18-1 copyright 2009 mcgraw-hill australia pty ltd ppts t/a financial institutions, instruments...

18-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by VineySlides prepared by Anthony Stanger

Chapter 18

An Introduction to Risk Management and Derivatives

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by VineySlides prepared by Anthony Stanger

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Learning Objectives• Understand the nature and importance of risk and risk

management, especially operational and financial risk exposures

• Construct and analyse a structured risk management process

• 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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Chapter Organisation

18.1 Understanding Risk18.2 The Risk Management Process18.3 Futures Contracts18.4 Forward Contracts18.5 Option Contracts18.6 Swap Contracts18.7 Summary


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18.1 Understanding Risk

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

• Categories of risk– Operational risk– Financial risk


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18.1 Understanding Risk• 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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18.1 Understanding Risk (cont.)

• 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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18.1 Understanding Risk (cont.)

• Financial risk (cont.)

– 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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18.2 The Risk Management Process• 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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18.2 The Risk Management Process (cont.)

• 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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18.3 Futures Contracts

• 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

• An exchange traded contract where standardised contracts are traded in a formal market


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18.3 Futures Contracts (cont.)

• 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 (see Figure 18.1, next slide)


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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

– Maintenance margin call—the top-up of an initial margin to cover adverse futures contract price movements


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18.4 Forward Contracts

• A financial instrument designed mainly to manage specified risks

• Offered over the counter by financial institutions– Therefore, more flexible than highly standardised exchange-

traded products like futures, as the terms and conditions of a forward contract, such as amount and timing of the contract, can be negotiated

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


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18.4 Forward Contracts (cont.)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

Is given effect by one party to the contract compensating the other party if the reference rate is different from the agreed rate

– Relevant terms FRA agreed rate—the fixed interest rate stipulated in the FRA at

the start of the contract FRA settlement date—the date when the FRA agreed rate is

compared with the reference rate to calculate the compensation amount

FRA contract period—the term of the interest rate protection built into the FRA


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18.4 Forward Contracts (cont.)


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18.4 Forward Contracts (cont.)

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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18.5 Option Contracts

• An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a predetermined 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

– Put options Give the buyer the right to sell the commodity or instrument at the

exercise price


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18.5 Option Contracts (cont.)

• An option will only be exercised if it is in the buyer’s best interests, i.e.:– A buyer will not exercise the right to sell if the physical

market price is above the exercise price of the option– A buyer will not exercise the right to buy if the physical

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

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


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18.5 Option Contracts (cont.)

• Premium– The price paid by an option buyer to the writer (seller) of the

option

• Exercise price or strike price– The price specified in an options contract at which the option

buyer can buy or sell


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18.5 Option Contracts (cont.)• Call option profit and loss payoff profiles


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18.5 Option Contracts (cont.)• Call option profit and loss payoff profiles


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18.5 Option Contracts (cont.)• Put option profit and loss payoff profiles


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18.5 Option Contracts (cont.)• Put option profit and loss payoff profiles (cont.)


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18.6 Swap Contracts• 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 contractsi. Interest rate swaps ii. Cross-currency swaps


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18.6 Swap Contracts (cont.)

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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18.6 Swap Contracts (cont.)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/USD0.8500, at the start of the contract one party would exchange USD1 million for AUD1 176 470.59

• At each future interest payment date, interest payments would be calculated using the same exchange rate, i.e. AUD/USD0.8500

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


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18.7 Summary• Risk can be categorised as operational and financial risk

• The risk management process involves a number of steps

• A futures contract is an agreement between two parties to buy or sell a specified commodity or instrument at a specified future date at a price specified today

• A forward contract is a financial instrument designed to manage specified risk– Two forward contracts are forward rate agreements (FRAs)

and forward exchange contracts


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18.7 Summary (cont.)• An option contract gives the buyer the right but not the

obligation to buy or sell a specified commodity or financial instrument at a specified price on or before a specified date

• Swaps facilitate the exchange of specified cash flows– Interest rate swaps are used to manage interest rate risk– Currency swaps are used when an interest rate swap

involves borrowing in different currencies Allow the management of interest rate and FX risk exposure Currency swaps differ from interest rate swaps in that the

principal amounts raised by the two borrowers are swapped at the commencement and re-exchanged at the end of the agreement

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