An Introduction To Risk Management and Derivatives: Viney & Phillips, Financial Institutions, Instruments and Markets, 9e

Chapter 18
An introduction to risk
management and derivatives
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-1

Viney & Phillips, Financial Institutions, Instruments and Markets, 9e
Learning objectives
LO 18.1 Understand the nature and importance of risk and
risk management, especially operational and
financial risk exposures.
LO 18.2 Construct and analyse a structured risk
management process.
LO 18.3 Examine the basic fundamentals of futures
contracts.
(cont.)

Learning objectives
LO 18.4 Review the operation of forward exchange
contracts and forward rate agreements.
LO 18.5 Understand the nature and versatility of options
contracts.
LO 18.6 Consider the structure of an interest rate swap
and a cross-currency swap.

Chapter outline
18.1 Understanding risk
18.2 The risk management process
18.3 Futures contracts
18.4 Forward contracts
18.5 Option contracts
18.6 Swap contracts

• Risk—the possibility or probability of something occurring
that is unexpected or unanticipated
• Categories of risk
– Operational risk
– Financial risk
(cont.)

• Operational risk
– Exposure that may impact on the normal commercial functions of a
business, affecting its operational and financial performance; for
example:
 technology
 property and equipment
 personnel
 competitors
 natural disasters
 government policy
 suppliers and outsourcing
(cont.)

• Financial risk
– Exposures that result in unanticipated changes in projected cash
flows or the structure and value of balance-sheet assets and
liabilities, for example:
 interest rate risk
 foreign exchange risk
 liquidity risk
 credit risk
 capital risk
– Relationships between risks can result in one risk impacting on
another risk.
 Direct risk is the initial risk event that impacts on the operational or
financial position of an organisation.
 Consequential risks are exposures that eventuate as a result of an
initial direct risk event

• Effective management of risk exposures requires a
structured risk management process
• Although the range of risks varies by organisation, one
such model is:
– identify operational and financial risk exposures
– analyse the impact of the risk exposures
– assess the attitude of the organisation to each identified risk
exposure
– select appropriate risk management strategies and products
– establish related risk and product controls
– implement the risk management strategy
– monitor, report, review and audit
(cont.)

• Identify operational and financial risk exposures
– Requires full understanding of the business, including operations,
personnel, competitors, regulators, legislative requirements,
stakeholders, cash flows and balance sheet structure
– Also need to understand interrelationships and causal links
between the above categories
• Analyse the impact of the risk exposures
– A business impact analysis is used to document each risk
exposure and measure the operational and financial impacts
should the risk event occur
– Need to consider both quantitative and qualitative risks
(cont.)

• Assess the attitude of the organisation to each identified
risk exposure
– Not all risks will be mitigated or removed.
– The risks to be avoided, controlled, transferred or retained should
be documented
• Select appropriate risk management strategies and
products
– An integrated process to analyse the risk management options
available
– Generally, several risk management strategies available, the
choice between them to be subject to cost–benefit analysis
– All risk management processes and strategies should be
periodically audited
(cont.)

• Establish related risk and product controls
– Ensure adequate controls established, documented and circulated
among personnel
– These include procedural controls and system controls
 Procedural controls document risk management products that can be
used by the organisation.
 System controls cover all electronic product delivery and information
systems relating to the identification, measurement, management and
monitoring of risk management
(cont.)

• Implement the risk management strategy
– Obtain written authority to proceed with implementation
– Check that time lags between the commencement of this process
and the implementation of the strategy have not impaired the
effectiveness of the strategy
– Risk strategies are developed for different planning periods
• Monitor, report, review and audit

– As risk management is ongoing, the strategies must be
continuously monitored to ensure they achieve the expected risk
management objectives and outcomes

• An agreement between two parties to buy, or sell, a
specified commodity or financial instrument at a specified
date in the future at a price determined today
• An exchange traded contract where standardised
contracts are traded in a formal market
(cont.)

• Examples include:
– a fund manager holding shares who is concerned the price may fall
before they are sold
– an investor concerned that share prices may rise before they are
purchased
• Strategy involves carrying out an initial transaction in the
futures market that corresponds with the transaction to be
conducted in the physical market at a later date (see
Figure 18.1, next slide)
(cont.)

Physical market (e.g. share Futures
market)
Today Today
Concern about risk exposure Buy (or sell) futures contract at

current futures market price
Date of physical market Contract expiry
transaction
Conduct the planned transaction Close out futures position
Use profit (or loss) from futures Difference between contract buy
market to offset transaction cost or and sell prices represents a profit
return or a loss
Net cost or return equals the risk managed or hedged position

• Relevant terms
– Clearing house—records transactions conducted on an exchange
and facilitates value settlement and transfer
– Initial margin—deposit lodged with clearing house to cover adverse
price movements in a futures contract
– Marked-to-market—the periodic repricing of an existing contract to
reflect current market valuations
– Maintenance margin call—the top-up of an initial margin to cover
adverse futures contract price movements

Talking markets and strategy
• What happens if your main risk is the weather?
• One of the enduring characteristics of the financial
markets is their innovation. A trader never misses an
opportunity to create a product if there is a need for it
• If weather is a risk, why not create a futures contract
whose value depends on the number of days of, say,
temperatures above 30 degrees (or below 20 degrees)?
• A farmer growing oranges, for example, faces the risk of
too many hot days. The farmer can hedge this risk in the
futures markets
• Weather derivatives, including weather futures, are an
established product. Where there is a need, there’s a
trader willing to fill it!

• A financial instrument designed mainly to manage
specified risks
• Offered over the counter by financial institutions
– Therefore, more flexible than highly standardised exchange-traded
products like futures, as the terms and conditions of a forward
contract, such as amount and timing of the contract, can be
negotiated
• Two main types
1. Forward rate agreements (FRAs)
2. Forward foreign exchange contracts
(cont.)

1. Forward rate agreements (FRAs)
– An over-the-counter product used to manage interest rate risk
exposures
– Allows a borrower to manage future interest rate risk exposure by
locking in an interest rate today that will apply at a specified future
date
 Is given effect by one party to the contract compensating the other
party if the reference rate is different from the agreed rate
– Relevant terms
 FRA agreed rate—the fixed interest rate stipulated in the FRA at the
start of the contract
 FRA settlement date—the date when the FRA agreed rate is compared
with the reference rate to calculate the compensation amount
 FRA contract period—the term of the interest rate protection built into
the FRA
(cont.)

(cont.)

2. Forward foreign exchange contracts
– Also known as a forward exchange contract; locks in an exchange
rate today for delivery of foreign currency at a specified future date
– For example, an Australian company may be importing goods from
overseas and the company will need to pay USD1 million in three
months’ time

• An option gives the buyer the right, but not the obligation,
to buy or sell a specified commodity or financial
instrument at a predetermined price (exercise or strike
price), on or before a specified date (expiration date)
• Types of options
– Call options
 Give the option buyer the right to buy the commodity or instrument at
the exercise price
– Put options
 Give the buyer the right to sell the commodity or instrument at the
exercise price
(cont.)

• An option will only be exercised if it is in the buyer’s best
interests
– A buyer will not exercise the right to sell if the physical market price
is above the exercise price of the option
– A buyer will not exercise the right to buy if the physical market
price is below the exercise price of the option contract at expiration
date
• Options can be exercised either:
– only on expiration date (European option)
– any time up to expiration date (American option)
(cont.)

• Premium
– The price paid by an option buyer to the writer (seller) of the option
• Exercise price or strike price
– The price specified in an options contract at which the option buyer
can buy or sell
(cont.)

• Call option profit and loss payoff profiles
(cont.)

• Put option profit and loss payoff profiles

Talking markets and strategy
• If you own shares in a company and the share price is not very active,
is there some way to generate a little extra cash while waiting for some
action? Yes!
• What the investor could do is write a call option on their block of
shares. If they own 1000 BHP shares, they could write a call option on
them
• Let’s say BHP shares are $25. A $30 call option might have a premium
of $1.50. The investor could sell (write) the call option and receive
$1500 (each contract is for 1000 shares)
• If the share price remains stable, the investor can keep the $1500
when the option expires out of the money. If BHP shares rise above
$30, then the investor will simply sell his shares at $30
• If the share price is very stable, the investor might do this over and
over again, collecting the option premium each time and never having
to sell their shares

18.6 Swap contracts
• An over-the-counter financial product allowing parties to
enter into a contractual agreement to exchange cash
flows
• Intermediated swap
– A party enters into a swap with a financial intermediary
• Direct swap
– Two parties enter into a swap with each other without using a
financial intermediary
• Two main types of swap contracts
– Interest rate swaps
– Cross-currency swaps
(cont.)

18.6 Swap contracts
1. Interest rate swaps
– The exchange of interest payments associated with a notional
principal amount
– Notional principal amount—the underlying amount specified in a
contract that is used to calculate the value of the contract
– Vanilla swap—a swap of a series of fixed interest rate payments
for floating interest rate payments
– Basis swap—a swap of a series of two different reference rate
interest payments
– Swap rate—the fixed interest rate specified in a swap contract
(cont.)

18.6 Swap contracts
(cont.)

18.6 Swap contracts
(cont.)

18.6 Swap contracts
2. Cross-currency swaps
– Two parties, such as a bank and a company, exchange debt
denominated in different currencies
– Interest payments are exchanged
– Principals are exchanged at beginning of agreement and then re-
exchanged at conclusion of agreement, usually at the same
exchange rate
 Example:
• If the swap is an AUD-USD contract based on USD1 million and an
exchange rate set at AUD/USD0.7245, at the start of the contract one
party would exchange USD1 million for AUD1 380 262.25
• At each future interest payment date, interest payments would be
calculated using the same exchange rate (i.e. AUD/USD0.7245)
• Finally, at the swap completion date, the original AUD and USD principal
amounts would be re-exchanged
(cont.)

18.6 Swap contracts

Summary
• Risk can be categorised as operational and financial risk
• The risk management process involves a number of steps
• A futures contract is an agreement between two parties to
buy or sell a specified commodity or instrument at a
specified future date at a price specified today
• A forward contract is a financial instrument designed to
manage specified risk
– Two forward contracts are forward rate agreements (FRAs) and
forward exchange contracts
(cont.)

Summary
• An option contract gives the buyer the right but not the
obligation to buy or sell a specified commodity or financial
instrument at a specified price on or before a specified
date
• Swaps facilitate the exchange of specified cash flows.
– Interest rate swaps are used to manage interest rate risk
– Currency swaps are used when an interest rate swap involves
borrowing in different currencies
 They allow the management of interest rate and FX risk exposure.
 Currency swaps differ from interest rate swaps in that the principal
amounts raised by the two borrowers are swapped at the
commencement and re-exchanged at the end of the agreement


An Introduction To Risk Management and Derivatives: Viney & Phillips, Financial Institutions, Instruments and Markets, 9e

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

An Introduction To Risk Management and Derivatives: Viney & Phillips, Financial Institutions, Instruments and Markets, 9e

Uploaded by

Copyright:

Available Formats

Chapter 18

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-1

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-2

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-3

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-4

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-5

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-6

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-7

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-8

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-9

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-10

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-11

• Monitor, report, review and audit

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-12

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-13

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-14

Concern about risk exposure Buy (or sell) futures contract at

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-15

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-16

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-17

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-18

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-19

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-20

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-21

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-22

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-23

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-24

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-25

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-26

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-27

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-28

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-29

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-30

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-31

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-32

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-33

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-34

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 18-35

You might also like