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Chapter 9: Financial Risk ManagementOutline: Overview of Risk Management in Treasury Derivative Instruments Used as Financial Risk
Management Tools FX Risk Management in Treasury FX Exposure Currency Derivatives Used to Hedge FX Exposure Interest Rate Exposure and Risk Management Commodity Price Exposure Other Issues Related to Financial Risk Management
Answer:The treasury department is a clearinghouse for daily functional information. Treasury professionals are asked to: Supply information to assist in analysis
to determine an organization’s riskappetite and profile.
Derivative Instruments Used as Financial Risk Management Tools Derivative instrument
is a financial product that acquires its value by inference through a formulaic connection to another asset (such as another financial instrument, currency or commodity).
Primary uses: Managing FX Managing interest
rates
Use of derivatives may have immediate favorable/unfavorable impact on cash flow.
Four basic types of derivative instruments: Forwards Futures Swaps Options
A customized agreement between two parties to buy or sell a fixed amount of an asset at a future date at a price agreed upon today
Futures Contracts
Similar to forwards in intent (payoff profiles from long and short positions are the same) but differ in execution (e.g., counterparty is the exchange itself).
Size of contract and its maturity date set by exchange.
Trading requires a margin account. Futures contracts are rarely settled by actual
delivery and are usually closed out prior to maturity.
A contract where one party has the right (but not the obligation) to buy or sell a fixed amount of an underlying asset at a fixed price on or before a specified date
Discussion QuestionWhich of the following is true of options?a) American option: exercise only on delivery
dateb) European option: exercise any time
through delivery datec) Bermuda option: exercise only on
specific dates that are evenly spacedover option’s life
A call option with a $50 strike price is purchased when the underlying asset is selling for $46 per unit. The premium paid is $1. Identify if the following put options are in-, at-, or out-of-the-money.
A put option with a $50 strike price is purchased when the underlying asset is selling for $54 per unit. The premium paid is $1. Identify if the following put options are in-, at-, or out-of-the-money.
International companies with cash flows in various foreign currencies must assess the volatility of the types and levels of FX rate fluctuations for each currency.
Cash flow complexity
Global companies must manage cash flows from subsidiaries, suppliers and customers in each country in which they operate.
Tax issuesGlobal treasury operations must interpret the rules and regulations of different tax authorities.
Sample Foreign Currency Quotation Formats
Currency USD Equivalent Currency per USD
GBP-British Pound GBP/USD 1.4870 USD/GBP 0.6725
CAD-Canadian Dollar CAD/USD 0.9742 USD/CAD 1.0265
EUR-Euro EUR/USD 1.3383 USD/EUR 0.7472
JPY-Japanese Yen JPY/USD 0.010804 USD/JPY 92.56
Given USD USD/rate = FC USD x rate = FC
Given foreign currency (FC) FC x rate = USD FC/rate = USD
Implicit and explicit transaction exposures are two pieces of a single transaction. Implicit is the piece from exposure initiation to balance sheet realization; explicit is the piece from balance sheet realization through cash flow.SOURCE: PRICEWATERHOUSECOOPERS LLP, 2007
FX Rate Exposure
Types of FX exposure Economic Transaction Translation
Currency Futures ExampleU.S. importer must pay invoice for GBP125,000 in 90 days. Company purchases futures contract for GBP/USD 1.6369. Margin requirement = $2,970.
Contract settle price: GBP/USD 1.6521Change in contract value = (1.6521 – 1.6369) x 125,000 = $1,900New margin account value = $2,970 + $1,900 = $4,870
Futures contract decreases to GBP/USD 1.6472Change in contract value = (1.6472 – 1.6521) x 125,000 = –$612.50New margin account value = $4,870 – $612.50 = $4,257.50
If exchange rate rises to GBP/USD 1.7245Profit on contract = $1.7245 – $1.6369 = $0.0876 per GBP
If exchange rate drops to GBP/USD1.5681Loss on contract = $0.0688 per GBP; however, next cost still GBP/USD 1.6369
The exchange of a floating-rate cash flow denominated in one currency with a fixed-rate cash flow denominated in another currency, as well as exchange of principal
Currency Swaps ExampleU.S.-based firm wishes to borrow JPY100 million for 10 years at exchange rate of USD/JPY 90.9091.Borrows $1,100,000 (USD equivalent to JPY100 million) for 10 years at 6% fixed interest rate.Currency swap to yen-denominated funding:
Semiannual payments in yen to counterparty at fixed rate of 5.2% Counterparty makes semiannual payments in USD to firm at fixed rate of
5.4%
Every six months for 10 years, firm pays counterparty JPY2,600,000 from local yen currency.0.052 x JPY100,000,000 x (180/360)
Every six months for 10 years, counterparty pays firm $29,700.0.054 x $1,100,000 x (180/360) = $29,700
End of 10 years, investment matures, returning JPY100 million principal, which firm pays counterparty; counterparty pays firm $1,100,000.6% interest rate = semiannual payment to creditors of $33,000(0.06) x (1,100,000) x (180/360) = $33,000
Give the buyer the right to buy (call) or sell (put) a fixed amount of foreign currency at a fixed exchange rate (strike price) on or before a specific future date
Parties A and B enter into a five-year swap with a notional value of $100M. A takes fixed side (exchanging floating rate exposure for fixed rate), B takes floating side (vice versa). A pays fixed rate (5.5%) to B, and B pays floating rate to A (LIBOR+3.5%). At the end of each year: Party A will owe Party B $100M x 5.5%. Party B will owe Party A $100M x (LIBOR + 3.5%).
In practice, there is a netting procedure and only the difference is settled. If LIBOR is < 2%, then A pays B, and if LIBOR > 2%, then B pays A. For example:
If LIBOR is 1.25%, then Party A pays Party B as follows:[0.0550 – (0.0125 + 0.0350)] x $100M = $750,000
If LIBOR is 2.50%, then Party B pays Party A as follows:[(0.0250 + 0.0350) – 0.0550] x $100M = $500,000