Risk and Derivatives etc.
Dr Bryan Mills
Traditional (internal) methods of risk
management
• External:
– banks, etc e.g. hedge, options, forward contracts
• Internal:
– invoice decision, lead/lag, netting, matching, asset/liability
management
• Netting:
– cover only the net exposure by hedge. If you have many subsidiaries
in different countries it is only the net risk/exposure that need be
considered.
• Matching:
– try to match invoice currencies with receipts (by careful supplier
selection).
Lead Payment Option
• Definition to learn:
• Leading and lagging is a currency risk
management technique in which the timings
of payments in foreign currencies are
adjusted.
• Lead
• Lag
–
–
pay before due
pay after due
Pay in Sterling Option
• This depends on the other company’s
willingness to take the risk!
Example
Payment to us of 5,000,000 Euros due in 3 months: Euros/£
Spot
11.121 – 11.150
3 month forward 10.948 – 10.976
Discount
Borrow Lend
Euro
11%
9%
Sterling 15.5%
12%
5,000,000 currently worth
5m/11.121 = £449,600
Hedge Option
Note that the forward rate suggests an appreciation of the Euro is likely
Pay in Sterling Option
Buy Ff 5,000,000 forward
£456,704
5m/ 10.948
=
the forward
This depends on the French company’s As
willingness
to price is greater than the spot it looks like
we may as well pay now. However, we should first
take the risk.
consider the interest cost of this approach.
£449, 600 * (1 + [(0.155 * 3 mnth)/12 mnth]) = £467, 020
this is more than Forward - not such a good idea!
Currency Overdrafts / Money Market
Hedging
1. Borrow money you expect to be paid now in
that currency. Convert this into sterling.
2. When the payments are due use this to settle
the foreign overdraft/loan.
3. You get your money at today's spot - no risk but Going
remember
to
factor
in
interest
payments.
to get $10,000 in +5 years
If r* = 10% then borrowing $6,209.2 now would cost ($10,000)/ (1 + 0.1)5
Our payment in 5 years time will pay off the loan but we get $6,209.2 NOW
We can forget about the US debt, spend the money and suffer no risk.
Checklist of Instruments to avoid risk
Interest
• Futures
• Forward Rate Agreement
(FRA)
• Options
• Swaps
• Swaptions
Currency
• Internal (lead/lag/net/etc)
• Forward contracts
• Futures
• Options
• Swaps
Futures Contracts
• Futures
contracts
are for a fixed amount and a fixed
Options
Contract
maturity date. It is tradable and so the value of the
‘right to buy or sell’ in itself goes up and down.
As with futures but this time you pay an
upfront
premium
andcontract
have thenot
right
but
• You
enter into
a futures
to guarantee
a
Options
Futures
rate
compensate
youversus
if the rate
goes against
notbut
thetoobligation
to buy/sell
you.
Futures are cheaper but cruder!
• If the rate is favourable you pay out most of your gain.
Futures protect against loss.
• You don’t win – it’sOptions
just thatprotect
you don’t
lose!loss and
against
allow gain
Example
Will get $486,500 in 3 months
Futures at $1.39 guarantees £350,000
Option (call) with same value at a premium of £500
per £25,000
Need
£350,000 = 14
£25,000
(14 x £500 = £7,000)
If sterling weakened to $1.20/£
the future is locked but the option
can be lapsed.
• Alternatively, a ‘deeper out of pocket’ option
of $1.50/£ could be bought for £100.
• In other words, there are various scenarios to
plan.
• The main advantage of options is the ability to
walk away losing only the premium.
Types of Options Available
Interest rate options:
Strike
Price
106
107
108
Call
Put
June
1.51
1.19
0.58
September
2.38
2.11
1.51
June
1.25
1.57
2.32
September
3.06
3.43
4.19
As with futures, tick values = 0.01%
Contracts are £100,000: Tick value is £100,000 x 0.01 = £10
If asked for the price of a June call contract at 106 then:
1.51 x £100,000 = £1,510 (this is the price)
If you bought this you could later buy a 7% UK gilt in June at a ‘price’ of £106 per
£100. In other words 7/106 x 100 = 6.6%
Put Option
Intrinsic value
Profit
Spot
increasing
Premium
Loss
Option
exchange value
(strike)
option is
above spot so
makes profit
• Short term Interest Rate Options
• These are 3 months and basically are the same as
longs, but with lower prices.
• OTC Interest Rate Options
• Again OTC are tailored and available from banks.
• Definition to learn:
• A short term OTC interest rate option contract (i.e. for
a period of up to one year) is called an interest rate
guarantee (IG).
Longer terms are:
•
•
•
•
Cap: option to limit a price to a given max
Floor: option to limit a price to a given max
Collar: a cap and a floor
Caption: option to buy a cap
Today is June 30th
Answer
KYT USA has to pay
a bill in Yen in 2 months time (1st September).
st as
a)
You
need
a
contract
as
near
to
September
1
The amount is yen 200m
possible
andgradually
Yen200m/12.5m
The risk therefore
reduces
over the (amount/contract
contract period size)
st not
th.
suggests
canthe
get30
cover
by buying 16
- but we
want
money
onthat
the
1you
Today's
spot
is Yen/$128.15
(0.007803)
contracts
(payment
are
in same
currency
If told contracts
that the spot
theand
1st contract
is actually
120yen/$
been– no
Futures
existonthat
are
per
12,500,000
yen and
conversion
required)
asked, with hindsight,
to work
out whether the forward
contract
was apremium
good idea.
Sept.
0.007985
(125.23)
b) Basis risk is simply(121.21)
the differences between
Dec 0.008250 premium
and
= 2.92 of months the
If we divide theforward
basis risk
byspot
the number
contract
runs for
a linear
month
by month
price:
(for
your dollar
youwe
areget
going
to get
less yen
- the dollar
is
depreciating) c) When F expires F should equal St
2.92/3 = 0.973
And these contracts are settled at the end of the month
Let’s look at what’s happening:
1. Select month closest to required date
2. Calculate number of contracts required:
Investment amount
Contract size
3.
4.
5.
6.
7.
Calculate basis:
Spot price – futures price = basis
Calculate out basis at date contract is closed out:
Basis *
Months left
Total futures months
Determine expected price of future at point t
Spot – Basis at t = Futures Price
Margin is then the difference between this and original price
Determine futures gain (loss)
Margin * contracts * contract size
Calculate efficiency of hedge
Profit on futures contract
Loss on spot
Spot 120
Future 119.58
Future 126.84
¥120 – ¥0.42 = ¥119.58
¥1.26 *
Basis 1.26
Spot 128.10
Assume today is June 30th. An amount of money is owed by an
American company trading in dollars to a Japanese company
trading in Yen. The money (¥100m) is due on the 1st of
September. Current spot price is $/¥128.10 ($0.007806).
Future Contracts exist per ¥12,500,000 settled on 30th.
Sept. 0.007884 premium (¥126.84)
Dec. 0.008334 premium (¥199.99)
Spot price on September 1st is ¥120
¥128.10 – ¥126.84 = ¥1.26
30th June
1 = ¥0.42
3
Basis 0.42
30th July
30th August
30th September