Service Expertise Integrity
Presented by: The Northern Trust Company
Fran Wawrzyniak, CTP
June 7, 2012
© 2012 Northern Trust Corporation

Chapter 9
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Studying this Chapter
 There are 8-10 questions from this chapter on the exam
 Know Overview of Financial Risk Management
 Know Derivatives Instruments
 Know Different Exposure
 Interest Rate
 FX
 Commodity
 Accounting and Tax Issues
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Overview of Risk Management in Treasury
 Financial risk is the risk of direct or indirect losses resulting from the uncertainty of the future level of interest rates, FX rates, commodity prices, or from adverse impacts on a company with highly leveraged capital structure
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Overview of Risk Management in Treasury
 Techniques to evaluate the impact of risk-reducing events

Value-At-Risk (VaR)

Developed by traders to estimate the possible loss for the entire trading operation

Volatility of an expected average value (such as cash flow) and a standard deviation of the distribution of future outcomes

Sensitivity Analysis

What-If exercise to determine how sensitive cash flow is to changes in variables

Scenario Analysis

Similar to Sensitivity Analysis but multiple variables are altered

High and low variables are used to find the overall best and worst possible outcomes

Monte Carlo Simulation

An extension of Sensitivity Analysis, but includes a series of probability distributions to produce an overall probability distribution of some final measure or outcome
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Overview of Risk Management in Treasury
 Measuring the exposure of changes of prices of assets which can alter the company’s risk profile.
 Hedging – Use of financial instruments to reduce or eliminate risk of future cash flows
 Speculation – Betting on the direction of the market - Will the price of an asset will go up (long) or down (short)?
 Arbitrage – Buying an asset in one market while simultaneously selling in another. Transaction assumes no risk but attempts to profit from market inefficiencies
 The Benefits of Risk Management
 Reduced financial stress on company
 Greater predictability of future cash flows
 Enhanced borrowing advantage
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Derivative Instruments Used As Financial Risk Management
Tools
 A derivative instrument is a financial product that acquires it value by inference through a formulaic connection to another asset.
 Companies usually need to sign an International Swap and Derivative
Association (ISDA) Agreement
 Standard industry contract
 Defines terms and conditions of the derivative contract
 Types of Derivative Instruments
 Forwards
 Futures
 Swaps
 Options
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Derivative Instruments
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 Forwards
 Contracts between two parties that require specific action at a later date at a price agreed upon today
 Future Date = Maturity Date
 Contract Price = Delivery price
 Not traded on an organized exchange
 The buyer is in a long position, the seller is in a short position
 Long position gains value when the price rises and loses when the price falls
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Derivative Instruments
 Forwards Contracts between two parties that require specific action at a later date at a price agreed upon today
 Future Date = Maturity Date
 Contract Price = Delivery price
 Not traded on an organized exchange
 The buyer is in a long position, the seller is in a short position
 Long position gains value when the price rises and loses when the price falls
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Derivative Instruments
 Futures Same as Forward, but have standardized contracts and are traded on organized exchanges
 Contract size and its maturity date set by exchange
 Requires a margin account
 Daily mark-to-market and margin calls if necessary
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Derivative Instruments
 Swaps - Agreement to exchange (or swap) a set of cash flows at a future point in time
 Interest rate swap most common type of swap. One party swaps its floating interest rate for a fixed rate and vice versa
 Allows Companies with weaker credit ratings to get better rates
 Other types include currency, commodity and basis swaps
 Primary risk is counterparty risk
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Derivative Instruments
 Options - Contract between two parties where the buyer has the right (not obligation) to buy or sell a fixed amount of underlying asset at a fixed price on or before a specified date
 Counterparty is the Writer of the option and received the price paid
 May be exchange-traded or negotiated between two parties
 Call Option: the contract allows the owner to buy the asset at a fixed price
 Put Option: the owner has the right to sell the asset at a fixed price
 Fixed price is the strike/exercise price of contract
 Possible relationships between premium and strike price:

At-the-money→ asset price = strike price

Call Out-of-the-Money →asset price less than strike price

Put Out-of –the-Money → asset price greater than strike price

Call In-the-Money → asset price greater than strike price

Put In-the-Money → asset price less than strike price
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Derivative Instruments
 Options (continued)
 Strike/exercise price—The fixed or contracted price of the underlying asset
 Maturity date (or exercise date)—Specified date after which the option expires
 Seller of option receives a premium from the buyer
 American Style – you can settle at any time during the option period
 European style – you can only settle on the option expiration date
 Bermuda style – you can settle at predetermined date or at expiration
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Foreign Exchange (FX) Risk Management in Treasury
 FX rates are quoted in several ways, depending on the currency and the markets involved
 One U.S. Dollar equivalent to foreign currency
 One foreign currency equivalent to U.S. Dollar
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Foreign Exchange (FX) Exposure
 Rates are obtained by real-time rate reporting services (Bloomberg,
Reuters), through a dealer or free on the internet
 FX Markets
 Spot Market

Current exchange rates

Settled in one or two days – such as Canadian dollars or Mexican pesos in the US
 Forward Market

Settled in more than two days – such as European and Asian currencies in the US

Current spot rate plus or minus interest rate differential (interest rate parity)

Forward points
 Par – interest rates are the same
 Discount – currency with higher rate will trade
 Premium – currency with lower rate will trade
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Foreign Exchange (FX) Exposure
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 Change in Foreign Exchange Rates
 Types of FX exposure
 Economic Exposure

Global markets and related currencies causes the price of goods to change

Even if a company does not have a global business perhaps their competitors do
 Transaction Exposure

Physically converting one currency for another currency
 Translation Exposure

Consolidating foreign subsidiary's financial statements into the parent company's currency

Accounting exposure
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Large amount to hedge, loans in the foreign currency can hedge this exposure
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Currency Derivatives Used to Hedge FX Exposure
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 FX Derivatives
 Currency or FX Forwards – Commitment to buy foreign currency at a future date.
 Currency Futures – Similar to forwards but traded on the exchange and standard contract.
 Currency Swaps – Exchange of floating rate cash flow in one currency for fixed in another currency.
 Currency Options
– Right to buy or sell fixed amount of foreign currency at a fixed exchange rate, on or before specified date.
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Currency Derivatives Used to Hedge FX Exposure
 Forward
 U.S. company agrees to pay an invoice for 125,000 GBP in 90 days
 Buy GBP and sell USD
 Forward FX exchange rate = 1.6365 (current spot rate plus or minus forward points)
 90 days the company must deliver $204,563
(125,000*1.6365) to counterparty
 Counterparty will deliver 125,000 GBP wherever the company needs it to
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Currency Derivatives Used to Hedge FX Exposure
 Futures
 U.S. company agrees to pay an invoice for 125,000 GBP in 90 days
 Buys future contract at an exchange rate of 1.6365 and puts up cash margin
 In 90 days company buys GBP in spot market to deliver to supplier and sells USD
 If futures contract has a gain then the company can sell the futures contract for a profit
 If futures contract has a loss then cash margin is lost
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Currency Derivatives Used to Hedge FX Exposure
 Swaps
 U.S. company borrows in the U.S. markets to fund an investment in Japan
 Interest expense in USD and interest income in Yen
 To reduce FX exposure company swaps Yen interest income for USD at a fixed rate over the term of the debt
 Company still owes money to the U.S markets but instead of receiving Yen it will receive USD
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Currency Derivatives Used to Hedge FX Exposure
 Options
 U.S. company agrees to pay an invoice for 125,000 GBP in 90 days
 Buy GBP and sell USD
 Buys option contract at an exchange rate of 1.6365 and pays an upfront premium
 Caps, floors, collars
 In 90 days company has the OPTION to buy GBP in spot market or at the option price depending on what the then current FX rates are trading at
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Interest Rate Exposure and Risk Management
 Companies with variable interest rate investments face lower earnings (interest income) when rates fall
 Companies with variable interest rate debt face higher borrowing costs (interest expense) in rising rate environment
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Interest Rate Exposure and Risk Management
 Forwards
 Buyer can lock in a rate (price) today to be used in the future
 Forward Rate Agreement (FRA)
 Futures
 Traded on the Chicago Mercantile Exchange
 Swaps
 Exchange cash flows of two different securities
 Fixed-floating swap most common
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Interest Rate Exposure and Risk Management

 Interest Rate Cap - ensures a floating rate loan receives a ceiling if interest rates rise
 Interest Rate Floor - a hedge against rates dropping below a certain level
 Interest Rate Collar - combo of Cap and Floor that effectively locks in a range for its borrowing costs
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Commodity Price Exposure
 Price Exposure- potential for changes in price of commodity
(agriculture and meat products, oil and gas, minerals, and metals)
 Two types of exposure
 Price – mitigate with derivatives
 Delivery – mitigate with long-term contracts
 Exposure hedged by Forwards, futures, swaps, and options
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Other Issues Related to Financial Risk Management
 Accounting Issues
 Addressed by International Accounting Standards Board
(IASB) and Financial Accounting Standard Board
(FASB)
 Valuation and Disclosure of Derivative Instruments
 Primary problem is determining accurate value when mark-to-market is applied
 Updates made to accounting rules
 Topic 820-10 (Fair Value Measurement)
 Topic 815 (Derivatives and Hedging)
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Other Issues Related to Financial Risk Management
 Impact on Derivatives from Dodd-Frank Act
 Brings more transparency and accountability to derivative markets
 Closes regulatory gaps
 Requires central clearing and exchange trading
 Requires market transparency
 Adds financial safeguards
 Sets higher standards of conduct
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Other Issues Related to Financial Risk Management
 Tax Issues Related to Hedging
 Very complex tax issues when using hedges
 Errors in the accounting treatment can be very costly especially if restatement of earnings is involved
 More complex for global companies
 Wrongs methods could impact gains and losses
 Obtain legal, tax, and accounting experts who specialize in this area
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Other Issues Related to Financial Risk Management
 Hedging Policy Statement
 Should come from the highest level in an organization as possible (board of directors)
 Policy statements for FX risks, interest rate risks, and commodity pricing risk
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Other Issues Related to Financial Risk Management
 Emerging Markets – Special challenges companies face:
 Tightly managed currencies (F/X and availability)
 Not all hedging instruments are available
 Emerging Market Currencies
 Fall into one of three baskets
 Free floating
 Capital controls
 Non-readily tradable in global F/X marketplace
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Other Issues Related to Financial Risk Management
 Issues with Exotic Currencies
 Liquidity
 Volatility
 Transparency
 Capital controls
 Carrying risk
 Pricing distortions
 Risk-sharing options
 Internal hedging alternatives
 Transfer risks
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Other Issues Related to Financial Risk Management
 Issues with Exotic Currencies
 Low level of transaction activity
 Dramatic fluctuations
 Central bank restrictions
 Less developed financial markets
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Hedging Tools Available for Emerging/Exotic Currencies
 Non-Deliverable Forward (NDF)
 Cash settled in a major base currency and used when exotic currency is not actively traded in the forward market
 On settlement, there is no exchange of currencies, only the difference between the NDF rate and the spot rate.
 Non-Deliverable Option (NDO)
 Same as NDF but buyer has the right (an option) to buy or sell
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