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Summary Financial Instruments: derivatives
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- Universiteit Gent (UGent)
Operational financial risk management and risk tolerance
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lOMoARcPSD|837380Financial Risk Management - F000738 A - prof. Luc
Keuleneer
Valuation and Risk management (Universiteit Gent)
StuDocu wordt niet gesponsord of ondersteund door een hogeschool of universiteit
Gedownload door Stefanie Deleu (stefaniedeleu46@hotmail.com)
, lOMoARcPSD|837380
Financial Risk Management
Inhoud
1. FRAMEWORK ................................................................................................................................... 2
1. Identification: identify the different risks ................................................................................... 2
2. Measurement of risk ................................................................................................................... 4
3. Financial Risk Strategy And Control............................................................................................. 6
4. Management ............................................................................................................................... 7
2. BUILDING BLOCKS............................................................................................................................ 9
1. SWAP ........................................................................................................................................... 9
Interest rate swap (IRS) ................................................................................................................. 10
Pricing and the valuation of swaps................................................................................................ 19
Currency rate swap (CRS) – Cross currency rate swap (CCRS) ...................................................... 25
2. FUTURES AND FORWARDS ........................................................................................................ 27
Forwards ........................................................................................................................................ 27
Futures........................................................................................................................................... 28
Forward agreement ....................................................................................................................... 32
Link between FRA and IRS ............................................................................................................. 38
Interest rates ................................................................................................................................. 40
3. OPTIONS .................................................................................................................................... 41
To buy a call ................................................................................................................................... 42
To buy a put ................................................................................................................................... 43
Pay off structures .......................................................................................................................... 46
CAP – FLOOR .................................................................................................................................. 51
Collar.............................................................................................................................................. 56
Currency rate risk management .................................................................................................... 60
FX options ...................................................................................................................................... 64
How to recognize call/put? (3 steps)............................................................................................. 65
Check the strategy of a company ...................................................................................................... 69
Overview course .................................................................................................................................... 71
1
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, lOMoARcPSD|837380
LECTURE 1 (20 nov)
Financial Instruments:
Derivatives
1. FRAMEWORK
You need a framework. The most important job of CEO? All about risk management, related to
strategy. If you know the risk → develop strategy.
1. Identification: identify the different risks
Identification: Financial (liquidity!!) and operational risks (bad governance at the top)
There are 2 types of risk: operational risk (non-financial) and financial risk.
➔ Operational risks (non-financial)
What is the most dangerous operational risk? Supply chain! Supply chain management. Biggest
problem is cyber security. Company can be hacked. Data is very important. Companies sometimes
have to close because of hacking. Bad governance is not good, this last are stupid decisions regarding
IT. Bad governance at the top is the problem. This can affect the existence of the bank. The most
dangerous of the operational risks is governance risk -> higher management takes bad/stupid
decisions.
➔ Financial risks
2
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, lOMoARcPSD|837380
Market risks: Market risks: price risk, interest rate risk and currency rate risk (transactional CRR,
economic CRR and translation CRR)
• Price risks: Price risk is the risk of a decline in the value of a security or an investment
portfolio excluding a downturn in the market, due to multiple factors. Investors can employ a
number of tools and techniques to hedge price risk, ranging from relatively conservative
decisions (e.g., buying put options) to more aggressive strategies (e.g., short selling).
Mitigation: hedging strategies but these almost always limit returns.
• Interest risks: Interest rate risk is the potential for investment losses that result from a
change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-
income investment will decline. The change in a bond's price given a change in interest rates
is known as its duration. Bond prices typically fall when interest rates rise, an unexpected
increase in interest rates means that your investment could suddenly lose value. If you
expect to sell the bond before it matures, this could mean you end up selling the bond for
less than you paid for it (a capital loss).
• Currency rate risk
o Transactional currency rate risk (CRR): the most dangerous – based on specific
transaction. It is the chance that currency exchange rate fluctuations will change the
value of a foreign transaction after it has been completed but not yet settled. It will
be greater when there exists a longer interval from entering into a contract or trade
and settling it. It can be hedged through the use of derivatives like forwards and
options contracts to mitigate the impact of short-term exchange rate moves.
Example: Production cost of 90 EUR, Swap rate: $1 = €1, Products are sold in the USA
for $110 (incl. profit margin), Clients buy product in t0 but only pay for it in t1, but
during that year, it is possible that the exchange rate changes:
$1 = €0,5: loss = €35 (=110*0,5-90)
$1= €2: profit = €130 (=110*2-90)
o Economic currency rates risks: Influence of changes in the swap rate (exchange rage)
on your competitive position.
Example: your competitor is a Chinese firm (they work with Yen), the Chinese firm
asks $130 for their products and you ask $110 for your product (see previous
example) → Result: American clients will prefer your products.
Example: the swap rate changes from $1=€1 to $1=€0,5. In order to have to same
profit, you will have to ask $220 for your product. The dollar-yen ratio does not
change so they still sell at $130, result: American clients will prefer the Chinese
products
o Accounting of the translation currency rate risk: It is possible that your profit in
dollars is the same in 2014 as in 2013. However, when you translate it to euros, the
results might be different because of the changing exchange rate. The influence on
your balance sheet or income statement coming from currency rates.
Credit risk: it is the possibility of losing a lender takes on due to the possibility of a borrower not
paying back a loan. Risk due to uncertainty in a counterparty’s ability to meet its financial obligations.
Liquidity risk: most dangerous risk. Ex. the moment the interbank market is going down, hence no
liquidity anymore, that’s the end; bankruptcy.
They have a financial risk, but making the risk bigger or create a new financial risk. Liquidity risk is
very dangerous. Don’t convert a less dangerous risk into a more dangerous one.
3
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