Managing Financial Risk Prof Ian Giddy New York

First Principles l Invest in projects that yield a return greater than the minimum

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 1998 Ian

Tools for Hedging l Pacasmayo has to pay for equipment from Japan, in Japanese

A Typical Forward Contract l We agree today to pay a certain price for

Customization, Performance Risk and Liquidity l Customization implies bilateral contracts, which carry performance risk

How Does the Bank Hedge a Forward Contract? Hedging approaches: u. Open u. Forward

The FX Swap Hedge 3 -month Swap 3 -month Forward Contract l l Dealers

The Roll-Over Swap Hedge 3 -month Swap 6 -month Forward Contract l l Dealers

The Forward Rate Tracks the Spot Rate Copyright © 1998 Ian H. Giddy Managing

Marking-to. Market of a Forward Contract

Forwards vs Futures vs Options l l Good credit: Forward usually best Sometimes, Money

Option Hedge CALL OPTION ON YEN FORWARD CONTRACT Copyright © 1998 Ian H. Giddy

Option Hedge Questions about options: n When should companies use them? n Which options?

Measuring Market Exposure Defining corporate exposure: “How will my company’s value be affected by

How Effective is My Company’s Risk Management? Warning Signs: l l Don’t measure risk

Risk Management is a Process Corporate Risk Management Define Copyright © 1998 Ian H.

Formalize Risk Management Policy and Control Framework • Develop an outline of a policy

Identification and Definition of Financial Exposures Goal: To identify significant financial risk exposures and

Market Risks: Definitions Three Views of Market Price Risk: l Transactions l Balance Sheet/Portfolio

Market Risks: Definitions Three Views of Market Price Risk: l Transactions Exposure l Balance

Transactions Exposure Portfolio Exposure l Economic Exposure Transactions exposure results from particular transactions such

But Transactions Exposure Can be Misleading. . . Transactions Exposure Portfolio Exposure Economic Exposure

Transactions Exposure Austin Computer Portfolio Exposure Economic Exposure NT$ Copyright © 1998 Ian H.

Interest Rate Risk: Portfolio Transactions Exposure Portfolio Exposure Economic Exposure Portfolio risk: interest rate

Transactions Exposure Pepsico Pension Portfolio Exposure Assets (each $10 m): u 1 -year E$

Transactions Exposure Value at Risk: Santos. Bank Portfolio Exposure INSTRUMENT 30 day 90 day

Transactions Exposure BIS: Minimize Value at Risk Portfolio Exposure INSTRUMENT 30 day 90 day

Transactions Exposure Market Price Risk: Economic Portfolio Exposure Economic Exposure l Economic risk arises

Inmet Mining Corp. In 1994 Canadian mining company Inmet bought 48% of Bougrine, a

Transactions Exposure Market Price Risks: Summary Portfolio Exposure Economic Exposure Three Views of Market

Heineken Hedges Heineken plans to borrow DM 15 million in 3 months to expand

Let’s Quote an FRA rate Monday, February 12, 1996 Copyright © 1998 Ian H.

FRA Mechanics Borrow for 6 months at 5% Invest for 3 months at 4%

The Law of One Price Borrow for 6 months at 5% Invest for 3

Interest Rate Swaps An interest-rate swap is an exchange of a fixed for a

Caps and Floors An interest-rate collar involves buying a cap and selling a floor:

Linkages Between Instruments Borrow for 6 months at 5% Invest for 3 months at

Reducing Positions to Factors Positions Assets & Liabilities FRAs Futures Swaps Hybrids Factors Copyright

Three Views of Interest Rate Risk Transactions Exposure Portfolio Exposure Copyright © 1998 Ian

Aero Lloyd l Aero Lloyd is wants to benefit from lower rates but is

Aero Lloyd Copyright © 1998 Ian H. Giddy Managing Financial Risk 62

Interest Rate Risks: Summary Three Views of Interest Rate Risk: w Transactions - lock

www. giddy. org Ian Giddy NYU Stern School of Business Tel 212 -998 -0332;

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Managing Financial Risk Prof. Ian Giddy New York University

First Principles l Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) u Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. u l l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. u l The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Manage corporate financial risk Copyright © 1998 Ian H. Giddy Managing Financial Risk 2

Tools for Hedging l Pacasmayo has to pay for equipment from Japan, in Japanese yen, in 3 months u. Borrow soles and pay now? u. Use a forward contract/FX swap? u. Hedge with options? Copyright © 1998 Ian H. Giddy Managing Financial Risk 8

Customization, Performance Risk and Liquidity l Customization implies bilateral contracts, which carry performance risk l Liquidity implies standardization and freedom from counterparty risk, through exchange-traded contracts Copyright © 1998 Ian H. Giddy Managing Financial Risk 12

The FX Swap Hedge 3 -month Swap 3 -month Forward Contract l l Dealers often hedge a long-term foreignexchange commitment with a spot plus (FX Swap”: spot sale plus forward purchase of a foreign currency The FX swap rate is determined by the interest differential Copyright © 1998 Ian H. Giddy Managing Financial Risk 14

The Roll-Over Swap Hedge 3 -month Swap 6 -month Forward Contract l l Dealers often hedge a long-term foreignexchange commitment with shorter-term contracts, which are “rolled over” as they come due Corporations themselves do this too. Copyright © 1998 Ian H. Giddy Managing Financial Risk 15

Marking-to. Market of a Forward Contract

Forwards vs Futures vs Options l l Good credit: Forward usually best Sometimes, Money Market Hedge better u Perfect market: same (covered int. arb. ) u Imperfect market: MMH may be better l Credit problem: Futures u But: limited and standardized u Requires margin and daily settlement l Uncertain future cash flows: u Liquid instrument (futures/forwards to assure flexibility u Options sometimes advisable Copyright © 1998 Ian H. Giddy Managing Financial Risk 19

Option Hedge Questions about options: n When should companies use them? n Which options? n How much do they cost, n Are they worth paying for? n What is the risk to the bank? Copyright © 1998 Ian H. Giddy Managing Financial Risk 24

Measuring Market Exposure Defining corporate exposure: “How will my company’s value be affected by market price fluctuations? ” l Types of exposure l u. Transactions u. Balance sheet/portfolio u. Economic l A risk management framework Copyright © 1998 Ian H. Giddy Managing Financial Risk 26

How Effective is My Company’s Risk Management? Warning Signs: l l Don’t measure risk No linkage of risk to value No effort to anticipate Lack of business risk policy Copyright © 1998 Ian H. Giddy l l Fragmented effort Narrow focus Poor risk communications Lack of an integrated risk assessment framework Managing Financial Risk 27

Formalize Risk Management Policy and Control Framework • Develop an outline of a policy statement, or recommend improvements to existing document • Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices Corporate Risk Management Define Measure Manage Monitor • Assess centralization issues related to financial risk management and treasury design Copyright © 1998 Ian H. Giddy Managing Financial Risk 32

Identification and Definition of Financial Exposures Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile. Translation Exposure, Transaction Exposure, and Economic Exposure • Long-term versus short-term exposure • Intracompany versus third party exposure • Cross currency exposure Absolute Rate Risk, Convexity, Basis or Correlation Risk Price Risk, Basis or Correlation Risk • Short-term liquidity portfolio • Procurement • Investment portfolio • Inventory • Capital markets borrowing • Sales elasticity • Leasing portfolio • Competitive exposures Currency Copyright © 1998 Ian H. Giddy Interest Rate Commodity Managing Financial Risk 33

Market Risks: Definitions Three Views of Market Price Risk: l Transactions Exposure l Balance Sheet/Portfolio l Economic risk. Portfolio Exposure Copyright © 1998 Ian H. Giddy Economic Exposure Managing Financial Risk 35

Transactions Exposure Portfolio Exposure l Economic Exposure Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date u. Example: If Nokia invoices a NTT of Japan in Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen. u. This kind of exposure is readily hedgable using forwards, futures or debt Copyright © 1998 Ian H. Giddy Managing Financial Risk 36

But Transactions Exposure Can be Misleading. . . Transactions Exposure Portfolio Exposure Economic Exposure Austin Computer purchases notebook computers in Taiwan for sale in the US. l Austin must pay in NT$. l Should it hedge its anticipated payments for 1996? l Copyright © 1998 Ian H. Giddy Managing Financial Risk 37

Interest Rate Risk: Portfolio Transactions Exposure Portfolio Exposure Economic Exposure Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio l Bond price fluctuations will affect the balance sheet l Can be hedged, using duration as a risk/sensitivity measurement tool l Can be hedged with futures, bond options, and swaps. l Copyright © 1998 Ian H. Giddy Managing Financial Risk 39

Transactions Exposure Pepsico Pension Portfolio Exposure Assets (each $10 m): u 1 -year E$ deposit u 5 -year, 6% T-note D=4. 6 u 10 -year Strip l What Economic Exposure Pension liabilities: u $10 m 3 years u $10 m 5 years u $10 m 7 years is Pepsico pension fund’s risk? u. Duration of the assets (+ve) u. Duration of the liabilities (-ve) u. Net duration is the risk to be hedged! Copyright © 1998 Ian H. Giddy Managing Financial Risk 40

Transactions Exposure Value at Risk: Santos. Bank Portfolio Exposure INSTRUMENT 30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr NET TOTAL Copyright © 1998 Ian H. Giddy SANTOSBANK POSITIONS ($1, 250, 000) ($100, 000) $450, 000 $120, 000 $1, 120, 000 $0 $0 Economic Exposure Asset and liability positions for a Brazilian bank’s New York branch. What risk does it face? $0 ($420, 000) $0 $160, 000 $3, 700, 000 Managing Financial Risk 41

Transactions Exposure BIS: Minimize Value at Risk Portfolio Exposure INSTRUMENT 30 day 90 day 180 day 1 yr 2 yr 3 yr 4 yr 5 yr 7 yr 9 yr 10 yr 15 yr NET TOTAL Economic Exposure SANTOSBANK POSITIONS ($1, 250, 000) ($100, 000) $450, 000 $120, 000 $1, 120, 000 $0 $0 $0 + ($420, 000) $0 $160, 000 $3, 700, 000 = Value-at-Risk Mean Copyright © 1998 Ian H. Giddy Managing Financial Risk 42

Transactions Exposure Market Price Risk: Economic Portfolio Exposure Economic Exposure l Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates, FX, commodity prices l It affects the shareholder value, but may be difficult to quantify l Hedging may require tailored solutions Copyright © 1998 Ian H. Giddy Managing Financial Risk 43

Inmet Mining Corp. In 1994 Canadian mining company Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds? l Answer: Business exposure is to lead & zinc prices (mine shutdown in Oct 96 because of low zinc prices) l Hedge with digital option linking cost of funds to lead & zinc prices l Copyright © 1998 Ian H. Giddy Managing Financial Risk 44

Transactions Exposure Market Price Risks: Summary Portfolio Exposure Economic Exposure Three Views of Market Price Risk: l Transactions - lock in forward rate l Portfolios u. Avoid duration mismatching l Minimize Value at Risk l Economic risk - business sensitivity to market prices. Copyright © 1998 Ian H. Giddy Managing Financial Risk 45

Heineken Hedges Heineken plans to borrow DM 15 million in 3 months to expand its Heineken Ice advertising campaign. l The Treasurer wishes to lock in a cost of funds. l One way is with a Forward Rate Agreement (FRA): Vereinsbank agrees to pay Heineken if 3 -mo DMLibor>6%, and vice-versa. l Copyright © 1998 Ian H. Giddy Managing Financial Risk 48

FRA Mechanics Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at 6% SET RATE AT 6% Copyright © 1998 Ian H. Giddy IF LIBOR > 6%, V PAYS H IF LIBOR < 6%, H PAYS V HOW MUCH? PV[(LIBOR-6%)/4] Managing Financial Risk 50

The Law of One Price Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at 6% FRA (forward rate agreement) Lock in 6% Futures contract Lock in 6% Interest rate swap Lock in 6% Copyright © 1998 Ian H. Giddy Managing Financial Risk 53

Interest Rate Swaps An interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time. Effectively, it involves paying the difference between a fixed rate and Libor: 10% Fixed BVB Swaps JAL 3 -mo Libor, floating Copyright © 1998 Ian H. Giddy Managing Financial Risk 54

The Law of One Price Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at 6% FRA (forward rate agreement) Lock in 6% Futures contract Lock in 6% Interest Rate Swap Lock in 6% Cap & Floor at 6% Lock in 6% Copyright © 1998 Ian H. Giddy Managing Financial Risk 56

Linkages Between Instruments Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at 6% FRA (forward rate agreement) Lock in 6% Futures contract Lock in 6% Interest rate swap Lock in 6% Commodity spread Lock in 6% Copyright © 1998 Ian H. Giddy Managing Financial Risk 57

Assignment

Aero Lloyd l Aero Lloyd is wants to benefit from lower rates but is afraid of a higher cost of funds in the future. Should it: u Convert the Vereinsbank line into a 3 -year fixed rate term loan at 8. 85% u Fix Aero Lloyd's short-term cost of funds by means of a 3 -month FRA , starting in three months. u Hedge against rising interest rates using interest rate futures. u Renegotiate the leases at a floating rate. u Convert Aero Lloyd's cost of funds into floating by means of an interest rate swap. The 3 -year swap rate was 6. 97%. u Do nothing at present? Copyright © 1998 Ian H. Giddy Managing Financial Risk 61

Interest Rate Risks: Summary Three Views of Interest Rate Risk: w Transactions - lock in a rate w Portfolios - avoid duration mismatching w Economic risk - evaluate the business sensitivity to interest rates. Copyright © 1998 Ian H. Giddy Managing Financial Risk 63