Pcf week 17 risk management forex 1


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  • + = less FC/£ (prem)- = more FC/£ (dis)
  • 1.5%
  • Pcf week 17 risk management forex 1

    1. 1. In this class we will discuss: The nature of Treasury Management Spot and forward exchange rates The nature of exchange rate risk Internal and external hedging Derivatives used for hedging
    2. 2.  What does a treasurer do? Concerned with cash flow and risk Size and responsibility of treasury function will vary Treasury aims,policies, authorisation levels, risk levels and structure determined by Board of Directors Eg Eon
    3. 3.  Liquidity and working capital management Financing Risk management
    4. 4. Centralisation Decentralisation Treasurer has  Local financing overview – opportunities maximises after-  Gives responsibility tax profits (control) to Greater expertise divisional managers Benefits of scale
    5. 5.  To ensure that enough cash is available at the right time Management of working capital Efficiency is key and can impact on financing requirements
    6. 6.  How much should firm raise this year? What form of financing should be used? What should the balance be between short and long-term funds? Currency of finance/Where should finance be raised?
    7. 7. “Risk management is the process of identifying and evaluating the trade-off between risk and expected return, and choosing the appropriate course of action” (Pike and Neale 2006) How does risk arise?
    8. 8.  The exchange (for an agreed price) of a risky asset for a certain asset Hedges can be created for: ◦ Commodities ◦ Foreign currencies ◦ Interest rates Derivatives ◦ Financial instruments used for hedging
    9. 9.  Forward contracts ◦ An agreement to buy or sell (commodity, currency or agreement on interest rate on future borrowing) at a fixed price at some time in the future Futures contracts ◦ Similar to a forward contract but standardised in terms of period, size and quality ◦ Can be traded on an exchange
    10. 10.  Options ◦ Gives the right, but not the obligation to buy/sell at an agreed price at or up to an agreed time Swaps ◦ An arrangement between two firms to exchange a series of future payments
    11. 11.  Exposure to interest rate risk is determined by how much profits and/or asset values are affected by interest rate changes. Depends on whether company is a net borrower or net investor
    12. 12.  Natural hedging Fixing the interest rate Hedging contracts ◦ Forward rate agreements ◦ Interest rate futures or options ◦ Interest rate swaps
    13. 13.  Two companies agree to exchange interest payments with each other over an agreed period Effectively they are swapping the different characteristics of the two loans Called a plain vanilla
    14. 14. Two companies have access to the following interest rates:Co. A Co. BLIBOR Fixed 11%Fixed 10% LIBOR +0.2%(LIBOR – London Interbank Offered Rate) Co. A has an absolute advantage Co. B has a comparative advantage over A with its floating rate
    15. 15. Company A Company B (wants to borrow (wants to borrow at floating rate) at fixed rate) LIBOR Fixed 11%Rates available: Fixed 10% LIBOR + 0.2%Borrowing action: Fixed 10% LIBOR + 0.2% Swap PaymentsBetter or worse off? 0.2% Worse off worse off 0.2%Better off 1% worse offBalancing payment 0.6%Post-swap borrowing LIBOR – 0.4% 0.2% worse off Fixed 10.6% 0.2% worse offrates Exhibit 12.5 An example of a plain vanilla interest rate swap between two companies, A and B Taken from Watson and Head (2007)
    16. 16.  Start and end dates of swap Notional principal Which party is paying floating interest and receiving fixed interest in return and vv Level of fixed rate and basis of floating rate Profit sharing terms
    17. 17.  What is meant by the „exchange rate‟? Exchange rates (in free floating markets) are determined by the interaction between the relative supply and demand for a currency. Quotations ◦ Direct How many units of FC per unit of HC eg $2.00 per £ ◦ Indirect How many units of HC per unit of FC eg £0.50 per $
    18. 18. Spot market rate Quotation for immediate delivery Eg Euro ◦ What is the „buy‟ rate? ◦ What is the „sell‟ rate? ◦ What is meant by the „spread‟? ◦ What determines the size of the spread?
    19. 19. Forward Market Rate ◦ The exchange rate for advance transactions ◦ Usually quoted as a premium or a discount on the spot rate Eg 3 month forward rate for  euros  Turkish lira
    20. 20.  Arises due to FC cash flows occurring at some point in time in the future Tends to be short-term Eg A UK company contracts to buy IT components from a German company with payment (in euros) to be made in 6 months time Unexpected changes in the euro/£ exchange rate could result in losses
    21. 21.  Internal management ◦ Cheaper than external hedging External management ◦ Forward contracts ◦ Money market hedge ◦ Derivatives
    22. 22.  Matching ◦ Matching FC denominated assets with FC denominated liabilities (or VV), or FC denominated inflows with FC denominated outflows eg Netting ◦ Netting off FC transactions ◦ Often used by multinationals ◦ UK company with German subsidiary. UK parent expects to receive $ inflows in 3 months and German subsidiary expects to make $ payment in 3 months time
    23. 23.  Leading and lagging ◦ Settlement of FC accounts either at beginning or after the end of the allowed credit period ◦ Choice depends on expectations of future exchange rate movements ◦ Eg company with a future $ payment may choose to lag its payment if £ is expected to appreciate relative to $ Invoicing in domestic currency ◦ Transfers transaction risk to other company ◦ May place home company at a competitive disadvantage
    24. 24.  Forward Contracts ◦ “Enable companies to fix in advance the future exchange rate on agreed quantities of FC for delivery or purchase at an agreed date” (Watson and Head, 2007) ◦ Tailor-made with respect to maturity and size ◦ Cannot be traded ◦ Cash flows occur at the end of the contract ◦ Locks out any potential benefit from favourable exchange rate movements
    25. 25.  Involves setting up the opposite FC transaction to the one being hedged Eg $ receipt expected in 3 month‟s time ◦ Set up $ debt by borrowing $s now ◦ Convert $ into £ at current spot rate ◦ Deposit £ on £ money market ◦ When $ loan matures it will be paid off by expected $ receipt
    26. 26. A company expects to receive $180,000 in 3 months time and wants to lock into current exchange rate of $1.65/£. The annual dollar borrowing rate is 7% (the 3-month borrowing rate is 7% * 3/12 = 1.75%). The annual sterling deposit rate is 6% and so the 3 month deposit rate is …..
    27. 27.  Borrow an amount (Z) which when interest is added in 3 months will be equal to $180,000 ◦ Z * 1.0175 = $180,000 ◦ Z = $180,000/1.075 = $176,904 Convert $ into £ at current spot rate ◦ $176,904/1.65 = £107,215 Invest £ in the sterling money markets for 3 months ◦ £107,215 * 1.015 = £108,822 The £ value of the $ inflow using the money market hedge is therefore £108,822 (compare with using a forward exchange contract)
    28. 28.  What if it were a $180,000 payment to be made instead? Steps ◦ Convert £ into $ at current spot rate ◦ Invest $ on US money market such that the deposit plus interest will equate with the payment to be made in 3 months ◦ Cost is the initial £ plus lost UK interest (or interest on UK loan if initial amount borrowed)
    29. 29.  Nature of Treasury Function will vary Mainly concerned with ◦ Liquidity and WC management ◦ Financing ◦ Risk Management Exchange rate risk arises because of the fluctuation in exchange rates Main hedging techniques ◦ Internal ◦ External Next week futures and options