Risk Management Flashcards
(28 cards)
Foreign Currency Exposure
What is Foreign Currency Exposure? (2)
What is another term for Foreign Currency Exposure? (2)
What does Foreign Currency Exposure indicate?
At what levels does Foreign Currency Exposure generally impact? (3)
What is Foreign Currency Exposure?
- It refers to the risks associated with the volatility of exchange rates, interest rates, and commodity prices.
- This volatility is further compounded by the increasing internationalization of firms, requiring evaluation of financial price risks.
What is another term for Foreign Currency Exposure?
- Foreign Currency Exposure is also known as Exchange Rate Exposure.
- These risks stem from changes in the relative valuation of currencies.
What does Foreign Currency Exposure indicate?
- It highlights the possibility that currency depreciation may negatively affect an organization’s assets, investments, and related payment streams, especially for foreign currency-denominated securities.
At what levels does Foreign Currency Exposure generally impact?
It is generally perceived to impact at three levels:
- Economic
- Translation
- Transactional
Economic, Translation and Transaction Exposures: Summary
What is Economic Exposure?
What is Translation Exposure?
What is Transaction Exposure?
What is Economic Exposure?
- Economic Exposure involves understanding the type of goods a company is selling and the degree of its internationalisation.
What is Translation Exposure?
- Translation Exposure is an accounting “on-paper-only” exposure that does not involve actual cash losses or gains.
What is Transaction Exposure?
- Transaction Exposure is a day-to-day operational level exposure that can be managed through various strategies.
Foreign Currency Exposure: Transaction Exposures
What is Transaction Exposure and transactional risk?
What is the risk associated with Transaction Exposure?
What assumption is made regarding currency regime?
What is this type of exposure usually associated with?
When do Transaction Exposures occur?
Can you provide an example of transaction exposure?
What is uncertain in transaction exposures?
Can companies have borrowings in a foreign currency?
What is Transaction Exposure and transactional risk?
- Transaction Exposure and transactional risk refer to operational, day-to-day exposure related to foreign currency commitments.
What is the risk associated with Transaction Exposure?
- The risk involves a commitment in a foreign currency, whose value fluctuates due to exchange rate movements.
What assumption is made regarding currency regime?
- It assumes a floating or simpler currency regime.
What is this type of exposure usually associated with?
- This exposure is commonly linked to imports and exports, particularly when using credit terms. A time lag occurs, for example, with 30-day credit agreements in foreign currencies.
When do Transaction Exposures occur?
- Transaction exposures occur with investments abroad in a foreign currency or at home when a seller demands payment in a specific currency.
Can you provide an example of transaction exposure?
- For example, an Australian mining company commits to purchasing a digging machine from a UK company, which invoices in sterling.
What is uncertain in transaction exposures?
- The amounts to be paid are uncertain between the time the contract is entered into and when it is fulfilled.
Can companies have borrowings in a foreign currency?
- Yes, companies can borrow in a foreign currency, leading to a consistent stream of foreign currency payments.
Derivatives: Basic Concepts
What is a derivative instrument?
What becomes an asset with its own value and is purchased or sold?
How effective are derivatives in limiting risk?
What are the negatives associated with derivatives for unsophisticated investors/users?
What is a derivative instrument?
- A derivative instrument is an asset whose performance is based on (or derived from) the behavior of the value of an underlying asset (commonly referred to as the “underlying”).
What becomes an asset with its own value and is purchased or sold?
- It is the legal right that becomes an asset, with its own value, and it is this right that is purchased or sold.
How effective are derivatives in limiting risk?
- They are powerful tools and, when used properly, can be remarkably effective at limiting risk.
What are the risks associated with derivatives for unsophisticated investors/users?
- For unsophisticated investors/users, derivatives can be highly risky. There are even cases of sophisticated companies losing significant sums.
Derivatives: Options and Simple Example
What does the example illustrate regarding options and land prices? (3)
What decisions does the company need to make regarding the options? (3)
What is the focus regarding the value of options?
What does the example illustrate regarding options and land prices?
- The example demonstrates how land prices and site valuations can vary greatly over time.
- Two sites may only be worth £500,000 each after planning permission.
- One site in a retail area with significant expansion could be valued at £1,500,000 if purchased.
What decisions does the company need to make regarding the options?
- The company may decide to exercise the option to purchase.
- Options on other plots could be allowed to lapse.
- Options may also be traded.
What is the focus regarding the value of options?
- The focus is on determining the value of the options, including their intrinsic value.
Share Options: Call Options
What does a share call option give the holder?
Who is referred to as the writer in options trading?
What are the types of options mentioned?
What other market exists for banks and other option writers?
What does a share call option give the holder?
- A right, but not an obligation, to buy a fixed number of shares at a specified price at some time in the future.
Who is referred to as the writer in options trading?
- The seller of the option, who receives the premium.
What are the types of options mentioned?
- American-style options: Can be exercised at any time up to a specified date.
- European-style options: Can only be exercised on a specified date.
What other market exists for banks and other option writers?
- An OTC (Over-The-Counter) market.
BUY LOW, SELL HIGH
Definitions
Exercise price (strike price)
In-the-money option (3)
Out-of-the-money option (3)
At-the-money option
Exercise price (strike price):
- The price at which the holder of an option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
In-the-money option:
- An option that would lead to a positive cash flow if exercised immediately.
- For a call option: The underlying asset’s price is above the strike price.
- For a put option: The underlying asset’s price is below the strike price.
Out-of-the-money option:
- An option that would lead to a negative cash flow if exercised immediately.
- For a call option: The underlying asset’s price is below the strike price.
- For a put option: The underlying asset’s price is above the strike price.
At-the-money option:
- An option where the underlying asset’s price is equal to the strike price.
Call Option: Worked Example
What is shown in the example about call options?
What is the cost of a call option for an exercise price of 2600p per share for September?
What is the cost of the same call option for December?
What does the difference in premiums represent? (2)
What is an out-of-the-money option?
What is an in-the-money option?
What is an at-the-money option?
What is shown in the example about call options?
- Call option prices vary based on the exercise price and expiration date.
What is the cost of a call option for an exercise price of 2600p per share for September?
- Assume on August 1st you wanted to have the right to buy 1,000 shares at an exercise price (strike price) of 2600p per share in September (1 month) then you would have to pay a premium to the writer of £135 (13.5p per share x 1000 shares).
What is the cost of the same call option for December?
- If you wanted a longer option until December (4 months) at that exercise price then you would have to pay a premium to the writer of £365 (36.5p per share x 1000 shares).
What does the difference in premiums represent?
- An additional time value of £230 (£365 - £135).
- Volatility
What is an out-of-the-money option?
- Purchasing a call option with an exercise price of 2600p when the share price is currently 2567p. It has no intrinsic value. (WORTHLESS OR LAPSE)
What is an in-the-money option?
- Purchasing a call option with an exercise price of 2500p when the share price is currently 2567p. It has an intrinsic value of 67p per share and higher premiums. (EXERCISE)
What is an at-the-money option?
- Would be an option where the exercise price equals the current share price of 2567p (not shown in the example). (BREAKEVEN)
Premium increasing trend. High premium higher the risk.
Call Option: Worked Example (Cont.)
Let’s assume that you are an investor, and you in August have a strong confidence through your analysis of the share that the price of Unilever shares will rise from their current share price of 2567p per share to a new share price of 3000p per share (£30) in March.
If in March you could sell the shares for £30, but buy them for £25 (using your option, you’re clearly going to make some money.
The cost of this right to purchase 1,000 shares is £1,015 (101.5p x 1,000 shares).
Let’s look at three possible outcomes for this:
- You’re wrong and the share price declines.
- You’re wrong and the share price stays at-the-money
- You’re right, and the share price does rise to 3000p per share
- DO NOT EXERCISE
- BREAKEVEN
- IN THE MONEY
Call Option: Simple Buy and Hold Strategy Pay-off Outcomes
[NOTE: THIS IS NOT AN OPTION.]
Say your exercise price is 2601.5p but market price is 3000p
Will you exercise your option?
Share options: Put Options
A share put option gives the holder: (6)
How does this differ to a call option?
A share put option gives the holder:
- a right,
- but not the obligation,
- to sell
- a fixed number of shares
- at a specified price
- at some time in the future.
The mirror of a call option, the right to sell this time.
Put option benefits when share price falls
Put Option Worked Example
Picture
don’t forget the cost of the premium when finding out the net profit
Put Option Worked Example 2
Picture
benefit when share price goes down, worthless if it goes up
What do the different colours mean (2,3,3)
The green line on the graph
- shows your profit and loss for straightforward changes in the share price.
- If price rises above $310.9 > profit and below > loss.
The purple line on the graph
- shows the profit per share from your put option.
- Profitable is price is below £300.
- Maximum loss is the premium paid (£300-£291.75= £8.25)
The orange line on the graph shows
- the combination of the outcomes if you combine the two. - Hedging strategy.
- If price rises the underlying asset gains value and offset put option loss and vice versa.
Derivatives: Forward Contract
What is a forward contract? (4)
What is a long position?
What is a short position?
What are some characteristics and risks of forward contracts? (2)
Where do forward contracts mainly originate? (2)
What is a forward contract?
- A forward contract is an:
- agreement between two parties
- to undertake an exchange of commodities, currencies, or assets
- at an agreed future date
- at a price agreed now
What is a long position?
- The party buying the contract to exchange at a future date is said to be taking the long position.
What is a short position?
- The counterparty which is delivering at the future date is taking the short position.
What are some characteristics and risks of forward contracts?
- Forward contracts are tailor-made ‘Over-the-counter instruments’.
- Because they are tailor-made contracts, they can be difficult to sell on, cancel, and there is always the risk of counterparty default.
Where do forward contracts mainly originate?
- They originate mainly with farmers and farming and agreeing prices for the sale of items well in advance of the harvest.
- The “locking in” of a price is central to their usage.
maybe for riskier people
Forward rate agreements (FRAs) – Locking in Interest Rates
What are Forward Rate Agreements (FRAs)?
How are FRAs similar to Forward Contracts?
How is compensation determined in FRAs?
What are Forward Rate Agreements (FRAs)?
- FRAs are agreements between two parties about the future level of interest rates.
How are FRAs similar to Forward Contracts?
- FRAs are similar to Forward Contracts in that they involve agreements about future interest rates.
How is compensation determined in FRAs?
- The rate of interest at some point in the future is compared with the level agreed when the FRA was established, and compensation is paid by one party to the other based on the difference.
Worked Example – Borrowing using FRA’s
For example, a company needs to borrow £6m in six months’ time for a period of a year. It arranges this with bank X at a variable rate of interest. The current rate of interest is 7%.
Separate agreement with another bank (Y) – an FRA. It ‘purchases’ an FRA at an interest rate of 7 per cent to take effect six months from now and relates to a 12-month loan.
Bank Y has committed itself to paying compensation should interest rates rise above 7%.
Suppose that in six months spot one-year interest rates are 8.5%.
In reality, FRAs are generally agreed for three-month periods.
The ‘sale’ of an FRA by a company protects it against a fall in interest rates.
Scenario:
A company expects to have £10 million available in three months to place into a one-year bank deposit.
To protect against interest rate fluctuations, the company enters into an FRA contract with a bank.
The FRA Contract:
The company sells an FRA to the bank, locking in an agreed interest rate of 6.5% for the deposit.
This means that in three months, the company has effectively secured a return of 6.5%, regardless of the actual market rate at that time.
What Happens in Three Months if the actual interest rate (spot rate) in three months turns out to be 6%?
If the actual interest rate (spot rate) in three months turns out to be 6%, the company deposits the £10m at this rate.
Since the FRA was agreed at 6.5%, but the actual rate is 6%, the bank compensates the company for the difference. This ensures that the company effectively earns 6.5% overall on its deposit.
Derivatives: Futures
What concepts do futures as a derivative tool take from forward contracts?
How do futures contracts evolve from forward contracts?
Who are the counterparties in futures contracts?
What role does the clearinghouse play in futures contracts?
How is it similar to Forward Contracts and what does that mean?
What concepts do futures as a derivative tool take from forward contracts?
- It is still to undertake an exchange.
- At an agreed future date.
- At a price agreed now.
How do futures contracts evolve from forward contracts?
- They evolve the counterparties to using a standardized contract market, using what is termed exchange-based instruments.
Who are the counterparties in futures contracts?
- The counterparties are no longer between two individuals; the contract is between the clearinghouse and a counterparty.
What role does the clearinghouse play in futures contracts?
- The clearinghouse significantly reduces non-compliance and default risks in the transactions.
How is it similar to Forward Contracts and what does that mean?
- Like Forward Contracts, Futures Contracts are difficult to dissolve. Once you have bought one, you are committed to it.
- This means that your maximum exposure could be significantly larger than say, an Option, which you could allow to lapse if it was out-of-the-money by a significant amount.
A clearinghouse is an intermediary that ensures trades are settled, accounts are balanced, and financial transactions are processed smoothly. It reduces risk and improves efficiency in markets.
Worked Example: The Coffee Growers Problem
Coffee will be harvested in three months. The Coffee farmer wants some kind of assurance that the coffee will sell at a certain price.
Why Does the Farmer Want This Deal?
The coffee farmer is concerned about price uncertainty—if the price of coffee falls, they might be forced to sell at a loss.
By locking in a guaranteed price of $97.25 per ton, the farmer secures a predictable income, reducing financial risk.
Even if coffee prices rise, the farmer still receives only $97.25 per ton, but they prioritise stability over potential extra profit.
Say, a trader agrees to purchase the coffee from the farmer three months hence at an at-the-money price of $97.25 per ton.
Why would the trader do this? The trader enters this contract because they expect coffee prices to increase.
Their logic is: (2)
What is the farmer concerned about?
What does the trader agree to do to address the farmer’s concern?
What is this action called?
What happens if the trader fails to complete the deal?
The trader’s logic is
- If the market price in three months is higher than $97.25 per ton, they can still buy at the agreed price of $97.25 and then sell at the higher market price, making a profit.
- If the market price falls below $97.25, they overpay compared to the spot market and make a loss.
What is the farmer concerned about?
- The farmer is concerned that the trader could walk away from the deal.
What does the trader agree to do to address the farmer’s concern?
- The trader agrees to place $9.73 per ton into a Margin Account.
What is this action called?
- This is called the Initial Margin.
What happens if the trader fails to complete the deal?
- If the trader fails to complete the deal, the farmer will be able to withdraw the trader’s money from the Margin Account and sell the coffee on the spot market.
Worked Example: The Coffee Growers Problem
(picture)
Derivatives: Futures Markets
What does the exchange provide?
Who is the counterparty for both parties in reality?
What happens if the price shoots up very high?
What system does the clearing house operate for both parties?
What is the likely range for the initial margin?
What is done daily in the margining system?
What does the exchange provide?
- Standardized legal agreements traded in highly liquid markets.
Who is the counterparty for both parties in reality?
- The clearing house.
What happens if the price shoots up very high?
- Both parties in a futures trade have a margin account.
What system does the clearing house operate for both parties?
- A margining system.
What is the likely range for the initial margin?
- Likely to be in the region of 0.1 per cent to 15 per cent of the value of the underlying.
What is done daily in the margining system?
- Daily marking to market.
The buyer profits as the price rises, the seller profits as it falls.
Futures Hedging: Index Hedging using Equity Futures
What is the Equity Index Futures Market?
How is the FTSE 100 Share Index Future valued?
What does FTSE100 at 7200 mean? (2)
What is the Equity Index Futures Market?
- A cash settlement market where the underlying derivative is a collection of weighted shares representing a world equity index, such as FTSE, DAX, or NIKKEI.
How is the FTSE 100 Share Index Future valued?
- By convention, each point of the FTSE 100 Share Index Future is worth £10, so a rise from 7200 to 7205 would be worth £50.
What does FTSE100 at 7200 mean?
- The index represents 100 companies on the London Stock Exchange by market capitalization and has a current value of 7200 points.
- It reflects the weighted average price movements of these 100 companies.
Worked Example: Index Hedging using Equity Futures
It is the morning of 14th October 2019 and the FT 100 is at 7,198.
Markets are incredibility volatile with a range over the last year of between 6,536.53 - 7,727.49
A fund manager wishes to hedge a £100,000,000 fund which is currently holding the FTSE Market Portfolio against a decline in market.
A December FTSE 100 Index Future is available at 7171 that morning.
Each futures contract is worth £71,710 (=7,171 x £10).
To cover the entire £100m portfolio 1395 are needed (£100,000,000/71,710 = 1394.5)
The investor sells 1395 index future contracts.
Scenario: The index falls by 10% to 6478.20 (=7198*10%), leaving the portfolio value at £90m and the Manager with £10m of losses.
What is the outcome?
