STFMChapter 17 ECM Chapter 14 Managing Financial Risk

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STFMChapter 17ECM Chapter 14Managing Financial
Risk
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Learning Objectives

• Understand the basic difference between hedging
  and speculating
• Discern between two types of hedging strategies
  using futures, options, swaps, and products such
  as interest rate ceiling, floor, and collars
• Develop appropriate interest rate hedging
  strategies

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Financial Risk Management

• Identification
• Measurement
• Hedging
• Monitoring

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Financial Risk

• Financial leverage
• Changes in
• interest rates
• foreign exchange rates
• commodities prices

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Risk Profile

• Attitude towards risk for each potential
  exposure.
• Risk-return tradeoff.
• Basis for financial risk management.

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Objectives of Financial Risk Management

• Determine Risk Profile
• Value at Risk(VAR)
• Set Basic Goals
• Identify and Measure the Level of Risk Exposure
• Manage Exposure
• Monitor Exposure

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Hedging vs. Speculating

• A hedger has a cash position or an anticipated
  cash position that he or she is trying to protect
  from adverse interest rate movements
• A speculator has no operating cash flow position
  to protect and is trying to profit solely from
  interest rate movements

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Some Important Terms

• Hedger
• Speculator
• Arbitrage
• Perfect vs imperfect hedge
• Pure vs anticipatory hedge
• Partial and cross hedge
• Long (buy) and short (sell) hedge
• Mark to market

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Hedger
Entity that uses financial instruments to reduce
the price risks associated with his basic
business activities. By assuming a position in
the futures market that is equal and opposite to
the position in the cash market, the hedger
established a situation where losses in the cash
market are offset by gains in the futures
market and vice versa.
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Speculator
An entity who takes a position in the financial
market that is not offset by an opposite
position in a basic line of business. A
speculator bets on the direction of the market
and is willing to assume risk.
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Arbitrage
Process by which buying in one market and selling
in another Leads to a riskless profit.
Arbitragers do not assume risk, but profit from
market inefficiencies.
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Perfect vs Imperfect Hedge
A perfect hedge is one where the individual is
able to eliminate all risk of price fluctuations.
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Pure vs Anticipatory Hedge
A pure hedge is one where the individual assumes
a position in the futures market equal and
opposite to the current position in the cash
market (such as hedging a riding the yield curve
position). An anticipatory hedge is taking a
position that is a temporary substitute for an
anticipated position in the cash market.
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Partial and Cross Hedge
A partial hedge is where the person takes a
position in the futures market that is smaller
than the cash position. A cross hedge is where
the manager uses a different hedging instrument
(futures instrument) than the hedged cash
instrument.
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Long (buy) and Short (sell) Hedge
A long hedge is where the firm BUYS a futures
contract. A short hedge is where the firm SELLS
a futures contract. A long hedge is appropriate
when the firm will buy an asset in the future or
sell a liability prior to maturity. A short
hedge is appropriate when the firm issues a
liability in the future or sells a current cash
position in the future.
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Mark to Market
Everyday the gain or loss on a futures position
causes your margin account to be adjusted, gains
or credited to your account and losses or
debited.
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Forwards

• A contractual obligation to deliver the
  underlying asset at a specific future date at a
  predetermined price.
• Advantage-can be custom-tailored to the needs of
  the company.
• Disadvantage-cost of negotiating contracts.
• Delivery of the underlying asset takes place at
  maturity.

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Futures

• Similar to forward contracts
• Contracts are standardized
• Traded on organized exchanges
• Requires margin accounts
• Contracts are marked to market
• Margin calls are made when value of contract
  falls below a specified level
• Normally contracts are closed out prior to
  maturity.

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Buy vs. Sell Hedge

• Type of hedge should depend on the nature of the
  cash flow position being hedged, not on the
  anticipated direction of interest rates.
• Buy Hedge A future investment or retiring a
  liability prior to maturity
• Sell Hedge Issue a liability in the future or
  sell an investment prior to its maturity

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Why Hedges Are Not Perfect

• Futures contract in general have only four
  expiration dates per year. (Note T-bills Mar,
  June, Sept, and Dec.
• Correlation coefficient of spot rates and futures
  rates is less than 1.0

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Options

• A contract which gives the purchaser the right,
  but not the obligation, to buy or sell an
  underlying asset at a specified price (strike
  price) during, or at the end of a future time
  period.
• Call options give the holder the right to buy.
• Put options give the holder the right to sell.

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Options (continued)

• Options provide protection from adverse price
  movements.
• Options provide potential for unlimited gains.
• No obligation to deliver or take delivery of the
• underlying asset.

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Interest Rate Swaps

• An agreement between two parties to exchange an
  underlying asset (or the stream of cash flows)
  for a specific period of time.
• Based on notional amounts.
• Financial intermediaries act as counter parties
  or swap dealers.

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Types of Swap Arrangements

• Interest Rate Swaps
• Currency Swaps
• Commodity Swaps

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Interest Rate Swaps
Interest rate swaps were created to take
advantage of arbitrage opportunities in the
various fixed- and floating-rate capital
markets. Arbitrage opportunities exist because
some markets react to change more rapidly than
others, because credit perceptions differ from
market to market, and because receptivity to
specific debt structures differs from market
to market. If, for instance, a corporation wants
term floating-rate funds but finds that the
market for its fixed-rate debt is com- paratively
cheaper than that for its floating-rate debt,
then it can issue a fixed-rate bond and swap it
into floating, for an all-in cost lower than
that for a floating-rate bond or loan. source
The Government Securities Pink Book
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A Swap Diagram (Fixed-for-Floating Liability Swap)
Floating Rate
Borrower
Counterparty
5.5
5.5
Floating Rate Bonds
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Liability Swap

• k swap fr so - si feefr financing
  rateso swap outflowsi swap inflowfee
  intermediary fee

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Other Hedging Instruments

• Interest rate caps
• Purchaser pays a premium and receives cash
  payments from the cap seller when the reference
  rate exceeds strike rate.
• Interest rate floors
• Purchaser pays a premium for the rate floor
  contract, receives cash payment when reference
  rate falls below strike rate.
• Interest rate collars
• Purchase a rate cap and sell or issue a rate
  floor. Pay a premium for the cap and receive a
  premium for the floor.
  
• 
  

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Types of Foreign Exchange Exposure

• Transaction Exposure
• Translation Exposure
• Economic Exposure

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Foreign Exchange Markets

• Spot Market and the Spot Foreign Exchange Rate
• Forward Market and the Forward Exchange Rate
• Forward Exchange Rate and Interest Rate Parity

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Type of FX Contracts

• Forwards
• Futures
• Currency Swaps
• Options