Chapter 9: Financial Risk
Management
Outline:
 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
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Session 6: Module 4, Chapter 9 - 1
Basics of Financial Risk
Management


Financial risk is the risk of direct or indirect
losses resulting from uncertainties in the
future levels of interest and FX rates and
commodity prices.
Financial risk has increased significantly
recently for two reasons:
1
The speed of business through advances in
technology and communications
2
The scope of business through trends toward
globalization
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Session 6: Module 4, Chapter 9 - 2
Discussion Question
Match the following terms with the clues provided.




Value at risk
Sensitivity analysis
Scenario analysis
Monte Carlo
simulation




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What-if exercises that
alter a single variable;
can identify most
influential variables.
Developed in trading
rooms to estimate
possible losses in a day.
Computer uses a series of
probability distributions
to set multiple variables.
Changes more than one
variable at a time;
experts supply range of
values.
Session 6: Module 4, Chapter 9 - 3
Discussion Question
What is the role of the treasury area?
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 risk
appetite and profile.
 Implement an overall risk management
strategy.
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Session 6: Module 4, Chapter 9 - 4
Hedging, Speculation and Arbitrage
Hedging
Reducing or eliminating risks
associated with the uncertain future
cash flows
Assuming risk and betting on the
direction of the market and whether
Speculation
the price of an asset will go up (long)
or down (short)
Arbitrage
Assuming no risk but attempting to
profit from market inefficiencies by
buying an asset in one market and
simultaneously selling in another
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Session 6: Module 4, Chapter 9 - 5
Benefits of Financial Risk
Management



The company’s probability of
financial distress decreases
because the firm can assess
costs and revenues more
accurately.
Greater predictability in
future cash flows makes the
company more attractive to
shareholders.
The company gains an
enhanced borrowing
advantage in credit markets
because lenders view the firm
as being less risky.
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Session 6: Module 4, Chapter 9 - 6
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:



Use of derivatives may
have immediate
favorable/unfavorable
impact on cash flow.

Four basic types of
derivative instruments:




Forwards
Futures
Swaps
Options
Managing FX
Managing interest
rates
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Session 6: Module 4, Chapter 9 - 7
Forward Contracts
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





Asset involved is referred to as the underlying
asset.
Future date (maturity date of the contract).
Price is delivery price of contract.
Company buying asset is one party; the other is
called the counterparty (bank or FX dealer).
Buying party is long a forward contract;
counterparty is short a forward contract.
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Session 6: Module 4, Chapter 9 - 8
Futures Contracts
A standardized contract between two parties traded on
an organized exchange




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.
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Session 6: Module 4, Chapter 9 - 9
Swaps
An agreement between two parties to exchange (swap)
a set of cash flows at a future point in time
Types of swaps include:
 Interest rate swap—an agreement to
exchange interest payments (e.g., a fixedrate loan for a floating-rate loan)
 Currency swap—an agreement to convert an
obligation in one currency to an obligation in
another currency
 Commodity swap—an agreement to
exchange a floating price for a commodity at
a fixed price
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Session 6: Module 4, Chapter 9 - 10
Options
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





Counterparty (writer of the option) selling the
option receives a premium from the buyer.
May be exchange-traded or negotiated with a
counterparty.
Call option: Contract giving the owner the right
to buy an asset.
Put option: Contract giving the owner the right
to sell an asset.
Strike/exercise price: The fixed or contracted
price of the underlying asset.
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Session 6: Module 4, Chapter 9 - 11
Discussion Question
Which of the following is true of options?
a) American option: exercise only on delivery
date
b) European option: exercise any time through
delivery date
c) Bermuda option: exercise only on
specific dates that are evenly spaced
over option’s life
Answer: c
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Session 6: Module 4, Chapter 9 - 12
Relationship Between an Option
Premium and Strike (Exercise) Price
If the underlying asset price is
equal to the strike price of the
option
Call or put
option
At-the-money
Call option
Out-of-the-money
If the asset price is less than the
strike price of the option
Put option
Out-of-the-money
If the asset price exceeds the
strike price of the option
Call option
In-the-money
If the asset price is greater than
the strike price of the option
Put option
In-the-money
If the asset price is less than the
strike price of the option
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Session 6: Module 4, Chapter 9 - 13
Discussion Question
A call option with a $50 strike price is
purchased when the underlying asset is
selling for $46 per unit. The premium paid is
$1. Identify if the following put options are
in-, at-, or out-of-the-money.
Answers:
Price of
Underlying
Asset ($)
$50 Call Option
Value ($)
Profit (+) or
Loss () ($)
OUT
46
0
−1
AT
50
0
−1
IN
54
4
+3
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Session 6: Module 4, Chapter 9 - 14
Discussion Question
A put option with a $50 strike price is
purchased when the underlying asset is
selling for $54 per unit. The premium paid is
$1. Identify if the following put options are
in-, at-, or out-of-the-money.
Answers:
Price of
Underlying
Asset ($)
$50 Call Option
Value ($)
Profit (+) or
Loss () ($)
OUT
54
0
−1
AT
50
0
−1
IN
46
4
+3
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Session 6: Module 4, Chapter 9 - 15
Managing FX Rate Fluctuations
Foreign
exchange
(FX) risk
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 issues
Global treasury operations must
interpret the rules and regulations of
different tax authorities.
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Session 6: Module 4, Chapter 9 - 16
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
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Session 6: Module 4, Chapter 9 - 17
Foreign Exchange (FX) Rates

Example: The quoted rate for the USD
equivalent is EUR 1.3383. How many euros
would $2 million buy?
$2,000,000
= EUR1,494,433
1.3383

Example: The quoted rate for the USD
equivalent is GBP 1.4870. How many pounds
would $2 million buy?
$2,000,000
= GBP1,344,990
1.4870
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Session 6: Module 4, Chapter 9 - 18
Foreign Exchange (FX) Rates

Example: The quoted rate for the Japanese
yen is USD/JPY 92.56. How many yen would
$2 million purchase?
$2,000,000  92.56 = JPY185,120,000

Example: The quoted rate for the Canadian
dollar is USD/CAN 1.0265. CAN250,000
would be equivalent to how many USD?
CAN250,000
= $243,546 (USD)
1.0265
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Session 6: Module 4, Chapter 9 - 19
Foreign Exchange (FX) Rates:
Bid-Offer Spreads and Dealer Profit




Bid rate: Dealer buys currency.
Offer rate: Dealer sells currency.
Bid/offer spread or bid/ask spread: Difference
between rates (dealer’s profit).
Dealer bid-offer quote; e.g., USD/JPY 90.57-63.
Company
Delivers
Dealer
Buys
Dealer
Sells
Company
Receives
Company wants to
buy Japanese yen
(JPY)
USD
USD at
bid rate
(JPY90.57)
JPY
JPY
Company wants to
sell JPY for USD
JPY
JPY
USD at
offer rate
(JPY90.63)
USD
Scenario
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Session 6: Module 4, Chapter 9 - 20
Foreign Exchange (FX) Markets


Spot market
(spot rate)
Forward market
(forward rate)




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Par
Discount
Premium
Interest rate
parity
Session 6: Module 4, Chapter 9 - 21
FX Rate Exposure
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
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Session 6: Module 4, Chapter 9 - 22
FX Rate Exposure

Types of FX
exposure



Economic
Transaction
Translation

Types of
derivatives




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Currency
forwards
Currency
Currency
Currency
or FX
futures
swaps
options
Session 6: Module 4, Chapter 9 - 23
Currency or FX Forward
Three factors:
 Current spot rate
 Term of forward
contract
 Current interest
rates in two
countries during
term
EXAMPLE:


A U.S. company (importer) has
agreed to pay an invoice for
GBP125,000 in 90 days.
The importer purchases a
forward contract today at
$1.6365 in USD per GBP,
deliverable in 90 days.
At the end of the 90 days, the
importer pays:
USD1.6365 x GBP125,000 =
USD204,563
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Session 6: Module 4, Chapter 9 - 24
Currency Futures




Traded on
organized
Common Contracts
exchanges
Margin
Currency Pair Contract Size
Required
Standardized
in amounts
EUR/USD
EUR125,000
$2,205
and maturity
USD/JPY
JPY12,500,000
$2,700
dates
GBP/USD
GBP62,500
$1,485
70% of daily
USD/CHF
CHF125,000
$1,350
volume on
USD/CAD
CAD100,000
$1,755
the CME
Contracts
generally
offered for sixmonth maturities
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Session 6: Module 4, Chapter 9 - 25
Currency Futures Example
U.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 1.6521
Change in contract value = (1.6521 – 1.6369) x 125,000 = $1,900
New margin account value = $2,970 + $1,900 = $4,870

Futures contract decreases to GBP/USD 1.6472
Change in contract value = (1.6472 – 1.6521) x 125,000 = –$612.50
New margin account value = $4,870 – $612.50 = $4,257.50

If exchange rate rises to GBP/USD 1.7245
Profit on contract = $1.7245 – $1.6369 = $0.0876 per GBP

If exchange rate drops to GBP/USD1.5681
Loss on contract = $0.0688 per GBP; however, next cost still GBP/USD
1.6369
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Session 6: Module 4, Chapter 9 - 26
Currency Swaps

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
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Session 6: Module 4, Chapter 9 - 27
Currency Swaps Example
U.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
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Session 6: Module 4, Chapter 9 - 28
Currency Options

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
EXAMPLE:


Foreign-currency call option sets
ceiling price to buy foreign
currency in terms of the domestic
currency.
Ceiling price is strike price plus
premium paid for call.
Call option on EUR has strike price
of $1.30 with premium of $0.10.
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Maximum ceiling = ($1.30 +
$0.10) = $1.40 per euro
Session 6: Module 4, Chapter 9 - 29
Interest Rate Exposure

Examples
Falling rates with
variable interest
rate investments
may mean lower
earnings.
 Rising rates with
debt tied to
variable interest
rates may mean
higher borrowing
costs.


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Interest rate
forwards




Forward rate
agreement (FRA)
Interest rate
futures
Interest rate swaps
Interest rate
options



Interest rate cap
Interest rate floor
Interest rate collar
Session 6: Module 4, Chapter 9 - 30
Interest Rate Futures Contract
Example
Futures contract pricing on one-year T-bill is
100 minus the promised interest rate.
Futures rate is 1.5%.
 Contract price = Predetermined price of 98.5 (100 – 1.5).

If
actual rate is 2.1% at end of year, realized value is
only 97.9.
100 – 2.1 = 97.9
The
holder of the long position will be paid by the
seller of the contract the difference.
98.5 – 97.9 = 0.6 per unit of the contract
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Session 6: Module 4, Chapter 9 - 31
Example: Interest Rate Swap
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
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Session 6: Module 4, Chapter 9 - 32
Commodity Price Exposure
Price exposure
 Results from
changes in the price
of a commodity
used or sold:


Rising prices for a
commodity used
creates exposure.
Declining prices for a
commodity sold
creates exposure.
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Delivery exposure
 Occurs when
regular supply of a
commodity is
crucial
 Can be mitigated by
entering into a
long-term
agreement with a
producer
Session 6: Module 4, Chapter 9 - 33
Discussion Question
What is one of the primary problems in the
valuation of, and subsequent accounting for,
derivatives?
Answer:
 Determining their accurate value.
As a general guideline, Topic
820-10: Fair Value Measurements
offers some guidance on this issue.
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Session 6: Module 4, Chapter 9 - 34
Discussion Question
How does the Dodd-Frank Act bring more
transparency and accountability to the
derivatives market?
Answer:
 Closes regulatory gaps
 Requires central clearing and
exchange trading
 Requires market transparency
 Adds financial safeguards
 Sets higher standards of conduct
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Session 6: Module 4, Chapter 9 - 35
Emerging Markets

Emerging market
currencies:




Exotic currency
characteristics
Free floating with
partial pricing
transparency and
liquidity
Capital controls
impacting
bilateral
availability at any
point in time
Non-readily
tradable in the
worldwide FX
marketplace
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









Illiquidity
Volatility
Reduced transparency
Limited derivative
availability
Capital controls
Heightened carrying risk
Pricing distortions
Limited risk-sharing
options
Minimal internal heading
alternatives
Transfer risks
Session 6: Module 4, Chapter 9 - 36