prof. ian giddy new york university managing financial risk

Prof. Ian GiddyNew York University

Managing Financial Risk

Copyright ©1998 Ian H. Giddy Managing Financial Risk 2

First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the

financing mix used - owners’ funds (equity) or borrowed money (debt)

Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend

upon the stockholders’ characteristics. Manage corporate financial risk


Corporate Finance

CORPORATE FINANCE

DECISONS

CORPORATE FINANCE

DECISONS

INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


Tools for Hedging

Pacasmayo has to pay for equipment from Japan, in Japanese yen, in 3 monthsBorrow soles and pay now?Use a forward contract/FX swap?Hedge with options?


A Typical Forward Contract

We agree today to pay a certain price for a currency in the future

BackusBackus SAN-

TANDER

SAN-

TANDER

Soles


Customization, Performance Riskand Liquidity

Customization implies bilateral contracts, which carry performance risk

Liquidity implies standardization and freedom from counterparty risk, through exchange-traded contracts


How Does the Bank Hedge a Forward Contract?

Hedging approaches:OpenForwardSpot plus swapRolloverMoney market


The FX Swap Hedge

3-month Forward Contract

3-month Swap

Dealers often hedge a long-term foreign-exchange commitment with a spot plus (FX Swap”: spot sale plus forward purchase of a foreign currency

The FX swap rate is determined by the interest differential


The Roll-Over Swap Hedge

6-month Forward Contract

3-month Swap 3-month Swap

Dealers often hedge a long-term foreign-exchange commitment with shorter-term contracts, which are “rolled over” as they come due

Corporations themselves do this too.


110

115

120

125

130

135

140

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

EXCHANGERATE, YENPER US$

FORWARDPREMUIM,PERCENTPER ANNUM

FORWARD(LEFT SCALE)

SPOT (LEFT SCALE)

FORWARD PREMIUM(RIGHT SCALE)

MONTHLY DATA, 1987-1989

FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100

The Forward Rate Tracks the Spot Rate

Marking-to-Market of aForward Contract

0.625

0.63

0.635

0.64

0.645

0.65

-25 -20 -15 -10 -5 -1

SHORT POSITION

LONG POSITION

DAILY GAINS AND LOSSES

DAILY DMFUTURES PRICEMOVEMENTS

FUTURES

SPOT

FUTURES PRICES,US$ PER MARK

DAYS BEFORE SETTLEMENT DATE


Forwards vs Futures vs Options

Good credit: Forward usually best Sometimes, Money Market Hedge better

Perfect market: same (covered int. arb.) Imperfect market: MMH may be better

Credit problem: Futures But: limited and standardized Requires margin and daily settlement

Uncertain future cash flows: Liquid instrument (futures/forwards to assure

flexibility Options sometimes advisable


Option Hedge

CALL

OPTION

ON YEN

FORWARD

CONTRACT


Option Hedge

Questions about options: When should companies use them? Which options? How much do they cost, Are they worth paying for? What is the risk to the bank?


Measuring Market Exposure

Defining corporate exposure:

“How will my company’s value be affected by market price fluctuations?”

Types of exposureTransactionsBalance sheet/portfolioEconomic

A risk management framework


How Effective is My Company’s Risk Management?

Don’t measure risk No linkage of risk to

value No effort to anticipate Lack of business risk

policy

Fragmented effort Narrow focus Poor risk

communications Lack of an

integrated risk assessment framework

Warning Signs:


Risk Management is a Process

Corporate Risk Management

DefineDefine MeasureMeasure ManageManage MonitorMonitor


Formalize Risk Management Policy and Control Framework



• Develop an outline of a policy statement, or recommend improvements to existing document

• Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices

• Assess centralization issues related to financial risk management and treasury design


Identification and Definition of Financial Exposures

Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile.

Translation Exposure, Transaction Exposure, and

Economic Exposure

• Long-term versus short-term exposure

• Intracompany versus third party exposure

• Cross currency exposure

• Competitive exposures

Absolute Rate Risk, Convexity, Basis or

Correlation Risk

Currency Interest Rate

• Short-term liquidity portfolio

• Investment portfolio

• Capital markets borrowing

• Leasing portfolio

Price Risk, Basis or Correlation Risk

Commodity

• Procurement

• Inventory

• Sales elasticity


Market Risks: Definitions

Three Views of

Market Price Risk:TransactionsBalance Sheet/PortfolioEconomic risk.


Market Risks: Definitions

Three Views of

Market Price Risk:TransactionsBalance Sheet/PortfolioEconomic risk.

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Transactions Exposure

Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain dateExample: If Nokia invoices a NTT of Japan in

Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen.

This kind of exposure is readily hedgable using forwards, futures or debt

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


But Transactions Exposure Can be Misleading...

Austin Computer purchases notebook computers in Taiwan for sale in the US.

Austin must pay in NT$. Should it hedge its anticipated

payments for 1996?

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Austin Computer

NT$

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Interest Rate Risk:Portfolio

Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio

Bond price fluctuations will affect the balance sheet

Can be hedged, using duration as a risk/sensitivity measurement tool

Can be hedged with futures, bond options, and swaps.

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Pepsico Pension

Assets (each $10m):1-year E$ deposit5-year, 6% T-note

D=4.610-year Strip

Pension liabilities:$10m 3 years$10m 5 years$10m 7 years

What is Pepsico pension fund’s risk? Duration of the assets (+ve)Duration of the liabilities (-ve)Net duration is the risk to be hedged!

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Value at Risk: SantosBank

Asset and liability positions for a Brazilian bank’s New York branch.

What risk does it face?

INSTRUMENTSANTOSBANK

POSITIONS

30 day ($1,250,000)

90 day ($100,000)

180 day $450,000

1 yr $120,000

2 yr $120,000

3 yr $120,000

4 yr $1,120,000

5 yr $0

7 yr $0

9 yr $0

10 yr ($420,000)

15 yr $0

NET $160,000

TOTAL $3,700,000

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


BIS: Minimize Value at Risk

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure

Mean

Value-at-RiskValue-at-Risk

INSTRUMENTSANTOSBANK

POSITIONS

30 day ($1,250,000)

90 day ($100,000)

180 day $450,000

1 yr $120,000

2 yr $120,000

3 yr $120,000

4 yr $1,120,000

5 yr $0

7 yr $0

9 yr $0

10 yr ($420,000)

15 yr $0

NET $160,000

TOTAL $3,700,000

+

=


Market Price Risk: Economic

Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates, FX, commodity prices

It affects the shareholder value, but may be difficult to quantify

Hedging may require tailored solutions

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Inmet Mining Corp.

In 1994 Canadian mining company Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds?

Answer: Business exposure is to lead & zinc prices (mine shutdown in Oct 96 because of low zinc prices)

Hedge with digital option linking cost of funds to lead & zinc prices


Market Price Risks: Summary

Three Views of

Market Price Risk:Transactions - lock in

forward ratePortfolios

Avoid duration mismatchingMinimize Value at Risk

Economic risk - business sensitivity to market prices.

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure


Heineken Hedges

Heineken plans to borrow DM15 million in 3 months to expand its Heineken Ice advertising campaign.

The Treasurer wishes to lock in a cost of funds.

One way is with a Forward Rate Agreement (FRA): Vereinsbank agrees to pay Heineken if 3-mo DMLibor>6%, and vice-versa.


Let’s Quote an FRA rate

MaturityDM Libor Implied Forward

3 mo 3.28 n.a.6 mo 3.41 3 to 612 mo 3.41 6 to 12

Monday, February 12, 1996


Borrow for 6 months at 5%Borrow for 6 months at 5%

FRA Mechanics

Invest for 3 months at 4%Invest for 3 months at 4% Lock in cost at 6%Lock in cost at 6%

SET RATE AT 6%

IF LIBOR > 6%, V PAYS H

IF LIBOR < 6%, H PAYS V

HOW MUCH?

PV[(LIBOR-6%)/4]



The Law of One Price

FRA (forward rate agreement)FRA (forward rate agreement)


Lock in 6%Lock in 6%

Futures contractFutures contract Lock in 6%Lock in 6%

Interest rate swapInterest rate swap Lock in 6%Lock in 6%


Interest Rate Swaps

An interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time.

Effectively, it involves paying the difference between a fixed rate and Libor:

JALJAL BVBSwaps

BVBSwaps

10% Fixed

3-mo Libor,

floating


Caps and Floors

An interest-rate collar involves buying a cap and selling a floor:

RATE

TIME

5%

7%



The Law of One Price





Interest Rate SwapInterest Rate Swap Lock in 6%Lock in 6%

Cap & Floor at 6%Cap & Floor at 6% Lock in 6%Lock in 6%



Linkages Between Instruments





Commodity spreadCommodity spread Lock in 6%Lock in 6%

Interest rate swapInterest rate swap Lock in 6%Lock in 6%


Positions

FRAsAssets & Liabilities

Futures Swaps

Hybrids

Factors

Reducing Positions to Factors


Three Views of Interest Rate Risk

Transactions

Exposure

Transactions

Exposure

Portfolio

Exposure

Portfolio

ExposureEconomic

Exposure

Economic

Exposure

Assignment


Aero Lloyd

Aero Lloyd is wants to benefit from lower rates but is afraid of a higher cost of funds in the future. Should it:Convert the Vereinsbank line into a 3-year fixed rate

term loan at 8.85%Fix Aero Lloyd's short-term cost of funds by means of

a 3-month FRA , starting in three months.Hedge against rising interest rates using interest rate

futures.Renegotiate the leases at a floating rate.Convert Aero Lloyd's cost of funds into floating by

means of an interest rate swap. The 3-year swap rate was 6.97%.

Do nothing at present?


Aero LloydExhibit 1. Current Interest Rates

EuroD M Interest Rates

1 month 3 months 6 months 1 year

5 1/4 - 5 7/16 5 7/16 - 5 5/8 5 11/16 - 5 7/8 6 - 6 3/16

3-Month EuroD M Futures Contracts (IMM) $1m points of 100%

Open Settle Change High Low Volume Open Interest

MarJunSep

94.1493.8293.67

94.2193.9393.80

+ 0.07+ 0.11+ 0.13

94.2794.0294.00

94.1193.7993.62

76,85986,70679,942

411,868440,381293,293

Bunds and S waps

Bund Yields (annual) Interest Rate SwapsSpreads over Bunds(basis points)

3 month6 month1 year2 year3 year5 year

5.265.505.746.216.406.59

45-4846-5052-5753-58

Exhibit 1. Current Interest Rates


Interest Rate Risks: Summary

Three Views of Interest Rate Risk:Transactions - lock in a ratePortfolios - avoid duration

mismatchingEconomic risk - evaluate the

business sensitivity to interest rates.


www.giddy.org

Ian Giddy

NYU Stern School of Business

Tel 212-998-0332; Fax 212-995-4233

[email protected]

http://www.giddy.org

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