FIN601 Lect Topic 7

Topic 7
1
Chapter 15: Risk management
Reference: Beal, Goyen & Shamsuddin, 2008
2
Managing risk
Risk in finance is defined as the chance that

the actual outcome from an investment will be
different from the expected outcome.
It is quantified by the standard deviation.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 15, Australia: Wiley. 3
Managing risk
Firms face risky outcomes with respect to
many business variables. These include:
Prices for own products (unless the firm has
market power)
Sales of products (depending on competitors
actions and consumer preferences)
Costs of business inputs including interest
rates and exchange rates.
Managing risk
Other factors such as national and

international economic policies, government
regulation and the weather also has an impact
on individual businesses.
Firms manage risk commonly by one or more
of the following methods:
insurance
fixed rate finance
forward contracting
Managing risk - Insurance
Firms buy insurance to cover all sorts of perils or

unwanted events.
The insured firms pay a relative small amount
premium each year, to insurance companies to
take over their individual risks.
The insurance companies take on risk and
charge premiums that they hope will be high
enough to cover all the claims in each period and
leave some over to compensate them for the
business risks that they are taking.
Managing risk - fixed rate finance
Another method that firms use to manage a

business risk is to enter contracts to fix the
interest rates on loans.
When interest rates are stable but expected to
rise, fixed rate loans will always be higher priced
(have a higher interest rate) than variable rate
loans (and vice versa).
Here borrowers are willing to pay higher rates in
order to enjoy certainty that rates for their loans
will not rise even further
Managing risk - forward contracting
Forward contracting involves the suppliers and

users of goods negotiating prices for the goods
for future delivery.
A futures contract is a type of forward
contract that is traded in a futures market and
covers the purchase or sale of a set quantity of
an asset to fix forward prices.
Managing risk - Derivatives
Apart from these three most common methods

of managing risks, there are many financial
products available to manage business risk
collectively known as derivatives.
Derivatives are synthetic financial products
whose value is derived from an underlying
product.
Types of traders in the markets
There are normally three types of traders who

operate in derivative markets:
hedgers
speculators
Arbitrageurs
Hedgers are traders who enter a market to try

to reduce the price risk in their normal business
operations.
Speculators take on risk in order to make
profits.
Arbitrageurs enter markets and trade to make
profits without risk by making complementary
trades in two or more markets virtually
instantaneously to exploit price differences.
Example: Arbitraging in the forex market

Geroge an Australian foreign exchange
arbitrageur sees the following quotes on his
computer screen
AUD 1 = USD 0.73
AUD 1 = 78
USD 1 = 106.6 and rising
Example contd
The first two quotes have been relatively stable.
There is then a flurry of activity as several
dealers sell Japanese yen and buy USD. The
USD/Yen quote is 109.10.
So George immediately sells AUD, buys USD,
uses the USD to buy YEN, then sells the YEN
and buys AUD.
All these trades happen within a few seconds,
before the markets have time to move very
much. George uses about AUD $500 000 to fund
each of his play. What is Georges profit?
Example contd
Firstly George sells AUD and buys USD
AUD 1 = USD 0.73
AUD 500 000 = USD 365 000
Secondly George sells USD and buys YEN
USD 1 = 109.10
USD 365 000 = 39 821 500
Thirdly George sells YEN and buys AUD
AUD 1 = 78
AUD 510 532.05 = 39 821 500
Example contd
Profit will be
AUD 510 532.05 - AUD 500 000
= AUD 10 532.05 (less any transaction costs)
Futures markets
A futures contract is a derivative security where
the contract stipulates the transfer of a specified
quantity of the underlying asset.
A firm wanting to buy (lock in the supply of)a
product for which there are futures contracts
traded would buy one futures contract just as
you would enter a contract to buy a house if you
wanted it.
A firm wanting to lock in a price at which it
could supply the product would sell futures
contracts, just as the house owner would sign a
contract to sell the house.
Futures markets
In addition to trading outright futures

contracts, the market also trades options on
futures contracts.
An option grants the right but not the
obligation to undertake a trade by a given date
at a given price.
A call option gives the buyer the right but not
the obligation to buy an asset by a given date at a
given price.
Futures markets
A put option gives the buyer the right but not

the obligation to sell an asset by a given date at
a given price.
There are futures exchanges in all major
countries in the world.
Futures markets
The terminology of futures
The spot market is a futures trading term to
indicate the market where trading for
immediate delivery occurs.
The contract unit or contract size is the
standard quantity of the product that is the
subject of each contract.
The contract months or delivery months
are the months in which deliveries are made or
contracts are settled.
Futures markets

The last trading day is the last day on which
trading occurs in a particular contract.
A clearing house facilitates settlement of
contracts and transfer of ownership between
the parties to transactions.
Deliverable contracts are contracts that may
be settled by physical delivery.
Mandatory-settled contracts are settled by
the clearing house at a cash settlement price
which is calculated according to principles laid
down for each contract.
Futures markets
The cash settlement price for a futures
contract is the current market value for the
assets that are the subject of the contract.
A margin is a deposit or bond that ensures
completion of the futures contract.
Both buyers and sellers must lodge deposits
with their brokers to pass on to the clearing
house attached to each market.
An initial margin is the first payment
required for a futures contract.
Futures markets
The purpose of the margin requirements is to
ensure that holders of contracts have no
incentive to default a contract.
Marking-to-market involves valuing each
open futures contract daily according to the
closing price in the futures market and
adjusting margin accounts at the clearing house
to show consequent gains or losses.
If the futures market has risen (fallen) during
the day, holders of bought positions will have
made gains (losses) on the day and their
accounts at the clearing house will be adjusted
to show those gains (losses).
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 15, Australia: Wiley.
22
Futures markets
If the futures market has fallen (risen) during
the day, holders of sold positions will have
made gains (losses) on the day and their
accounts at the clearing house will be adjusted
to show those gains (losses).
The clearing house goes through the marking-
to-market process to reduce its business risk by
preventing traders from accumulating losses
over a period greater than 1 business day.
Futures markets
Daily-settlement margin calls are demands
for extra funds to be placed in traders margin
accounts to cover any shortfalls in the value of
open positions in comparison with current
market prices at the end of the trading day.
Intra-day margin calls are demands for extra
funds to be placed in traders margin accounts
to cover any shortfalls in the value of open
positions in comparison with current market
prices during a trading day.
Futures markets
Open contracts are closed out when the
clearing house takes out an opposite contract
for the same goods for the same delivery terms
so that the 2 contracts cancel each other in all
details except price.
Position limits are maximum numbers of
contracts that speculators may hold for any
individual type of commodity or asset.
Simple interest
Simple interest is interest calculated on the original or

principal sum borrowed.
The equation for the calculation of simple interest is:
Simple interest is applied to many sorts of bank deposits,

such as savings accounts and term deposits, as well as
many types of loans. Debenture and commercial loans
on an interest-only basis also operate on a simple interest
basis.
Simple interest
Future and present values of a single sum
The future value of a single sum calculated using simple interest is:
The present value of a single sum calculated using simple interest

is :
Futures markets
The anatomy of a futures trade
Example
Classy Coats (CC) needs nearly $1M for the
purchase of materials over the summer to
prepare for the winter.
CC is worried that interest rates will rise
significantly before it is able to arrange the
physical loans in December.
The firm sells 1 December 90-day BAB (Banks
Accepted Commercial Bills) futures contract
currently trading at 95.05.
Futures markets
Notice that CC sells the contract (not buys) to
fix the supply of cash.
BABs are quoted in terms of 100 minus the
nominal annual yield. Thus, 95.05 means a
nominal annual yield of (100 95.05) = 4.95%.
If CC believes a cost of 4.95% is cheaper
funding than it will be able to access funds in
the physical market, even after allowing for
transaction costs of the futures trade, it will go
ahead with selling a futures contract.
Futures markets
For example, if the best (lowest) price for the

which CC believes it could obtain funds
contract from alternative sources were 6.5% and
transaction costs of the futures trade were
0.15%, then there is still a 1.4% cost reduction
[6.5%-(4.95%+0.15%)] to be had in entering the
futures contract.
Futures markets
The quoted price of contract CC is interested in

is 95.05 so what is the price of the futures
contract?
P = 1 000 000/(1+0.0495 x 90/365)

= $987 941.70
Futures markets
Electronic bank-accepted bills (EBAs) and
electronic certificates of deposit (ECDs) are
electronically recorded debt obligations that
prevent the need for paper securities.
A strip hedge is the simultaneous sale of a run
of given futures contracts with sequential
contract dates which is undertaken to fix prices
over a longer term than the term of each
contract.
Futures markets
Futures trading allows firms that produce

relevant goods to lock in sales prices through
taking sold positions.
Conversely, firms that buy relevant inputs are
able to fix purchase costs by taking bought
positions.
If prices in the physical market move against
these firms, their futures trading will bring
gains.
Futures markets
Options on futures
Options on futures contracts give the buyers of
those options the rights, but not the
obligations, to buy (calls) or sell (puts) the
underlying futures contracts.
A trader who buys an option to buy or sell a
contract has the right to take up that contract at
any time and will do so if the physical market
moves in the desired direction and gains are to
be made on the futures contract.
If, on the other hand, the physical market
moves against the traders position, then the
option will not be exercised.
Futures markets
Options on futures
In this instance, the trader will not crystallise
the futures market loss. Instead, the only loss
will be the costs involved in purchasing the
option.
Option trades have 2 sides. Hedgers may buy
options that confer the right to buy or the right
to sell. The party on the other side of the option
trade is called the writer.
The writer of an option,
option therefore, is the party
that grants the right to the option buyer and the
writer must buy or sell the asset if the option is
exercised.
Futures markets
Options on futures
Writers are speculators. They make these deals

to profit from the sale prices of the options,
which are non-refundable when options are not
exercised.
Conversely, writers make losses when options
are exercised.
Futures markets
Using Options on futures
Example: Eureka Gold Mines wants to manage
some of the price risk associated with its gold
sales. It decides to enter options on futures
contracts and pays a premium of $1000 each to
purchase June 350 gold put options. These
options each give Eureka the right to sell one
100-ounce gold futures contract at $350 per
ounce.
The price of gold declines so that the June futures
price is only $300 per ounce.
Futures markets
Using Options on futures
Example contd: Eureka may sell the option or
exercise its right and gain $4000 on each
contract.
[(350-300 * 100)-1000] = $4000
If the marked price had increased, contrary to

Eurekas expectations, the firm would have
allowed its option to lapse and thus would have
incurred only the cost of the premium of $1000
per contract.
Futures markets
Gains and losses on Options on futures
In the previous example, when Eureka exercised
its option to sell, the writer of each contract was
forced to buy the contract for the supply of gold
at $350 an ounce when the current futures price
was $300. Thus the writers all made a loss of
$4000 per contract ($5000-1000).
If the market price had increased, in accordance
with their expectations, the writers would have
made gains of the $1000 premiums on each
contract as Eureka would have allowed the
options to lapse.
The FRA market
A forward rate agreement (FRA) is a deal

between 2 parties that fixes an interest rate for a
period which begins some time in the future.
Thus, firms can reduce their borrowing cost risk
by coming to an agreement about the rate that
will prevail at some future date.
With FRAs, there is no commitment to lend or
borrow the principal amount. They are
therefore effectively a non-deliverable discount
security.
The FRA market
The FRA trade date is the date on which the

contract is signed.
The FRA settlement date is the date
settlement takes place at the start of the
contract period.
The FRA maturity date is the date at the end
of the contract period.
The FRA market
FRAs are often described in terms of the time

from trade to settlement and the contract
period. Thus, an agreement reached 4 months
before a 3-month contract period is described as
a 4:7 FRA.
FRAs are settled by the payment of the
difference in interest payable on a notional
principal at the agreed rate and at the current
market rate.
The FRA market
If the market has risen, the seller must pay the

buyer of the FRA who is the potential borrower.
If the market has fallen, the buyer must pay the
seller of the FRA who is the potential lender.
FRAs are also contracted for foreign exchange.
Buying or selling forex forward manages the
risk associated with trading in goods and
services in foreign currencies.
The swaps market
A swap is the exchange of 2 sets of cash flows

that, although different in character, have the
same expected present value.
The swaps markets are normally concerned
with two sources of business risk interest rates
and foreign currencies.
Just as in the case of with forward contracts,
firms enter swap agreements in order to manage
the risk they face.
The swaps market
Interest rate swaps
Interest rate swaps are used by borrowers to

convert obligations to pay interest on a fixed
rate basis to obligations to pay on a floating rate
basis, or conversely to convert floating rate
obligations to fixed rate commitments.
The most common type of swap is a fixed for
floating or a floating for fixed.
The swaps market
Interest rate swaps
Swaps are undertaken because the two

principals who are party to each agreement can
do so to their mutual advantage, as a result of
lenders having differing perceptions of the risk
they are facing in lending to the principals
Swaps exploit differences in interest rates in
different markets and also allow firms to take
advantage of differences in risk margins that
financial institutions impose on them.
The swaps market
Interest rate swaps
The terminology of swaps
Swaps do not have an organised trading market
and there are no set swaps contracts.
There are, however, a number of conventions or
characteristics that most swap deals include:
there is no exchange of principal amount
swaps normally deal with very large notional
amounts (in millions)
swaps are normally concerned with the
relatively short or medium term (less than a
year or 2)
The swaps market
Interest rate swaps
swap obligations are settled when one party

pays to the other the net monetary effect of
the swap
at the start of each reset period, the parties
agree to the value of swap rate that will apply
for the next period.
The swaps market
Interest rate swaps
The notional amount of a swap is the

hypothetical principal amount on which the
payment of the swap obligations is based.
The swaps reset period is the period for which
each determination of the value of swap rate is
valid.
The swaps market
The mechanics of an interest rate swap
There are six steps is working out an interest
rate swap:
1. Calculate the difference in fixed rates.
2. Calculate the difference in floating rates.
3. Calculate the net difference between the 2
rates.
4. Ascertain how the net benefit will be split
between the 2 parties.
5. Calculate the final outcome or net cost of
borrowing for both parties.
6. Calculate the swaps necessary between the
2 parties.
The swaps market
Currency swaps
Currency swaps involve the exchange of loan

obligations in one currency for the payments
on loans made in another currency.
The simplest version of a currency swap
involves the exchange of both principal and
fixed interest payments.
Currency swaps are undertaken for 2
principal reasons: to lower the final cost of
funds and to hedge foreign exchange risk.
The swaps market
Currency swaps
Borrowing funds from international sources

has long been a business practice, because of
the ready availability of funds from overseas
capital markets.
Currency swaps provide certainty about the
size of the cash flows that are exchanged
under the swap agreement.
The swaps market
Currency swaps
Currency swaps are used in at least 3
situations:
by firms which operate predominantly in
their domestic markets and can borrow in
their home countries more cheaply than
elsewhere but need foreign currency funds
by firms which can borrow more cheaply
internationally where the exchange rate risk is
hedged with relevant additional derivative
instruments
The swaps market
Currency swaps
by firms which operate in both domestic
and overseas markets and have foreign cash
flows that may be used to service debt
internationally, but which may borrow
more cheaply in their home countries. In
these situations, there is no need to hedge
exchange rate risk, because the operating
cash flows of the firms are used to repay the
debt, so they are not exposed to forex risk in
servicing the loans.
The swaps market
Currency swaps
Financial institutions often act as facilitators

of currency swaps.
In return for their services, the financial
institutions charge fees that reduce slightly
the magnitude of the savings available to the
parties to the deals.
Company-issued options
Company-issued options are options to buy

shares in the company at a future date at a
stipulated price.
Options may be used as golden handcuffs
which help to keep valuable senior
employees.
Employee option plans can ensure that good
employees do not leave and that employees
personal interests and the interest of the
company are aligned.
Company-issued options
Options may be used as sweetners to make it

easier for firms to raise funds.
A firm might use options to put in place a
program of future funds raising.
Rules for hedgers using derivatives
The most important rule for firms using the
derivative markets to manage risk is to ensure
that their trading is always carried out in a
kind and magnitude consistent with hedging,
not speculating.
Hedgers use the underlying assets in the
course of their normal businesses and they
use derivatives to reduce the risk of prices
falling for produced output, or of prices
increasing for inputs including funding.
Speculation, on the other hand, is involved if
a firm takes on risk in the quest of profits or
makes bigger deals than are necessary to
hedge normal business operations.
The general principle implies that:

trading or risk limits should be set by each
companys board
individual traders should have personal
risk limits set and rigorously monitored
sensitivity analyses should be carried out to
identify the worst-cast situations
duties must be separated so there are
different people performing the various
duties associated with trading
relevant senior managers must fully

understand the trading systems
the trading section must not be made
profit centre.
accounting for trades must be conservative.
Recent disasters among those who ignored the
rules
Futures trading
MG, a German company dealing in metal and
energy products, built up over time an
enormous trading position. Eventually the
firm was not able to support the funding
necessary to maintain its positions and the
losses were realised.
China Aviation Oil lost USD550M in 2004
after speculative trading in the oil futures
market.
rules
Forex trading
A currency trader at the Queensland Growers
Association, tasked with hedging forex
exposures, took on large speculative positions
using forex derivatives. These positions
moved against QGA and the business
subsequently failed.
A similar situation arose at AWA, an
Australian communications and electrical
goods company, where a trader took on large
speculative forex derivative positions which
moved against the company.
rules
Interest rate derivatives

Procter and Gamble, the US cosmetics, drugs
and households products group, lost about
USD 150M in the 1990s when living up to their
name and gambling on the direction of
interest rates with interest rate swaps.
rules
The case of Barings Bank.
It was bankrupted in 1995 by the trading
activities of a junior employee in Singapore,
Nick Leeson.
Instead of undertaking the low risk arbitrage
trades in the Nikkei 225 equity futures
contract for which he was authorised, Leeson
took on massive positions using outright
futures and options trades. However, the Kobi
earthquake sent the value of the contract
tumbling and Barings subsequently become
bankrupt.
65

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Topic 7

Reference: Beal, Goyen & Shamsuddin, 2008

Risk in finance is defined as the chance that

Other factors such as national and

Firms buy insurance to cover all sorts of perils or

Another method that firms use to manage a

Forward contracting involves the suppliers and

Apart from these three most common methods

There are normally three types of traders who

Hedgers are traders who enter a market to try

Example: Arbitraging in the forex market

In addition to trading outright futures

A put option gives the buyer the right but not

The terminology of futures

Simple interest is interest calculated on the original or

Simple interest is applied to many sorts of bank deposits,

The present value of a single sum calculated using simple interest

For example, if the best (lowest) price for the

The quoted price of contract CC is interested in

P = 1 000 000/(1+0.0495 x 90/365)

Futures trading allows firms that produce

Writers are speculators. They make these deals

If the marked price had increased, contrary to

A forward rate agreement (FRA) is a deal

The FRA trade date is the date on which the

FRAs are often described in terms of the time

If the market has risen, the seller must pay the

A swap is the exchange of 2 sets of cash flows

Interest rate swaps are used by borrowers to

Swaps are undertaken because the two

swap obligations are settled when one party

The notional amount of a swap is the

Currency swaps involve the exchange of loan

Borrowing funds from international sources

Financial institutions often act as facilitators

Company-issued options are options to buy

Options may be used as sweetners to make it

The general principle implies that:

relevant senior managers must fully

Interest rate derivatives

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