Derivatives And Risk Management - Essay Example

?DERIVATIVES AND RISK MANAGEMENT By (Lecturer) TABLE OF CONTENTS 0 Introduction 3 2.0 Hedging Vs. Speculation 43.0 International Airlines Group 6 3.1 Organizational Background 6 4.0 Foreign exchange risk exposure for IAG 7 5.0 Hedging Strategy for Interest Rate Risk 8 6.0 Interest Rate Swaps 10 7.0 Stock Market Option: Straddle Strategy 13 LIST OF REFERENCES 16 APPENDICES 18 Appendix 1: P&L Analysis. 18 Appendix 2(a): Long Straddle 19 Appendix 2 (b): Long Straddle 19 Appendix 3.0: Technical Analysis of IAG 20 1.0 Introduction Risk can be seen as the probability that a chosen action may lead to an undesirable action in the future. Risk involves the uncertainty of the future. In business risk can be said to be the probability that an investments actual return will not be as per the expectations. Risk management is the process of identifying, understanding, analysing, accepting, or mitigating risk. Risk management can be divided into two main processes, determining the level of risk exposure in an investment and then handling that risk in the best way possible in line with the objectives of the investment (George, 2012, pp.34-38). The risk of financial exposure affects all organisations, both directly and indirectly. Though financial exposure presents the opportunity for loss, it may also present strategic benefits for making profits. The financial losses of a company arise from three main sources. The first source of risk is a company’s exposure to changes in the market prices of commodities (Philippe, 2001, pp.23-25). Second is through actions and transactions of third parties such as creditors and counterparties to derivative transactions, and finally are financial risks occurring from the internal failures of the organisation, people, or processes. Financial risk arises from countless transactions of a financial nature which an organization engages in such as purchases, investments, and loans repayments. If financial prices rise, there is the possibility that the company makes financial losses (Philippe, 2001, pp.3-6). The process of dealing with the uncertainties in the market is called financial risk management. Financial risk management is concerned with assessing an organisation’s risk exposure and then forming appropriate strategies to address these risks. Financial risk management usually involves the use of derivatives which are traded widely among financial market players. A derivative is a security whose price is derived from one or more other assets. It is just a contract between two parties specifying conditions under which payments will be made in future between the two parties. Examples of derivatives are options, futures, forwards, and swaps. In the past, diversification was the main way of financial risk management but has now been overrun by the availability of derivatives in most markets which makes it possible for both corporate as well as individual investors to manage risks (Whittaker, 2009, p.19). This paper will analyse the concept of hedging in financial risk management, the best hedging strategies, swaps, and options as they are used in risk management. 2.0 Hedging Vs. Speculation The management of risks involves the use of derivatives. Derivatives in financial risk management refer to securities whose value depends on the value of the underlying asset. Among the kinds of derivatives that exist in financial market includes futures, forward contracts, option, and swaps (Smith & Stulz, 2009, pp.267-284). The underlying assets whose values the derivatives depend on are stocks, bonds, interest rate, foreign exchange instruments, and even commodities. The respective derivatives for these assets are stock options, interest rates futures, currency futures, bond options, and commodity futures. Hedging is the strategy that is used when managing the risk of the underlying asset using derivatives (Nance, et al, 1993, pp.267-284). In financial markets, a hedge can be referred to as an investment position whose purpose is to offset a potential future loss or gain that may be incurred by another investment in the same portfolio. Its sole purpose is to reduce the effects of this potential future result. Hedging therefore can be defined as the process of managing potential future price changes by offsetting that risk in the futures market. The process can vary in technical complexity from relatively simple activities to very complex strategies like futures and options. The ability to hedge means that an investor is able to decide on his level of risk appetite (Smith & Stulz, 2009, pp.267-284). Hedging can be regarded as the act of protecting oneself from the risk of losing the financial value of their open position. For instance, a derivative that hedges a purchaser against the rise in the price of crude oil is one that protects the purchaser against the risk of financial loss should the prices of crude oil rise. The importance of the hedge as a business strategy is that it gives business certainty in the prices in the future (Johnson, 1960, pp.139-151). This certainty is important since it allows business managers to make decisions with greater certainty of the future. The concept of hedging is closely related to the concept of correlation in the returns of the assets in that a person holds two positions of the same value but which are negatively or weakly correlated to each other. The prices of assets are said to be negatively or weakly correlated when their values or prices are expected to move together but in opposite direction such that if one asset makes a loss, the loss is nullified by the other asset, in effect, eliminating or marginally reducing risk and uncertainty when investing (Kolb & Overdahl, 2008, pp.67-69). Speculation on the other hand is the betting on the movement of the price of a stock in either direction. It is the practice of engaging in financial transactions in an attempt to gain from the short term or medium term movements in the market value of the stock rather than attempting to gain from the financial attributes of the stock or financial instrument. Many speculators in the financial markets pay little attention to the fundamental value of a security but instead they focus more on the price fluctuations i.e. technical analysis (Kolb & Overdahl, 2008, pp.56-58). Since future prices are unpredictable, they present an opportunity to forecast the likely price of the underlying asset in the future when the hedging contract is supposed to expire. A trader, in expectation of the price of the underlying asset to differ from the exercise price, may either decide to buy or sell, based on his or her assessment of whether the asset is undervalued or overvalued, a derivative instrument. Such a trader who undertakes additional risk to earn a profit is called a speculator (Cootner, 1967, pp.262-67). This is the main difference between hedging and speculating in derivatives. Hedging is fundamentally different from speculators regarding their positions regarding risks prior to entering into contracts. While speculators take positions that increase their risk exposure, hedgers aim at minimising their risk exposure. The major drive of hedgers to enter into the derivative market is because their normal businesses present risks which they wish to reduce (Koch & MacDonald, 2009, p.341). Therefore, hedging can be used a risk management tool in the derivatives market while speculation cannot. Speculation increases the level of risk incidence to the investor. It should be noted however that speculation is assuming of calculated risks and is not dependent on pure chance or luck. 3.0 International Airlines Group 3.1 Organizational Background International Airlines Group which is officially referred to as International Consolidated Airlines Group, S.A. is a multinational airline holding company headquartered in London, United Kingdom and with its registered office in Madrid, Spain. International Airlines Group is the seventh-largest airline company in the world (and third-largest based in Europe) measured by 2010 revenues and has a fleet of 348 aircraft flying to 200 destinations and carrying more than 50 million passengers each year. IAG was formed in 2011 and is the parent company of British Airways, Iberia and BMI. It is a Spanish registered company with shares traded on the London Stock Exchange and Spanish Stock Exchanges. The corporate head office for IAG is in London, UK. IAG's mission is to play its full role in future industry consolidation both on a regional and global scale. 4.0 Foreign exchange risk exposure for IAG Foreign exchange risk (Exchange rate risk, Currency risk) can be defined as the financial risk inherent by an exposure to unplanned changes in the exchange rate between two currencies. Multinationals and other firms dealing with exports and import trade are faced with this form of risk and it can cause severe financial losses if not well managed. International Airlines like IAG sell their tickets in different countries and in different currencies. They also incur operating expenses in the currencies of the countries that they operate in and make capital expenditures from the major aerospace exporting countries like US and Canada (Morell, 2007, pp.62-67). Foreign exchange exposure has gained increased importance in the airline industry as most of the large airlines expand to the international market. There are two major causes of exchange rate exposure. The largest cause arises from the lag between the sale of a ticket in foreign currency and the receipt of the sale proceeds in The British Pound. In most cases, this delay averages between 15 to 45 days in the major markets. After a ticket is sold in a foreign currency, a delay of several days will occur before IAG can receive the same money in foreign currency. If in that duration there is a substantial fluctuation in the exchange rate for example the foreign currency depreciates, then IAG will incur a loss in the transaction. The second cause of exposure arises from the impact of exchange rates on the anticipated future cash inflows from a sale (Levi, 2009, pp.285-308). Since it is not possible to readjust ticket prices at short intervals, the depreciation of a foreign currency will reduce the pound value of anticipated future cash flows if the foreign currency price and the value of transactions are stable. From this argument, an appreciation of foreign currencies should be associated with increased profitability and an appreciation of IAG stock in the securities market. The vice versa is also true. Movements in exchange rates are also believed to reflect the underlying economic conditions. The prospect of a recession in the Great Britain will reduce the demand for the British currency and lead to a depreciation of the same. Since airline travel is cyclical, the anticipated revenue from ticket sales is likely to decline with prospective recession. Exchange rate movement is also likely to affect energy prices. When the pound value depreciates to the Dollar, then the Oil prices in Britain will have to rise in order to maintain parity with world price. This will mean additional costs to IAG and if they cannot react to this with increased ticket prices, then their future profitability will be adversely affected (Levi, 2009, pp.285-308). 5.0 Hedging Strategy for Interest Rate Risk Interest rate risk refers to the risk borne by an interest bearing asset such as a loan or a bond. Managing interest rate risk is a fundamental component of the management of a company. It involves the prudent management of mismatching positions with the aim of exercising control within set limits, the likely impacts of volatile interest rates (Jareno & Navarro, 2011, pp.337–348). Although the management of interest rates varies from company to company due to the unique position of every company’s liability and asset position, interest rate management involves establishing policies to manage risks, implementing appropriate management techniques, and, lastly, implementing effective control procedures to manage risks. Depending on the risk attitude of the company, there are two policies that a company could utilise. The first is to assume risks and second is the prudent limiting of a company’s risk exposure. Although managing interest rate risks requires oversight from all levels of management, hedging is the best way to manage interest rate risks. There are two main types of derivatives that IAG can adopt i.e. caps and swaps. In this case, a swap would be the best option. A swap will allow IAG to exchange the variable-rate payments for a guaranteed fixed rate. A swap does not generally require any advance payment to the lender. There are a many varieties of swap instruments available, reflecting the international nature of the debt market. For example, although there would be no advantage for IAG in swapping a fixed rate for another fixed rate within the same currency i.e. the British pound, as the outcome would be known, it would be advantageous to swap fixed rates between two currencies. All the variables of currency, floating and fixed exchange rate can be swapped (Coyle, 2004, pp.37–48). There are several advantages that would accrue to IAG as a result of the adoption of this strategy. For example, since the amount of the swap is notional, it may not be necessary for IAG to match the whole ?30m or to ensure that the 3 months are covered. Also a swap is flexible, which would allow IAG to adjust its maturity, payment frequency, and principal to suit its on-going financial status. Also interest rates can be managed separately from the financing arrangements and there is no initial payment required (Coyle, 2004, pp.33–38). The terms of the interest rate swap are as follows: Notional amount ?30 million Trade date Jan 1, 2013 Start date Jan 1, 2013 Maturity date March 31, 2013 IAG pays 5.50% IAG receives LIBOR Pay and receive dates annually on the debt payment dates Variable reset annually (on March 31) Initial LIBOR 5.00% P&L Analysis when Interest rate increase or decreases Debt ?1.5M Profit or Loss ?1.5M Profit or Loss ?1.5M Swap ?1.5M The net effect of P&L reflects that the changes in the fair value of the swap offset fully the changes in the fair value of the debt for the designated risk. 6.0 Interest Rate Swaps Interest Rate SWAPs are a type of contract in which the parties to the contract agree to exchange interest rate payments on a specified notional amount from a either a fixed floating rate to a flexible interest rate and vice versa or float on floating rate contract to another. SWAPs can be in the same currency or a different currency (Whittaker, 2009, pp.3-13). A bank can arrange to have two parties to exchange interest rate payments in the same or different currency as those in the same currency from fixed to floating rates and vice versa. For example, a certain company enters into an interest rate swap with a bank to reduce the risk from interest rate movements on a $10 million loan it has borrowed on a floating rate. The bank agrees to a fixed rate of, for example, 6% over five years, while the floating rates are based on the six-monthly Libor (London Interbank Borrowing Rate) plus 2%. If the Libor is 4% at the start of the agreement, the amount payable is 6% in both cases, although any percentage could be agreed. If the Libor rises to 6%, the amount payable every six months would be 8% of $10 million divided by two, or $400,000. The company’s agreement with the bank is for a rate of 6% or a payment of $300,000 in this case. The company will receive the difference of $100,000 from the bank. This arrangement assures a hedge for the party with a security with a floating rate while giving the party with a more conservative asset the change to make speculative gains from interest rate variations (Bank of England, 2012, np). The role of banks as intermediaries in swap transactions exposes them in a variety of risks. These risks arise because in some instances, these swaps can lead to banks suffering capital losses. There are concerns that banks may be charging very little for their services and therefore are not being adequately compensated for the risks they assume in such transactions. Another risk is the counterparty risk which is the risk that the counterparty may default on payments. Banks also face the Basis Risk which is a risk that occurs in situations where the variable rate paid by the issuer on its loans is different from the floating interest rate received from the swap (Skarr, 2004, pp.6-8). It has been argued that the growth of derivatives and the increased financial innovations and their growing complexities, poor regulations in the financial markets and poor risk management practices by banks have played a significant role in the banking sector’s failure in the financial crisis (Voinea & Anton, 2008, pp.25-30). According to Voinea & Anton (2008, pp.25-30), an important characteristic of periods of financial innovation is that the increase in new products and changes in the structure of financial markets can outpace the development of the risk management practices by banks. Recently the growth of the credit default swaps market has been thought to worsen the financial crisis and also threatening the stability of members of the Euro (Rickards, 2010, pp.6-12). The problem with the instruments is that they allow insurance without insurable interest. 7.0 Stock Market Option: Straddle Strategy A straddle strategy can be said to be an investment strategy that involves the purchase or sale of a particular derivative that allows the investor to gain based on how much the price of the underlying security fluctuates regardless of whichever direction of the movement. A long straddle is the purchase of particular option derivatives while a short straddle is the sale of the particular option derivative. A straddle refers to a basic volatility strategy that is based on the notion that the underlying asset’s value is going to move significantly in one direction although the investor is not certain per the exact direction of the move (Tung & Quek, 2011, pp.45-49). Straddles are direction-neutral and medium instruments that provide the investor with unlimited potential for gain. The strategy involves both the put and call option where the investor buys at-the-money and calls together at the money option. The loss is usually limited to the amount that the investor is required to pay for the two options cumulatively since they are not under any obligation to exercise their right should the option move in the undesired direction. The purchasing of particular option derivative is known as the long straddle while the short straddle involves the sale of option derivatives (Izraylevich & Tsudikman, 2010, pp.25-30). A long straddle strategy involves going through taking positions with both a call and a put option bought at the same exercise price whose expiry dates are the same. The buyer of a long straddle only makes a profit if the price of the underlying asset moves substantially away from the strike price in either direction. It is the best strategy to take when the investor is not certain of the direction that the asset will move towards. A long straddle presents unlimited potential for gain at constant risk since the investor’s risk is limited only to the exercise price paid for the call and the put. The investor can decide to exercise the call or the put depending on the direction of the market (Franke, et al, 2011, pp.519-533) From a technical profit and loss analysis, the price is expected to go up (see appendix 3). Since the prices are expected to rise, a long straddle position shall be taken. The contract specifications are: Call option exercise price: ?128; put option exercise price: ?128; and the term to maturity: 6 months. It is also assumed that American option conditions apply. Long Straddle Strategy Long 1 IAG Sep 50 call @ ?128.75, Long 1 IAG Sep 50 put @ ?129.15 Total Cost Option Premium Paid, ?130 Maximum Loss Option Premium Paid, ?130 Maximum Profit Unlimited Potential The payoffs under different prices are given below: MONTH 1ST 1-4 WKS 2ND 5-8WKS 3RD 9-12 WKS 4TH 6TH Market price 126. 127 130 124 128 Premium .75 .75 .75 .75 .75 Call Payoff (EP 128) (.75) (.75) 1.75 (.75) - Put Payoff (EP 128) 1.15 .25 (.75) (.75) (.75) If the firm chose to go long, it has the opportunity to make ?1.15 per option by exercising the put and ?1.75 by exercising the call at the 3rd month i.e. week 12. LIST OF REFERENCES Bank of England, (2012) Option-implied Probability Density Functions for Short Sterling Interest Rates and the FTSE 100. Bank of England [Online]. Available at: http://www.bankofengland.co.uk/statistics/Pages/impliedpdfs/default.aspx [Accessed August 17, 2012]. Cootner, P. H., (1967). Speculation and Hedging. Working paper (Sloan School of Management), pp.262-67. Coyle, B. (2004) Interest-Rate Swaps. London: Financial World Publishing, 2004. Franke, J., Hafner, W. K., & Matthias, C., (2011). Volatility Risk of Option Portfolios. Statistics of Financial Markets, pp.519-533. George, E., (2012). Principles of Risk Management and Insurance. LAVOISIER S.A.S. Izraylevich, S. & Tsudikman, V., (2010). Systematic Options Trading: Evaluating, Analyzing, and Profiting from Mispriced Option Opportunities. Mumbai: FT Press. Jareno, F.& Navarro, E., (2011). Stock Interest Rate Risk and Inflation Shocks. European Journal of Operational Research, Vol. 201 (2), pp.337–348 Johnson, L. L., (1960). The Theory of Hedging and Speculation in Commodity Futures. The Review of Economic Studies, Vol. 27 (3), pp.139-151. Koch, T. W. & MacDonald, S. S., (2009). Bank Management. Belmont, CA: Cengage Learning. Kolb, R. W. & Overdahl, J. A., (2008). The Pricing of Forward and Futures Contracts. New Jersey: John Wiley & Sons. Levi, M.D. (2009) International Finance 5th edn, Routledge, Madison Avenue New York. Morell, P.S, (2007) Airline Finance 3rd edn, Ashgate Publishing limited, Hampshire England. Nance, D. R., Smith, C. W., & Smithson, C. W., (1993). On the Determinants of Corporate Hedging. The Journal of Finance, Vol. 48 (1), pp.267-284. Philippe, J., (2001). Value at Risk: The new Benchmark for Managing Financial Risk. Gestion Des Entreprises. Rickards J. (2010), “How Markets Attacked the Greek Pinata”, Financial Times, February, 12. Skarr, D. (2004) the Fundamentals of Interest Rate Swaps, California Debt and Investment Advisory Commission Research Unit, Vol 12-04 pp. 6-8 Smith, C. W. & Stulz, R. M., (2009). The Determinants of Firms' Hedging Policies. Journal of Financial and Quantitative Analysis, 20, pp. 391-405. Stulz, R. M., (2005). Rethinking Risk Management. Journal of Applied Corporate Finance, 9 (3), pp. 3-25. Tung, W. L. & Quek, C., (2011). Financial Volatility Trading Using a Self-Organising Neural- Fuzzy Semantic Network and Option Straddle-Based Approach. Centre for Computational Intelligence, 38 (5), pp. 4668–4688. Voinea, G. & Anton, S.G.(2008), Lessons from the Current Financial Crisis. A Risk Management Approach, Journal of Risk Management Vol 5-08, pp.25-30 Whittaker, G., (2009). Interest Rate Swaps. Economic Review, pp.3-13 APPENDICES Appendix 1: P&L Analysis. Appendix 2(a): Long Straddle Source: The Options Guide Appendix 2 (b): Long Straddle Source: The Options Guide Appendix 3.0: Technical Analysis of IAG Sources: LSE Read More