BSM939 Risk and Uncertainty in Business

Lectures 3 & 4 Interest rate and exchange rate risk

Sumon Bhaumik

http://www.sumonbhaumik.net

How volatile are interest and exchange rates?

Interest rate volatility

Data source: Federal Reserve Bank of St. Louis (Libor), http://research.stlouisfed.org/fred2/categories/33003, Federal Reserve Bank of New York (Federal funds rate), http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html.

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Exchange rate volatility

Data source: European Central Bank, http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=120.EXR.D.USD.EUR.SP00.A .

US dollar per Euro

Anticipating interest rate movements

Monetary policy intervention

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Data sources: Federal Reserve Bank of New York (Federal funds rate) & Bureau of Labor Statistics, Federal Reserve Bank of Cleveland (Inflation)

Change in risk perception

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“The European Central Bank agreed on Thursday to launch a new and potentially unlimited bond-buying program to lower struggling eurozone countries' borrowing costs and draw a line under the debt crisis.” Source: Reuters (September 6, 2012)

Data source: Eurostat, http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

Yield curves and interest rate risk

Yield curves

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US Yield Curves

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Data source: US Department of the Treasury, http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx

Interest rate risk – I

• Repricing risk

– “[A] bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase.”

• Yield curve risk

– “[T]he underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.”

Source: Basel Committee on Bank Supervision (2001). Principles for the management and supervision of interest rate risk, Consultative document, Basel, Switzerland; pp. 5-6.

Interest rate risk – II

• Basis risk

– “[A] strategy of funding a one year loan that reprices monthly based on the one month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one month Libor, exposes the institution to the risk that the spread between the two index rates may change unexpectedly.”

• Optionality

– Consider, for example, “loans which give borrowers the right to prepay balances, and various types of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties.”

Hedging interest rate risk

Interest rate swap Context

• Two firms:

– A and B; A has superior credit rating

• A’s cost of capital:

– Long term: 30-year (US) T-bond yield + 40 basis points

– Short term: Libor + 20 basis points

• B’s cost of capital:

– Long term: 30-year (US) T-bond yield + 400 basis points

– Short term: Libor + 150 basis points

• Benchmark interest rates

– 30-year (US) T-bond yield = 7%

– Libor = 5%

Interest rate swap Structure

• B has to pay a higher premium than A for both long term and short term loans, but the spread is higher for long term loans

• Can A and B gain by swapping interest rate obligations?

Firm A

Firm B

Fixed rate long run loan@ 7.4%

Floating rate short run loan@ Libor + 150 bps

7.8% fixed

Libor

(Notional) principal = £10 million

• Final cost of capital:

• A: 7.4% + Libor – 7.8% = Libor – 40 bps

• B: Libor + 150 bps + 7.8% – Libor = 7% + 230 bps

Adding further structure Swaptions – I

• A swaption gives the buyers the right, but not the obligation, to enter into an interest rate swap at some specified exercise date in the future”

– The “payer” swaption entitles the buyer to enter into a swap, whereby he will be paying the fixed rate. He obtains protection against higher rates.

– The receiver swaption entitles the buyer to enter into a swap whereby he will be receiving a pre-determined fixed rate, thus protecting him against lower rates.

• Characteristics

– Swaption can be European or Bermudan (one or several exercise dates)

– Exercise date can be from 1 month to 20 years

– Underlying swap can have maturity from 1 year to 30 years

– The premium can be a percentage of the notional amount

Source: Interest Rate Derivatives Handbook 2008, BNP Paribas; pp. 32.

Adding further structure Swaptions – II

• Example

– A floating rate borrower wishing to fix his debt and looking to borrow in 3 months for a 5 year period could enter into a forward starting payer swap. However, he wants to benefit from any potential decrease in swap rates during the 3 months to come, while fixing the maximum cost of debt: hence he purchases a 3-month into 5 year payer swaption.

– An investor has funds coming due in 3 months and wishes to protect his reinvestment risk. To protect against lower rates, he purchases a 3 month into 5 year receiver swaption.

Interest rate futures

• Interest rates are inversely related to bond prices

• Context

– A company has an outstanding bond issue of £1 billion

– If the interest rate increases by 100 basis points, its interest rate payment obligations will increase by £10 million

• Hedge

– The company shorts bond futures contracts

– If interest rate rises, the price of bonds fall, and the company gains, thereby offsetting the loss on account of higher interest rate payment obligation

Risk management gone awry

Procter & Gamble

• In 1993, P&G enter into a deal with Bankers Trust – Swap with notional contract of $200 million – Bankers Trust to pay fixed interest rate of 5.3% per annum – P&G to pay 75 basis points below the commercial paper rate

• Problem

– The 75 basis point advantage was offered against a put option on interest rates that P&G wrote

– The put option was deep out of the money at the time when the deal was struck, making it appealing for P&G’s treasury

• Outcome

– When interest rate rose in the summer of 1993, the underlying asset for the put option (namely, bonds) fell in value, making the exercise of the option sensible for Bankers Trust

– P&G lost $150 million

LTCM Trading strategies

• “Convergence arbitrage” trades – Suppose that a Treasury (T-) bond has a yield of 6.1% and a more frequently

traded (on-the-run) T-bond has a yield of 6%; the difference is the compensation for liquidity risk

– LTCM goes long on the 6.1% bond and shorts the 6% bond – If the yields converge over time, the return is 10bp for every $1 invested

• Since profit margins are small, returns can be attractive only if the

positions are leveraged – Leverage ratio = 25:1 (Equity = $5 billion, Total assets = $125 billion) – Notional principal of off-balance sheet swaps = $1.25 trillion – LTCM set target ceiling risk level to the volatility of an unhedged positions in

US equity

• Rapid growth ($1 billion in 1994 to $7 billion in 1997), and high fees

(annual charge of 2% of capital and 25% of profits)

Source: Jorion, P. (2000). Risk management lessons from Long-Term Capital Management, European Journal of Management, 6(3): 277-300.

LTCM Leverage and crisis

• Leverage – LTCM raised cash through repurchase agreements (repos) that enabled them

to use their assets as collateral without significant haircut – Short-term repo positions covered with term financing from Wall Street

without initial margin – A $900 million credit line from Chase and other banks

• Crisis

– As yield spreads narrowed, LTCM increased leverage to 28:1 by returning money to investors

– Capital declined further from $4.7 billion to $4 billion because of downturn in the mortgage backed securities market, and leverage increased to 31:1

– Spreads on bond yields jumped dramatically when Russia de facto defaulted on its sovereign debt in 1997, and stock markets fell; LTCM’s loss on August 21 was $550 million

– On September 21, there was a margin call on a losing T-bonds futures position, wiping out liquidity and leading to a call for increased collateral

– NY Fed organised a bail out on September 23

Digression Value at Risk (VaR) – I

• “Value at risk is a summary statistic that quantifies the exposure of an asset or portfolio to market risk that a position declines in value with adverse market price changes. .... Alternatively, VaR is the dollar loss that is expected to occur no more than 5% of the time over a defined time horizon.”

• What might be the problem with VaR, given how it is computed?

Probability = 5%

Probability VaR distribution

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Source: Culp, C.L., Miller, M.H., Neves, A.M.P (1998). Value at risk: Uses and abuses, Journal of Applied Corporate Finance, 16(4): 26-38; pp. 27.

Digression Value at Risk (VaR) – II

• Advantages – Summary measure of risk that has implications for capital cushion – Probability based measure that permits flexibility about the certainty

with which a firm wants to predict possible losses – Measure of company-wide risk rather than risk of a particular unit of

operation – Easily comparable across companies and across business lines

• Uses

– VaR is perhaps of more use for those who are value risk managers than for those who are cash flow risk managers

– In companies that manage total risk, VaR facilitates explicit risk control decisions such as setting and enforcing exposure limits, and in companies that manage risk selectively, VaR is useful as a diagnostic tool for areas in which a company has no comparative advantage (e.g., jet fuel exposure of airline companies)

LTCM Problems with use of VaR

• Insufficient time horizon – Basle Committee has chosen 10 days, which is the likely reaction time

for intervention in case a bank is in trouble – For LTCM a 10-day period was insufficient to unwind large positions

without making significant losses, and also insufficient to raise new capital

• Poor assumptions about volatility

– LTCM was targeting maximum daily volatility (i.e., 99% VaR) of $45 million

– In May and June, losses were $310 million and 450 million, respectively, which is consistent with daily volatility of over $100 million

• Dependence on historical data

– Implicitly assigned low probability to events like sovereign defaults that, among other things, led to flight to liquidity

Moving on to exchange rates .... What determine exchange rates?

Theory Interest rate parity

• An investor investing in the domestic market earns a return that is related to the domestic interest rate, but an investor investing in foreign markets earns a return that is related to both the foreign interest rate and appreciation/depreciation of the exchange rate

• If there is full capital mobility, returns to investments in the two countries should be equal

• If an investor has the choice of investing in the UK (home) and earning a return of 5% and investing in Japan (foreign) and earning a return of 1%, she would expect the pound sterling to depreciate in the future

– Investors will buy pound sterling in the spot market (to capture the higher returns in UK) and sell pound sterling in the forward market

– The pound sterling will then sell at a forward discount to the yen

Source: Mishkin, F.S. (2004). The Economics of Money, Banking and Financial Markets, 7th edition, Pearson-Addison Wesley; Chapter 19.

Evidence Interest rate parity

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Change in USD/GBP

Data source: US Department of the Treasury (5-year yield), http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield, Bank of England (all other data), http://www.bankofengland.co.uk/statistics/Pages/yieldcurve/default.aspx.

Theory Purchasing power parity

• Under free trade, prices of (tradable) commodities should be equal across countries

• Example

– Steel sells for $100 per tonne in the USA and JPY10,000 per tonne in Japan, i.e., the exchange rate has to be $1 = JPY100

– If steel price rises to JPY11,000 in Japan (10%), and there is no change in steel price in the USA, the exchange rate has to change to $1 = JPY110 (10%)

• In other words, if there is a rise in the price level in one country relative to the price level in another country, the currency of the former country will depreciate proportionately relative to the price level in the latter country

Source: Mishkin, F.S. (2004). The Economics of Money, Banking and Financial Markets, 7th edition, Pearson-Addison Wesley; Chapter 19.

Indicator of over- (under-) valuation of currency Real effective interest rate

• Information – USD/EUR = $1.36

• If Big Mac costs $1.36 in the USA and

€1 in Germany , then REER is 1 (or 100, depending on choice of scale)

• If Big Mac costs €1.2 in Germany instead, then it costs 20% more in Germany than in the USA – Arbitrage requires buying dollars to

buy Big Macs in the USA to sell in Germany

– Nominal exchange rate of the dollar will rise until the prices in the USA and Germany are equal again;

– REER will return to 1

• The price rise in Germany led to a depreciation of the currency relative to USD

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Source: Catao, L.., Real exchange rates: What money can buy, Finance & Development, IMF, http://www.imf.org/external/pubs/ft/fandd/basics/realex.htm.

Data source: BIS effective exchange rate indices, http://www.bis.org/statistics/eer/index.htm.

Global capital flows

Source: UNCTAD secretariat calculations, based on IMF, DOTS and BIS, Triennial Central Bank Survey http://dgff.unctad.org/chapter1/1.2.html Note: Merchandise exports in April are first converted into daily figures for the ratio calculation

Ratio of foreign exchange market turnover divided by value of merchandise exports, 1989-2010 (Average daily turnover in April, $ billions (left scale) and ratio (right scale))

Hedging exchange rate risk

Currency futures

• On August 18, 2008, the USD/EUR spot rate is $1.4704 per Euro, and the December 2008 futures price is 1.4605

• A company is expecting a future payment of €50,000,000 on October 17, and wants to protect the dollar value of this payment, which is $73,520,000 at the spot exchange rate – Each EuroFX contract has the contract size of €125,000, and hence 400 contracts

are required to hedge an exposure of €50,000,000

• In August, the company sells 400 EuroFX December contracts, at 1.4605

• On October 17, the USD/EUR spot rate is $1.3425 and hence the dollar value of the payment is $67,125,000, a decline of $6,395,000

• The December futures price also declines, to 1.3420, and hence the profit from the futures transactions is $5,925,000 [= (1.4605 – 1.3420) x 400 x 125,000], offsetting the loss on account of the decline in the spot price

• Why is the loss of $6,395,000 not fully offset?

Source: Labuszewski, J.W., Managing Currency Risk with Futures, CME Group, http://www.cmegroup.com/trading/fx/files/FX-261_FX-Managing-Currency-Risks-with-Futures.pdf.

Simple options

• Straddle

– A straddle is a combination of a Call and a Put on the same underlying asset with the same strike price and expiry date

– Example: Spot = 1.4000; Strike = 1.4100; Expiry = 6 months; Volatility = 7.77%; Premium = 4.32% EUR

– At expiry, the investor exercises either the Put or the Call at the corresponding strike price, and benefits if the spot rate at expiry is far from the strike

• Strangle

– A strangle is a combination of a Call and a Put on the same underlying asset, with the same expiry date, but with a different strike price (the Call strike is higher than the Put strike)

– Example: Spot = 1.400; Strikes = Call 1.4200 and Put 1.3800; Expiry = 6 months; Premium = 3.04% EUR

– If the spot ends above 1.4200 or below 1.3800, the investor can exercise the Call or the Put, respectively, and if the spot ends between 1.3800 and 1.4200 then the options are not exercised

Source: Foreign Exchange Derivatives Handbook 2008, BNP Paribas; pp. 22-23.

Simple but exotic structures Flexiterm forward

Indicative terms and conditions

Expiry date Trade date + 6 months

Settlement date Expiry date + 2 business days

Notional amount EUR 50,000,000

Strike rate 1.4000

Activation period From trade date to expiry date

Current 6m outright 1.4035

Description Client will sell the EUR amount (full or partial) at the strike rate at any time during the activation period with delivery 2 business days later If, by the expiry date, the total amount has not been executed, the remainder of the total amount will be executed for delivery on the settlement date, at the strike rate

Business days TARGET New York

Source: Foreign Exchange Derivatives Handbook 2008, BNP Paribas; pp. 124.

Anatomy of a hedging strategy – Merck

Source: Lewent, J.C., Kearney, A.J. (1990). Identifying, measuring and hedging currency risk at Merck, Journal of Applied Corporate Finance, 2(2): 19-28.

Currency risk

• Exposure to foreign currency

– 40% of assets overseas

– Half of sales overseas

– A sales index measuring the strength of the US dollar against a basket of other currencies (where an index value greater than 100 implies strengthening of foreign currencies) declined sharply to 60 in the early 1980s, resulting in a dollar revenue loss of $900 million

• Risk exposure

– Changes in dollar value of current and future overseas revenue; most important because of potential impact on cash flow

– Changes in dollar value of overseas assets

– Changes in the company’s competitive position (through changes in price); not significant for pharmaceutical companies

• Reducing exchange rate risk by relocation of assets overseas not an option

Step 1 Forecasting exchange rates

• Consider the likelihood of change in exchange rates

– Major factors such as capital flows

– Government and central bank policies aimed at managing exchange rates

– Poll of outside forecasters

• Quantify potential extent of exchange rate changes

– Consider the maximum year-to-year change in exchange rates of the dollar vis-a-vis currencies such as the yen and (in the 1990s) the Deutsche mark

– Consider 5 years of continual weakening and strengthening of the dollar

– Consider the lower likelihood of the dollar strengthening or weakening over successive years

Step 2 Assessing the impact on the 5-year strategic plan

• Estimate the impact on future cash flows and earnings under strong dollar and weak dollar scenarios

• Measure the potential impact of exchange rate change on a cumulative basis

Step 3 Decision about hedging the exposure

• Concerns about shareholders

– Not much correlation between exchange gains and losses and share price movements

– Dividend growth affected by strengthening of the dollar

• Strategic concern

– Adverse shock to earnings and cash flows can have negative impact on the company’s ability to invest in R&D, marketing and capital expenditure

• The final decision to hedge was not driven by short term concerns about share prices but by concerns about the company’s long term value

Step 4 Selecting the appropriate financial instrument

• Currency options were preferred despite up front cost because of their advantage over forward contracts in a weak dollar scenario

Unhedged income

Hedged with options

Selling forward

Opportunity cost of forward

Net income

DM/USD DM strengthening

Step 5 Constructing a hedging programme

• Modelling risk

– Forecast overseas earnings in local currencies

– Use sophisticated simulation models to generate random exchange rates

– Use of sophisticated methodology to calculate theoretical prices of forwards, options etc

– Estimate impact of alternative hedging strategies (e.g., purchasing options and holding them for 5 years vs. dynamic revision of options portfolio every year)

– Compute cash flow estimates for each combination of exchange rates, hedging strategies etc

– Plot quarterly cash flow estimates for each scenario, hedged and unhedged

• Additional considerations

– Consider out-of-the-money options to reduce cost

– Consider different percentage of income or cash flow to be hedged, also for cost considerations