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Copyright anbirts1 MSc In General Management FX and Interest Rate Risk Management.

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Presentation on theme: "Copyright anbirts1 MSc In General Management FX and Interest Rate Risk Management."— Presentation transcript:

1 copyright anbirts1 MSc In General Management FX and Interest Rate Risk Management

2 copyright anbirts2 FX and Interest Rate Risk Management Agenda 1 Foreign Exchange Caveat, there will be some overlap!! Exchange rate exposures - Translation - Economic - Transaction Reading foreign exchange rates - Spot rates - Forward rates Money markets

3 copyright anbirts3 FX and Interest Rate Risk Management Agenda 2 Interest Rate Risk Defining exposure Measuring impact Hedging instruments - Forward forward money - Futures - FRAs - Interest rate swap - Option based instruments

4 copyright anbirts4 Why Manage Risk? Objective of the Organisation Maximise Shareholder Wealth How? Cash Flow = Value Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital

5 copyright anbirts5 Should We Manage Risk? Perfect Markets Parity Portfolio Theory

6 copyright anbirts6 Translation Exposure Translation exposure represents the effects, as reflected in the balance sheet and/or profit and loss account, of a movement in exchange rates between reporting dates on the translation of assets and liabilities denominated in foreign currencies.

7 copyright anbirts7 Translation Exposure (In Millions) GBP GBP Cash151210Creditors due in one year Investments201713Creditors due over one year 654 Debtors655444Provisions111 Fixed Assets201713Shareholder Funds

8 copyright anbirts8 Economic Exposure The risk that, long term, the relative appreciation in real terms, of the currency in which a companys major costs are denominated, will adversely affect that companys competitive position.

9 copyright anbirts9 Economic Exposure: An Example CoA Manufacturer in UK selling to France Inflation rate 4% p.a. Current Price GBP 100 Current Exchange Rate EUR/GBP.6503 Competitor in France Inflation Rate2% p.a. Current PriceEUR At Year End If PPP held UK Price GBP 104 (100 x 1.04) French Price EUR ( x 1.02) Therefore Exchange Rate 104 = But if rate has moved to EUR/GBP.6300 then UK Price of GBP 104 = EUR French price of EUR Will they sell any goods?

10 copyright anbirts10 Transaction Exposure The risk that arises from exchange rate changes reflected in the day to day trading activities of a company. TRANSACTION EXPOSURE EXAMPLE Receipt due 180 days USD1,000,000 GBP current spot of ,444 GBP current spot of ,666 LOSS27,778

11 copyright anbirts11 Approaches To Hedging 1.Foreign Exchange –Spot –Forwards –Money Market Hedge –Swaps –Options (not covered today)

12 copyright anbirts12 Illustrations Spot Situation: Receipt of USD 10,000,000 in two business days time Spot RateGBP/USD – Sell USD to Bank, Buy GBP Rate ReceiptGBP 6,110,228.52

13 copyright anbirts13 Illustration Forward Situation: Receipt of USD 10,000,000 in 32 days time Spot Rate GBP/USD – month Points97 1 Month Forward Outright – Sell USD to Bank one month forward and Buy GBP rate Receipt GBP 6,112,843.08

14 copyright anbirts14 Illustration: Money Market Hedge Spot Rate GBP/USD – Month Points 9 – 7 Forward Outright – Interest Rates GBP 5 5/8 – 5 13/32 USD 4 31/ /32 Borrowing Spread ½% Borrow 4 31/32 + ½ for 30 days = % Amount Borrowed 10,000,000 = 9,954, ( x 30/360 ) Spot USD 9,954,634 to GBP at = GBP 6,082,509 Invest GBP 6,082,509 at 5 13/32 ( ) = 6,082,509 x x 30/365 = GBP 27,028 = Total GBP at Day 32 = 6,109,537 Situation: Receipt of USD 10,000,000 in 32 days time

15 copyright anbirts15 Swaps

16 copyright anbirts16 FX SWAP The Spot Purchase and Forward Sale of Currency. The Two Transactions are Executed Simultaneously and are based off the Same Spot Rate

17 copyright anbirts17 FX Swap Rates As with a forward contract the Bank will quote a spot and a forward rate for both sides of the market GBP/CAD Month Points 14 12

18 copyright anbirts18 FX SWAP RATES However it is only the Forward Points representing the differential in interest rates between the two currencies that will affect the swap. The forward points to be used will be determined by the forward transaction in the Swap. The Same Spot Rate will be used for both the purchase and sale of the currency

19 copyright anbirts19 EXAMPLE Your Canadian subsidiary tells you that it wishes to borrow Canadian dollars for one month (30 days). Their local bank will lend at 5.5% pa. Your GBP interest cost is 6% pa. Is it cheaper for the subsidiary to borrow from you or from the bank?

20 copyright anbirts20 THE SWAP CALCULATION 1 Questions to ask 1 What will it cost in CAD? 2 In the Swap, what side will we be on in the forward? (this will determine the spot rate to use) 3 Therefore how many GBP do we need to borrow today to give CAD 3,000,000? 4 Therefore how many GBP will we have to pay back at 6.0% in the future? 5 At the forward rate, how many CAD will be needed? 6 Is this more or less than borrowing CAD directly?

21 copyright anbirts21 THE SWAP CALCULATION 2 Borrowing CAD directly from the local bank will cost 3,000,000 x.055 x 30/365 = 13,561.64

22 copyright anbirts22 THE SWAP CALCULATION 3 Spot Day Points month forward outright Today At spot of Buy CAD 3,000, Sell GBP 1,281, ,281,886.94x.06x30/365 = 6, Forward At forward of Sell CAD 3,013, Buy GBP 1,288,208.57

23 copyright anbirts23 ANSWER Borrow CAD Direct at 5.5% Cost CAD 13, Borrow CAD via the swap Cost CAD 13, So, on financial basis, do the swap Effective interest rate in CAD 13, x 365/30 = 5.37% 3,000,000

24 copyright anbirts24 USES OF THE SWAP Can be used to invest or borrow in a foreign currency for a specified period of time without creating an fx exposure concentrate funds from a number of different currencies into one currency to obtain better rates without creating an fx exposure offset surplus funds in one currency against deficit in another currency for a specified period of time without creating an fx exposure

25 copyright anbirts25 FX and Interest Rate Risk Management Agenda 2 Interest Rate Risk Defining exposure Measuring impact Hedging instruments - Forward forward money - Futures - FRAs - Interest rate swap - Option based instruments

26 copyright anbirts26 Interest Rate Risk The risk of loss of interest revenue that occurs when interest rates change, through the mismatch of re-pricing of assets and liabilities.

27 copyright anbirts27 Interest Rate Risk - Gap Analysis (1)At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit Months Principal % Principal Op profit % Principal % Principal Op profit Short Fall(78)(7) (1) Op Profit Short Fall(393)(326)(257)(189)(119)(52)1686 (2) Op Profit Short Fall(302)(246)(188)(132)(74)(18)3997

28 copyright anbirts28 Interest Rate Risk Instruments Forward Forward Money Futures Forward Rate Agreement Interest Rate Swap Interest Rate Options

29 copyright anbirts29 Forward Forward Money Situation: Need to borrow GBP 1,000,000 from 30 days time for 30 days Current Interest Rate 1 month 3-3½ 2 month 3¾-4 Borrowing Spread ¼% Action: Borrow for 2 months at 4¼%, Deposit for 1 month at 3% Borrow today GBP 997, and Deposit for 1 month 997, x.03 x 30/365 = 2, = 1,000,000 in total at T30 Cost of Borrowing: 997, x.0425 x 60/365 = Total to Repay at 60 days = 1,004, Effective Cost of Borrowing = 4, x 365/30 = from T30-T60 1,000,000

30 copyright anbirts30 Financial Futures Definition A term used to designate the standardised contracts covering the purchase or sale of an agricultural commodity e.g. corn, commodity e.g. oil, foreign currency or financial instrument for future delivery on an organised futures exchange

31 31 Financial Futures An Example Three Month Eurodollar Interest Rate Future Unit of Trading USD 1,000,000 Delivery/Expiry Months March, June, September, December and four serial months, such that 24 delivery months are available for trading, with the nearest six delivery months being consecutive calendar months Delivery /Expiry Day First business day after last trading day Last Trading Day11.00 Two business days prior to third Wednesday of delivery month Quotation minus rate of interest Minimum Price Movement (tick size & value) 0.01 (USD 25) Initial Margin (Straddle Margin) USD 625 (USD 200) Trading hours08.30 – 16.00

32 copyright anbirts32 Financial Futures Example Date: 21 st October 2009 Situation: USD 1,000,000 due November 21 st 2009 Intention: Invest three month on interbank market Problem: Expect rates to fall from current rate of 2 % Questions 1)Will you buy or sell futures? 2)How many?

33 copyright anbirts33 Financial Futures Example Action Today Today in the Futures Market: Buy one December contract at 98.1 ( %) Note: at todays rate of 2 % USD 1,000,000 would earn 1,000,000 x.02 x 90/360 = 5,000

34 copyright anbirts34 Financial Futures Example Action on 21st November In cash market, arrange three month deposit of USD at current rate of 1.5 % 1,000,000 x.015 x 90/360 = 3,750 This equals a loss of 1,250 over 2% rate Sell the future for 98.6 ( )

35 copyright anbirts35 Financial Futures Example Net Result 1,000,000 x.015 x 90/360 = 3,750 Bought Future at Sold Future at Gain 50 basis points At USD 25 per tick =1,250 = 5,000

36 copyright anbirts36 Financial Futures Example Question? Why have we managed a perfect hedge? i.e. ended up with USD 1,005,000 at end of deposit? Note: the cash price moved from 2 to 1.5 A movement of 50 basis points The futures price also moved by 50 basis points exactly offsetting the loss on the cash market

37 copyright anbirts37 Financial Futures Example Will this always be so? No Cash market Futures market Today Expiry Basis

38 copyright anbirts38 Financial Futures Example So what if held to expiry? Cash market = 1.5 therefore futures price would be But bought at Gain 40 basis points Therefore net result = 40 x 25 = 1,000 Plus interest earned at 1.5 = 3,750 Total 4,750 So effective interest = 4,750/1,000,000 x 360/90 x 100 = 1.9%

39 copyright anbirts39 Forward Rate Agreements (FRAs) An agreement between two parties to compensate one another, in cash, on a certain date for the effect of any subsequent movement in market rates in respect of a future interest period.

40 copyright anbirts40 FRA Example Need to borrow GBP 1,000,000 in 30 days time for 30 days. Worried rates will rise. Rate Agreed 5 1/8 (5.125) Actual Rate On Day T30 5 1/4 Compensation amount paid by Bank to Company 1,000,000 x x 30/365 = 4, ,000,000 x.0525 x 30/365 = 4, = = = (.0525 x 30/365 ) QuotePeriodRate / /8 -5 1/ /4 -5 3/8

41 copyright anbirts41 Test 1,000,000, = 999, , x.0525 x 30/365 = 4, Less Compensation Amount = Total Net Interest Paid 4,212.33

42 copyright anbirts42 Interest Rate Swap Comparative Advantage FixedFloating AAA8Libor + 1/4 BBB10Libor + 1/2 Difference2 1/4 Benefit1 3/4

43 copyright anbirts43 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0 AAA -(8) /2 -L Net – (L – 1/2 ) Benefit ¾ /4 BBB 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0

44 copyright anbirts44 Interest Rate Swap AAA -(8) /2 -L Net – (L – 1/2 ) 1/4 ¾ 1 3/4 Benefit Bank 8 1/2 L -(L + ½ ) +(L) -8 3/4 –9 1/4 BBB L 8 3/4 + 1/4

45 copyright anbirts45 Interest Rate Cap or Ceiling Agreement An interest rate cap is an agreement between the seller or provider of the cap and the borrower to limit the borrowers floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above.

46 copyright anbirts46 Interest Rate Cap Effective Interest Rate Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million

47 copyright anbirts47 Interest Rate Collar Agreements An interest rate collar is an agreement whereby the seller or provider of the collar agrees to limit the borrower/investors floating interest rate to a band limited by a specified ceiling rate and floor rate.

48 copyright anbirts48 Interest Rate Collar Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%

49 copyright anbirts49 Duration You have a bond, life 5 years with annual interest payments of 8%, face value GBP 1,000 What is your problem? Market Price Risk Re-Investment Rate Risk

50 copyright anbirts50 Duration Duration gives an average life of the cash flows of an instrument by weighting the Net Present Values of the cash flows by their timing. Cash FlowYearNPVNPV x Y ,0004,312.13

51 copyright anbirts51 Duration Duration = 4, = 4.31 years 1,000 Known as Macauley Duration

52 copyright anbirts52 Uses of Duration Immunisation Wish to fix yield on a portfolio of bonds regardless of whether interest rates go up or down. Done by creating a portfolio of bonds with a Duration equal to the required period.

53 copyright anbirts53 Uses of Duration Price Sensitivity Modified Duration which is Macauley Duration (1 + y/n) Wherey = yield n = number of discounting periods 4.31 = 3.99 (1.08) Or increase in the market interest rate of 1% will lead to a drop in the value of the bond of approximately 3.99%.

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