Chapter 23

Risk Management

Risk Management Structure

• Define the risk– The potential loss in the future– Types of risk: Market risk, Credit risk, Liquidity risk, O

peration risk, ALM risk• Measure the risk

– Use the historical data to predict the future• Manage the risk

– Reduce the risk• Hedge• Diversification

– Capital preparation• Risk-adjusted performance

Hedging by Forward Contract and Money Market

• American Airlines is trying to decide how to go about hedging SFr70 million in ticket sales receivable in 180 days. Suppose it faces the following exchange and interest rates.

Spot rate:$0.6433-42/SFr

Forward rate (180 days): $0.6578-99/SFrSFr 180-day interest rate (annualized):

4.01%-3.97%U.S. dollar 180-day interest rate (annualized):

8.01%-7.98%

a.What is the hedged value of American's ticket sales using a forward market hedge?

• Answer. By selling the ticket receipts forward, American Airlines can lock in a dollar value of 70,000,000 x 0.6578 = $46,046,000.

b.What is the hedged value of American's ticket sales using a money market hedge? Assume the first interest rate is the rate at which money can be borrowed and the second one the rate at which it can be lent.

• Answer. American can also hedge it euro receivable by borrowing the present value of SFr 70 million at a 180-day interest rate of 2.005% (4.01%/2), sell the proceeds in the spot market at a rate of $0.6433/SFr, and invest the dollar proceeds at a 180-day interest rate of 3.99% (7.98%/2). Using this money market hedge, American can lock in a value for its SFr 70 million receivable of $45,907,296 (70,000,000/1.02005 x 0.6433 x 1.0399).

c.Which hedge is less expensive?

• Answer. The forward market hedge yields a higher dollar value for the ticket receivables, so it is preferable.

d. Is there an arbitrage opportunity here?

• Answer. Yes. By borrowing dollars at a semiannual rate of 4.005% (8.01%/2), converting them to euros at the ask rate of $0.6442, and simultaneously investing the euros at a semiannual rate of 1.985% (3.97%/2) and selling the loan proceeds forward at a bid rate of $0.6578, you can lock in an arbitrage spread of 0.133% semiannually.

e.Suppose the expected spot rate in 180 days is $0.67/SFr with a most likely range of $0.64-$0.70/SFr. Should American hedge? What factors should enter into its decision?

• Answer. Based on the expected 180-day spot rate and its expected range, it would appear that American would be better off waiting to convert its ticket sales at the future spot rate. However, American must ask itself where its comparative advantage lies? Does it lie in running an innovative airline or does it reside in trying to outguess apparently sophisticated financial markets? If the former, which most would agree with, American should stick to its knitting and leave the speculation to financial institutions specifically organized for that purpose.

• Assume the following rate scenario:• Four-month Eurodollars 16.37%• Four-month Saudi riyals 12.50%• Spot rate for US$1 SR3.3980• A company in Saudi Arabia needs to borrow U.S. dollars for four mo

nths. However, they find the Eurodollar rate to be at unusually high levels and decide to borrow Saudi riyals instead at 12.5 percent to save interest expenses. The riyals are then converted to U.S. dollars at the spot rate of SR3.3980. After four months the spot rate moves to SR3.3620. Did the company save money or lose money?

• What was the net effective cost? What was the break-even exchange rate (資金成本損益兩平點 ) initially?

• Assume the following rate scenario:• Three-month U.S. dollars 12.50%-12.62%• Three-month Swiss francs 5.25%-5.50%• Spot rate for US$1 Swf1.5640-Swf1.5645• Three-month forward rate for US$1 Swf1.5355-Swf1.5370• What action would you take if you wish to (a) invest in S

wiss francs?(b)borrow swiss francs?

• A U.S. importer of batik form Malaysia must pay Malaysian dollars in four months. She wishes to cover this exposure. Assume the following market rates:

• Four-month U.S. dollars 14.75%-15.00%• Four-month Malaysian dollars 8.00%-8.50%• Spot rate for US$1 Mal$2.30-Mal$2.30• Four-month forward rate for US$1 Mal$2.25-Mal$2.26

• A U.S. importer of batik form Malaysia must pay Malaysian dollars in four months. She wishes to cover this exposure. Assume the following market rates:

• Four-month U.S. dollars 14.75%-15.00%• Four-month Malaysian dollars 8.00%-8.50%• Spot rate for US$1 Mal$2.30-Mal$2.30• Four-month forward rate for US$1 Mal$2.25-Mal$2.26

• As is well known, there are two methods to hedge the payables. Please describe them in detail. Moreover, which one would she like to adopt?

• Suppose today's exchange rate is $1.05/€. The six-month interest rates on dollars and euros are 6 percent and 3 percent, respectively. The six-month forward rate is $1.0478. A foreign exchange advisory service has predicted that the euro will appreciate to $1.0790 within six months.

• a. How would you use forward contracts to profit in the above situation?

• b. How would you use money market instruments (borrowing and lending) to profit?

• c. Which alternatives (forward contracts or money market instruments) would you prefer? Why?

Hedging by OptionContract

• Apex Corporation must pay its Japanese supplier ¥125 million in three months. It is thinking of buying 20 yen call options (contract size is ¥6.25 million) at a strike price of $0.00800 in order to protect against the risk of a rising yen. The premium is 0.015 cents per yen. Alternatively, Apex could buy 10 three‑month yen futures contracts (contract size is ¥12.5 million) at a price of $0.007940 per yen. The current spot rate is ¥1 = $0.007823. Suppose Apex's treasurer believes that the most likely value for the yen in 90 days is $0.007900, but the yen could go as high as $0.008400 or as low as $0.007500.

• a. Diagram Apex's gains and losses on the call option position and the futures position within its range of expected prices. Ignore transaction costs and margins.

PROFIT (LOSS) ON APEX CORPORATION'S FUTURES AND OPTIONS POSITIONS

($60,000)

($40,000)

($20,000)

$0

$20,000

$40,000

$60,000

75 76 77 78 79 80 81 82 83 84

Pro

fit

(lo

ss)

Yen price ($0.0000 omitted)

Profit (loss) on futures position

Profit (loss) on call option position

79.4

$31,250

$57,500

81.5

($18,750)

• b. Calculate what Apex would gain or lose on the option and futures positions if the yen settled at its most likely value.

• Answer. If the yen settles at its most likely price of $0.007900, Apex will not exercise its call option and will lose the call premium of $18,750. If Apex hedges with futures, it will have to buy yen at a price of $0.007940 when the spot rate is $0.0079. This will cost Apex $0.000040/¥, for a total futures contract cost of 0.000040 x 125,000,000 = $5,000.

• c. What is Apex's break‑even future spot price on the option contract? On the futures contract?

• Answer. On the option contract, the spot rate will have to rise to the exercise price plus the call premium for Apex to break even on the contract, or $0.008000 + $0.000150 = $0.008150. In the case of the futures contract, break-even occurs when the spot rate equals the futures rate, or $0.007940.

• d. Calculate and diagram the corresponding profit and loss and break‑even positions on the futures and options contracts for the sellers of these contracts.

• Answer. The sellers' profit and loss and break-even positions on the futures and options contracts will be the mirror image of Apex's position on these contracts. For example, the sellers of the futures contract will breakeven at a future spot price of ¥1 = $0.007940, while the options sellers will breakeven at a future spot rate of ¥1 = $0.008150. Similarly, if the yen settles at its minimum value, the options sellers will earn the call premium of $18,750 and the futures sellers will earn $55,000. But if the yen settles at its maximum value of $0.008400, the options sellers will lose $31,250 and the futures sellers will lose $57,500.

Interest Rate SWAP

Why Use Interest Rate SWAP?

• Why Use Interest Rate SWAP?

• Reduce interest rate risk– RSA (rate-sensitive asset) not equal to RSL (r

ate-sensitive liability)– If RSA >RSL, then increase RSA (from fixed-r

ate to floating-rate) or/and decrease RSL (from floating-rate to fixed-rate)

• Reduce borrowing cost

Interest Rate SWAP 典型的利率交換合約 固定利率與浮動利率的交換 例如：甲公司想以 6%的固定利率發行一筆 2000萬美元的 3年期公司債，但以該公司的信用等級，只能以 6.5%的利率發行，惟若向銀行借款，則因該公司與銀行往來關係良好，可以 6個月 LIBOR(London Inter Bank Offered Rate)加碼 0.5個百分點的浮動利率借到資金。此時，恰好乙公司也需要一筆 2000萬美元 3年期的資金，該公司雖偏好以浮動利率的方式借入，惟卻必須負擔 6個月期 LIBOR加碼1個百分點；至若發行公司債，因為乙公司在國際債券市場上有良好的知名度，故可以 6%的固定利率發行。從而，甲公司與乙公司可各自發揮在浮動利率市場及固定利率市場的價格優勢，進行利率交換合約。透過利率交換，雙方皆可節省利息成本。

Interest Rate SWAP

• Borrowing costs – Big Boy:

• T-bill+2% for debt with floating rate and 7% for debt with fixed rate

• Would like to borrow the money with floating rate

– Little Guy: • T-bill+2.5% for debt with floating rate and 9% for debt with

fixed rate• Would like to borrow the money with fixed rate

• The borrowing costs of Big Boy are smaller than Little guy regardless of fixed or floating rate

Interest Rate SWAP

• No need to SWAP?

• Comparative advantage versus Absolute advantage

Interest Rate SWAP

• For Big Boy– if he borrows the debt with fixed rate, then he

can add a benefit of 2%– if he borrows the debt with floating rate, then

he can add a benefit of 0.5%

• For Little Guy, – if he borrows the debt with fixed rate, then he

can add a benefit of -2%– if he borrows the debt with floating rate, then

he can add a benefit of -0.5%

Interest Rate SWAP

• If Big Boy borrows the debt with fixed rate and Little Guy borrows the debt with floating rate, then the benefit for the whole system is?

• How to allocate the benefit?

• How to decide the swap contract?

An Interest Rate Swap Between Two Corporations