Corporate Finance and Derivatives - Assignment Example

a) How derivatives are used to manage financial risk? A derivative is a financial instrument whose value depends on the value of an underlying asset.The underlying asset can be anything, from equity to commodities [Arditti, Fred D. (1996)]. A derivative is not a stand-alone asset because it has no value of its own. Its value is derived from the value of the underlying asset (John C. Hull, 2007). Financial risks are of many types. They can range from credit risks to market risks like interest rate risks and foreign exchange risks. Credit risks arise from the lending and borrowing activity of the organization. Market risks arise because of the exposure to market variables (Prasanna Chandra, 2008). Hedging is the term that is generally used to describe the process of managing financial risks through the use of derivatives (Whaley Robert, 2006). The financial risks of an organization or corporation can be broadly classified into following groups: i) Credit Risk. ii) Market Risk. iii) Liquidity risk. The market risks, caused by the unanticipated movements in exchange rates and interest rates, are the most important financial risks that are hedged through the use of financial derivatives. Risk management is the umbrella term used to define the process that includes identification, assessment, prioritization and management of risks in such a way so as to minimize or eliminate, if possible, the adverse impacts of the risks (I.M.Pandey, 2006). A multi-national corporation operating in different countries of the world is exposed to the foreign exchange risk. The multi-national corporation receives and makes payments in different currencies of the world. The three different kinds of foreign exchange risks are [Lioui, Abraham; Poncet, Patrice, (2005)].: i) Transaction risks. ii) Economic risks. iii) Translational risks. Transaction risks arise because of the possible gain or loss on existing foreign currency denominated transactions (Boumlouka, Makrem (2009)). Take an example of firm A. Firm A, headquartered in US, exports electronic goods to a firm B in UK. The importer, B, in UK pays the US firm in British pounds. Now suppose at the time of entering into the contract to export goods to B, the exchange rate was: £ 1 = $ 1.57 The exporter A, exported 5000 units of the good at the price of £ 50 per unit. So in GBP he expected to receive: £ 50 * 5000 = £ 250,000. At the existing rate of £ 1 = $1.57, the exporter A expects to receive in dollars: 1.57 * 250,000 = $ 392,500 Now suppose the importer makes the payments at the end of three months, after receiving the consignment of goods. At this time the foreign exchange rate comes down to: . £ 1 = $ 1.47 The exporter will therefore only receive$ 367,500 ($ 1.47 * 250,000) instead of $ 392,500 which he expected at the time of entering the contract. The exporter can manage this foreign exchange risk by using derivatives. He can enter into a three month foreign currency forward contract where he goes into the contract of selling £ 250,000 at the exchange rate of £ 1 = $ 1.57 at the end of three months when he expects to receive the payments from the exports. Thus at the end of three months when the payment of £ 250,000 is received, the exporter will sell the £ 250,000 at the exchange rate of £ 1 = $ 1.57, exercising the forward contract. The forward contract will eliminate the downside risk of the foreign exchange fluctuations, but it will also eliminate the upside potential. Suppose at the time of receiving the payments, the GBP appreciates against the dollar. Lets say that the foreign exchange rate is £ 1 = $ 1.67 then. By entering the forward contract of selling GBP 250,000 at GBP 1 = $ 1.57, the exporter will actually incur a loss of $ 25000, if the GBP appreciates (£ 1 = $ 1.67). So an alternative course of action, that the exporter may choose, is to buy foreign currency options instead of entering into forward contracts. The forward contracts place an obligation on the contractual parties. Options do not place any such obligation. The exporter can buy a put option to sell the pounds at the exchange rate of : £ 1 = $ 1.57. He will exercise this put option at the time of receiving the payments if the exchange rate goes below GBP 1/ $ 1.57. If the GBP appreciates and the exchange rate goes up then he will not exercise this option. The price of buying the put option is the option premium that he has to pay at the time of buying the put option. Economic risks arising from foreign currency fluctuations arise because of the change in the value of the multi-national firm because of the unexpected changes in the foreign currency fluctuations. These changes in value come because of the changes in global cash flows of the firm due to exchange rate fluctuations. The objective of the risk management in this case is to smooth the flow of cash under the variable exchange rate situations. Economic risks arising out of foreign exchange fluctuations can be managed using the same derivative instruments like forward contracts and foreign currency options. Translation exposure in foreign currency risks arise from the exchange losses because of foreign currency fluctuations at the beginning and end of the year. The translation risks can be hedged using similar derivative instruments as those used in managing economic and transaction risks. Managing interest rate risks through the use of derivatives: Interest rate risks arise because of the fluctuations in the market driven interest rates[ Harris, Larry (2003)]. A company that has borrowed or lent at floating interest rate is vulnerable to the interest rate risks. Interest rate risks can be hedged using derivative instruments like interest rate swaps . The interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments with interest payments at floating (or fixed rate). Let’s take the example of a company Z. Company Z is an AAA rate company in UK. The company has borrowed £ 50 million for five years at floating-rate loan to finance a capital expenditure investment. This five year floating interest rate is indexed to the London Interbank Offer Rate (LIBOR). LIBOR is the market determined interest rate at which banks borrow from each other in the Eurodollar market. The interest payments of the above company Z will be: LIBOR rate* 50 million. This exposes the company to risks arising from the changes interest rates i.e. changes in the LIBOR rates. To manage this risk the company can therefore enter into a kind of hedging derivative that is known as interest rate swaps. The company can swap its floating rate loan with a fixed rate loan with a counter-party. The company can for instance enter into a swap agreement with a swap dealer, where the company pays 6% of the notional sum of £ 50 million to the swap dealer who acts as the counter party. The swap dealer on its part will give the company: LIBOR rate * £ 50 million. It can be seen that through this swap agreement the company has totally hedged its interest risk. It is to be noted that in interest swap agreements ,like the above one, there is no real change of principal sums ( £ 50 million in the above example). Only the interests on this notional sum are interchanged. Interest rate swaps are the most widely used financial derivatives product. They account for 75% of the $ 550 trillion, global financial derivatives market. Managing credit risk through financial derivatives: Credit risk on bonds can be managed through derivative instruments like credit default swaps. A credit default swap is an instrument that gives the holder the right to sell a bond for its face value in the event of default by the issuer of bond. The CDS provides insurance against the risk of default by a particular company. The bond issuing company in this case is known as reference entity and the default by the company is known as credit even [Brealey, Richard A.; Myers, Stewart (2003)]. The buyer of the CDS makes periodic payments to the seller of the CDS until the end of the life of the CDS or until a credit event occurs. These payments are made in arrears ever quarter, every half year or every year. Managing the financial risk of a portfolio through hedging: The financial risk of a portfolio of investment is managed through hedging by the use of financial derivatives. Portfolio managers often use index options to limit their potential financial risks. If the value of S& P 500 index today is 1000, then a portfolio worth $100,000 with a beta of 2, can be hedged against its value falling below a certain level say, 960,000, by buying two put options of exercise price 960 for every 100 S dollars in the portfolio. It is to be noted here that each option on S& P 500 is worth 100 times the value of the index. Similarly if in the above example, the beta of the portfolio is 3 and not 2, then the portfolio manager can hedge it by buying three put options. Derivatives like futures, forwards and options were initially used to hedge price risks on commodities. Financial innovation and ingenuity have led to their extensive use in managing almost all kinds of financial risks. b) The financial crisis that began in 2007 had many causes. Why have derivative instruments been identified as one cause of the financial crisis? b) The 2007 financial crisis had its root in the sub-prime crisis of United States of America. Banks were giving home loans to sub-prime borrowers. These sub-prime borrowers were classified as sub-prime because they didn’t fulfill the minimum eligibility requirements for mortgage loans. Some of these sub-prime borrowers were those that had no income , no job and no assets (subsequently came to be known as NINJA borrowers). The security or the mortgages on these loans were the houses that these borrowers were using the home loans to buy. Now soon the sub-prime borrowers started defaulting on their loans, as was to be expected. Foreclosures increased. As a result more and more houses started coming up for sale. The supply of the houses soon outstripped the demand and the property market crashed. Why did banks lend to these sub-prime borrowers who had little income and fewer assets? This was because the banks were able to transfer their risks through the used of derivative instruments known as collateralized debt obligations and collateralized Mortgage obligations. Through the aid of investment banks like Lehman, the banks securitized these mortgage debts into tranches of securities. The different tranches were to bear a certain amount of losses in the event of a default. Based on the risk they were exposed to, the different tranches of securities had different levels of yields. Credit rating agencies like Moody’s, Fitch and Standard & Poor, gave ratings to these tranches of securities created from the sub-prime mortgage loans. The least risk bearing tranches were given ratings as high as AAA which made them investment grade. Institutional investors like pension funds and endowment funds invested heavily in these investment grade tranches of mortgage backed securities. When the defaults increased and the sub-prime crisis cascaded into a financial crisis of global proportions, the banks, investment banks and the institutional investors who were exposed to the sub-prime loans in some way or the other lost heavily. What made matters worse was leverage or trading on excessive debt. The banks had bankrolled many of their sub-prime loans with short term risky debts. When the defaults increased, they found it difficult to meet their liabilities. They had to then run to the government for bailouts. The problem with the huge American Insurance group came due to another derivative product- the Credit Default Swaps. The Credit default swaps, as has been explained above, are a kind of insurance. The holder of the CDS is insured against the risk of default on his bond by the seller of the CDS [Valdez, Steven (2000)]. AIG was one such major seller of credit default swaps. The buyer of the credit default swaps paid AIG premiums throughout the life of the CDS or till the event of default, whichever occurred earlier. Take for instance CalPERS, the huge Californian pension fund. The pension fund owned $ 150 million worth of investment grade mortgage backed securities and insured against the risk of their default by buying Credit Default Swaps from AIG. The pension fund paid annual premiums (say 2% of the notional principal amount of $ 150 million) to AIG in return for which AIG contracted to pay for any losses that would accrue to CalPERS in the event of default on its mortgage based security bonds. Now if the mortgage loans default AIG had to pay back CalPERS any losses that it suffered because of the default. This is one such example. AIG’s CDS liabilities became monstrous when the defaults on the mortgage backed securities started shooting through the sky.. The whole chain of events that actually led to the collapse of AIG was much more complex. Not only the defaults on mortgage securities increased, but the value of the existing mortgage backed securities declined because of the crash in real estate prices after the housing bubble collapsed. The new stringent accounting rules, implemented after the collapse of Enron, required AIG to mark down the value of its mortgage based securities portfolio. This resulted in the reduction of the capital reserves of the company. The capital reserves were the core measure of the financial strength of AIG. Reduction in capital reserves meant that the rating of AIG was downgraded by the various rating agencies like the Standard & Poor’s and Moody’s. Four weeks before its crisis, AIG was a triple A rated insurance company. As the financial crisis unfolded the rating of AIG came down to single A. The downgrading triggered the margin or collateralization requirements on the existing Credit Default Swaps of AIG. AIG had Credit default Swaps worth $ 450 billion. The total margin requirements because of the ratings downgrading amounted to $ 100 billion. AIG hadn’t that much cash available. The United States Federal Reserve had to offer bailout to AIG to prevent it from going down under. In September 2008, the Federal Reserve had to open $ 85 billion credit facility so that the company could meet its enhanced collateral obligations. In exchange for this bail-out the company issued warrants to the Federal Reserve, which on exercise would have amounted to 79.9% of the equity capital of American International Group ( AIG). Subsequently the total amount of bailout to AIG reached to $ 182.5 billion. The Federal Reserve and the United States Treasury had invested $ 70 billion in AIG, had given credits worth $ 60 billion and used another $ 52.5 billion to buy the toxic mortgage-backed assets of the company. The fall of the giants like Lehman and the crisis in major banks and financial institutions like Citi and AIG meant that the financial crisis soon spread from the UK to the rest of the globe. Credit growth soon froze and this brought and unprecedented credit crunch which adversely affected corporations and consumers all over the world. This brought the worst global economic crisis since the Great Depression. There were many other factors also like poor risk management, loose regulatory environment, and excessive risk taking etc. that contributed to the financial crisis. But the derivatives in the form of credit default obligations and credit default swaps were also one of the main factors behind the financial crisis. Will the use of centralized counterparties in trading derivatives reduce the risk of a similar financial crisis in future? In the financial crisis of 2007-08, what exacerbated the situation was a number of over-the-counter trades in derivatives. Over-the-counter derivate contracts are those that are not traded in any exchange. They are done exclusively between the parties to the contract. The counter-party risk in these over-the-counter trades is very high [Fabozzi, Frank J. (2002)] . When Lehman collapsed, the domino effect of its collapse was intensive because of the large number of its over-the-counter derivative contracts. The parties to these contracts were left in a crisis because the obligations of Lehman to them remained unfulfilled due to its collapse. This strengthened the negative feedback effect and exacerbated the economic crisis. Hedge funds too entered into a number of over-the-counter trades during the last crisis. This posed a systematic threat to the financial system because the financial regulators were largely unaware of these over-the-counter trades. The more extensive use of centralized counter-parties and exchanges will definitely reduce the risk of a similar financial crisis in future. It will not only mitigate the counter-party risk but will also increase transparency, neutrality and efficiency. The extensive use of centralized counterparties and exchanges will mean that the regulatory agencies will have more control over risk management in financial derivatives. They will be able to manage the systematic risks more effectively. For instance, in exchanges and centralized counterparties, position limits have been implemented lately, in the wake of the recent financial crisis. These position limits check excessive speculation by entities like hedge funds and go a long way in checking systematic risk. Position limits mean that the traders in derivative instruments cannot have more than a certain percentage in net long or short positions. It will also reduce the asymmetries of information between the various parties to a derivative contract or trade. The reduction in the systematic risk to the financial system will greatly reduce the probability of a similar financial crisis in future. References: John C. Hull, 2007, Options, futures & Derivatives, Prentice-Hall. 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