1. 18-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger Chapter 18 An Introduction to Risk Management and Derivatives

2. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-2 Learning Objectives Understand the nature and importance of risk and risk management, especially operational and financial risk exposures Construct and analyse a structured risk management process Examine the fundamentals of futures contracts Review the operation of forward exchange contracts and forward rate agreements Understand the nature and versatility of options contracts Consider the structure of an interest rate swap and a cross-currency swap

3. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-3 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

4. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-4 18.1Understanding Risk Risk — the possibility or probability of something occurring that is unexpected or unanticipated Categories of risk –Operational risk –Financial risk

5. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-5 18.1Understanding Risk Operational risk –Exposure that may impact on the normal commercial functions of a business, affecting its operational and financial performance, e.g.:  technology  property and equipment  personnel  competitors  natural disasters  government policy  suppliers and outsourcing –Can be managed through the use of real options

6. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-6 18.1Understanding Risk (cont.) Financial risk –Exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities, e.g.:  interest rate risk  foreign exchange risk  liquidity risk  credit risk  capital risk

7. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-7 18.1Understanding Risk (cont.) Financial risk (cont.) –Relationships between risks can result in one risk impacting on another risk  Direct risk — the initial risk event that impacts on the operational or financial position of an organisation  Consequential risks — exposures that eventuate as a result of an initial direct risk event

8. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-8 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

9. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-9 18.2The Risk Management Process Effective management of risk exposures requires a structured risk management process Although the range of risks varies by organisation, one such model is: –identify operational and financial risk exposures –analyse the impact of the risk exposures –assess the attitude of the organisation to each identified risk exposure –select appropriate risk management strategies and products –establish related risk and product controls –implement the risk management strategy –monitor, report, review and audit

10. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-10 18.2The Risk Management Process (cont.) Identify operational and financial risk exposures –Requires full understanding of the business, including operations, personnel, competitors, regulators, legislative requirements, stakeholders, cash flows and balance sheet structure –Also need to understand interrelationships and causal links between the above categories Analyse the impact of the risk exposures –A business impact analysis is used to document each risk exposure and measure the operational and financial impacts should the risk event occur –Need to consider both quantitative and qualitative risks

11. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-11 18.2The Risk Management Process (cont.) Assess the attitude of the organisation to each identified risk exposure –Not all risks will be mitigated or removed –The risks to be avoided, controlled, transferred or retained should be documented Select appropriate risk management strategies and products –An integrated process to analyse the risk management options available –Generally, several risk management strategies available, the choice between them to be subject to cost–benefit analysis –All risk management processes and strategies should be periodically audited

12. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-12 18.2The Risk Management Process (cont.) Establish related risk and product controls –Ensure adequate controls established, documented and circulated among personnel –These include procedural controls and system controls  Procedural controls document risk management products that can be used by the organisation  System controls cover all electronic product delivery and information systems relating to the identification, measurement, management and monitoring of risk management

13. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-13 18.2The Risk Management Process (cont.) Implement the risk management strategy –Obtain written authority to proceed with implementation –Check that time lags between the commencement of this process and the implementation of the strategy have not impaired the effectiveness of the strategy –Risk strategies are developed for different planning periods Monitor, report, review and audit –As risk management is ongoing, the strategies must be continuously monitored to ensures they achieve the expected risk management objectives and outcomes

14. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-14 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

15. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-15 18.3Futures Contracts An agreement between two parties to buy, or sell, a specified commodity or financial instrument at a specified date in the future at a price determined today An exchange traded contract where standardised contracts are traded in a formal market

16. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-16 18.3Futures Contracts (cont.) Examples include: –A fund manager holding shares who is concerned the price may fall before they are sold –An investor concerned that share prices may rise before they are purchased Strategy involves carrying out an initial transaction in the futures market that corresponds with the transaction to be conducted in the physical market at a later date (see Figure 18.1, next slide)

17. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-17 18.3Futures Contracts (cont.)

18. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-18 18.3Futures Contracts (cont.) Relevant terms –Clearing house — records transactions conducted on an exchange and facilitates value settlement and transfer –Initial margin — deposit lodged with clearing house to cover adverse price movements in a futures contract –Marked-to-market — the periodic repricing of an existing contract to reflect current market valuations –Maintenance margin call — the top-up of an initial margin to cover adverse futures contract price movements

19. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-19 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

20. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-20 18.4Forward Contracts A financial instrument designed mainly to manage specified risks Offered over the counter by financial institutions –Therefore, more flexible than highly standardised exchange- traded products like futures, as the terms and conditions of a forward contract, such as amount and timing of the contract, can be negotiated Two main types 1.Forward rate agreements (FRAs) 2.Forward foreign exchange contracts

21. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-21 18.4Forward Contracts (cont.) 1.Forward rate agreements (FRAs) –An over-the-counter product used to manage interest rate risk exposures –Allows a borrower to manage future interest rate risk exposure by locking in an interest rate today that will apply at a specified future date  Is given effect by one party to the contract compensating the other party if the reference rate is different from the agreed rate –Relevant terms  FRA agreed rate — the fixed interest rate stipulated in the FRA at the start of the contract  FRA settlement date — the date when the FRA agreed rate is compared with the reference rate to calculate the compensation amount  FRA contract period — the term of the interest rate protection built into the FRA

22. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-22 18.4Forward Contracts (cont.)

23. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-23 18.4Forward Contracts (cont.) 2.Forward foreign exchange contracts –Also known as a forward exchange contract; locks in an exchange rate today for delivery of foreign currency at a specified future date –Example, an Australian company may be importing goods from overseas and the company will need to pay USD1 million in three months’ time

24. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-24 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

25. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-25 18.5Option Contracts An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date) Types of options –Call options  Give the option buyer the right to buy the commodity or instrument at the exercise price –Put options  Give the buyer the right to sell the commodity or instrument at the exercise price

26. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-26 18.5Option Contracts (cont.) An option will only be exercised if it is in the buyer’s best interests, i.e.: –A buyer will not exercise the right to sell if the physical market price is above the exercise price of the option –A buyer will not exercise the right to buy if the physical market price is below the exercise price of the option contract at expiration date Options can be exercised either: –only on expiration date (European option); or –any time up to expiration date (American option)

27. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-27 18.5Option Contracts (cont.) Premium –The price paid by an option buyer to the writer (seller) of the option Exercise price or strike price –The price specified in an options contract at which the option buyer can buy or sell

28. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-28 18.5Option Contracts (cont.) Call option profit and loss payoff profiles

29. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-29 18.5Option Contracts (cont.) Call option profit and loss payoff profiles

30. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-30 18.5Option Contracts (cont.) Put option profit and loss payoff profiles

31. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-31 18.5Option Contracts (cont.) Put option profit and loss payoff profiles (cont.)

32. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-32 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

33. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-33 18.6Swap Contracts An over-the-counter financial product allowing parties to enter into a contractual agreement to exchange cash flows Intermediated swap –A party enters into a swap with a financial intermediary Direct swap –Two parties enter into a swap with each other without using a financial intermediary Two main types of swap contracts i.Interest rate swaps ii.Cross-currency swaps

34. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-34 18.6Swap Contracts (cont.) 1.Interest rate swaps –The exchange of interest payments associated with a notional principal amount –Notional principal amount — the underlying amount specified in a contract that is used to calculate the value of the contract –Vanilla swap — a swap of a series of fixed interest rate payments for floating interest rate payments –Basis swap — a swap of a series of two different reference rate interest payments –Swap rate — the fixed interest rate specified in a swap contract

35. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-35 18.6Swap Contracts (cont.)

36. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-36 18.6Swap Contracts (cont.)

37. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-37 18.6Swap Contracts (cont.) 2.Cross-currency swaps –Two parties, such as a bank and a company, exchange debt denominated in different currencies –Interest payments are exchanged –Principals exchanged at beginning of agreement and then re-exchanged at conclusion of agreement, usually at the same exchange rate  Example: If the swap is an AUD-USD contract based on USD1 million and an exchange rate set at AUD/USD0.8500, at the start of the contract one party would exchange USD1 million for AUD1 176 470.59 At each future interest payment date, interest payments would be calculated using the same exchange rate, i.e. AUD/USD0.8500 Finally, at the swap completion date, the original AUD and USD principal amounts would be re-exchanged

38. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-38 18.6Swap Contracts (cont.)

39. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-39 Chapter Organisation 18.1 Understanding Risk 18.2 The Risk Management Process 18.3 Futures Contracts 18.4 Forward Contracts 18.5 Option Contracts 18.6 Swap Contracts 18.7 Summary

40. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-40 18.7Summary Risk can be categorised as operational and financial risk The risk management process involves a number of steps A futures contract is an agreement between two parties to buy or sell a specified commodity or instrument at a specified future date at a price specified today A forward contract is a financial instrument designed to manage specified risk –Two forward contracts are forward rate agreements (FRAs) and forward exchange contracts

41. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 18-41 18.7Summary (cont.) An option contract gives the buyer the right but not the obligation to buy or sell a specified commodity or financial instrument at a specified price on or before a specified date Swaps facilitate the exchange of specified cash flows –Interest rate swaps are used to manage interest rate risk –Currency swaps are used when an interest rate swap involves borrowing in different currencies  Allow the management of interest rate and FX risk exposure  Currency swaps differ from interest rate swaps in that the principal amounts raised by the two borrowers are swapped at the commencement and re-exchanged at the end of the agreement