1. copyright anbirts1 Definition of Risk Variability of Possible Returns Or The Chance That The Outcome Will Not Be As Expected

2. copyright anbirts2 Why Manage Risk? Objective of the Organisation Maximise Shareholder Wealth How? Cash Flow = Value Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital

3. copyright anbirts3 Should We Manage Risk? Perfect Markets Parity Portfolio Theory

4. copyright anbirts4 Risk Management Culture – Focus Identify Categorise Measure Impact Manage Define Accountability Report Policy Risk Management Process

5. copyright anbirts5 Why Identify Risks? Unidentified risks will not be managed Managing risks can improve performance Identification provides information about riskiness Alerts the Organisation to the importance of risk

6. copyright anbirts6 Categorisation Different Ways BusinessFinancial Avoidable Transferable Manageable

7. copyright anbirts7 Financial Risks Price/Market Risk Foreign Exchange Interest Rate Equity/Bonds Commodity

8. copyright anbirts8 Financial Risks Liquidity Cash Flow Opportunity Cost Cash Concentration

9. copyright anbirts9 Financial Risks Credit Default Concentration Systemic

10. copyright anbirts10 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.

11. copyright anbirts11 Translation Exposure (In Millions) ASSETSUSD@ 1.20 GBP @ 1.50 GBP LIABILITIESUSD@ 1.20 GBP @ 1.50 GBP Cash151210Creditors due in one year 957963 Investments201713Creditors due over one year 654 Debtors655444Provisions111 Fixed Assets201713Shareholder Funds 181512 1201008012010080

12. copyright anbirts12 Economic Exposure The risk that, long term, the relative appreciation in real terms, of the currency in which a company’s major costs are denominated, will adversely affect that company’s competitive position.

13. copyright anbirts13 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 153.7752 At Year End If PPP held UK Price GBP 104 (100 x 1.04) French Price EUR 156.85068 (153.7752 x 1.02) Therefore Exchange Rate 104 =.6630509 156.85068 But if rate has moved to EUR/GBP.6300 then UK Price of GBP 104 = EUR 165.08 French price of EUR 156.85 Will they sell any goods?

14. copyright anbirts14 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 value @ current spot of 1.44 694,444 GBP value @ current spot of 1.50 666,666 LOSS27,778

15. copyright anbirts15 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.

16. copyright anbirts16 Approaches To Hedging 1.Foreign Exchange –Spot –Forwards –Money Market Hedge –Swaps –Options (not covered)

17. copyright anbirts17 Illustrations Spot Situation: Receipt of USD 10,000,000 in two business days time Spot RateGBP/USD 1.6356 – 1.6366 Sell USD to Bank, Buy GBP Rate 1.6366 ReceiptGBP 6,110,228.52

18. copyright anbirts18 Illustration Forward Situation: Receipt of USD 10,000,000 in 32 days time Spot Rate GBP/USD 1.6356 – 1.6366 1 month Points97 1 Month Forward Outright1.6347 – 1.6359 Sell USD to Bank one month forward and Buy GBP rate 1.6359 Receipt GBP 6,112,843.08

19. copyright anbirts19 Illustration: Money Market Hedge Spot Rate GBP/USD 1.6356 – 1.6366 1 Month Points 9 – 7 Forward Outright 1.6347 – 1.6359 Interest Rates GBP 5 5/8 – 5 13/32 USD 4 31/32 - 4 27/32 Borrowing Spread ½% Borrow USD @ 4 31/32 + ½ for 30 days = 5.46875% Amount Borrowed 10,000,000 = 9,954,634 1 + (.0546875 x 30/360 ) Spot USD 9,954,634 to GBP at 1.6366 = GBP 6,082,509 Invest GBP 6,082,509 at 5 13/32 (5.40625) = 6,082,509 x.0540625 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

20. copyright anbirts20 Illustration: Swap A Swap is a pure time operation which involves two way flows. In Foreign Exchange terms it is a simultaneous spot and forward. It will be priced off the forward transaction but use the same spot. Example:Receiving Spot USD 10,000,000 Paying Away in 32 Days USD 10,000,000 Spot GBP/USD 1.6356 – 1.6366 1 Month Points 9 7 1 Month Forward 1.6347 1.6359

21. copyright anbirts21 Illustration: Swap Spot Sell USD 10,000,000 at 1.6356 Buy GBP 6,113,964 In Forward Buy USD 10,000,000 at 1.6347 Sell GBP 6,117,330

22. copyright anbirts22 Foreign Exchange Policy Issues Define Exposures to Be Managed –Economic –Translation –Transaction Objective: Minimise FX losses and Maximise FX Gains Commensurate with a defined level of Risk

23. copyright anbirts23 Foreign Exchange Policy Issues Which exposures are important Time Period –Start Date Price List, Forecast, Order Date –End Date Year end or beyond, invoiced or expected date Policy Alternatives Cover Everything Leave Open Selective Cover Hybrid

24. copyright anbirts24 Foreign Exchange Policy Issues Instruments –Define proportions in each –Options – write covered or uncovered, buy Set Limits –Overall limits –Individual limits Treasury Procedures

25. copyright anbirts25 Value at Risk (VAR) VAR estimates the potential pre-tax loss resulting from an adverse movement in market prices over a defined holding period. Equities Commodities FX Interest Rates

26. copyright anbirts26 VAR Correlation Approach Historic Data Normal Distribution 68% of changes within one Standard Deviation (SD) 95% of changes within two SD’s 99% of changes within three SD’s 10 million (GBP equivalent) long position in USD SD.15% Want 95% confidence Max loss = 10,000,000 x.0015 x 2 = 30,000 Example: Single Asset

27. copyright anbirts27 VAR Two Assets [(VAR 1 ) 2 + (VAR 2 ) 2 ] Example: Two Unrelated Assets 10,000,000 (GBP equivalent) long in USD SD.15% 10,000,000,Long (GBP equivalent) long in Euro SD.20% 95% Confidence VAR = [(10,000,000 x.0015 x 2) 2 + (10,000,000 x.002 x 2) 2 ] VAR = (30,000) 2 + (40,000) 2 VAR = 900,000,000 + 1,600,000,000 = 2,500,000,000 =50,000

28. copyright anbirts28 VAR Correlation (Related Movements) VAR = [(VAR 1 ) 2 + (VAR 2 ) 2 + 2 x VAR 1 x VAR 2 x R] Example Same as above but Correlation Coefficient.6 VAR = (30,000) 2 + (40,000) 2 + 2 x 30,000 x 40,000 x.6] VAR = 62,769

29. copyright anbirts29 VAR Advantages –Reasonably simple concept to communicate –Used to aggregate risks –Can correlate Profits to Risk (Performance Measurement) Disadvantages –Based on major assumptions (normal distribution, history repeats itself) –Complex mathematics –Sudden shifts of volatility –Appears scientific

30. copyright anbirts30 Setting Limits: An Approach Co Net Worth GBP 10,000,000 Prepared to Lose 2,000,000 Currency Exposure USD Annual Volatility 20% and Monthly Volatility 20 x Maximum Exposure Period: 6 months Month123456 Volatility5.778.1610.0011.5512.9014.14 Position 3,198,976 Possible Loss 184,581261,036319,898369,482412,668452,335 Maximum Loss 2,000,000

31. copyright anbirts31 Interest Rate Risk - Gap Analysis (1)At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit Months0-66-1212-1818-2424-3030-3636-4242-48 Principal90007875675056254500337522501125 i @ 8%3653192732281821379146 + Principal14901444139813531307126212161171 Op profit15981597159815971598 15971598 I @ 10%45639934228522817111457 + Principal15811524146714101353129612391182 i @ 12%54747941134227320513768 + Principal16721604153614671398133012621193 Op profit15981597159815971598159715981597 Short Fall(78)(7)62130200267336404 (1) Op Profit127912781279127812791278 Short Fall(393)(326)(257)(189)(119)(52)1686 (2) Op Profit Short Fall(302)(246)(188)(132)(74)(18)3997

32. copyright anbirts32 Interest Rate Risk Instruments Forward Forward Money Forward Rate Agreement Interest Rate Swap Interest Rate Options

33. copyright anbirts33 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 997,540.31 and Deposit for 1 month 997,540.31 x.03 x 30/365 = 2,459.69 = 1,000,000 in total at T30 Cost of Borrowing: 997,540.31 x.0425 x 60/365 = 6969.12 Total to Repay at 60 days = 1,004,509.43 Effective Cost of Borrowing = 4,509.43 x 365/30 = 5.4865 from T30-T60 1,000,000

34. copyright anbirts34 Forward Rate Agreements (FRA’s) 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.

35. copyright anbirts35 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.05125 x 30/365 = 4,212.33 1,000,000 x.0525 x 30/365 = 4,315.07 = 102.74 = 102.74 = 102.30 1 + (.0525 x 30/365 ) QuotePeriodRate 1-25-5 1/8 1-45 1/8 -5 1/4 3-125 1/4 -5 3/8

36. copyright anbirts36 Test 1,000,000, - 102.30 = 999,897.70 999,897.70 x.0525 x 30/365 = 4,314.63 Less Compensation Amount = 102.30 Total Net Interest Paid 4,212.33

37. copyright anbirts37 Interest Rate Swap Comparative Advantage FixedFloating AAA8Libor + 1/4 BBB10Libor + 1/2 Difference2 1/4 Benefit1 3/4

38. copyright anbirts38 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0 AAA -(8) + 8. 1/2 -L Net – (L – 1/2 ) Benefit ¾ + 1 1 3/4 BBB 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0

39. copyright anbirts39 Interest Rate Swap AAA -(8) + 8.5 1/2 -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

40. copyright anbirts40 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 borrower’s floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above.

41. copyright anbirts41 Interest Rate Cap Effective Interest Rate Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million

42. copyright anbirts42 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.

43. copyright anbirts43 Interest Rate Collar Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%

44. copyright anbirts44 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

45. copyright anbirts45 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 80174.07 80268.59137.18 80363.51190.53 80458.80235.20 10805735.033675.15 1,0004,312.13

46. copyright anbirts46 Duration Duration = 4,312.13 = 4.31 years 1,000 Known as Macauley Duration

47. copyright anbirts47 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.

48. copyright anbirts48 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%.