Treasury and Risk Management - Essay Example

? TREASURY AND RISK MANAGEMENT Table of Contents Answer 4 Section (a) 4 Section (b) 5 Section (c) 6 Answer 2. 6 Section (a) 6 Introduction 6 Argument 7 Conclusion 9 Section (b) 10 Introduction 10 Argument 11 Conclusion 12 References 13 Bibliography 14 Answer 1. Section (a) The net gain or loss for the stock prices between $121 and $231 per share at option maturity is calculated as follows: Purchased Share Price ($) Current Stock Price ($) (i) Long Share Profit & Loss ($) Strike Price ($) Premium Paid ($) (ii) Long Put Profit & Loss [Max((Option Value - Premium Paid), Premium paid)] Strategy [(i)+(ii)] Protective Put (Net) 171 121 -50 165 28 $16.00 Exercise -$34.00 171 141 -30 165 28 -$4.00 Exercise -$34.00 171 165 -6 165 28 -$28.00 Exercise -$34.00 171 171 0 165 28 -$28.00 Do Not Exercise -$28.00 171 181 10 165 28 -$28.00 Do Not Exercise -$18.00 171 201 30 165 28 -$28.00 Do Not Exercise $2.00 171 221 50 165 28 -$28.00 Do Not Exercise $22.00 171 231 60 165 28 -$28.00 Do Not Exercise $32.00 Long Share Profit or Loss = Current Stock Price – Spot Share Price For instance, when current stock price is $121 and the Purchase price is $171, the Long Share Profit or Loss = $(121-171) = -$50. Option Value = Strike Price – Current Stock Price For Instance, when the strike price is $165 and the current stock price is $121, the Option Value = $(165-121) = $44 (In-the-Money) Long Put Profit & Loss = Max [(Option Value – Premium paid), Premium paid] For Instance, when the premium paid is $28, Long Put Profit & Loss = Max [(44-28), -28] = $16 The option will be exercised only when there is a Long Put Profit otherwise the option will not be exercised and the loss will be limited to the initial premium paid. Hence, this strategy is also known as the ‘Protective put’ strategy. For instance, when current stock price is $121 and premium paid is $28, the option should be exercised. Similarly, for different current stock prices, the protective put strategy can be computed. Section (b) The break-even Share price for Dec $165 put is $y (say) Given that, Premium Paid = $28, Spot rate = $171, current stock price = $121, strike price = $165 Therefore, the long share profit/loss = $(121-171) = -$50 (loss) The put profit = Max [(Strike price – Current price), Premium paid] = Max [(165-121), -28] = $34 So, from the above it can be said that if the put is at $121, only loss of $34 and if put is not exercised, loss will be $50. Hence, the breakeven share price is $199. It implies that the hedger will start to make profit after crossing the breakeven point of $199 when all premiums are paid and initial purchasing cost of shares are taken into consideration. Section (c) The protective put strategy diagram along with the breakeven point is shown below, Answer 2. Section (a) Introduction Many analysts believe that the European economy is likely to face more turmoil before it finally gets better. Greece owes a total debt of €490 billion to various banks in Euro zone. Analysts believe that if Greece fails to repay its debt then the impact of default will be directly felt by the small as well as the large businesses in UK. With such a huge amount of debt, if Greece really fails to repay and leave Euro, then the consequence of that will be mostly felt by the various banks in UK and Euro to whom Greece owes. Argument Defaulting of Greece or separating Greece from the Euro zone may not be suitable options to revive the European economy since the implication of both outcomes will paralyze the European economy as well as the global markets. This is mainly because of the fact that the banks do not work in isolation. They are connected to each other through debt guarantees or collaterals and insurance products (Mylonas, 2011, pp.81-84). Assuming that the Greece will default and then the most probable impact will be that about eighty percent of British banks will have less money to lend out to individuals and businesses. Consequently, if the bank’s lending slows down then the consumer consumption will decline leading to deflation in the economy. When the consumer stops spending and the business halts investment, it will impact the overall economy by slowing down the economic activity and progress. This is also known as the “credit crunch”. The credit crunch mostly affects the stock markets by surging volatility and uncertainty. The uncertainty which glooms over the economy damages the financial stability and the banking sector. As a result the banks will start freezing credit lines which will impact the interest rates and interbank offer rates. The prices of goods and services will fall rapidly due to less investment. Low quality products will be sold for high prices which will damage the exports and the manufacturing sectors in UK. Over the time the GDP of the country will fall rapidly indicating that the economy is slowly heading into recession (Chinn and Frieden, 2012, pp.8-11). (Source: IMF, 2012) Apart from the chances of Greece defaulting and UK heading into recession, the fear of most analyst is that the impact of default will not be limited to Greece. It is likely to spread like a chain reaction and engulf other Eurozone economies including Spain, Italy, Portugal, and Ireland. The total impact of the impact is huge since only Britain’s exposure to these countries is over ?60 billion. Over fifty percent of trade in United Kingdom is done with the Eurozone countries (Shambaugh, 2012, pp.1-5). Hence from the above discussion it can be said that the impact of default will be significantly felt globally. The following graph shows the funding requirement of Greece government for the year 2010: (Source: Credit Suisse, 2010) The impact of countries leaving euro on the UK economy and UK firm will be severe with chances of Greece defaulting (Atrissi and Mezher, 2010, pp.1-2). It is likely to spread like a chain reaction and engulf other Eurozone economies including Spain, Italy, Portugal, and Ireland. The total impact of the impact would be huge since only Britain’s exposure to these countries is over ?60 billion. In such a scenario if the UK firms want to mitigate the impact, they should increase their cash reserves and focus on cutting operational costs. If possible, the companies may also discretionary spending such as advertisements and travelling expenses. Plans for business expansions should be postponed till credit market regains confidence. Some firms may have business properties which they can lease on new terms. But most important of all is to ensure secure line of credit. Also, uncertainties in the currency markets will require the international UK firms to adopt risk management strategies to hedge against fluctuating currencies (Skaperdas, 2011, pp.1-6). Conclusion Departing of Greece from the Eurozone would imply the requirement of a separate currency for Greece which will replace Euro. Such is move is not supported by many banks since the entire procedure of creating a new or alternative currency is time consuming and many small and large businesses along with the banks will have to bear the brunt of default of over €490 billion. Many traders will be bankrupt, deals will be broken, debt will pile up due to non-repayments and the entire UK and Eurozone will be in a financial nightmare. Section (b) Introduction The impact of countries leaving the euro on other euro zone economies such as Ireland, Italy, Portugal and Spain could severely affect the financial stability of the global economy. The immediate impact will be requirement of alternate or new currencies which will be followed by departing countries to devalue their liabilities and assets. Not to mention the huge quantum of sovereign debt that member countries owe, the magnitude of austerity measures will be enormous. (Source: Citi, BIS, 2012) Ironically, the Eurozone was created to bring credibility and stability in the financial markets which was dependent upon the irreversibility of the Euro. The government was the biggest beneficiary of the Eurozone since they now have access to the financial markets from where they will be able to raise loans at cheaper rates. But this concept of cheaper debt and lower service costs exposed the Euro banks to higher risks. One of the reasons as to why the departing of Euro countries will adversely affect the economy is the banks and the financial systems are interconnected. A political fear regarding EU sovereign debt crisis and leaving of member countries from Eurozone will send a global economic shock wave of disrupting the financial markets throughout the world (Eichengreen, 2007, pp.4-7). Argument The consequences of the member countries leaving the euro zone can be understood from the micro-economic point of view and then its implications can be extended globally. As long as the banks can pull out money by selling loans on the basis of securities, they do not feel the dependency to rely on the savers. Some of the banks started to buy securities as well. This increased the exposure of the banks to risks. When the problem will be realized, the process of lending will be slowed. Some of the banks might be on the verge of most risky loans which was beyond the intention of the investors. The problem will spread as it burden of debt gets intensified. Even the banks with large capital reserves might feel the pressure and consequently tighter capital adequacy norms will have to be followed. The government will have to bear most of the brunt by providing bailouts and austerity measures. When the banks begin to feel nervous to loan out the injected money it will then shrink banks’ money out of the economy. Among the other effects include rise in the level of unemployment, rising in the levels of international and domestic debt, crisis in housing and mortgage, failure of key businesses such as automobile, realty and manufacturing industry of U.K., along with various banks and housing lenders (Begg and et.al., 2003, p.14). There were downturns in the share market along with declines in the wealth of the consumers when the media reported possible exit of defaulting member countries from Eurozone. The actual impact can be estimated by analyzing the recent bailout requirement of Cyprus since in less than a month the cost of bailout has escalated sharply. Initially, it was estimated that the Cyprus will have to contribute about $9 billion to get $13 billion bailout package but more recently it was reported that the bank need an additional $8 billion to $16 billion more if it has to be rescued. To raise the additional money, about three-fourths Island’s gold reserves will have to be sold along with liquidation of assets and levy of additional taxes. It is fifth out of 17 nations that urgently need bailout. Conclusion From the above discussion it can be said that the implications of countries like Spain, Italy, Ireland, and Portugal leaving euro zone can be quiet significant. First of all, the entire financial market will have to be reconfigured with new sets of currencies which will make the domestic banks to devalue their balance sheet. The government will have to provide austerity measures to manage the debt of defaulting countries. Banks will have to renegotiate their payments and cash management cycle. The risk exposures of the new financial currencies will require to be evaluated which will be developed from the separation. All existing loans, borrowings and transactions will have to be renegotiated in terms of new currency or even the exiting countries may push the government for austerity measures. Many official believe that Cyprus plan will not be repeated in future as it was a unique case but departure of other economies such as Ireland, Italy, Portugal and Spain might force European Central Bank and IMF bear the cost of withdrawal from Euro. Overall, in order for UK economy to revive and to protect the Eurozone from heading into recession, the various policies adopted by the government should focus on reducing debt and boosting growth. References Atrissi, N. and Mezher, F., 2010. Sovereign Debt Crisis and Credit Default Swaps: The Case of Greece and Other PIIGS. [Pdf]. Available at: http://www.fgm.usj.edu.lb/files/a32010.pdf. [Accessed on April 12, 2013]. Begg, D. et.al, 2003. The Consequences of Saying No. [Pdf]. Available at: http://faculty.london.edu/rportes/research/BeggCommissionReport.pdf. [Accessed on April 12, 2013]. Chinn, M. D. and Frieden, J. A., 2012. The Eurozone Crisis: Origin and Prospects. [Pdf]. Available at: http://www.lafollette.wisc.edu/publications/workingpapers/chinn2012-001.pdf. [Accessed on April 12, 2013]. Eichengreen, B., 2007. The Breakup of Euro Area. [Pdf]. Available at: http://emlab.berkeley.edu/~eichengr/breakup_euro_area.pdf. [Accessed on April 12, 2013]. Mylonas, H., 2011. Is Greece a Falling Developed State? Causes and Socio-Economic Consequences of Financial Crisis. [Pdf]. Available at: http://www.wcfia.harvard.edu/sites/default/files/Mylonas_fulltext.pdf. [Accessed on April 12, 2013]. Shambaugh, J. C., 2012. The Euro’s Three Crises. [Pdf]. Available at: http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2012_spring_bpea_papers/2012_spring_BPEA_shambaugh.pdf. [Accessed on April 12, 2013]. Skaperdas, S., 2011. Seven Myths about the Greek Debt Crisis. [Pdf]. Available at: http://www.socsci.uci.edu/~sskaperd/SkaperdasMythsWP1011.pdf. [Accessed on April 12, 2013]. Bibliography Allen, F. and Ngai, V., 2012. In What Form Will the Eurozone Emerge from the Crisis?. [Pdf]. Available at: http://finance.wharton.upenn.edu/~allenf/download/Vita/Eurozone-Emerge-from-Crisis-20Aug12.pdf. [Accessed on April 12, 2013]. Chance, D. M. and Brooks, R., 2009. An Introduction to Derivatives and Risk Management. United States: Cengage Learning. Eichengreen, B., 2009. The Crisis and the Euro. [Pdf]. Available at: http://emlab.berkeley.edu/~eichengr/crisis_euro_5-1-09.pdf. [Accessed on April 12, 2013]. Read More