Managing Financial Risk - Assignment Example

MANAGING FINANCIAL RISK By of the of the School (a) Explain the nature of the currency risk that the UScompany is exposed to and discuss the factors that might influence the company’s decision as to whether to hedge this risk. The company has an account payable of INR900 million hence has a currency exchange rate risk in the form of transaction exposure. This is due to the impact of the fluctuation in exchange rate on the company’s future cash flow. It arises from the company’s obligation to deliver the foreign currency, Indian Rupee, at a future date. Any currency exchange rate movement therefore poses a risk to the company (Poitras, 200, pg. 42). There are several factors that influence the company to decide whether to hedge or not. First, the company has information asymmetry problem. It lacks enough information about the foreign exchange market movements. It should therefore hedge this risk so that the information asymmetry problem is captured for. Second, the company is exposed to uncertainties in the foreign exchange market as a result of future cash payment. Finally, the company is subject to fluctuation in exchange rates. In order to reduce the risk associated with the unfavorable movements in the currency exchange rates the company needs to hedge the risk (Poitras, 200, pg. 47). (b) For the first delivery on 31st March 2014 suggest 3 alternative ways of hedging the currency risk. The three best alternatives to hedge against the currency risk include (Teall, 2013, pg. 78): i) Forward contract This contract will allow the company to either buy or sell a specified foreign currency amount at a foreign exchange rate specified today on a future date. The company has an open short position for payable of INR900 million to be settled after 3 months. Any depreciation of US dollars against the Indian Rupee is a risk for the company. By expecting a depreciation of US dollars the company should go for purchase of forward contracts ii) Money market hedge This means gives the company an opportunity to borrow in one currency, convert the borrowed money into a second currency and put the money on deposit basically until the a future date when the transaction is completed. Since the company has a future liability, accounts payable, it will create an asset by borrowing in domestic currency. iii) Currency futures These are contracts that are standardized and allows for the purchase or sale of a set quantity of foreign currency at a set future date. Since the company is going to make a future payment, it will therefore buy appropriate foreign currency futures contracts now. Then sell the same foreign currency futures contract on the date it buys the actual currency, closing out. (c) For the first delivery on 31st March 2014, determine the effectiveness of the 3 hedging strategies suggested in (b) above. Additionally critically discuss the merits of these strategies relative to remaining unhedged. Money market hedge Purchase and invest the Indian Rupee so that after three months the company may have INR 900 million. The company needs to deposit enough Indian Rupees now so that the total including interest will be INR900 million in three months time. This means depositing, at 7.5% INR900 million/ (1+0.01875) = INR883435582.80 Convert the Indian rupee to US dollars at the current spot rate of 1USD=INR60.565 (883435582.8/60.4550)= $14,613,110.29 The company will therefore borrow $14,613,110.29 and with three months interest of 0.225% pa will have to repay $14,613,110.29(1+0.0005625) = $14,621,330.17 Forward contracts Cost payable in three months 900000000/63.273= $ 14,224,076.62 Futures contract (900million/61.6)= $14610389.61 Unhedged strategy (900million/60,565)= $14,860,067.70 The three hedging strategies are very effective as they help the company reduce the risk. From the four scenarios it is evident that the account payable is considerably reduced when the three hedging strategies are used. Merits of the hedging strategies i) Hedging using futures allows long term traders and investors to minimize risks in short term. ii) Hedging tools are normally used for speculation reasons because they lock the profit for the investors. iii) With the help of hedging, traders are able to survive in the hard market periods because they give them a protection against the commodity price fluctuations, interest rate changes, currency exchange rate fluctuations and inflation. iv) They also help save time since the long term trader has no obligation to adjust or monitor their portfolio with daily volatility in the market. The main merit of these hedging strategies is that they help in the reduction of the losses and risks experienced by investors especially in the foreign investment opportunities. When investors put their money in the riskier foreign exchange market, they are faced with price volatility but with the help of these hedging strategies, they are more leveraged. Hedging the currencies therefore allows them to survive the economic downturns (Teall, 2013, pg. 78). (d) Given that the second consignment was not necessarily going to be ordered suggest a suitable hedging strategy using currency options. Additionally, use the Black-Scholes option pricing model to determine the likely cost of this option, justifying any assumptions made. The company can use a put option. This currency option type will give him the right but not an obligation to sell the specified amount of the underlying security at a specified exercise price within a specified time. The company is going to sell the domestic currency to acquire the foreign currency which will be used to settle the accounts payable. Black Scholes option pricing model This is a method used to determine the premium or value for the European put option. For this model to work effectively, there are numerous assumptions that are made. These assumptions include (Collier, & Agyei-Ampomah, 2008, pg. 126): i) No dividends are paid before the expiry date of the option ii) The investors borrow at risk free rate iii) No transaction taxes or costs iv) The options are for European calls v) Over the life of the option, the volatility of the shares and the risk free interest rate is constant. Value of put P= c - Pa + Pe × e-rt Where: Pa = current price of underlying asset Pe = exercise price r = risk-free rate of interest t = time until expiry of option in years e = 2.71828, the exponential constant Value of put option= (300-80+100*2.71828^ (-0.0025*0.5) =$120.12 Question 2 Derivatives time bomb refers to a situation in which the financial market basically plunge into chaos especially if the massive derivatives positions that are owned or in the possession of the large banks and the hedge funds should move against. Most of the institutional investors have basically increased their usage of the derivatives so that they can either speculate on the commodities or markets, or to hedge against their existing positions. The possible growth in the popularity of these instruments can be both bad and good because even though they can be employed to mitigate risks in portfolios, those institutions that are highly leveraged normally suffers a huge losses especially if the position hedged against move against their expectation (Mackenzie, 2008, pg. 85). In the light of the ensuing financial crisis and credit crunch a number of well known hedge funds in the recent years have imploded due to the dramatic decline in value of their derivative positions. This has forced the hedge funds to sell their securities at a markedly lower price so that they can meet customer redemptions and margin calls. In the recent years, according to the financial times, the Long Term Capital Management which is one of the largest hedge funds has collapsed due to the results of adverse and unfavorable movements in their derivative positions. These leverages afforded by the derivatives are used by investors to increase their investment returns and when properly used. The goal is met. However, as was the case with LTCM, the loss was amplified due to the excessive increase in the volume of leverage and the substantial decline in value of the underlying securities. This increase in the number of derivative positions taken by investment banks and hedge funds as well as increased leverage leads to an industry wide meltdown (Krager, 2012, pg. 267). As pointed out by Buffet, derivative arrangements are very dangerous. According to Economist, derivatives are normally bets that are made today between two parties with payoff in the future and is based on the value of some bond, stock, or index. Any unfavorable movement in the price of the stock, bond or index causes a loss to the other party who is to receive the settlement at a future date. For instance, J.P. Morgan lost over $5 billion due to the complex derivatives trade. The basic problem with derivatives is that they do not usually derive from an original investment or loan but are exclusively created to make new bets. This therefore means that they actually create risks out of thin air instead of moving them into strong hands. This therefore implies that derivatives do not reduce the risks but instead they grow them exponentially. Recently there was a miss-sell of mortgage backed securities (MBS) and collateralized debt obligations (CDO’s in the US and this lead to great depression in the economy. Mortgage-backed securities (MBSs) are basically shares of a home loan that are sold to the investors. These loans are created when a bank lends money to a borrower who then buys a house. The bank collects monthly repayments towards the loan. The loan and numerous other are then sold to a larger and greater bank that then packages them together into a mortgage-backed security. Shares called tranches are then issued by the large bank to investors who then buy them and consequently collect dividends. These tranches are further repackaged and sold as other securities that are called collateralized debt obligations, (CDOs). The investments banks miss sold these MBSs and CDOs to numerous investors and due to the default by homeowners on their loans in large numbers, the US teetered on a brink of a financial disaster. Boston Globe points out that this lead to the highest unemployment rate ever in two decades. Large investment banks were forced to endure great depression hence collapsing even though they had been in business and investment activities for more than a century. This forced the economy to circle the drain. Unique financial instrument known as the MBS was responsible for the last part of the economic disaster that loomed (Schwartz & Rubenstein, 2013, pg. 49). This implies Buffet was right in his proposition even though it was ignored. The proliferation of these derivative products that were related to the US home loans caused a global financial crisis because the loans ceased to perform hence triggered hundreds of billions of dollars in the write downs thereby causing the collapse of the Lehman Brothers Holdings Inc (Schwartz & Rubenstein, 2013, pg. 50). Another derivative that has caused a financial crisis in the recent time is Credit default swaps (CDS) as pointed out by Financial Times. A CDS is a bond-like security or a form of insurance based on a bond. It is therefore an instrument that enables companies to raise money. Basically a CDS has two types of risks, interest rate risk and default risk. It works by allowing one party to swap its default risk to another party. It is however, not possible to swap the interest rate risk. The two main demerits of CDSs is that they are not actually owned by investors because they are over the counter derivative contracts that are personally negotiated by the sellers and buyers thereby providing a choice to bet on the probability that the company under discuss is going to go bankrupt. The second demerit is that they are not regulated. So when bonds go bad in the market, the prices of CDSs therefore shots up leading to financial losses to the investment banks and the individual investors. This clearly points out that the CDSs contributed to the losses on the subprime mortgages which triggered write downs at the numerous financial institutions. This worsened when banks like Lehman and Bear Stearns began to fall causing further and larger losses to people who had previously sold CDS on their debts. Economist article notes that these credit default swaps were greatly responsible for the collapse or bringing down of WaMU, AIG, Bear Stearns and other mammoth corporations. It further claims that unexpected fluctuations in the rate of interest could further cause a major and great bloodbath in the interest rate derivatives (Schwartz & Rubenstein, 2013, pg. 49). From the above discussion it is right to conclude that Buffet was true about his view about the derivatives and the trading activities that are associated with them. They are time bombs to the economic system and the parties that deal in them. This is because they have plunged financial markets into chaos if the massive derivatives positions moves against them. This has therefore led to an industry wide meltdown. References Collier, P. M., & Agyei-Ampomah, S. (2008). Management accounting--risk and control strategy. Oxford, CIMA. Krager, T. (2012). Skullduggery!: the true causes of the financial crisis. [S.l.], Authorhouse. Mackenzie, I. (2008). English for the financial sector. Cambrige, Cambridge University Press. Poitras, G. (2002). Risk management, speculation, and derivative securities. Amsterdam, Academic Schwartz, D., & Rubenstein, D. (2013). The future of finance how private equity and venture capital will shape the global economy. Hoboken, N.J., Wiley. Teall, J. L. (2013). Financial trading and investing. Amsterdam, Academic Press. Read More