying a call and selling a put
option with a lower exercise price, or
buying a put and selling a call
option with a higher exercise price.
Example:
A UK company will need to buy US$2 million in three months’ time
and due to the high volatility of the dollar-sterling exchange rate it wants to
hedge its currency exposure on this transaction. There is a possibility that
the dollar will increase in value, but there is also a possibility that it will
fall in value. The company decides to hedge the risk with an FX collar. The
collar consists of a call option with a strike rate of $1.4500 = £1 and a put
option with a strike rate of $1.5000 = £1. (The put option has a ‘lower’ strike
rate in the sense that the value of the dollar is lower at a rate of 1.5000
than at a rate of 1.4500.)
If the spot exchange rate at expiry
is $1.4000, the company will exercise the call option in the
collar, buy the $2 million at a
rate of 1.4500.
If the spot exchange rate at expiry
is $1.5500, the put option in the collar will be exercised, and the company
will have to buy the $2 million at a rate of 1.5000.
If the spot exchange rate at expiry
is $1.4700 – between the two strike rates – neither option will be exercised
and the company will buy the dollars at the spot rate of 1.4700.
3.11
Currency swaps: A currency swap (or cross-currency swap) is an interest rate swap
with cash flows in different currencies.
For example, one party may make payments on
interest on £10 million and the other party may make payments of interest on a
corresponding amount of another currency, say $15 million.
Like interest rate swaps, currency swaps can be
arranged for terms of several years.
Currency swaps are arranged over-the-counter
with a bank.
Worked
example: Currency swaps 2: Consider a UK company
X with a subsidiary in France that owns vineyards. Assume a spot rate of £1 =
1.2 euros. Suppose the parent company wishes to raise a loan of 1.2 million
euros for the purpose of buying another French wine company. At the same time,
the French subsidiary Y wishes to raise £1 million to pay for new up-to-date
capital equipment imported from the UK. The UK parent company X could borrow
the £1 million sterling and the French subsidiary Y could borrow the 1.2
million euros, each effectively borrowing on the other's behalf. This is known
as a back-to-back loan.
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Advantages of currency swaps
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Disadvantages of currency swaps
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Flexibility Cost
Access to finance Financial
restructuring
Conversion of debt type
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Counterparty risk)
Position or market risk
Arrangement fees
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3.12
Forex (FX) swaps: An FX swap is a spot currency transaction coupled with
an agreement that it will be reversed at a prespecified date by an offsetting
forward transaction.
Although the forex swap is arranged
as a single transaction, it consists of two separate legs. The counterparties
agree to exchange two currencies at a particular rate on one date and to
reverse payments normally at a different rate on a specified future date. The
two legs can therefore be seen as one spot transaction
and one forward transaction going the opposite
direction.
Interactive
question 15: El Dorado part 1
Interactive
question 16: El Dorado part 2
4
Hedge accounting: Hedge accounting is the accounting process which reflects in
financial statements the commercial substance
of hedging activities.
4.1
Hedge accounting: The main components of hedge accounting are:
The hedged
item: this is an asset, a liability, a firm commitment or a
forecast transaction which exposes the entity to risks of fair value/cash flow
changes.
The hedging
instrument: this is a derivative or other financial instrument
whose fair value/cash
flow changes are expected to offset
those of the hedged item.
There are two main types of hedge:
– The fair
value hedge: the gain and loss on such a hedge are recognised in
profit or loss.
– The cash
flow hedge: the gain and loss on such a hedge are initially
recognised in other comprehensive income and subsequently reclassified to
profit or loss.
Hedge effectiveness should be tested
on both a prospective and retrospective basis
The highly effective is achieved if
the actual results of a hedge are within from 80% to 125%.
4.4
Fair value hedges: A fair value hedge is a hedge of an entity's exposure to
changes in fair value of a recognised asset or liability or an unrecognised
firm commitment, or a part thereof.
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Hedging instrument
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Loss
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DR
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PL- FV loss on hedge items
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CR
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FP - Financial liabilities from hedging instruments
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Gain
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DR
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FP - Financial assets from hedging instruments
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CR
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PL- FV gain on hedge items
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Hedged item:
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Loss
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DR
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P/L – Loss on the hedged item
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CR
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FP – Hedged item (e.g. inventories)
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Gain
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DR
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FP – Hedged item (e.g. inventories)
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CR
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P/L – Gain on the hedged item
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4.5
Cash flow hedges: A cash flow hedge is a hedge of the variability in an
entity's cash flows.
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Hedging instrument effective porting
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Loss
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DR
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OCI – Cash flow hedge reserve
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CR
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FP – Financial liabilities from hedging instruments
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Gain
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DR
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FP – Financial assets from hedging instruments
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CR
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OCI – Cash flow hedge reserve
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Hedging instrument- – ineffective
portion
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Loss
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DR
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P/L – Ineffective portion of loss on hedging instrument
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CR
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FP – Financial liabilities from hedging instruments
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Gain
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DR
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FP – Financial assets from hedging instruments
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CR
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P/L – Ineffective portion of gain on hedging instrument
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Note: P/L = profit or loss, FP = statement of financial position,
OCI = other comprehensive income.
As you can see, you don’t even touch the hedged item
here and you only deal with the hedging instrument. So that’s completely
different from fair value hedge accounting.
Interactive
question 17: Hedging strategies
Self test 4
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