Week 6 - Chapter 18-21 slides.pdf

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An introduction to risk managementand derivatives

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Understand the nature and importance of risk and risk management, especially operational and financial risk exposures

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

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Risk—the possibility or probability of something occurring that is unexpected or unanticipated

Categories of risk◦ Operational risk◦ Financial risk

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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

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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

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Financial risk

◦ 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

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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

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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

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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

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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

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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

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A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying".

Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages).

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Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these such as caps, floors, collars, and credit default swaps.

Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange.


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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

Most are traded on an exchange◦ standardised contracts◦ Removes counter-party risk

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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

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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◦ Margin call - the top-up of an initial margin to

cover adverse futures contract price movements

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Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party

The change in the market price of a commodity or security is offset by a profit or loss on the futures contract

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Example: A farmer wants to sell wheat in a couple of months, but is concerned that the price is going to fall in the mean time.

How can the farmer hedge this price risk? What does that mean? How does the farmer protect today’s price!

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◦ Solution◦ Enter into a wheat futures contract to sell his wheat at a

future date at a price fixed today! If wheat prices fall, the futures contract will rise in value,

offsetting the loss in the physical market from the fall in the wheat price

If wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat price

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Although futures contracts are highly standardised, variations exist between countries, exchanges and contracts

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Margin requirements◦ Both the buyer (long position) and the seller

(short position) pay an initial margin, held by the clearing house, rather than the full price of the contract

◦ Margins are imposed to ensure traders are able to pay for any losses they incur◦ Margins create leverage ! e.g. in OMF cTrader Challenge, it is 1:100

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Margin requirements ◦ A contract is marked-to-market on a daily basis

by the clearing house i.e. repricing of the contract daily to reflect current

market valuations

◦ Price changes may result in margin calls require a contract holder to pay a maintenance

margin to top up the initial margin to cover adverse price movements

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Closing out of a contract◦ Involves entering into an opposite position

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Contract delivery◦ Most parties to a futures contract: manage a risk exposure or speculate do not wish to actually deliver or receive the underlying

commodity/instrument and close out of the contract prior to delivery date

So most close the position prior to settlement

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Main categories of participants◦ 1. Hedgers◦ 2. Speculators◦ 3. Cash Management

◦ Contrary to text, these are NOT unique participants: Traders Arbitragers

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1. Hedgers◦ Attempt to reduce the price risk from exposure to changes

in interest rates, exchange rates and share prices◦ Take the opposite position to the underlying, exposed

transaction◦ Example: An exporter has USD receivable in 90 days. To protect

against falls in USD over the next three months, the exporter enters into a futures contract to sell USD

Payable he might enter a contract to buy USD

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2. Speculators

◦ Expose themselves to risk in an attempt to make profit◦ Enter the market with the expectation that the market price

will move in a direction favourable for them

◦ Example: Speculators who expect the price of the underlying asset

to rise will go long and those who expect the price to fall will go short

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3.Cash Management

Suppose a fund manager wants to keep some cash in the portfolio (for liquidity)But wants to generate equity returns with that cash.

Equity based futures, e.g. SP500, can get those returns, but are as liquid as cash.

See example from CREF:


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Chinese auto importer◦ on June 10, 2015, agree to buy USD 1 million of

cars in August, but concerned about fluctuations in the Yuan, particularly down

Spot rates:Sept futures contract

CNY/USD USD/CNY (for 100 yuan)0.16114 6.2059 1.6254

Cars today would be USD 1 mill * 6.2059 = 6,205,900 CNYimplies:

SELL 6205900 / 1.6254

3,818,076 contracts

On 12 & 13 Aug, Beijing de-valued the currency on14 Aug: Spot USD/CNY = 6.4003 Sept futures contract 1.5485 “Loss” on cars:

Gain on the short futures position:

Net 98,961◦ (Assuming you closed both positions on 14 Aug.)

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6,205,900 - 6,400,300= 194,400

6,205,900 - 5,912,290= 293,361

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The risks of using the futures markets (for any purpose) :

◦ standard contract size◦ margin risk◦ basis risk◦ cross-commodity hedging

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Standard contract size

◦ Owing to contract size the physical market exposure may not exactly match the futures market exposure, making a perfect hedge impossible E.g. for the SP500, as of Friday’s close 1 contract was $522,885

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Margin payments

◦ Further cash required if (when?) prices move adversely (i.e. margin calls) You might run out of cash before the price turns in

your favour If you can’t make a margin call, the position will be

closed and you’ll get 0.

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Basis risk The difference between the price in the physical

market and the futures market

◦ Two “types” of basis risk Initial basis at commencement of a hedging strategy

Final basis at completion of a hedging strategy

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Cross-commodity hedging

◦ It may not be possible to find a futures contract in the exact instrument you need

◦ So, you look for something that *does* have a contract, which has a high correlation with “your” instrument

◦ Risk is – high correlations are not guaranteed to continue (recall supposedly low correlation in the sub-prime CDS’s)

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A financial instrument designed mainly to manage specified risks

Offered over the counter by financial institutions◦ Therefore, more flexible than exchange-traded products terms and conditions can be negotiated

◦ More flexible, but have counter-party risk

Two main types1. Forward rate agreements (FRAs)2. Forward foreign exchange contracts

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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 one party compensates the other, if the reference

rate is different from the agreed rate

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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

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An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified 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 Doing so is called “exercising the option”

◦ Put options Give the buyer the right to sell the commodity or instrument

at the exercise price

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An option will only be exercised if it is in the buyer’s best interests (“in the money”)◦ Buyer of a call will not exercise the right to buy if the

physical market price is below the exercise price of the option contract at expiration date

◦ Buyer of a put will not exercise the right to sell if the physical market price is above the exercise price of the option

Options can be exercised either:◦ only on expiration date (European option); or◦ any time up to expiration date (American option)

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Premium◦ The price paid by an option buyer to the writer

(seller) of the option Value is determined by:◦ Exercise price or strike price The price specified in an options contract at which the

option buyer can buy or sell◦ Current price of underlying asset (e.g. the stock)◦ Maturity◦ Volatility◦ Interest rate

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Call option profit and loss payoff profiles

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Put option profit and loss payoff profiles

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Put option profit and loss payoff profiles

A few more examples from CBOE

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Options differ from futures because they ◦ provide asymmetric cover against price movements◦ Are optional (to exercise)◦ With Futures, you are committed

Options limit the effects of adverse price movements without reducing profits from favourable price movements

Options involve the payment of a premium by the buyer to the seller (writer)

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Call option profit and loss payoff profiles

◦ The value of the option to the buyer or holder (long call party) is:◦ V = max(S - X, 0) - P◦ The value of the option to the writer (short call

party) is:V = P - max(S - X, 0)

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Covered and naked options

◦ Unlike the case with futures, the risk of loss for a buyer of an option contract is limited to the premium◦ However, sellers (writers) of options have

potentially unlimited risk and may be subject to margin requirements unless they write a covered option I.e. the writer of an option holds the underlying

asset or provides a financial guarantee

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Covered and naked options ◦ The writer of a call option has written a

covered option if the writer either: owns sufficient of the underlying asset to satisfy

the option contract if exercised; or is also the holder of a call option on the same

asset, but with a lower exercise price◦ The writer of a put option has written a

covered option if the writer is also the holder of a put option on the same asset, but with a higher exercise price

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Option markets are categorised as:◦ Over the counter◦ Exchange-traded These are recorded through a clearing house Clearing house acts as counterparty to buyer

and seller, thus creating two options contracts through the process of ‘novation’

The clearing house allows buyers and sellers to close out (i.e. reverse) their contracts

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International options markets◦ An exchange in a particular country will usually specialise in

option contracts that are directly related to physical or futures market products also traded in that particular country

◦ Trading on international exchanges varies The largest exchanges, the Chicago Board of Trade

(CBOT) and Chicago Mercantile Exchange (CME), retain open-outcry trading on the floor involving 4000 to 5000 people

◦ International links between exchanges allow 24-hour trading

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1. Intrinsic value◦ The market price of the underlying asset relative to the

exercise price◦ The greater the intrinsic value, the greater the premium, i.e.

positive relationship◦ Options with an intrinsic value Positive are ‘in the money’ and the buyer is able to

exercise contract at a profit Negative are ‘out of the money’ and the buyer will not

exercise Zero are ‘at the money’


2. Time value

◦ The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a profit (‘in the money’); i.e. positive relationship◦ If the spot price moves adversely, the loss is

limited to the premium

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3. Price volatility

◦ The greater the volatility of the spot price, the greater the chance of exercising the option for a profit, or a loss◦ The option will be exercised only if the price

moves favourably◦ The greater the spot price volatility, the greater

the option premium; i.e. positive relationship

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4. Interest rates◦ Interest rates have opposite impacts on put and call options Positive relationship between interest rates and the price

of a call Benefit of present value of deferred payment if exercised

> lower present value of profit if exercised Negative relationship between interest rates and the price

of a put Opportunity cost of holding asset Lower present value of the profit if exercised

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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◦ Interest rate swaps ◦ Cross-currency swaps

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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


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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/USD0.9245, at the start of the contract one party would exchange USD1 million for AUD1081 665.76

At each future interest payment date, interest payments would be calculated using the same exchange rate; i.e. AUD/USD0.9245

Finally, at the swap completion date, the original AUD and USD principal amounts would be re-exchanged

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Documents

Week 6 - Chapter 18-21 slides.pdf