Derivatives - AshifHvc

Risk Management
Prepared & presented by:

Asif Md. Tanvir Hossain, ACA
Prepared by: Asif Md. Tanvir Hossain ACA

©All rights reserved
Risk Management:
Management of unpredictable events that have adverse
impacts for the firm.
3 steps of Risk Management:

Identify the risks faced by the firm/company.
Measure the potential impacts of these risks.
Decide how each relevant risk should be dealt with.

Risk exposures can be dealt with by following
techniques:
Transfer the risk to an insurance company.
Transfer the risky function to a third party.
Purchase derivatives contracts.
Reduce the probability of occurrence of an adverse
event.
Reduce the magnitude of the loss.
Totally avoid the activity that gives rise to the risk.

Business Risk:
The riskiness inherent in the firm’s operations if it uses no
debt.
Financial Risk:
An increase in shareholder/equity holders’ risk over the
firm’s basic business risk, resulting from the use of debt
(financial leverage or gearing).

Some common types of risk:
 Credit risk
 Foreign investment risk
 Liquidity
 Asset liquidity
 Funding liquidity
 Market risk
 Equity Risk is the risk that stock prices in general (not related to a particular
company or industry) or the implied volatility will change.
 Interest Rate Risk is the risk that interest rates or the implied volatility will change.
 Currency Risk is the risk that foreign exchange rates or the implied volatility will
change, which affects, for example, the value of an asset held in that currency.
 Commodity Risk is the risk that commodity prices (e.g. corn, copper, crude oil) or
implied volatility will change.
 Operational risk
 Legal risk
 IT risk Prepared by: Asif Md. Tanvir Hossain ACA
Hedge:
Hedge is a transaction that reduces risk.

Hedging:
Hedging is a method for reducing risk where a combination
of assets are selected to offset the movements of each other.
For example, when investing in a stock it is possible to buy
an option to sell that stock at a defined price at some point
in the future. The combined portfolio of stock and option is
now much less likely to move below a given value. As in
diversification there is a cost, this time in buying the option
for which there is a premium. Derivatives are used
extensively to mitigate many types of risk.
Derivatives
Derivatives are financial instruments whose values are determined by
the market price or interest rate of some other asset or security.
Derivatives are used for:

Hedging purpose (manage Business or Financial risk)
Speculation purpose (to make gain or loss)
Some examples of Derivative instruments:

Forward contracts
Futures contracts
Options
Structured notes
Inverse floaters
Swaps. Prepared by: Asif Md. Tanvir Hossain ACA
Forward contract:
A contract under which one party agrees to buy a commodity
on a specific future date at a specific price agreed today and
the other party agrees to make the sell.
**Here physical delivery occurs.

**Forwards are tailor made contracts.
Binding agreement between counterparties

1st Party Create obligation 2nd Party
(Diagram: Forward contract- two parties)

Futures contract:
Standardized contracts that are traded on exchanges and are ‘marked to market’ daily.

Like a forward contract, a future contract also specifies the price today for a future cash
transaction.
There are two separate markets:

The ‘underlying asset’ market.
The ‘Future’ market.

Physical delivery of the goods takes place in the spot market, not in the Future market.
In the Future market, the opening contract (buy/sell) is eventually cancelled by an
opposing contract (sell/buy).
Futures are traded or exchanged contract.

Buying or selling goods/
Deposit or borrowing fund
1st party 2nd Party
Binding agreement- create obligation
Future Market
(Financial Institution)
(Diagram: Future contract- three parties)

Mechanism of Future trading:
Determine the number of contracts using today’s spot
price.
Buy/sell contracts at today’s Future price.
Close the position (sell/buy) at the Future price on
transaction date.
Calculate gain/loss in the Future market.
Final transaction at the spot price on transaction date.
Net off overall position (gain/loss) on transaction date.

Main elements of Future transactions:
The contract size.
The contract price.
The settlement date.
The initial margin.
Basis.
Hedge efficiency.

‘Forward’ and ‘Future’ contract reduce
both the ‘downward risk (Risk)’ and
‘upward potential (opportunity)’.
This limitation can be overcome by

‘Option Contract’.

Option Contract:
Option is a contract that gives its holder the right (not obligation) to buy
or sell something (asset or security) at a predetermined price within a
specific period of time.

**Main differences of ‘Option’ from Forwards and Futures are:
 Forwards and Futures are obligatory contract, and they reduce both the
Risk and Opportunity.
 Options are optional contract (not obligatory) at the option of the

holder, and they reduce only the Risk.

Options can be:
Negotiated or tailor made or OTC (over the counter) options,
Traded options.
Options Terminology:
Call option: A right to buy a specified number of shares or asset.
Put option: A right to sell a specified number of shares or asset.
Exercise Price or Strike Price: The price that must be paid for when an option is
exercised.
In the money: An option is said to be in the money when, if it is exercised today,
a profit would be made.
Out of the money: An option is said to be out of the money when, if it is

exercised today, a loss would be made.
At the money: An option is said to be at the money if the exercise price equals
the underlying assetPrepared
or security price.
by: Asif Md. Tanvir Hossain ACA
Option Premium:
Option writer takes all the risks of an option contract in exchange of
Premium. It is similar to ‘Insurance premium’ in an Insurance
contract.
Option premium is the ‘price’ or ‘cost’ or ‘value’ of an option.
**Premium = Intrinsic value + Time value
Value of an Option depends upon the following factors:

Current underlying asset or security price.
Exercise price of the option.
Volatility of the underlying asset or security price.
Time to expiration of the option.
Risk free rate of the interest.
Comparative analysis of
Forwards, Futures and Options:
Forwards Futures Options
Tailor made May be either Customized or
Standardized
(customized) Standardized
Traded or Exchanged May be either OTC or Traded
OTC Contracts
Contracts contract
Remove both downside Remove both downside risk Remove downside risk but
risk and upside potential and upside potential leave upside potential
Obligatory to exercise Obligatory to exercise Optional to exercise
Transaction cost via Transaction cost via spread

Transaction costs via Premium
spread and brokerage fee
Can be arranged in all Can be arranged in some Can be arranged in some
currencies selected currencies only selected currencies only
Problem:
Panda wishes to borrow Tk 4 million fixed rate in June for nine months and
wishes to protect itself against rates rising above 6.75%. It is 1st May and the
spot rate is currently 6%. The data is as follows:
Tk 500,000
Calls Puts
Strike Price
June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10
Panda negotiates the loan with the bank on 30 June and close out the hedge.
What will be the outcome of the hedge and the effective loan rate if prices
on 12 June are as follows:
Closing prices Case – 1 Case – 2
Spot price 7.4% 5.1%
Futures price 92.31 94.75
Relevant FRA Rate on 1 May is 6.75-6.70
Calls Puts
Strike Price
June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10

Solution:
Set up the hedge:

FRA Future Option
Which contract 2-11 (or 2v11) June June
What type Buy FRA Sell Future Buy Put option
(100-6.75)
Future Price N/A = Tk 93.25
N/A
(100-6.75)
Strike Price N/A N/A = Tk 93.25
(4,000,000/500,000)x(9/3) 4,000,000/500,000)x(9/3)
How many N/A =24 Contracts =24 Contracts
500,000 x 24 x 0.14% x 3/12

Premium N/A N/A =Tk 4,200

Forward Rate Agreement (FRA)
Case – 1 Case – 2
A. Payment on underlying loan:
4,000,000 x 7.4% x 9/12 Tk (222,000) -
4,000,000 x 5.1% x 9/12 - Tk (153,000)
B. FRA Payment or Receipt:

4,000,000 x (7.4% - 6.75%) x 9/12 Tk 19,500 -
4,000,000 x (5.1% - 6.75%) x 9/12 - Tk (49,500)
C. Net Payment:
A+B Tk 202,500 Tk 202,500

Future Contracts
A. Interest Rate Market outcome:
4,000,000 x 7.4% x 9/12 Tk (222,000) -
4,000,000 x 5.1% x 9/12 - Tk (153,000)
B. Future Market outcome:

Selling price 93.25 93.25
Buying price (92.31) (94.75)
Profit/Loss 0.94 (1.5)
So: 500,000 x 24 x 0.94% x 3/12 Tk 28,200 -
500,000 x 24 x (1.5)% x 3/12 - Tk (45,000)
Net outcome:
A+B Tk (193,800) Tk (198,000)
Option Contracts
A. Interest Rate Market outcome:
4,000,000 x 7.4% x 9/12Tk (222,000) -
4,000,000 x 5.1% x 9/12 - Tk (153,000)
B. Option Market outcome:

Strike/Exercise price 93.25 93.25
Buying price (92.31) (94.75)
Exercise Yes No
Gain: 500,000 x 24 x 0.94% x 3/12 Tk 28,200 -
C. Premium Tk (4,200) Tk (4,200)
Net outcome:
A + B + C Tk (198,000)Tk (157,200) Prepared by: Asif Md. Tanvir Hossain ACA
Effective Interest Rate:
Case – 1 Case - 2
Forward Rate Agreement (FRA)

202,500/4,000,000 x 12/9 6.75% 6.75%
Future Market:
193,800/4,000,000 x 12/9 6.46% -
198,000/4,000,000 x 12/9 - 6.60%
Option Market:
198,000/4,000,000 x 12/9 6.60% -
157,200/4,000,000 x 12/9 - 5.24%

Managing Foreign
Exchange Risk

Exchange Rate
The number of units of a given currency that can be purchased for
one unit of another currency.
Direct Exchange Rate

Units of domestic currency that can be converted into one unit of
foreign currency.
Indirect Exchange Rate
Units of foreign currency that can be converted into one unit of
domestic currency.

Exchange Rate System
Fixed Exchange Rate system

A system under which exchange rates are fixed by the
government policy.
Floating Exchange Rate system

A system under which exchange rates are not fixed by the
government policy, but are allowed to float up or down in
accordance with supply and demand.

Exchange Rate
Spot Rate
The effective exchange rate for a foreign currency for
delivery on the current day.
Forward Exchange Rate

An agreed-upon price at which two currencies will be
exchanged at some future date.

Risk and Foreign Exchange (FX)
Transaction Risk
Risk of adverse exchange rate movements occurring in the course of
normal international trading transactions.
Translation Risk
This is the risk that the organization will make losses when the
accounting results of its foreign branches or subsidiaries are
translated into the home currency.
Economic Risk
Effect of exchange rate movements on the international
competitiveness of a company.
Exchange rate risk reduction methods
Direct methods
Mechanism within the financial market.
Indirect methods
Using Hedging tools or Derivatives.

Direct methods
Invoice currency:
An exporter should bill the customer at his home currency. Also, an importer should pay his supplier in his
home currency. However, either of the parties (not both) can invoice in home currency and the other
party is yet exposed to exchange rate risk.
Matching receipts and payments:

It is important for companies to open a foreign currency bank account (denominated in the major trading
foreign currency) through which it can collect foreign currency receipts and make foreign currency
payments. However, hedging is required for the outstanding balance of the account (receipts net of
income).
Matching assets and liabilities:

FC trade receivables can be hedged by FC loan. And FC trade payables can be hedged by a FC bank
account.
Leads and lags:

A company may expedite or delay payments in foreign currency, according to its expectation of exchange
rate movement.
Bilateral netting:
Each two or more foreign subsidiaries of an MNC can offset their reciprocal receipts and payments. So
netting means offsetting intercompany balances of related parties.
Indirect Method
Derivatives:
Forwards, Futures, Option, Swap etc.
Factors to be considered before entering into hedge:

Costs (cost-benefit analysis)
Exposure (the amount of risk)
Attitude to risk (risk taker, risk neutral or risk averse)
Portfolio effect (pooling assets and liabilities, pooling
different currencies)
Shareholders (when fully diversified, no hedging required)
Insolvency risk and cost of capital (reduced)
How are Forward Exchange Rates set?
Discount on Forward Rate
The situation when the spot rate is less than the forward rate.
Premium on Forward Rate

The situation when the spot rate is greater than the forward
rate.
**A discount is therefore added to the spot rate, and a

premium is subtracted. (Remember ADDIS, i.e. add discount)

Market forces determine whether a currency sells at a
forward premium or discount, and the general relationship
between spot and forward exchange rates is specified by a
concept called “Interest Rate Parity (IRP)”
Interest Rate Parity (IRP)

Specifies that investors should expect to earn the same
return in all countries after adjusting for risk.
Forward Rate = Spot Rate x (1+if)/(1+id)

Where, if = Foreign interest rate
id = domestic interest rate

A treasurer has Tk 1,000,000 available to place on deposit for 12 months
Spot rate $1.5234/Tk
Annual Bangladesh rate of interest 6%
Annual US rate of interest 7.2%
Invest in Bangladesh @ 6% will give

Tk 1,000,000 x 1.06 = Tk 1,060,000
Invest in US @ 7.2% will give

USD 1,000,000 x 1.5234 x 1.072 = $1,633,100
That gives exchange rate, 1,633,100/1,060,000 = 1.5407
This can be simplified by,

Spot Rate x (1+if)/(1+id) = 1.5234 x (1.072/1.060)
= 1.5407
A treasurer has Tk 1,000,000 available to place on deposit for 12 months
Spot rate Tk 80/Tk
Annual Bangladesh rate of interest 6%
Annual US rate of interest 7.2%
Invest in Bangladesh @ 6% will give

Tk 1,000,000 x 1.06 = Tk 1,060,000
Invest in US @ 7.2% will give

USD 1,000,000/80 x 1.072 = $13,400
That gives exchange rate, 1,060,000/13,400 = 79.10
This can be simplified by,

Spot Rate x (1+id)/(1+if) = 80 x (1.060/1.072)
= 79.10
Purchasing Power Parity (PPP)
The relationship in which the same products cost roughly
the same amount in different countries after taking into
account the exchange rate.
Forward Rate = Spot Rate x (1+if)/(1+id)
Where, if = Foreign inflation rate

id = domestic inflation rate
PPP (sometimes referred to as the law of one price,

implies that the level of exchange rates adjust so as to
cause identical goods to cost the same amount in
different countries.
Future
A US exporter is expected to receive £250,000 in
December.
It is currently August. The spot rate is now $1.85/ £.

In December spot rates moved to $1.90/ £.
Contract size is £62,500.
Assuming zero basis risk, show the outcome of a futures

hedge.

Money Market Hedging (Matching assets
and liabilities)
Mechanism for Foreign Currency (FC) payment
Borrow the appropriate amount in DC (Taka) now (by
discounting)
Convert the Taka to FC immediately (using spot rate)
Put the FC on deposit in a FC bank account
When the time comes to pay the company:

(a) Pays the creditor out of the FC bank account
(b) Repays the Taka Loan account
Money Market Hedging (Matching assets
and liabilities)…. (contd….)
Mechanism for Foreign Currency (FC) Receipt
Borrow the appropriate amount in FC now (by discounting)
Convert the Taka to DC (Taka) immediately (using spot rate)
Put the FC on deposit in a Taka bank account
When the time comes to pay the company:

(a) Repay the FC Loan
(b) Take the cash from Taka bank account
Problem:
On 01 July Stark inc, a US company, is due to receive £3.75m from a debtor in three
months time at the end of September. Company's CFO wishes to hedge against FE risk.
For this, he has the following alternatives:
 Using Forward exchange contracts
 Using Currency Future contracts
 Using Currency Options
 Using money market borrowing or lending
Following information are available in this regard

Exchange Rates
$/Tk exchange rate
Spot $1.5404 – $1.5425
1 month forward 0.50c – 0.48c pm
3 months forward 1.50c – 1.45c pm
Interest Rates
US Dollar ($) Sterling (£)
Deposit rate Borrowing rate Deposit rate Borrowing rate
1 month 7.00% 10.25% 10.75% 14.00%
3 months 7.00% 10.75% 11.00% 14.25%
Problem contd….
Quote for September and December futures are $1.54/Tk and $1.55/Tk respectively with a
standard contract size of £62,500.
Prices on 01 July for Sterling traded currency options on Philadelphia Stock exchange are in
the following table:
Sterling £31,250 contracts (cents per £)
Calls Puts
Strike Price
$/£ Sep’16 Dec’16 Mar’17 Sep’16 Dec’16 Mar’17
1.50 5.55 7.95 11.35 0.42 1.95 7.05
1.55 2.75 3.85 5.65 4.15 6.30 14.15
1.60 0.25 1.00 1.50 9.40 11.20 20.30
Information on the payment date:

Spot exchange rate $1.4800/Tk $1.5700/Tk
Futures rate $1.4785/Tk $1.5705/Tk
Requirement: Evaluate the results of different hedging methods with an option exercise price
of $1.55. Which is the cheapest alternative for Stark?
Solution
Target receipt is 3,750,000 X 1.5404 = $5,776,500.
Set up the hedge:

Forward Future Option Money Market
Hedge
Which contract 3 months September September N/A
What type N/A Sell Future Buy Put option N/A
1.5404 – 0.015
Forward Price = $1.5254/£ N/A N/A N/A
Strike Price N/A N/A $1.55/£ N/A
£3,750,000/62,500 £3,750,000/31,250
How many N/A =60 Contracts =120 Contracts N/A
31,250 x 120 x 0.0415
Premium N/A N/A =$155,625 N/A
Borrow N/A N/A N/A FC (discounted)
Convert N/A N/A N/A to DC
Deposit N/A N/A N/A DC
Forward Exchange Contract

£3,750,000 X 1.5254 $5,720,250 $5,720,250
Future Contract
A. Currency market outcome
£3,750,000 X 1.48 $5,550,000
£3,750,000 X 1.57 $5,887,500
B. Future Market outcome

Selling price 1.5400 1.5400
Buying price (1.4785) (1.5705)
Profit/Loss $0.0615/£ $(0.0305/£)
So: £62,500 x 60 x 0.0615 $230,625 -

£62,500 x 60 x (0.0305) - $(114,375)
Net outcome:
A+B $5,780,625 $5,773,125
Option Contracts
A. Currency Market outcome:
£3,750,000 X 1.48 $5,550,000
£3,750,000 X 1.57 $5,887,500
B. Option Market outcome:

Strike/Exercise price 1.55 1.55
Market exchange rate 1.48 1.57
Exercise Yes No
Gain: £31,250 x 120 x 0.07 $262,500 -
C. Premium $(155,625) $(155,625)
Net outcome:
A + B + C $5,656,875 $5,731,875
Money Market Hedge
Today (01 July) September
Borrow Discount @14.25% Target receipt

£3,621,090*£3,750,000/(1+i) £3,750,000
=£3,750,000/(1+0.1425/4)
=£3,750,000/1.035625
Convert @1.5404
$1.5135/£
Deposit Receive
Compound @ 7.00%
$5,577,927 $5,675,540
*$5,577,927 x (1+i)
=$5,577,927 x (1+0.07/4)
=$5,577,927 x 1.0175

Comparison:
Case – 1 Case - 2
Outcome
Without hedge $5,550,000 $5,887,500
Forward Exchange Contract $5,720,250 $5,720,250
Future Contract $5,780,625 $5,773,125
Option Contract $5,656,875 $5,731,875
Money Market Hedge $5,675,540 $5,675,540
Effective exchange rate

Without hedge 1.4800 (5th)1.5700 (1st)
Forward Exchange Contract 1.5254 (2nd) 1.5254 (4th)
Future Contract 1.5415 (1st) 1.5395 (2nd)
Option Contract 1.5085 (4th)1.5285 (3rd)
Money Market Hedge 1.5134 (3rd) 1.5135 (5th)
Currency swap
Problem
El dorado plc, an engineering company based in the UK has won a
contract to build a theme park ride in Sri Lanka. This project will
require an initial investment of 500 million Sri Lankan rupees and
will be sold for 900 million rupees to the Sri Lankan’s government in
one year’s time. As the SL government will pay in rupees, El Dorado
is exposed to movements in the £/rupees rate.
The currency spot rate is 100 rupees/£ and the SL government has
offered a forex swap at that rate. The estimated spot rate in one
year’s time (when the government will pay for the theme park ride)
is 180 rupees/£. The current UK borrowing rate is 8%.
Requirement:
Construct a forex (FX) swap that will help to hedge the exchange
rate risk. Should El Dorado hedge the exposure using the swap or
should it just do nothing? Prepared by: Asif Md. Tanvir Hossain ACA
Answer:
Construction of FX swap:
 Swap pounds today at an agreed swap rate for the
rupees required to make the initial investment.
 Take out a sterling loan today to purchase the rupees.
 In one year’s time, swap back the rupees obtained in

bullet point one for pounds at the same agreed upon
rate.
 In a similar way to taking out a loan in rupees, El Dorado

is only exposed on the profit earned from the project.
With the swap
Year 0 Year 1
£m £m
Buy 500m rupees (Spot rate = 100) (5.00)
Swap 500m rupees back (Spot rate 100) 5.00
Sell 400m rupees at 180/£ 2.22
Interest on sterling loan (£5m x 8%) (0.40)
(5.00) 6.82
Net outcome is a net receipt of £1.82m
Do nothing
Year 0 Year 1
Buy 500m rupees (Spot rate = 100) (5.00)
Sell 900m rupees at 180/£ 5.00
Interest on sterling loan (£5m x 8%) (0.40)
(5.00) 4.60
Net outcome is a net payment of £0.40m
El Dorado should hedge the exposure using the swap. Prepared by: Asif Md. Tanvir Hossain ACA
Thank
You

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Risk Management

Prepared & presented by:

Prepared by: Asif Md. Tanvir Hossain ACA

3 steps of Risk Management:

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

Derivatives are used for:

Some examples of Derivative instruments:

**Here physical delivery occurs.

Binding agreement between counterparties

(Diagram: Forward contract- two parties)

Prepared by: Asif Md. Tanvir Hossain ACA

There are two separate markets:

Futures are traded or exchanged contract.

Prepared by: Asif Md. Tanvir Hossain ACA

(Diagram: Future contract- three parties)

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

This limitation can be overcome by

Prepared by: Asif Md. Tanvir Hossain ACA

 Options are optional contract (not obligatory) at the option of the

Put option: A right to sell a specified number of shares or asset.

Out of the money: An option is said to be out of the money when, if it is

Option premium is the ‘price’ or ‘cost’ or ‘value’ of an option.

**Premium = Intrinsic value + Time value

Value of an Option depends upon the following factors:

Obligatory to exercise Obligatory to exercise Optional to exercise

Transaction cost via Transaction cost via spread

93.25 0.16 0.19 0.21 0.14 0.92 1.62

93.50 0.05 0.06 0.07 0.28 1.15 1.85

93.75 0.01 0.02 0.03 0.49 1.39 2.10

Prepared by: Asif Md. Tanvir Hossain ACA

Set up the hedge:

What type Buy FRA Sell Future Buy Put option

500,000 x 24 x 0.14% x 3/12

Prepared by: Asif Md. Tanvir Hossain ACA

B. FRA Payment or Receipt:

Prepared by: Asif Md. Tanvir Hossain ACA

B. Future Market outcome:

B. Option Market outcome:

C. Premium Tk (4,200) Tk (4,200)

Forward Rate Agreement (FRA)

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

Direct Exchange Rate

Prepared by: Asif Md. Tanvir Hossain ACA

Fixed Exchange Rate system

Floating Exchange Rate system

Prepared by: Asif Md. Tanvir Hossain ACA

Forward Exchange Rate

Prepared by: Asif Md. Tanvir Hossain ACA

Prepared by: Asif Md. Tanvir Hossain ACA

Matching receipts and payments:

Matching assets and liabilities:

Leads and lags:

Factors to be considered before entering into hedge:

Premium on Forward Rate

**A discount is therefore added to the spot rate, and a

Prepared by: Asif Md. Tanvir Hossain ACA

Interest Rate Parity (IRP)

Forward Rate = Spot Rate x (1+if)/(1+id)

Prepared by: Asif Md. Tanvir Hossain ACA