Risk and Derivatives etc.

Dr Bryan Mills

Traditional (internal) methods of risk management

• External:– banks, etc e.g. hedge, options, forward contracts

• Internal:

– invoice decision, lead/lag, netting, matching, asset/liability management

• Netting:

– cover only the net exposure by hedge. If you have many subsidiaries in different countries it is only the net risk/exposure that need be considered.

• Matching:

– try to match invoice currencies with receipts (by careful supplier selection).

• Internal asset/liability management:

– balance sheet hedging – ensures assets are in strong currencies and liabilities in weak ones.

Lead Payment Option

• Definition to learn:• Leading and lagging is a currency risk

management technique in which the timings of payments in foreign currencies are adjusted.

• Lead – pay before due• Lag – pay after due

Pay in Sterling Option

• This depends on the other company’s willingness to take the risk!

Example Payment to us of 5,000,000 Euros due in 3 months: -Euros/£Spot 11.121 – 11.1503 month forward 10.948 – 10.976Discount

Borrow LendEuro 11% 9%Sterling 15.5% 12% 5,000,000 currently worth 5m/11.121 = £449,600

Note that the forward rate suggests an appreciation of the Euro is likelyHedge Option Buy Ff 5,000,000 forward 5m/ 10.948 =

£456,704

As the forward price is greater than the spot it looks like we may as well pay now. However, we should first consider the interest cost of this approach. £449, 600 * (1 + [(0.155 * 3 mnth)/12 mnth]) = £467, 020this is more than Forward - not such a good idea!

Pay in Sterling Option This depends on the French company’s willingness to take the risk.

Currency Overdrafts / Money Market Hedging

1. Borrow money you expect to be paid now in that currency. Convert this into sterling.

2. When the payments are due use this to settle the foreign overdraft/loan.

3. You get your money at today's spot - no risk - but remember to factor in interest payments.

Going to get $10,000 in +5 years If r* = 10% then borrowing $6,209.2 now would cost ($10,000)/ (1 + 0.1)5

Our payment in 5 years time will pay off the loan but we get $6,209.2 NOW We can forget about the US debt, spend the money and suffer no risk.

Risk Management

Unfortunately, currency is not our only financial risk –

we also have to content with changes in interest rates

(and inflation).

Checklist of Instruments to avoid risk

Interest• Futures• Forward Rate Agreement

(FRA)• Options• Swaps• Swaptions

Currency• Internal (lead/lag/net/etc)• Forward contracts• Futures• Options• Swaps

Futures Contracts

• Futures contracts are for a fixed amount and a fixed maturity date. It is tradable and so the value of the ‘right to buy or sell’ in itself goes up and down.

• You enter into a futures contract not to guarantee a rate

but to compensate you if the rate goes against you. • If the rate is favourable you pay out most of your gain. • You don’t win – it’s just that you don’t lose!

Options Contract As with futures but this time you pay an upfront premium and have the right but not the obligation to buy/sellOptions versus Futures

Futures are cheaper but cruder! Futures protect against loss.Options protect against loss and allow gain

Example Will get $486,500 in 3 months

Futures at $1.39 guarantees £350,000

Option (call) with same value at a premium of £500 per £25,000 Need £350,000 = 14 (14 x £500 = £7,000)

£25,000

If sterling weakened to $1.20/£ the future is locked but the option can be lapsed.

• Alternatively, a ‘deeper out of pocket’ option of $1.50/£ could be bought for £100.

• In other words, there are various scenarios to

plan. • The main advantage of options is the ability to

walk away losing only the premium.

Types of Options AvailableInterest rate options:

Strike Price

Call Put

June September

June September

106 1.51 2.38 1.25 3.06107 1.19 2.11 1.57 3.43108 0.58 1.51 2.32 4.19

As with futures, tick values = 0.01%

Contracts are £100,000: Tick value is £100,000 x 0.01 = £10 If asked for the price of a June call contract at 106 then:

1.51 x £100,000 = £1,510 (this is the price) If you bought this you could later buy a 7% UK gilt in June at a ‘price’ of £106 per £100. In other words 7/106 x 100 = 6.6%

Spot

increasing

Profit

Premium

Loss

Option exchange value (strike)

Put Option

option is above spot so makes profit

Intrinsic value

• Short term Interest Rate Options • These are 3 months and basically are the same as longs, but

with lower prices. • OTC Interest Rate Options • Again OTC are tailored and available from banks. • Definition to learn: • A short term OTC interest rate option contract (i.e. for a period

of up to one year) is called an interest rate guarantee (IG).

Longer terms are:

• Cap: option to limit a price to a given max• Floor: option to limit a price to a given max• Collar: a cap and a floor• Caption: option to buy a cap

Today is June 30th

KYT USA has to pay a bill in Yen in 2 months time (1st September). The amount is yen 200m Today's spot is Yen/$128.15 (0.007803) Futures contracts exist that are per 12,500,000 yen Sept. 0.007985 premium (125.23)Dec 0.008250 premium (121.21) (for your dollar you are going to get less yen - the dollar is depreciating) And these contracts are settled at the end of the month

Answer a) You need a contract as near to September 1st as possible and Yen200m/12.5m (amount/contract size) suggests that you can get cover by buying 16 contracts (payment and contract are in same currency – no conversion required) b) Basis risk is simply the differences between forward and spot = 2.92 c) When F expires F should equal St

The risk therefore reduces gradually over the contract period - but we want money on the 1st not the 30th. If told that the spot on the 1st is actually 120yen/$ and been asked, with hindsight, to work out whether the forward contract was a good idea. If we divide the basis risk by the number of months the contract runs for we get a linear month by month price: 2.92/3 = 0.973

Let’s look at what’s happening:1. Select month closest to required date2. Calculate number of contracts required:

Investment amount Contract size

3. Calculate basis: Spot price – futures price = basis 4. Calculate out basis at date contract is closed out:

Basis * Months leftTotal futures months

5. Determine expected price of future at point t Spot – Basis at t = Futures PriceMargin is then the difference between this and original price

6. Determine futures gain (loss) Margin * contracts * contract size

7. Calculate efficiency of hedge Profit on futures contract

Loss on spot

Basis 0.42 Sp

ot 1

20

Futu

re 1

19.5

8

30th June 30th July 30th August 30th September

Spot

128

.10

B

asis

1.2

6

F

utur

e 12

6.84

Assume today is June 30th. An amount of money is owed by an American company trading in dollars to a Japanese company trading in Yen. The money (¥100m) is due on the 1st of September. Current spot price is $/¥128.10 ($0.007806). Future Contracts exist per ¥12,500,000 settled on 30th.Sept. 0.007884 premium (¥126.84)Dec. 0.008334 premium (¥199.99)Spot price on September 1st is ¥120

¥128.10 – ¥126.84 = ¥1.26

¥1.26 * 1 = ¥0.42 3

¥120 – ¥0.42 = ¥119.58