1. F9 Financial Management

2. 2 Designed to give you the knowledge and application of: Section H: Risk Management H1. The nature and type of risk and approaches to risk management H2. Courses of exchange rate differences and interest rate fluctuations H3. Hedging techniques for foreign currency risk H4. Hedging techniques for interest rate risk

3. 3 Learning Outcomes H3: Hedging techniques for foreign currency risk  Traditional and basic methods of foreign currency risk management, including: i. currency of invoice [1] ii. netting and matching [2] iii. leading and lagging [2] iv. forward exchange contracts [2] v. money market hedging [2] vi. asset and liability management [1]  Evaluate traditional methods of foreign currency risk management. [2]  Types of foreign currency derivatives used to hedge foreign currency risk and how they are used in hedging. [1]

4. 4 Internal techniques Currency of invoice Netting & matching Leading & lagging Asset & liability management External techniques Forwards Futures Financial swaps Options Money market hedging Traditional and basic methods of foreign currency risk management Foreign currency risk management

5. 5 Currency of invoice 2 choices set the export price at the foreign-currency equivalent of their domestic sales price set the export price in local currency terms or exporting firm sets the price prior to knowing the exchange rate for that period Example Miller Plc, a US-based exporter of fridges, can invoice for a transaction of US$1,000,000 in either US$ or EUR. At the date of this invoice, US$/EUR is 1.0065. So, Miller Plc could either invoice EUR 993,542 or US$1,000,000. After 3 months, when the invoice is paid, Miller Plc will always receive US$1,000,000, whether the rate has changed or not, if the invoice was in US$. However, if Miller Plc had invoiced in EUR, then the amount of dollars they would ultimately receive after three months is dependent on the change in EUR rate against the US$. So, if the US$/EUR rate is 1.0025, then Miller Plc would only receive US$991,064 once converted from EUR. So Miller Plc would actually receive US$8,936 less by invoicing in EUR.

6. 6 Netting process where debit balances are netted off against credit balances, so that only the net amounts remain to be paid in actual currency flows Types of netting Bilateral nettingMultilateral netting  netting between two parties  wherein the lower balances are netted off against the higher balances  the remainder is paid or received  netting among more than two parties  clearing-house or central exchange used for the purpose (usually some form of centralised treasury function) Netting and matching In order for netting to be conducted effectively,  it is important that the settlement dates of the contracts match each other  the foreign currency involved is the same for the receipts and the payments that are due Continued …

7. 7 Bilateral netting N (Subsidiary company) P (Subsidiary company) O (Subsidiary company) M (Parent company) Multilateral netting X (Subsidiary company) Y (Subsidiary company) Z (Subsidiary company) W (Subsidiary company) H (Parent company) Disadvantages of netting  it has a legal risk (enforceability)  exchange control restrictions need to be carefully considered  dates of settlement of the contracts and the foreign currency involved may not match Advantages of netting  reduces the banking transaction costs  reduces the credit risk and the liquidity risk  saving considerable time Continued …

8. 8 Matching expected payments in one currency are matched as closely as possible with receipts in another currency Leading & lagging technique try to equate foreign exchange assets and liabilities by speeding up or slowing down receivables or payables Leadingpayment of an obligation before the due date Laggingdelaying the payment of an obligation past the due date Example A US dollar asset is typically funded in US dollars, a euro liability is offset by an asset in euros. This avoids profits and losses arising from retranslation at the prevailing exchange rates.  it may happen that no cash changes hands and the transactions are simply treated as bookkeeping entries  used to minimise foreign currency transactions and risk exposures  the currency of the assets matched with the currency of the liabilities which fund them Leading and lagging Matching

9. 9 Advantages of leading & lagging technique avoid unnecessary hedging costs Disadvantages of leading & lagging technique appropriate matches may not be available Derivative financial instrument whose value is derived from the value of one or more basic variables called the underlying Before discussing forward exchange contracts and money market hedging, it is important to understand the term ‘derivatives’. Features of derivatives  provides a mechanism for hedging against the interest rate risks  based on different types of assets such as commodities, equities or bonds, interest rates, exchange rates, or indices  performance of a derivative can determine both the amount and the timing of the payoffs.  used to either remove risk or take on risk depending on whether one is a hedger or a speculator Derivative Continued …

10. 10 Example Interest rate futures, currency futures and options and Brent Crude oil futures Example A company exposed to movements of the US dollar against Sterling might hedge its exchange risk by using traded currency futures or options. A company whose exposure is some less traded currency, like the Polish Zloty or the Thai Baht, would probably use an OTC contract to hedge. Types of derivative contracts Exchange-traded derivative contracts OTC derivative contracts standardised contract with a standard underlying instrument, quantity and timing of settlement privately negotiated derivative contract in which two parties agree to settle a financial trade or agreement at a future date Continued…

11. 11 more liquid in nature (e.g. futures contracts)less liquid in nature (e.g. forward contracts) OTC derivativesExchange-traded derivatives highly standardised both in size and in terms of their delivery mechanism tailored to meet the needs of the parties concerned can be used by banks, companies, financial institutions and individuals access to individuals and small companies is limited rare physical delivery, contracts are usually settled prior to the settlement date. usually made with the intention of delivery of the underlying asset an initial margin is required, a further mark- to-market margin may be necessary margin requirements do not exist trading takes place on an organised exchange trading takes place mainly through telephone / telex / touch-screen trading, often via banks single specified price published by the clearing house price can vary according to size of deal and customer exchange traded derivatives are settled daily by settling the difference in the contracted price and the traded price in cash settlement of the OTC derivative contract happens at the end of the maturity period by delivery of the underlying asset Distinction between exchange-traded derivatives and OTC derivatives

12. 12 Forward contract an agreement made today between a buyer and seller to exchange a specified quantity of an underlying asset at a predetermined future date, at a price agreed upon today Futures contract  traded on a futures exchange  standardised contract  agreement to buy or sell an underlying asset at a specified price sometime in the future  the pre-specified price is the futures price  this future date is the delivery date or final settlement date  the settlement price is the price of the underlying asset on the delivery date Forward exchange contract Features of a forward contract  privately negotiated derivative contract in which two parties agree to settle a financial trade / agreement at a future date  tailored to meet needs of parties  limited access  made with intention of delivery  margin requirements do not exist  settlement at end of maturity period by delivering of underlying  less liquid

13. 13 Money market hedge the process of borrowing in the money market of a country, converting the funds borrowed at the spot rate of the currency of the country in which payment is due, and investing in a second country From the view point ofBorrower / importerInvestor / exporter Find out whether there is Forex liability or asset Will have a foreign currency (FC) Liability Will have a foreign currency (FC) Asset Create a hedging positionCreate FC AssetCreate FC Liability Borrow amount required to create hedging position Borrow domestic currency for an amount equal to the Present Value (PV) of FC liability (PV to be calculated with discount rate i.e. deposit rate in foreign country) Borrow foreign currency loan abroad for amount equal to PV of Forex asset (PV to be calculated with discount rate i.e. borrowing rate) Convert borrowed money into required currency Domestic currency into FC using spot rate Foreign currency into domestic currency at spot rate Invest the amount convertedInvest the FC abroad carrying interest at FC deposit rate Invest domestic currency carrying interest at domestic deposit rate Settle the position on due dateGet maturity proceeds with interest on FC deposit and settle FC liability with those proceeds. Receive FC from customer and use it to settle the FC borrowing. Get back the domestic fixed deposit with interest.

14. 14 Asset & liability management procedure a firm should deploy procedures to manage asset and liabilities in such a way that will minimise foreign currency risk Example The use of recently developed risk management tools typically allows for a separation between considerations about the funding strategy and risk management targets. Another desirable feature of these risk models is that all sovereign liabilities are managed as a single (integrated) portfolio. The next conceptual and practical step is to expand the pure liability risk management framework with public assets, resulting in an asset and liability management (ALM) framework. The central insight here is that resources (and the assets that generate them) are key for the assessment and management of risk (and not only the structure of liabilities). Asset and liability management

15. 15 Considerations whilst selecting a hedging technique Percentage of payable & receivable in foreign currency Sensitivity to foreign exchange fluctuations Matching of due dates Major short-term investments Accurate exports (amount and dates) Passing on currency losses to customers by increasing prices Sharing of foreign exchange risk Traditional methods of foreign currency risk management

16. 16 takes a position in a derivative financial instrument involving opposite return characteristics of the item being hedged so as to off-set losses & gains Hedger Speculator Arbitrageur interested in short-term gains & losses & attempts to profit from price difference set losses & gains takes an open position, in search of profits & is willing to accept risk Main types of foreign currency derivatives used to hedge foreign currency risk Derivative market players

17. 17 Margin requirements Futures contracts require payment of margin, which is comparable to a security deposit Initial margin Variation / mark-to-market margin (VM) Required by clearing house as collateral against trader’s open position Calculated by comparing daily settlement price of futures contract with previous day’s settlement price in case of losses, client may be asked to deposit additional margin if price settlement results in profit, client can withdraw cash from margin account with broker Margin requirements Continued …

18. 18 Clearing mechanism  clearing house acts as mediator in futures contract  sells for the buyer  buys for the seller  eliminates counterparty risk  secures the interests of both parties to a futures contact  monitors solvency of its members by specifying solvency norms Continued …

19. 19 Swap A bilateral OTC derivative contract in which two parties exchange one stream of future cash flows for another stream of cash flows over a period of time. Swap 1 2 3 principal amounts re-exchanged at the end of the swap interest payments exchanged periodically throughout the life of the swap exchange the principal currency amounts Steps involved in currency swap

20. 20 contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price, on or before a specified future date. Call option Put option the right (but not the obligation) to buy a specified asset at a specified price, on or before a specified date the right (but not the obligation) to sell a specified asset at a specified price, on or before a specified date Currency options Continued …

21. 21 Features of currency options right to buy (call option) or sell (put option) a quantity of one currency in exchange for another, can be purchased over-the-counter or on an exchange traded currency options are for a standard quantity of one currency in exchange for another currency could be American or European strike prices quoted as exchange rates premiums quoted as an amount in one currency per unit of the other currency Continued …

22. 22 Recap  Traditional and basic methods of foreign currency risk management, including: i. currency of invoice [1] ii. netting and matching [2] iii. leading and lagging [2] iv. forward exchange contracts [2] v. money market hedging [2] vi. asset and liability management [1]  Evaluate traditional methods of foreign currency risk management. [2]  Types of foreign currency derivatives used to hedge foreign currency risk and how they are used in hedging. [1]

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