Ch18-FinancialRisks

8/13/2019 Ch18-FinancialRisks

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Chapter 18 Identifying, Measuring and Managing Financial Risks

Topic List

Page1. The risk framework

1.1 Risk strategy and management 429

1.2 Business and financial risk 429

1.3 Types of financial risk 429

2. !change rate system

2.1 "i!ed e!change rate system 43#

2.2 "reely floating e!change rate system 43#

2.3 $anaged floating e!change rate system 43#

3. Types of foreign currency risk

3.1 Transaction risk 431

3.2 conomic risk 431

3.3 Translation risk 431

4. %auses of e!change rate fluctuations

4.1 Balance of payments 433

4.2 Purchasing power parity &PPP' 433

4.3 (nterest rate parity &(RP' 434

4.4 !pectation theory 43)

4.* The international "isher effect 43)

4.) "our+way e,ui-alence 43)

*. edging techni,ues for foreign currency risk

*.1 /eal in home currency 430

*.2 /o nothing 430

*.3 eading and lagging 430

*.4 $atching 43

*.* etting 43*.) "orward contract 439

*.0 $oney market hedge 439

). "oreign currency deri-ati-es

).1 %urrency futures 442

).2 %urrency options 444

).3 %urrency swap 44)

0. (nterest rate risk 44

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. %auses of interest rate fluctuation

.1 Term structure of interest rates 449

.2 ield cur-es 449

.3 "actors affecting the shape of the yield cur-e 4*#

.4 5ignificance of yield cur-es to financial managers 4*2

9. edging techni,ues for interest rate risk

9.1 $atching and smoothing 4*2

9.2 "orward rate agreement &"R6' 4*2

9.3 (nterest rate futures 4*4

9.4 (nterest rate options 4*)

9.* (nterest rate caps 4*0

9.) (nterest rate floors 4*

9.0 (nterest rate collar 4*

9. (nterest rate swaps 4*9

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1. The Risk Frameork

1.1 Risk strategy and management

1.1.1 Risk management happens at three le-els7

!trategic7 risks deri-ed from e"ternal sources8 the responsiility of the oard

of directors.

#perational7 risks deri-ed from the processes 8 the responsiility of process

owners: ut risk management solutions must consider the needs of the

company as a whole.

Tactical7 to synchroni$e actionthat address oth strategic and operational risks

8 the responsiility of a risk manager.

1.% &usiness and financial risk

1.2.1 &usiness risk8 The riskthat a company;s commercial acti'ities and operations are

less successful than in the past or as forecast&for e!ample: a fall in re-enues due to

a competitor introducing a ri-al product'.

1.2.2 Financial risk 8 The risk that financial conditions &for e!ample: the cost of

orrowing: the yield from in-estments: the a-ailaility of money to orrow: customer

ad dets' could change or (e less fa'oura(le than e"pected: resulting in a

deterioration of (usiness positions in financial terms &i.e. profitaility and

sol-ency'.

1.) Types of financial risk

1.3.1 Li*uidity riskis the risk of ha-ing insufficient cash resources to meet day+to+day

o(ligations: or take ad'antage of profita(le opportunities when they arise.

i,uidity is the aility to otain7 The right amount of funds

(n the right currency

6t the right cost: etc.

1.3.2 Interest rate riskis the risk that ad'erse mo'ements in interest rates will affect

profity increasing interest e!posure or reducing interest income.

1.3.3 Foreign e"change riskis the risk that the rate of e"change usedto con-ert foreign

currency re-enues: e!penses: cash flows: assets or liailities to the home currency will

mo'e ad'ersely: resulting in reduced profita(ility andor shareholder ealth.

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1.3.4 Commodity price riskis the risk of a price change in a key commodity&input or

putput' that would affect financial performance.

1.3.* Credit risk is the risk that the other party to a financial transaction defaults and

does not meet its financial o(ligations: or fails to meet its financial oligations on

time. There are three key categories of credit risk7

&1' Counterparty risk8 the other party to a financial transaction will not meet its

oligations as to timing or amount of settlement.

&2' Country risk8

-olitical risk8


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"ample 1 0 Transaction risk

6 => company: uy goods from Redland which cost 1##:### Reds &the local currency'. The

goods are re+sold in the => for ?32:###. 6t the time of the import purchases the e!changerate for Reds against sterling is 3.*)*# 8 3.*##.

Re*uired2

&a' @hat is the e!pected profit on the re+saleA

&' @hat would the actual profit e if the spot rate at the time when the currency is

recei-ed has mo-ed to7

&i' 3.### 8 3.#9*#

&ii' 4.#)*# 8 4.###A

(gnore ank commission charges.

!olution2

&a' The => company must uy Reds to pay the supplier: and so the ank is selling Reds.

The e!pected profit is as follows.

?

Re-enue from re+sale of goods 32:###:##

ess7 %ost of 1##:### Reds in sterling (3.*)*#' 2:#*#.49

!pected profit 3:949.*1

&'&i' (f the actual spot rate for the => company to uy and the ank to sell the Reds is

3.###: the result is as follows.

?


ess7 %ost of 1##:### Reds in sterling (3.###' 32:4)0.*3

oss &4)0.*3'

&'&ii' (f the actual spot rate for the => company to uy and the ank to sell the Reds is

4.#)*#: the result is as follows.

?


ess7 %ost of 1##:### Reds in sterling (4.#)*#' 24:)##.2*

Profit 0:399.0*

This -ariation in the final sterling cost of the goods &and thus the profit' illustrated the

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concept of transaction risk.

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3. Causes of "change Rate Fluctuations

4.1 &alance of payments ( )7 5ince currencies are re,uired to finance international trade:

changes in trademay lead to changes in e"change rates.

6 country with a current account deficitwhere imports e"ceed e"portsmay

e!pect to see its e"change rate depreciate: since the supply of the currency

&imports' will e"ceed the demand for the currency&e!ports'.

4.2 -urchasing poer parity 4---5 ( )7 The la of one price suggests that identical goods selling in different

countries should sell at the same price: and that e"change rates relate these

identical 'alues.

This leads on to purchasing poer parity theory: which suggests that

changes in e"change rates o'er time must reflect relati'e changes in

inflation (eteen to countries.

(f purchasing power parity holds true: the e!pected future spot rates can e

e!pressed in the following formula7

b

c

h

h

S

S

+

+=

1

1

#

1

@here7 5#C %urrent spot rate

51C !pected future rate

hC (nflation rate in country for which the spot is ,uoted &ase country'

hcC (nflation rate in the other country &country currency'.

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"ample %

6n item costs D3:### in the =5.

6ssume that sterling and the =5 dollar are at PPP e,uilirium: at the current spot rate ofD1.*#E?: i.e. the sterling price ! current spot rate of D1.*# C dollar price.

The spot rate is the rate at which currency can e e!changed today.

The =5 market The => market

%ost of item now D3:### D1.*# ?2:###

stimated inflation *F 3F

%ost in one year D3:1*# ?2:#)#

The la of one pricestates that the item must alays cost the same. Therefore in one year7

D3:1*# must e,ual ?2:#)#: and also the e!pected future spot rate can e calculated7

D3:1*# E ?2:#)# C D1.*291E?

By formula7

*291.1D

F31

F*1

*#.1

1

1

=

+

+=

S

S

"ample ) 0 &ig Mac Inde"

6n amusing e!ample of PPP is the conomistGs Big $ac (nde!. =nder PPP mo-ements in

countriesG e!change rates should in the long+term mean that the prices of an identical asket

of goods or ser-ices are e,ualiHed. The $c/onalds Big $ac represents this asket.

The inde! compares local Big $ac prices with the price of Big $acs in 6merica. This

comparison is used to forecast what e!change rates should e: and this is then compared with

the actual e!change rates to decide which currencies are o-er and under+-alued.

4.3 Interest rate parity theory 4IR-5 () "or shorter periods: forard rates can (e calculated using interest rate

parity theory: which suggests that changes in e"change rates reflect

differences (eteen interest rates (eteen countries.

(RP predicts that the country ith the higher interest rate will see the

forard rate for its currency su(6ect to a depreciation .

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(f it needs to calculate the forward rate in one yearGs time7

b

c

i

i

S

F

+

+=

1

1

#

#

@here7 "#C "orward rate

5#C %urrent spot rate

icC interest rate for counter currency

iC interest rate for ase currency

"ample 3

=> in-estor in-ests in a one+year =5 ond with a 9.2F interest rate as this compares well

with similar risk => onds offering 0.12F. The current spot rate is F1.*E?.

@hen the in-estment matures and the dollars are con-erted into sterling: (RP states that the

in-estor will ha-e achie-ed the same return as if the money had een in-ested in =>

go-ernment onds.

(n 1 year: ?1.#012 million must e,uate to D1.)3 million so what you gain in e!tra interest:you lose on an ad-erse mo-ement in e!change rates.

The forward rates mo-es to ring aout interest rate parity amongst different currencies7

D1.)3 ?1.#012 C D1.*291

By formula7

1#


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*291.1D

F12.01

F2.91

*.1

#

#

=

+

+=

F

F

4.4 "pectations theory

(f there were e*uili(rium (eteen relati'e inflation rates and relati'e interest

ratesetween two countries: the e"pected spot rate and the current forard

rate 4set using interest rate parity5 ould (e the same.

4.* The international Fisher effect7

The (nternational "isher ffect assumes that all countrieswill ha'e the same

real interest rate: although nominal or money rates may differ due to

e"pected inflation rates.

Thus the interest rate differentialetween two countries should e e*ual to

the e"pected inflation differential. Therefore: countries with higher

e"pected inflation rateswill ha'e higher nominal interest rates: and -ice

-ersa.

The currencyof countries with relati'ely high interest ratesis e!pected to

depreciate against currencies with lower interest rates: (ecause the higher

interest ratesare considered necessary to compensate for the anticipated

currency depreciation.


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7. edging Techni*ues for Foreign Currency Risk

7.1 9eal in home currency

*.1.1 (nsist all customers pay in your own home currency and pay for all imports in home

currency. This method7

Transfer risk to the other party

But may not e commercially acceptale

7.% 9o nothing

*.2.1 In the long run: the company would Iin some, loss someJ. This method7 works for small occasional transactions

sa'es in transaction costs

ut dangerous.

7.) Leading and lagging

*.3.1 Lead payments7

-ayment in ad'ance

Beneficial to the payer if this currency ere strengtheningagainst his own

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There is a finance cost to consider 8 this is the interest cost on the money used

to make the payment: ut early settlement discounts may e a-ailale

*.3.2 Lagged payments7

9elay payments

eyond the due date

6ppropriate for the payer if the currency ere eakening

7.3 Matching

*.4.1 @hen a company has receipts and payments in the same foreign currency due at the

same time: it can simply match them against each other.

*.4.2 (t is then only necessary to deal on the foreign e!change markets for the unmatched

portion of the total transactions.

=5 sustomer

=5 supplier

=nmatched

e!posure

D)m

&to e hedged y other methods'

6B% %o

Recei-es D1)m

Pays D1#m

7.7 :etting

*.*.1 (t only applies to transfers ithin a group of companies.

*.*.2 The oKecti-e is simply to sa'e transactions costs y netting off inter+company

(alancesefore arranging payment.

*.*.3 (t is not technically a method of managing e!change risk.

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7.; Forard contract

*.).1 (t is a contract ith a (ankco'ering a specific amount of foreign currencyat an

e"change rate agreed no.

*.).2 6d-antages and disad-antages7


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/uestion % 0 #(6ecti'es of orking capital management, #/, 6 %o is a uropean company that sells goods solely within urope. The recently+appointed financial manager of P>6 %o has een in-estigating the working capital

management of the company and has gathered the following information7

In'entory management

The current policy is to order 1##:### units when the in-entory le-el falls to 3*:### units.

"orecast demand to meet production re,uirements during the ne!t year is )2*:### units. The

cost of placing and processing an order is L2*#: while the cost of holding a unit in stores is

L#M*# per unit per year. Both costs are e!pected to e constant during the ne!t year. Nrders

are recei-ed two weeks after eing placed with the supplier. ou should assume a *#+week

year and that demand is constant throughout the year.


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Re*uired2

&a' (dentify the oKecti-es of working capital management and discuss the conflict that mayarise etween them. &3 marks'

&' %alculate the cost of the current ordering policy and determine the sa-ing that could e

made y using the economic order ,uantity model. &0 marks'

&c' /iscuss ways in which P>6 %o could impro-e the management of domestic accounts

recei-ale. &0 marks'

&d' -aluate whether a money market hedge: a forward market hedge or a lead payment

should e used to hedge the foreign account payale. & marks'

&Total 2* marks'

/uestion ) 0 IR-, --- and foreign currency risk management

P5 %o: whose home currency is the dollar: took out a fi!ed+interest peso ank loan se-eral

years ago when peso interest rates were relati-ely cheap compared to dollar interest rates.

conomic difficulties ha-e now increased peso interest rates while dollar interest rates ha-e

remained relati-ely stale. P5 %o must pay interest of *:###:### pesos in si! monthsG time.

The following information is a-ailale.

Per D

5pot rate7 pesos 12.*## 8 pesos 12.*2

5i! month forward rate pesos 12.#* 8 pesos 12.9

(nterest rates that can e used y P5 %o7

Borrow /eposit

Peso interest rates 1#.#F per year 0.*F per year

/ollar interest rates 4.*F per year 3.*F per year

Re*uired2

&a' !plain riefly the relationships etweenQ

&i' e!change rates and interest ratesQ

&ii' e!change rates and inflation rates. &* marks'

&' %alculate whether a forward market hedge or a money market hedge should e used

to hedge the interest payment of * million pesos in si! monthsG time. 6ssume that P5

%o would need to orrow any cash it uses in hedging e!change rate risk. &) marks'

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;. Foreign Currency 9eri'ati'es

;.1 Currency Futures

).1.1 6 currency futures contract is a standardised contractfor the (uying or sellingof a

specified *uantity of foreign currency.

).1.2 (t is traded on a futures e"change and settlement takes place in three+monthly

cyclesending in $arch: une: 5eptemer and /ecemer: ie a company can uy or sell

5eptemer futures: /ecemer futures and so on.

).1.3 The price of a currency futures contract is the e"change rate for the currencies

specified in the contract.

).1.4 @hen a currency futures contract is ought or sold: the (uyer or seller is re*uired to

deposit a sum of moneywith the e!change: called initial margin.

).1.* (f losses are incurredas e!change rates and hence the prices of currency futures

contracts change: the (uyer or seller may (e called on to deposit additional funds

&'ariation margin' with the e!change. ,ually: profits are credited to the margin

account on a daily (asisas the contract is Smarked to marketG.

).1.) $ost currency futures contracts are closed out (efore their settlement dates (y

undertaking the opposite transactionto the initial futures transaction: i.e. if uying

currency futures was the initial transaction: it is closed out y selling currency futures.

6 gainmade on the futures transactionswill offset a loss made on the currency

marketsand -ice -ersa.

).1.0 6d-antages and disad-antages7


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company to take ad'antage of

fa'oura(le currency mo'ements.

"ample 7 0 Currency futures

6 =5 company uys goods worth L02#:### from a


19/37

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;.% Currency options

).2.1 >ey Terms

&1' Call option8 gi-es the purchaser a right: ut not the o(ligation: to (uy afi!ed amount of currency at a specified price at some time in the future.

&2' The seller of the option: who recei-es the premium: is referred to as the

riter.

&c' -ut option 8 gi-es the holder the right: ut not the o(ligation: to sell a

specific amount of currency at a specified date at a fi!ed e"ercise price 4or

strike price5.

&4' In+the+money option ( )8 the underlying price is a(o'e the strikeprice.

&*'


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"ample ; 0 Currency options2 uro call option against 9ollars

6 euro call option against dollars gi-es the uyer the right: ut not the oligation: to purchase

a certain amount of euros: such as L1 million: with dollars at a particular e!change rate: suchas D1.2#EL. (f the spot e!change rate of dollars per euro in the future is greater than the

e!ercise price of D1.2#EL: the uyer of the option will e!ercises the right to purchase euros at

the lower contractual price. @hen e!ercise the option: the uyer pays the seller of the option7

L1 million D1.2#EL C D1:2##:###

6nd the seller deli-ers the L1 million. The uyer of the option can then sell the euros in the

sport market for dollars at whate-er spot rate.

"or e!ample: if the spot rate is D1.2*EL: the net dollar re-enue from e!ercising the euro call

option on L1 million is

&D1.2*EL 8 D1.2#EL' L1 million C D*#:###

otice also that the right to uy L1 million with dollars at the e!change rate of D1.2#EL us

e,ui-alent to the right to sell D1:2##:### for L1 million. This option is descried as a dollar

put option against the euro with contractual amount of D1.2 million and a strike price of

1 D1.2EL C L#.333ED

These options are the sameQ they are Kust descried differently.

6lso: note that the uyer of the option could accept a payment of D*#:### from the seller of

the option to close out the position rather than take deli-ery of the L1:###:### and resell the

euros in the spot market. $any option contracts are closed in this way: and this is how

options on the 65/6U N$V PV are settled.

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"ample = 0 Currency options2 ?en put option against -ound

6 apanese yen put against the British pound in a uropean contract gi-es the uyer of the

option the right: ut not the oligation: to sell a certain amount of yen: say W1##:###:###: forBritish pounds to the seller of the option at the maturity of the contract. The sale takes place

at the strike price of pounds per 1## yen: say ?#.)494 X W1##. (f the spot e!change rate of

pounds per 1## yen at the e!ercise date in the future is less than the strike price: the uyer of

the option will e!ercise the right to sell the W1##:###:### for pounds at the higher contractual

price. @hen e!ercising the option: the uyer deli-ers W1##:###:### to the seller of the

option: who must pay

&?#.)494 W 1##' W 1##:###:### C ?)49:4##

5uppose that the spot e!change rate at maturity is ?#.)###EW1## yen: which is less than the

strike price. Then: the uyer of the option can purchase W1##:###:### in the spot foreign

e!change market for ?)##:### and sell the yen to the person who wrote the put contract. By

e!ercising the option: the uyer of the yen put generates pound re-enue e,ual to the

difference etween the e!ercise price of ?#.)494EW1## and the current spot price of

?#.)###EW1## multiplied y W1##:###:###7

Y&?#.)494 E W 1##' 8 &?#.)### E W 1##'Z W 1##:###:### C ?49:4##

otice: also: that the right to sell W1##:###:### for British pounds at the e!change rate of

?#.)494 E W1## is e,ui-alent to the right to uy ?)49:4## with yen at the e!change rate of

W 1##:###:### E ?)49:4## C 1 E &?#.)494 E W 1##' C W 1*3.99 E ?

This latter option is a British pound call option against the apanese yen.

;.) Currency sap

).3.1 %urrency swaps are appropriate for hedging e"change rate risk o'er a longer periodof timethan currency futures or currency options.

).3.2 6 currency sap is an interest rate sap where the det positions of the

counterparties and the associated interest payments are in different currencies.

).3.3 6 currency swap (egins ith an e"change of principal: although this may (e a

notional e"change rather than a physical e"change.

).3.4 /uring the life of the swap agreement: the counterparties undertaketo ser-ice each

othersG foreign currency interest payments. 6t the end of the swap: the initial

e!change of principal is re-ersed.

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"ample 8 0 Currency sap

%onsider a => company V with a susidiary in "rance which owns -ineyards. 6ssume aspot rate of ?1 C 1.) uros. 5uppose the parent company V wishes to raise a loan of 1.)

million uros for the purpose of uying another "rench wine company. 6t the same time: the

"rench susidiary wishes to raise ?1 million to pay new up+to+date capital e,uipment

imported from the =>. The => parent company V could orrow the ?1 million sterling and

the "rench susidiary could orrow the 1.) million uros: each effecti-ely orrowing on

the otherGs ehalf. They would then swap currencies.

=> "rance

%ompany V 5usidiary 4

Borrow Borrow

?1 million L1.) million

Bank Bank

?1 million

L1.) million

/uestion 3 0 9e(t finance, (ond 'aluation and foreign currency risk management

Three years ago BoluKe %o uilt a factory in its home country costing D3.2 million. To

finance the construction of the factory: BoluKe %o issued peso+denominated onds in a

foreign country whose currency is the peso. (nterest rates at the time in the foreign country

were historically low. The foreign ond issue raised 1) million pesos and the e!change rate

at the time was *.## pesosED.

ach foreign ond has a par -alue of *## pesos and pays interest in pesos at the end of eachyear of ).1F. The onds will e redeemed in fi-e yearsG time at par. The current cost of det

of peso+denominated onds of similar risk is 0F.

(n addition to domestic sales: BoluKe %o e!ports goods to the foreign country and recei-es

payment for e!port sales in pesos. 6ppro!imately 4#F of production is e!ported to the

foreign country.

The spot e!change rate is ).## pesosED and the 12+month forward e!change rate is ).#0

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pesosED. BoluKe %o can orrow money on a short+term asis at 4F per year in its home

currency and it can deposit money at *F per year in the foreign country where the foreign

onds were issued. Ta!ation may e ignored in all calculation parts of this ,uestion.

Re*uired2

&a' Briefly e!plain the reasons why a company may choose to finance a new in-estment

y an issue of det finance. &0 marks'

&' %alculate the current total market -alue &in pesos' of the foreign onds used to finance

the uilding of the new factory. &4 marks'

&c' 6ssume that BoluKe %o has no surplus cash at the present time7

&i' !plain and illustrate how a money market hedge could protect BoluKe %o

against e!change rate risk in relation to the dollar cost of the interest payment to

e made in one yearGs time on its foreign onds. &4 marks'

&ii' %ompare the relati-e costs of a money market hedge and a forward market

hedge. &2 marks'

&d' /escrie other methods: including deri-ati-es: that BoluKe %o could use to hedge

against e!change rate risk. & marks'

&Total 2* marks'

=. Interest rate risk

0.1 (nterest rate risk is faced y companies with floating and fi!ed rate det. (t can arise

from gap e"posure and (asis risk.

0.2 @apinterest rate e"posure ( ) The degree to which a firm is e!posed to interest rate risk can e identified y

using the method of gap analysis.


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@ith a positi'e gap: the company will lose out if interest rates fall y

maturity.

0.3 &asis risk( ) The asis is the difference (eteen the futures price and the spot price .

&asis A Futures 0 !pot

ormally: the futures do not completely eliminate interest rate e"posure

and the remaining e"posure is knon as (asis risk.

8. Causes of Interest Rate Fluctuations

8.1 Term structure of interest rates

.1.1 6 key factor here could e the duration of the de(t issues: linked to the term

structure of interest rates. ormally: the longer the time to maturityof a det: the

higher ill (e the interest rateand the cost of det.

8.% ?ield cur'es

.2.1 The yield cur-e is an analysis of the relationship etween the yields on det with

different periods to maturity.

.2.2 6 yield cur-e can ha'e any shape: and can fluctuate up and down for different

maturities.

.2.3 There are three main types of yield cur-e shapes7 normal: in-erted and flat &humped'7

:ormal yield cur'e8 longer maturity (ondsha-e a higher yieldcompared

ith shorter+term (ondsdue to the risks associated with time.

In'erted yield cur'e 8 the short+term yields are higher than the longer+term yields: which can e a sign of upcoming recession.

Flat 4or humped5 yield cur'e 8 the shorter+ and longer+term yields are

'ery close to each other: which is also a predictor of an economic transition.

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8.) Factors affecting the shape of the yield cur'e

.3.1 Li*uidity preference theory7

(t suggests that in'estors re*uire compensation for deferring consumption:

i.e. for not ha-ing access to their cash in the current period: and so pro'iders

of de(t finance re*uire higher compensation for lending for longer

periods.

The premium for lending for longer periods also reflects the way that

default risk increases ith time.

.3.2 "pectation theory7

(t suggests that the shape of the yield cur-e depends on e"pectations as to

future interest rates.

(f the e"pectation is that future interest rates will e higher than current

interest rates: the yield cur-e will slope upards.

(f the e!pectation is that future interest rates ill (e loerthan at present:the yield cur-e will slope donards.

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.3.3 Market segmentation theory7

(t suggests that future interest rates depend on conditions in different de(t

markets. "or e!ample: the short+term market: the medium+term market and

the long+term market.

The shape of the yield cur-e therefore depends on the supply of, and

demand for, funds in the market segments.

The result is separate yield cur-es that proaly do not meet 'ery smoothly.

This introduces a SkinkG to the yield cur-e presumaly determined y aritrage

etween the different markets to gain risk+free return.

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/uestion 7 0 9ifferent (onds ith different cost of de(t

/iscuss the reasons why different onds of the same company might ha-e different costs of

det. &) marks'

8.3 !ignificance of ?ield Cur'es to Financial Managers

.4.1 "inancial managers should inspect the current shape of the yield cur'e when

deciding on the term of (orroings or deposits: since the cur-e encapsulates the

marketBs e"pectations of future mo'ements in interest rates.

. edging Techni*ues for Interest Rate Risk

.1 Matching and smoothing

9.1.1 Matchingis where lia(ilities and assets ith a common interest rate are matched:

e.g. ank with fi!ed rate income prefer fi!ed rate finance.

9.1.2 !moothingis where a company keeps a (alance(eteenits fi"ed rate and floating

rate (orroing. (n other words: alancing the F of det that is fi!ed and floating.

"ample

!u(sidiary


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"ample 1D

6 companyGs financial proKections show an e!pected cash deficit in two months; time of D

million: which will last for appro!imately three months. (t is now 1 o-emer 2#1#. Thetreasurer is concerned that interest rates may rise efore 1 anuary 2#11. Protection is

re,uired for two months.

The treasurer can lock into an interest rate today: for a future loan. The company takes out a

loan as normal: i.e. the rate it pays is the going market rate at the date the loan is taken out. (t

will then recei-e or pay compensation under the separate "R6 to return to the locked+in rate.

6 2+* "R6 at *.## 8 4.0# is agreed.

This means that7

The agreement starts in 2 months time and ends in * months; time.

The "R6 is ,uoted as simple annual interest rates for orrowing and lending: e.g. *.## 8

4.0#.

The orrowing rate is always the highest.

Re*uired2

%alculate the interest payale if in two monthsG time the market rate is7

&a' 0F

&' 4F.

!olution2

199


30/37

The "R67 0F 4F

(nterest payale7 m 0F 3E12 &14#:###'m 4F 3E12 :###'

%ompensation recei-ale 4#:###

Payale &2#:###'

ocked into the effecti-e interest rate of *F &1##:###' &1##:###'

(n this case the company is protected from a rise in interest rates ut is not ale to enefit

from a fall in interest rates 8 it is locked into a rate of *F 8 an "R6 hedges the company

against oth an ad-erse mo-ement and a fa-ourale mo-ement.

:ote2

The "R6 is a totally separate contractual agreement from the loan itself and could e

arranged with a completely different ank.

They can e tailor+made to the companyGs precise re,uirements.

nales you to hedge for a period of one month up to two years.

=sually on amounts X ?1 million. The daily turno-er in "R6s now e!ceeds ?4 illion.

.) Interest rate futures

9.3.1 Interest rate futures can e used to hedge against interest rate changes etween the

current date and the date at which the interest rate on the lending or orrowing is set.

9.3.2 &orroers sell futuresto hedge against interest rate rises: lenders (uy futuresto

hedge against interest rate falls.

"ample 11 0 Interest Rate Futures

Interest rate futures can e used to hedge against interest rate changes etween the current

date and the date at which the interest rate on the lending or orrowing is set. &orroers sell

futuresto hedge against interest rate rises: lenders (uy futuresto hedge against interest

rate falls.

(nterest rate futures are notional fi"ed+term deposits: usually for three+month periods

starting at a specific time in the future. The (uyerof one contract is (uying the 4theoretical5

right to deposit moneyat a particular rate of interest for three months.

2##


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(nterest rate futures are ,uoted on an inde! asis rather than on the asis of the interest rate

itself. The price is defined as7

P C 1## 8 i@here P C price inde!Q

i C the future interest rate in percentage terms

Nn 29 o-emer 2##4 the settlement price for a une three+month sterling future was

9*.2: which implies an interest rate of 1## 8 9*.2 C 4.02 per cent for the period une

to 5eptemer.

The 5eptemer ,uote would imply an interest rate of 1## 8 9*.33 C 4.)0 per cent for the

three months 5eptemer to /ecemer 2##*.

The 4.02 per cent rate for three+month money starting from une 2##* is the annual rate

of interest e-en though the deal is for a deposit of only one+,uarter of a year.

(f traders in this market one week later: on ) /ecemer 2##4: pushed up the interest

rates for three+month deposits starting in une 2##* to: say: *.# per cent then the price of

the future would fall to 9*.##.

"ample 1% 0 edging three+month deposits

The treasurer of a company anticipates the receipt of ?1##m in /ecemer 2##*: almost

13 months hence

The money will e needed for production purposes in the spring of 2##) ut for thethree months following late /ecemer it can e placed on deposit

The 5terling 3m /ec. future shows a price of 9*.33: indicating an interest rate of 4.)0:

that is 1## 8 9*.33 C 4.)0

To achie-e certainty in /ecemer 2##* the treasurer uys: in o-emer 2##4:

/ecemer 2##* e!piry three+month sterling interest rate futures at a price of 9*.33

5he has to uy 2## to hedge the ?1##m inflow

5uppose in /ecemer 2##* that three+month interest rates ha-e fallen to 4 per cent

?

2#1


32/37

Return at 4.)0 per cent &?1##m #.#4)0 3E12' 1:1)0:*##

Return at 4.## per cent &?1##m #.#4# 3E12' 1:###:###

oss &1)0:*##'

Futures profit

The 2## futures contracts were ought at 9*.33

The futures in /ecemer ha-e a -alue of 1## 8 4 C 9).##

The treasurer in /ecemer can close the futures position y selling the futures for 9).##

Therefore the gain that is made amounts to 9).## 8 9*.33 C #.)0

6 tick is the minimum price mo-ement on a future

6 tick is a mo-ement of #.#1 per cent on a trading unit of ?*##:###

Nne+hundredth of 1 per cent of ?*##:### is e,ual to ?*#

?*#E4 C ?12.*# is the -alue of a tick mo-ement in a three+month sterling interest rate

futures contract

@e ha-e a gain of )0 ticks with an o-erall -alue of )0 ?12.*# C ?30.* per contract:

or ?1)0:*## for 2## contracts

"ample 1) 0 edging a loan

(n o-emer 2#1# olwell plc plans to orrow ?*m for three months eginning in une

2#11

olwell hedges y selling ten three+month sterling interest rate futures contracts with

une e!piry

The price of each futures contract is 9*.2: so olwell has locked into an annual interest

rate of 4.02 per cent or 1.1 per cent for three months

The cost of orrowing is therefore7 ?*m #.#11 C ?*9:###

5uppose that interest rates rise to annual rates of ) per cent: or 1.* per cent per ,uarter

?*m #.#1* C ?0*:###

owe-er: olwell is ale to uy ten futures contracts to close the position on the

e!change

ach contract has fallen in -alue from 9*.2 to 94.## &1## 8 )'Q this is 12 ticks. Bought

at 94.##: sold at 9*.27

12 ticks ?12.*# 1# contracts C ?1):###

.3 Interest rate options

9.4.1 6n interest rate optiongrants the (uyer of it the right : ut not the o(ligation: to

deal at an agreed interest rate&strike rate' at a future maturity date. Nn the date of

2#2


33/37

e!piry of the option: the uyer must decide whether or not to e!ercise the right.

9.4.2 %learly: a (uyerof an option to (orrowill not ish to e"erciseit if the market

interest rate is now (elothat specified in the option agreement. %on-ersely: an

option to lendwill

not (e orth e"ercising if

market rates ha'e risen a(o'e the

rate specified in the optiony the time the option has e!pired.

"ample 13 0 Interest rate option

uma has =5D2# million of orrowings at a floating rate: =5D ase rate [ #.0*F: with a

three month rollo-er. The treasurer is considering hedging the interest rate for the period

starting on the ne!t rollo-er date and has een offered a cap at 1#F interest for a premium

cost of 1F per annum payale ,uarterly in arrears.

The effecti-e interest rate paid for the ,uarter if uma uys the cap under each of the

following scenarios is7

5cenario 1 5cenario 2 5cenario 3 5cenario 4

F F F F

=5D ase rate ).*# .2* 1#.## 12.##

Bank margin #.0* #.0* #.0* #.0*

umaGs rate paid if no hedge 0.2* 9.## 1#.0* 12.0*

=se of 1#F option &cap'7

!ercise optionA

&es if rate X 1#F' o o es es


F F F F

(nterest rate paid &pa' 0.2* 9.## 1#.0* 1#.0*

Nption cost &pa' 1.## 1.## 1.## 1.##

Total effecti-e rate .2* 1#.## 11.0* 11.0*

The option effecti-ely caps uma;s orrowing cost at a ma!imum of 11.0*F: ut allows the

company to take ad-antage of any fall in interest rates.

.7 Interest rate caps ()9.*.1 6n interest rate capis a contract that gi'es the purchaser the righteffecti-ely to set

a ma"imum le'elfor interest rates payale. Compensationis paid to the purchaser

2#3


34/37


35/37


F F F F

(nterest rate paid &pa' .0* 9.## 1#.0* 1#.0*

et collar cost paid &pa' #.2* #.2* #.2* #.2*Total effecti-e rate 9.## 9.2* 11.## 11.##

The collar (eteen E and 11E effecti'ely fi"esuma;s orrowing cost.

.8 Interest rate saps ( )

9..1 (nterest rate swaps are where two parties agree to e"change interest rate payments.

There is no e"change of principal.

9..2 5wap can e used to hedge against an ad'erse mo'ementin interest rates.

"ample 1; 0 Interest rate sap

%at plc and /og plc: oth want to orrow ?1*#m for eight years

%at would like to orrow on a fi!ed+rate asis

/og prefers to orrow at floating rates

"i!ed "loating

%at can orrow at 1#F (BNR [2F


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Cat

Pays (BNR [2F

Recei-es (BNR [2F

Pays "i!ed 9.*F

et payment "i!ed 9.*F

9og

Pays "i!ed F

Recei-es "i!ed 9.*FPays (BNR [2F

et payment (BNR [#.*F

There is a sa-ing of *# asis point or ?0*#:### per year.

2#)


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Ch18-FinancialRisks

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