equity price risk• risk resulting from holding equities or assets with performance tied to equity prices• faced by all organizations possessing or issuing equities• main risks include: – equity price risk – systematic risk
interest rate risk• risk resulting from volatility of interest rates• faced by all companies with borrowings (affecting cost of funds) – loan with fixed rate of interest – loan with floating (variable) rate of interest• impact depends on company structure / relation of: – capital and debt (leverage ratio) – short and long term debt – fixed and floating rate debt
foreign exchange rate risk• risk resulting from change in the exchange rate of one currency against another• faced by all organizations involved in foreign exchange or utilizing commodities denominated in other currency• fx rates risk arise mainly from: – transaction risk exposure – translation risk (affecting the value of balance sheet items incl. AP and liabilities) – reporting translation risk (from the operating currency into a reporting currency) – strategic exposure - based on organization’s competitive position of its local currency
commodity price risk• risk resulting from commodity prices rising or falling• faced by all organizations that produce or purchase commodities• main commodity risks include: – commodity price risk – commodity quantity risk – cost of carry risk (financing, storage, transportation) – special risks (e.g. shortage)
derivatives• is an asset whose performance is based on the behaviour of an underlying asset (commonly called underlying)• main market risks could be mitigated using derivatives contracts• most common derivatives include: – forward contracts – future – swap – option
forward• non-standardized contract between two parties to buy or sell an asset at a future date at a price agreed today• differs from spot contract which is to buy or sell an asset at the moment at the current price• the difference between the spot and the forward price is the forward premium or forward discount• deliverable or non-deliverable (difference payment)
main types of forwards• repurchase agreement (repo) - the sale of securities together with an agreement for the seller to buy back the securities at a later date• forward rate agreement (FRA) - contract where party pay/receive the difference between a agreed interest rate and the rate which actually eventuates at agreed future date• currency forward• commodity forward contract
forward example• Company A (coffee maker) wants to buy a 10 tons of raw coffee from Company B (producer) in one year time.• Current spot price of 1 ton is 90,000 USD. Forward contract of 10 tons is agreed with forward price 950,000 USD.• In one year time: – what will be profit/loss of Company A if coffee price will be the same – what will be profit/loss of Company A if coffee price will increase by 10%
future• standardized contract between two parties to exchange a specified asset of standardized quantity and quality at a future date at a price agreed today• future contracts are traded on a futures exchanges• used for commodities as well as currencies, securities or referenced items such as stock indexes
how future works• exchange requires both parties to put up an initial amount of cash on account - the margin• as margin is usually smaller than notional amount it gives possibility of leverage• daily valuation to agreed price - difference is paid from one party to another party account• if the margin account goes below a certain value then a margin call is made
swap• non-standardized derivative contract in which counterparties exchange cash flows (payments) for financial instruments• swap may be direct contract between two companies or with third party acting as intermediary• swap agreement defines the dates when the cash flows are to be paid and the way they are calculated• cash flows are calculated over a notional principal amount - usually not exchanged between counterparties
main types of swaps• interest rate swap - exchange of fixed and floating interest rate• currency swap - exchange principal and interests of loan in one currency on equivalent of another currency• commodity swap - exchange of spot and fixed price of underlying commodity• credit default swap (CDS) - exchange of credit default
swap example (I)• company A with AAA credit rating – fixed rate 10.00% – floating rate LIBOR + 0.30% – seeks floating financing• company B with BBB credit rating – fixed rate 11.20% – floating rate LIBOR + 1.00% – seeks fixed financing• total financing cost = LIBOR + 0.30% + 11.20% = LIBOR + 11.50%
swap example (II)• two companies enters swap contract: – company A issue debt for 10.00% – company B issue debt for LIBOR + 1.00%• total financing cost = 10.00% + LIBOR + 1.00% = LIBOR + 11.00% = total gain = 0.50%• companies swap its payments (equal distribution of gain): – company A receive 10.00% to repay debt and pays LIBOR + 0.05% – company A net gain is (LIBOR + 0.30%) - LIBOR + 0.05% = 0.25%
swap example (III)• in case bank act as intermediary swap contract will have bank spread as its cost
swap exercise• company A – fixed rate 8.00% – floating rate EURIBOR + 1.00% – seeks floating financing• company B with BBB credit rating – fixed rate 10.00% – floating rate EURIBOR + 2.00% – seeks fixed financing
swap – what will be total gain from swap contract ? – what kind of debt each company should issue and what will be its cost ? – in case of swap how much each company will have to pay into the intermediary bank ? – what will be net gain of each company (equal distribution of gain) if bank swap spread is 0.40% ?
options• options are contracts that give the owner the right, but not the obligation, to buy or sell an asset – in case of buy - call option – in case of sell - put option
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