US future markets and risk management - Essay Example

Supervisor "Discuss the use of the US futures markets as a risk management technique companies could use to reduce their risk" February,2009 1.0Introduction The drive by countries to improve the efficiency and resilience of their financial systems through deregulation, the development of domestic capital markets, the privatization of state-owned financial entities and the encouragement of foreign bank entry were all measures adopted of late by governments to encourage efficiency into the banking system (BIS Paper No 33,2005). Today, bankers are increasingly becoming conscious about recent developments in their respective markets and have resorted into various method of managing risk in bank. Risk management appears to have improved in most sub-regions as a result of the introduction of new approaches in conducting business as well as better measurement and pricing of the various risks (BIS Paper No 33, 2005). 1.1 Overview of Financial Market Risks According to BIS paper No.33, financial markets are subject to various sources of risk: credit, market, liquidity, operational and legal risks. These risks tend to be more pronounced in the developing world than in developed countries due to a lower level of economic, financial and institutional development. Credit risk tends to be more acute as a result of a lack of highly rated counterparties. Market and liquidity risks are higher due to thinly traded markets. Operational risks may also be exacerbated because of inadequate human resources or the failure of manual, mechanical or electronic systems to process payments. Finally, legal risk may also be part of the environment (for instance, due to the inability to foreclose on collateral). The next section discusses credit risk and some of its components and how it can be managed. The aim of this paper is to examine futures as risk management techniques companies could use to manage their risks. The paper first of all examines the risks companies are prune too before analyzing how the risks can be solved with futures. This paper is however limited only to the credit risk aspect of organization. 1.2 Types of risks 1.2.1 Credit Risk The risk that a debt issuer will default is known as credit risk; this is typically the most important form of risk for commercial banks Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001).Solt & Wayne (2001) argues that, in assessing credit risk, an institution needs to consider three issues: default probabilities over the horizon of the obligation, credit exposure (ie how large the obligation is when the default occurs) and the recovery rate (ie what part of the exposure may be recovered through bankruptcy proceedings or some other form of settlement) (Solt and Wayne, 2001). Credit risk is often difficult to assess due to the lack of information on the credit history and financial position of borrowers, inadequate accounting practices and standards that make it difficult to evaluate credit exposures, macroeconomic volatility and deficiencies in the institutional environment (e.g., political instability) (BIS Paper No.33, 2005). Weak enforcement of creditor rights may also contribute to uncertainty regarding recovery rates. Although many of these factors have been improving in recent years, progress in some cases is slow (Mohanty et al., (2006). Moreno (2006) highlights two key issues related to credit risk that are relevant for emerging market economies (EMEs). First, the distinct increase in the share of credit to the household sector that has been observed in a number of countries could lower credit risk if the concentration of bank assets fell, if consumer credit diversifies risk among a larger number of borrowers. 2.0 Risk Management In management of credit risk, I will focus only on the currency risk exposure aspect of credit risk. That is in a situation where credit is offered in multiple denominations of currency. Currency risk or foreign exchange exposure or better still foreign exchange risk refers to the risk that a company's cash flows, transactions and future business operations may be affected by changes in exchange rates. (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001). Foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are therefore clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, a home based bank accepting deposit and offering credit in foreign countries through subsidiaries or international lending, as such its expected future cash flows will be affected by exchange rate movements between the home and the foreign currency. (Buckley, 1996). Exposure to foreign exchange risk is classified into three types including transaction exposure, translation exposure and economic or operating exposure. (Buckley, 1996; Shapiro, 2003 Transaction Exposure Here, I have considered transaction exposure, with the exposure of a firm's foreign currency-denominated balance sheet items (asset and liabilities) to changes in exchange rate changes due to credit being offered in foreign currency. Transaction exposure is therefore a measure of the change in the asset or liability's value that occurs as a result of an exchange rate change. (Shapiro, 2003; Muller and Verschoor, 2005). Here credit risk is the risk that, the value of the credit will be less than the initial value of the credit granted due to currency translation. Here, when preparing a consolidated financial statement for the entity credit dominated in foreign currency needs to be converted to the local currency. The is a risk of foreign exchange losses, where the value of the foreign currency has depreciated with respect to the local currency. . Translation Exposure Translation exposure is the exposure a firm faces in relation to changes in its foreign currency-denominated cash flows owing to a change in the exchange rate. Translation exposure is principally concerned with the firms accounts receivables and payables that are denominated in foreign currency. (Shapiro, 2003). Translation exposure affects both balance sheet and income statement items of the firm as well as cash flow items. Both translation and transaction exposure constitutes accounting exposure, that is, exposure that is based on the changes of balance sheet and income statement items that occur as a result of an exchange rate change. (Buckley, 1996; Shapiro, 2003). Economic Exposure Economic, operating, or competitive exposure is the exposure that a firm faces owing to the fact that its competitive position may change as a result of changes in exchange rates. It is exposure that the firm faces in relation to its future transactions. Unlike translation and transaction exposure, economic exposure does not deal with changes in already existing income statement and cash flow statement. Rather, it considers how changes in exchange rates may affect the firm's future position competitive position in relation to transactions that have not yet been entered into the balance sheet although contracts might have been established. (Buckley, 1996; Shapiro, 2003; Muller and Verschoor, 2005). While it is possible to eliminate transaction and translation exposure through the use of hedging instruments such as forwards, futures, options as well as other hedging strategies such as exposure netting it is not possible to hedge against economic exposure. (Shapiro, 2003; Faff and Irio, 2001; Solt and Wayne, 2001). Managing Foreign Exchange Exposure. The United Kingdom and French banks can mange its currency exposures arising from credit through hedging. By so doing it will take a position such as acquiring a cash flow or an asset or a contract that will rise or fall in value and offset the fall or rise in value of an existing position. (Moffet et al, 1995). Shapiro (2003, pp 329) states that hedging a particular currency refers to establishing an offsetting position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Banks can further use currency futures, currency swaps, currency forwards and currency options to hedge its expected future exposure to exchange rates. Translation and transaction exposure can be managed using the following hedging strategies: Forward market Hedge If a bank or credit company is expecting to receive a future stream of cash flows in a foreign-currency, she can sell the stream of cash flows in a forward market to lock in a minimum value of the cash flows in terms of the home currency. No matter what happens, with the exchange rate, the company will still receive its guaranteed amount of home currency cash flows. (Shapiro, 2003). The only expenditure that will be incurred will be the price paid for establishing the hedge position. On the other hand if the company has foreign-currency-denominated liabilities, it can minimize the risk by buying a forward contract to hedge against an appreciation of the foreign currency. (Shapiro, 2003).Therefore a company that is long in a foreign currency will sell the foreign currency forward while a company that is short in a foreign currency will buy the currency forward. (Shapiro, 2003). However, by establishing this hedging strategy, the company also foregoes any benefits that may accrue if on the other hand the foreign currency appreciates relative to the local currency. Therefore downside risk is protected at the expense of upside potential. (Shapiro, 2003). Options Market Hedge Instead of establishing the hedge with a forward contract the company could hedge its 10million ZAR receivable by buying a put option. By using this technique she will be able to speculate on the appreciation of the ZAR as well, while limiting downside potential. (Shapiro, 2003). A currency put option gives the holder the right but not the obligation to deliver a currency at a specified price known as the exercise price at the expiry date. (Moffett et al, 1995; Shapiro, 2003). Thus if we assume that instead of the forward contract, there is a put option on the ZAR with exercise price 14ZAR/, then the company can purchase this contract and lock in a minimum value of 714,285.71. In this case she protects herself against downside risk but upside potential is unlimited. Should the value of the ZAR falls below 14ZAR/, at the expiry date, she will exercise her option to sell the Thai ZAR at 14ZAR/. On the other hand if the value of the ZAR is above the exercise price of 14ZAR/, at the expiration day, she will not exercise her option to sell the pound at 14ZAR/, since she has the right but not the obligation. Instead, she will convert her 10ZARmillion receivable at the current exchange rate. Thus downside risk is limited but upside potential is unlimited. If we assume the put option premium (that is the price paid for one put option) is 14ZAR/, then we can graph the profit and payoff to the hedged position as shown in the figure below: Source: Adapted from Bodie et al. (2002) As can be seen downside risk is limited while upside potential is unlimited. The minimum loss that can be made will be the premium paid for the put option to establish the hedge. This type of hedge is analogous to establishing a protective put position in the case of hedging against stock price decreases. (Bodie et al, 2002). Swap Hedging. One way investors can take advantage of the US futures is through a currency Swap. A currency swap contract is a contract between two counter-parties (Parties to the contract) where one counter-party exchanges a stream of cash flows (debt-service obligations) in one currency for a stream of cash flows in another currency. By so doing both counter-parties can achieve their desired currencies. (Shapiro, 2003). By entering a currency swap contract, the company can also manage its currency exposure. In this way the company which has borrowed, ZAR at a fixed interest rate can transform its ZAR debt into a fully hedge pound liability by exchanging cash flows with another counter-party who desires to have a fully hedged ZAR liability. The two loans comprising the currency swap have parallel interest and principal repayment schedules. At each payment date, the company will pay a fixed interest rate in pounds and receive a fixed rate in ZAR. The counter parties also exchange principal amounts at the start and end of the swap arrangement. (Shapiro, 2003). In a nutshell, the company can engage in a currency swap by borrowing a foreign currency and converting its proceeds to pounds, while simultaneously arranging for the other counter-party to make requisite foreign currency payments at each period. In return for this foreign currency payment, the company pays an agreed-upon amount of pounds to the counter-party. Given the fixed nature of the periodic exchanges of currencies, the currency swap is equivalent to a package of forward contracts of currencies. (Shapiro, 2003). Futures Hedging The United States (US) futures market provide an environment in which operational and financial risks associated with businesses can be easily managed and controlled using futures. To take maximum benefits from futures, businesses should first of all understand their risk and position. Futures are used for portfolio management and composition, fund management where they amend the risk return profile. Banks use futures as another income generating activity. For example, let's assume that, an American based tyre manufacturing company buying its raw materials from Africa, expects to have 1000tonnes of rubber in six months time. However, why investors in America are concerned about the fluctuation of rubber prices, thus the American based company takes advantage of the future market through hedging. So the lock into a price of 1000tonnes of rubber in six months. Through an initial margin agree , and the market reverse the trading position known as closing out. The price is now locked and the business is protected from a price fall. Currency futures contracts are contracts for specified quantities of a given currency, in which the exchange rate is fixed at the date of the contract. (Shapiro, 2003). For contracts traded on the International Monetary Market (IMM), the delivery date of the contract is determined by the board of directors of the IMM. Like forwards and options, Futures contracts can be used to eliminate currency risk as well. (Shapiro, 2003). Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican Peso, New Zealand dollar, Russian rubble, South African rand, and Swiss Franc. (Shapiro, 2003: p. 267). However, these contracts have limited delivery dates and are traded only in small quantities. Thus designing a hedging strategy using futures contracts can be very difficult. (Shapiro, 2003). According to Shapiro (2003) futures are a contract to buy or sell an amount of an item at a future date agreed upon a specified price. In most situations, items being trade on a future contract are mostly agricultural products, and energy source or a financial instrument. Many academics have argued that, futures provide counterparties with some form of arbitrary gains. Since they are considered a little more than gambling. Brealey & Myers (2005) argue that, with futures investors guard against financial risk and at the same time offers investors an opportunity to trade. Futures as financial instruments are quite significant. Commonly traded future instruments are currency, interest rates, stocks which are indexed based. The current global financial crisis and credit crunch has pushed analyst into other futures and risk management strategy such as USING US Treasury Notes and bond futures. For many businesses today, their future cash obligation is partly a function of the interest rate between now and the time of their expected cash flow. US futures' market provides enough risk management option. A fall in interest rate is offsetted by a gain in the hedge strategy. Conclusions and Recommendations Based on the analysis above, we can conclude that there are a number of different forms of risks faced by banks. These risks require that the firm to adopt a global strategy as well as a series of risk management strategies to hedge against risk as examined above. However, futures provide investors with a uniform way to manage it risks exposures. Futures offer alternative vehicles both for trading and for diverse management of financial risks. They are thus of vital importance not only to financial market players but more to multinational companies that wish to manage their foreign exchange or interest risk exposure. Futures and options together have become an integral part of the international capital market. References Buckley A. (1996). Multinational Finance. Third Edition. Prentice Hall. Moreno, R (2006): "The changing nature of risks facing banks", BIS Papers, No. 28, August. Mohanty, M, G Schnabel and P Garcia-Luna (2006): "Banks and aggregate credit: what is new" BIS Paper No. 28, August. Shapiro A.C. (2003). Multinational Financial Management. Seventh Edition. Wiley and Sons Inc. Solt M. E., Wayne L. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Vachani S. (2005). Problems of foreign subsidiaries of SMEs compared with large companies. International Business Review, vol. 14, pp. 415-439. Muller A., Verschoor W. F.C. (2005) Foreign exchange risk exposure: Survey and suggestions. Journal of Multinational Financial Management. Read More