Derivatives and Risk: Green plc - Assignment Example

1) b) a Describe the main types of risk facing an organisation (like Green plc) which has dealings in foreign currency. Ans – The main types of risksfacing an organisation like Green Plc are – Transaction Risk, Translation Risk and Economic Risk. These are explained briefly as follows: Currency Risk- As per Wikipedia.org, ‘currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.” Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts- Wikipedia.org Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency. Economic risk is due to trading position is exposed to adverse movement in the foreign exchange rates. b) Describe and illustrate the three hedging strategies available to Green plc. Weigh up the advantages and disadvantages of each strategy. Show all calculations. Ans- Hedging using money markets- Here Green Plc would borrow in sterling at 3% per quarter converting it into M$ and putting it in deposit. The spot rate being 5.4165 it would need to borrow £ 110772.6392 @ 3% costing it £ 830.79. Depositing the required amount in Malaysian dollars @ 3% 4500 M$ interest earning. After the expiry of 3 months this deposit would be used to repay the Malaysian seller and the bank would be repaid in Pounds as the Malaysian $ rate in forward has fallen. 2 a) Describe the two hedging transactions that the treasurer could employ. Ans. The treasurer has two options for hedging transactions in case of expected fall in rate of interest as follows: FRA (Forward Rate Agreement) In the methodology of hedging there is no need for a third party and is executed between a company and a bank at mutually agreed rates, amounts, size and dates. Investopedia.com defines FRA as an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. The interest earning on £20 m @ expected rate of 8% p.a stands at £ 40,000 for the three month period between September and December. Any fall in actual interest rate would be a loss to the company. Likewise in case the interest rate was to increase it would be a gain for it. If Green Plc was to enter into an FRA for the above value it would be termed as: 3X6 FRA £ 20m at 8% Green Plc will be a seller by receiving fixed rate of 8% and paying floating 3 month LIBOR. STIR (Short Term Interest Rate Future)- As defined by Markets Wiki.com, “Short-term interest rates are the interest rates on loans or debt instruments such as Treasury bills, bank certificates of deposit or commercial paper, that have maturities of less than one year. Short term interest rate futures (STIR futures) are one of the largest financial markets in the world. The two main contracts, the Eurodollar and Euribor regularly trade in excess of one trillion dollars and Euros of US and European interest rates each day. STIR futures are traded on a completely electronic market place. Participants in the interest rate futures market are taking a view on the market’s direction -- on whether interest rates will rise or fall in the future. Those who want to protect against higher rates will want to pay a fixed rate and receive a floating rate in an interest rate swap. Correspondingly, those who anticipate a decline in rates may want to receive fixed interest rate payments and pay floating rates. Both sides are hedging against risk. A speculative market also exists for interest rates, consisting of traders seeking opportunities to profit from interest rate adjustments or market volatility.” In the given case three-month sterling interest futures (STIRs) starting in late September are available, priced at 92.00. In other words the rate of interest is 8% (100-92). The treasurer will buy the 3 months future at current trading level of 92 as he expects the interest rate to fall below 8% in the near future Number of contracts will be £20 m / 0.5 m = 40 contracts Futures price = 92 b) Show the profit/loss on the underlying and the derivative under each strategy if market interest rates fall to 7 per cent, and if they rise to 9 per cent Ans- FRA scenario if the interest rate falls to 7%. We can see that the company would gain as it had hedged by paying 3 month LIBOR and receiving 8% fixed rate. As LIBOR (payable rate) is less than fixed rate (receivable rate), the difference of 100 points would be the gain for the company. In absolute terms it would mean Green Plc would receive 1 % difference between the two interest rates. Interest settlement amount would be £20m X.(.08-.07) X 90/360 = £ 50,000 discounted at 7% or £ 50,000 /[1+(90/360)(0.07)]=£ 49,140 (net receivable or gain) If the interest rate rises to 9%. In other words the 3 month LIBOR (floating rate) has climbed up contrary to expectations thus the company pays 9% but receives only 8%. Hence there is net payment by Green Plc of 1%. There is loss to the tune of 1% on the agreed amount. Interest settlement amount would be £20m X.(.09-.08) X 90/360 = £ 50,000 discounted at 9% or £ 50,000 /[1+(90/360)(0.09)]=£ 48,900 (net payment or loss) STIR scenario- If the interest rate falls to 7% then as the buy was at 8% and sale is at 7% the net gain is calculated as 40*12.5*100= £ 50,000 If the interest rate rises to 9% then there would be loss of £ 50,000 as there is negative movement of interest compared to base rate of 8%. 3. Describe an interest-rate swap and show the interest-rate payments flows in a diagram under a swap arrangement in which each firm pays the other’ interest payments. ISDA (International Swaps and Derivatives Association Inc.) describes an interest rate swap as an agreement to exchange interest rate cash flows, calculated on a notional principal amount, at specified intervals (payment dates) during the life of the agreement. Each party’s payment obligation is computed using a different interest rate. In an interest rate swap, the notional principal is never exchanged. Although there are no standardized swaps, a plain vanilla swap typically refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate (usually Libor). In the current example Green Plc has a long term loan of £50m (10 year) from Bank A at LIBOR + 150 basis points. In other words it pays floating rate of interest on this loan. Current rate of Libor being 8% the total interest payout works to 9.5% (8% + 150 bps). Now the treasurer is worried that the interest rates are likely to harden and move in upward direction so as to jeopardise the financial ability of the firm to service the loan. The swap with Blue Plc which pays its bank B a fixed rate of 9% means that Green Plc would be able to recover the floating rate being paid to Bank A from Blue Plc. In turn Green Plc would have to pay fixed rate of 9% to Blue Plc. At current rates alone there seems saving of 5 basis points as the fixed rate payment to Blue Plc is less in absolute terms. If the hunch of treasurer at Green Plc rings true there will be further saving. Green Plc Pays Receives Green Plc LIBOR + 150 bps to Bank A 9% to Green Plc LIBOR +150 bps from Blue Plc Blue Plc 9% to Bank B LIBOR + 150 bps to Green Plc 9% from Green Plc Graphical Representation b. What are the drawbacks of this swap arrangement for Green plc? Ans. Interest rate swaps come with a number of underlying risks as follows: Credit Risk- There is a possibility that Blue Plc stops honouring its commitment to pay floating rate over the 10 year term especially if the rates of interest really move up substantially. Green Plc would be exposed to floating rate of interest once again i.e. its hedge against rise in interest rates would disappear. Interest Rate Risk- In case if the LIBOR moves downwards i.e. instead of increasing as expected it decreases to lower than 7.5% then the advantage of the swap would be lost as Green Plc would pay higher fixed rate of 9% Investopedia.com - http://www.investopedia.com/terms/f/fra.asp web 14 January 2010 ISDA International Swaps and Derivatives Association, Inc - http://www.isda.org/educat/ web 14 January 2010 MastersWiki.com-http://www.marketswiki.com/mwiki/Short-term_interest_rate_products web 14 January 2010 Wikipedia.org - http://en.wikipedia.org/wiki/Currency_risk web 14 January 2010 Read More