Treasure Management - Credit Default Swaps - Essay Example

Running Head: TREASURE MANAGEMENT Treasure management Name: Date: Table of Contents Table of Contents 1 Introduction 3 Characteristics of credit default swaps 3 simmilarities 4 Difference 4 Hedging 7 Speculation 7 Defensive risk management strategy 9 Aggressive risk management strategy 9 Conclusion 10 Introduction Credit default swaps (CDS) is an instrument which is commonly bought by investors so as to insure against defaults on corporate and other bonds. This means that the buyer transfer payment to the seller or any other party he or she is dealing with and in exchange, the buyer will be entitled to the right of payoff incase of any default of a credit instrument. The diagram below shows how the credit default swaps works between the parties concerned (Taylor, 2009). Characteristics of credit default swaps The credit default swap market is commonly categorized into various sectors. Some of these common sectors comprised of corporate, credit from banks and emerging market sovereigns. This credit default swaps can either be used to cover only one credit or can be used to cover many credits. The maturity of the credit default swap differs greatly because there are those which mature within a year while others mature in ten years after it is established. Most sellers and businessmen prefer those which mature after five years. simmilarities The similarities between the credit default swaps, currency swaps and interest rate swaps are that all of them involve payment of interest rates from one party to the other. Another similiraty is that swaps are priced basing on the following factors. These include the creditworthiness of the counterparties, the availability of the additional counterparties and the structucture of interest rates. The risk involve in these swaps depends on the personalities of the parties involved. The parties participating on these instruments should know their counterparts well before trading with them. Furthermore, swaps are never traded over the counter instead they are agreed upon by the parties involved. Difference There are various differences between the credit default swaps and the interest rate swap. Some of these differences are that credit default swaps works like a standby letter of credit while the currency or interest rates swaps does not call for the third parties. This means that credit default swaps involves three parties while the interest rate swaps involve two parties. Furthermore, currency swap is usually established for long term, it nomally takes many years. On the other hand credit default swaps can be made for short term and long term (Cima, 2009) Most of the countries especially super power countries such as United State of America do not recognised credit default swaps as loan. Accounting rules in such countries does not allow credit default swaps to be reflected in the balance sheet because they are not recognised as loan. These superpower countries recognised it as a way of guaranteeing a party that he will be paid in future, this happens especially when the parties has involved themselves in forex transactions. The other difference is that there is no charging of interest in currency swap especially when the currency swap are made the principle amount to be used.this isdirectly oppositre on what happen to the credit default swap. The world wide financial crisis which took place in the year 2008 had several and different chapters which could not be understood easily, however, the credit default swaps played a significant role in the whole process of financial crisis. The crisis was at the centre of $180 billion bailout of AIG. This was very large amount which caused various shortages in financial sectors in financial intuitions. The only way out at those days was the credit default swaps which cause the banks and other authorized intuitions to carryout financial transactions to lessen their conditions and reduced the regulatory capital requirements to an extremely risky level for bank to carryout business. Furthermore, the credit default swaps contributed to undesirable underwriting standards, especially for those assets which were securitized. All these had taken place when investors and Wall Street allowed credit default swaps to represent the analysis of the required level of the credit (Bragg, 2010). According to financial analyst, over-the-counter derivatives and the credit default swaps have various characteristic that are the same. This means that they can be used as tools of hedging risks within the financial institutions or private parties who have involve themselves with the financial issues. The values of these instruments are commonly based in the reference entity. Credit default swaps and the over-the-counter derivatives are instruments with unique characteristics which have make it simple to be differentiated from other derivatives. On the other hand, the interest rates values and the commodity derivatives are flexible and they keep on changing on how the asset has been priced, this means that the credit default swaps function just like binary options. The party who sell the credit default swaps will continuously collect the regular payment with no such thought of defaulting payment by the paying company due to various factors such as winding up of the company. This can also be explained in a manner that the credit default swap can be ruinous cost to the party involved. It has become difficult to manage the credit default swaps risk because of this payout structures which are commonly referred to as “jump-to-default”. Credit default swaps have some unique elements which are closely related to that of bond insurance which are frequently issued by mono-line insurance providers. This credit default swap normally reflected the structure and the amount of the capital in that company. Furthermore, the credit default swaps can directly relates with the way securities such as bonds, equities etc are priced in the company (Hull, 2009). Other characteristics of the credit default swaps are comparable to other over-the-counter derivatives. This make them to be used as tools for hedging risk, though the values of them are heavily relying on the reference entity. However, credit default swaps can easily be differentiated with the other derivatives basing on their unique characteristics. Hedging is an act of taking precaution or strategies used to eliminate the risk in which financial assets might be facing. Most investors and other players in the financials market hedge their assets with the aim of balancing any gains and losses that might be underlying on those assets. In other words, hedging can be defined as means of stabilizing the prices of the assets in future. On the other, speculation can be defined as an act whereby the market players bet on the future prices and purchase this prices hoping that the prices will rise in future. The major difference between hedging and speculations has been summarized below. Hedging This is a way of reducing risk and managing margins of the prices of the assets Used to stabilize prices of various assets especially assets whose payments are expected to be received in future time. It has been used as a base line when calculating profit or the expected return for sellers who are selling on credit. Hedging has become an important tool for exporters because they used to minimized risk. Speculation This is the act of "Betting" on the movement of prices. For example, the speculators might foretell the nature price Retailers buy products in low prices and sell them at higher prices Speculation then to increases risk and creates uncertainty on retail margins If not carefully studied, then speculation can literally put you out of business Most banks do not participate in these activities because there are risks to their operations. The reason for this is that banks operate under strict regulation. Some of these conditions is that they should participate in a business which will ensure the safety of customers deposits and furthermore, those deposits should be available for the customer in anytime the customer demands them (Hull, 2009). Re-pricing can be defined as the difference between the price sensitivity of the assets and that of the liabilities. The table below has analyzed the performances of the Australia National Bank. Example re-pricing gap in the Australia National Bank Assets Liabilities Gap Cum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0 Risk management is the most essential element of any sound and prudent bank in the world. The sensitive part in managing the risk is the management of the mismatched position in order to control the movement of interest changes in an organization (Resti, 2009) Defensive risk management strategy Most of the top managers in banks fail to realize that risk management of various factors such as interest rates is the key to a successful management of funds. Most of these managers ignore these important issues thinking that the market forces will control the prices. By ignoring this step they overlook risk management yet it is the most important part of the project planning. It is always advisable to know all the risk which might interfere with the project and be prepared in case of any unusually happening on the project. Defensive risk management of the interest rates in the financial institutions means the act of controlling the movement of interest rates with the aim of protecting the occurrence of losses relative to the target portfolio. This defensive risk management theory can be strategic or tactical. Strategic can involve on the issues of long term behaviors of interest rates while tactical are only concern with the short term plans (Belton, 2008). Aggressive risk management strategy From the above analysis of the risk management strategy in the bank, it is evidence that risk management is an essential part of the organizational management. But in the most case the effective management of the organization does not work because of poor planning and the act of negligence by the top managers in the bank. Managers should understand that the business environment is changing as time goes and therefore the interest rates are also affected in one way or another. Furthermore, the managers should embrace for the effective strategies so that they improve on how they maintained stable interest rates as required so as to avoid losses in the bank. The second factor which is causing risk management to fail is the issue of management in the bank. Some of the managers in the banks fail to take all the precaution seriously because they think they can handle all the issues by themselves. This is mostly contributed by the system of the management being practiced in the organization. Psychologist such as Taylor had pointed out that organization structure is the key determinant of the success of an organization. For this reason, the bank should ensure that they established the right structure which will enable the organization to succeed (Chance, 2009). Conclusion In conclusion, risk management is an important part of project planning and every manager should ensure that a lot of attention is put on this part while carryout a project plan. Banks managers should ensure that experts are involved on this so that the proper References Bragg, S. (2010). Treasury management: The practitioner's guide. John Wiley and Sons Belton, T. (2008). The Treasury bond basis: an in-depth analysis for hedgers, speculators, and arbitrageurs. McGraw-Hill Professional. Taylor, P. (2009). Fundamentals of International Financial Management. PHI Learning Pvt. Ltd. Hull, (2009). Risk Management and Financial Institutions. Pearson Education Chance, D. (2009). Introduction to Derivatives and Risk Management. Cengage Learning Cima, (2009). Management Accounting Information Strategy Beyond 2000 Pilot Paper. Elsevier Resti, A. (2009) Risk management and shareholders' value in banking: from risk measurement models to capital allocation policies. John Wiley and Sons Read More