DERIVATIVES IN FINANCIAL RISK MANAGEMENT

Introduction
Risk can be defined as the chance of loss or an unfavorable outcome associated with an action.
Uncertainty does not know what will happen in the future. The greater the uncertainty, the greater
the risk. For an individual farm manager, risk management involves optimizing expected returns
subject to the risks involved and risk tolerance.
Risk is what makes it possible to make a profit. If there was no risk, there would be no return to
the ability to successfully manage it. For each decision there is a risk-return trade-off. Anytime
there is a possibility of loss (risk), there should also be an opportunity for profit. Growers must
decide between different alternatives with various levels of risk. Those alternatives with minimum
risk may generate little profit. Those alternatives with high risk may generate the greatest possible
return but may carry more risk than the producer will wish to bear. The preferred and optimal
choice must balance potential for profit and the risk of loss.
Financial risk encompasses those risks that threaten the financial health of the business and has
four basic components:
1) The cost and availability of capital;
2) The ability to meet cash flow needs in a timely manner;
3) The ability to maintain and grow equity;
4) The ability to absorb short-term financial shocks.
Types of Risks
1. Interest rate risk
Firms are exposed to interest rate risk in two ways:

i. The cost of existing borrowings (or the yield on deposits) may be linked to interest rates in
the economy. This risk exposure can be eliminated by using fixed rate products.
ii. Cash flow forecasts may indicate the need for future borrowings/deposits. Interest rates
may change before these are needed and thus affect the ultimate cost/yield
2. Foreign exchange risk

Firms may be exposed to three types of foreign exchange risk:

Transaction risk- The risk of an exchange rate changing between the transaction date and the
subsequent settlement date on an individual transaction. i.e. it is the gain or loss arising on
conversion. Associated with exports/imports.

Economic risk- Includes the longer-term effects of changes in exchange rates on the market
value of a company (PV of future cash flows). Looks at how changes in exchange rates affect
competitiveness, directly or indirectly.
Translation risk- How changes in exchange rates affect the translated value of foreign assets and
liabilities (e.g. foreign subsidiaries).
3. Political risk
Political risk is the risk that a company will suffer a loss as a result of the actions taken by the
government or people of a country. It arises from the potential conflict between corporate goals
and the national aspirations of the host country.
4. Regulatory risk
Regulatory risk is the potential for laws related to a given industry, country, or type of security to
change and affect: how the business as a whole can operate and the viability of planned or ongoing
investments
5. Fiscal risk
Fiscal risk from a corporate perspective is the risk that the government will have an increased
need to raise revenues and will increase taxes, or alter taxation policy accordingly. Changes in
taxation will affect the present value of investment projects and thereby the value of the
company.

6. Operational risk

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred
for inadequate or failed internal processes, people and systems, or from external events
(including legal risk), differ from the expected losses".

Hedging Currency Risks

Hedging is a risk management strategy used in limiting or offsetting probability of loss from
fluctuations in the prices of commodities, currencies, or securities.
Hedging is a strategy, usually some form of transaction, designed to minimize exposure to an
unwanted business risk, commonly arising from fluctuations in exchange rates, commodity prices,
interest rates etc. Hedging employs various techniques but, basically, involves taking equal and
opposite positions in two different markets(such as cash and futures markets).
The Internal Techniques
Internal techniques to manage/reduce forex exposure should always be considered before
external methods on cost grounds. Internal techniques include the following:
1. Invoice in home currency- One easy way is to insist that all foreign customers pay in your
home currency and that your company pays for all imports in your home currency.
2. Leading and lagging- If an importer (payment) expects that the currency it is due to pay
will depreciate, it may attempt to delay payment (lagging). This may be achieved by agreement
or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next
three months it may try to obtain payment immediately (leading). This may be achieved by
offering a discount for immediate payment.
3. Matching and netting- When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total
transactions. An extension of the matching idea is setting up a foreign currency bank account.
Netting and matching is a feature of foreign exchange risk management and are carried out to
reduce the scale of external hedging required.
For example, Group X is expecting to receive sh.10 million in one subsidiary and pay sh.6 million
at the same time in another subsidiary. Clearly the group only has a net exposure of a receipt of $4
million.
The terms 'netting' and 'matching' are often used interchangeably but strictly speaking they are
different:
 Netting refers to netting off group receipts and payments, as in the example above.
 Matching extends this concept to include third parties such as external suppliers and
customers.
 DERIVATIVES
A derivative is an asset whose performance (and hence value) is derived from the behaviour of the
value of an underlying asset (the "underlying").
The most common underlying’s commodities (e.g. tea, pork bellies), shares, bonds, share indices,
currencies and interest rates. Derivatives are contracts that give the right and sometimes the
obligation, to buy or sell a quantity of the underlying or benefit in some other way from a rise or
fall in the value of the underlying assets.
Usage of Derivatives
Derivatives are used by investors for the following:
o hedge or mitigate risk in the underlying asset, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all of
it out;
o create optionability where the value of the derivative is linked to a specific condition or
event (e.g. the underlying reaching a specific price level);
o obtain exposure to the underlying assets where it is not possible to trade in the underlying
(e.g., weather derivatives);
o provide leverage(or gearing), such that a small movement in the underlying value can cause
a large difference in the value of the derivative;
o speculate and make a profit if the value of the underlying asset moves the way they expect
(e.g., moves in a given direction, stays in or out of a specified range, reaches a certain
level).
Derivatives include the following:
1. Forwards.
2. Forward rate agreements ("FRAs").
3. Futures.
4. Options.
5. Swaps
1. Options

Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a
call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is
known as the strike price, and is specified at the time the parties enter into the option. The option
contract also specifies a maturity date. A currency option is a right, but not an obligation, to buy
or sell a currency at an exercise price on a future date. If there is a favorable movement in rates
the company will allow the option to lapse, to take advantage of the favorable movement. The
right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.

Terms

 Holder: The buyer of an option is called the holder.

 Writer: The seller of an option is called a writer or a grantor.
 Call: A call is an option to buy foreign currency.
 Put: A put is an option to sell foreign currency.
 Strike Price: The strike price or exercise price is the price at which the foreign currency
can be purchased or sold.
 Premium: The premium or option price is the cost, price, or value of the option.
 American Option: An American option gives the holder the right to exercise the option at
any time between the date of writing and the expiration or maturity date.
 European Option: A European option gives the holder the right to exercise the option only
at the expiration date.
 At-the-Money (ATM): An option whose exercise price is the same as the spot price of the
underlying currency is said to be at-the-money
 In-the-Money (ITM): An option that would be profitable if exercised immediately is said
to be in the-money.
 Out-of-the-Money (OTM): An option that would not be profitable to exercise immediately
is said to be out-of-the-money.
 Exchange-Traded Options: Options traded in organized exchanges
 Bermudan option – an option that may be exercised only on specified dates on or before
expiration.
 Asian option – an option whose payoff is determined by the average underlying price over
some preset time period.
 Barrier option – any option with the general characteristic that the underlying security's
price must pass a certain level or "barrier" before it can be exercised.
 Binary option – An all-or-nothing option that pays the full amount if the underlying
security meets the defined condition on expiration otherwise it expires worthless.
  Exotic option – any of a broad category of options that may include complex financial
structures.
 Vanilla option – any option that is not exotic

Types of Options
 A call option gives the holder the right to buy the underlying currency.
 A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures. A European option can only
be exercised on the expiry date whilst an American option can be exercised at any time up to the
expiry date.
Foreign Currency Options Markets
Foreign currency options are available on the over-the-counter market and on organized
exchanges.
a) Over-the-Counter (OTC) Market
Over-the-counter options are written by financial institutions. These OTC options are more liquid
than forward contracts. At any moment, the holder can sell them back to the original writer, who
quotes tow-say prices.
The main advantage of OTC options is that they are tailored to the specific needs of the firm:
Financial institutions are willing to write or buy options that vary by contract size, maturity, and
strike price. As a consequence, the bid-ask spread in the OTC market is higher than in the traded
options market. Firms buying and selling currency options as part of their risk management
program do so primarily in the OTC market. In OTC market, most of the options are written at a
strike price equal to the spot price of that moment (at-the-money options).
A firm wishing to purchase an option in the OTC market normally places a call to the currency
option desk of a major money center bank, specifies the currencies, maturity, strike price (s), and
asks for an indication (a bid-ask quote). The bank normally takes a few minutes to a few hours to
price the option and return the call.
Option types commonly traded over the counter include:
•Interest rate options
•Currency cross rate options, and
•Options on swaps or swaptions.
 b) Organized Exchange Trade Options
Options on the underlying currency are traded on a number of organized exchanges worldwide,
including the London International Financial Futures Exchange (LIFFE). An organized option
exchange, like a futures market, has an organized secondary market, with a clearing-house as a
guarantor. That is, exchange traded options are settled through a clearing-house, so buyers do not
deal directly with sellers. The clearing-house is the counterpart to every option contract and it
guarantees fulfillment. Exchange-traded options include
 stock options,
 bond options and other interest rate options
 stock market index options or, simply, index options and o
 options on futures contracts
 callable bull/bear contract
Contract Specifications
Every financial option is a contract between the two counterparties with the terms of the option
specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they
usually contain the following specifications:
 whether the option holder has the right to buy (a call option) or the right to sell (a put
option)
 the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock)
 the strike price, also known as the exercise price, which is the price at which the underlying
transaction will occur upon exercise
 the expiration date, or expiry, which is the last date the option can be exercised
 the settlement terms, for instance whether the writer must deliver the actual asset on
exercise, or may simply tender the equivalent cash amount
 the terms by which the option is quoted in the market to convert the quoted price into the
actual premium – the total amount paid by the holder to the writer
2. Futures

Futures is a standardized contract between two parties to buy or sell a specified asset of
standardized quantity and quality for a price agreed upon today (the futures price or strike price)
with delivery and payment occurring at a specified future date, the delivery date. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two parties. The party
agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long",
and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short".
The terminology reflects the expectations of the parties—the buyer hopes or expects that the asset
price is going to increase, while the seller hopes or expects that it will decrease in near future. A
futures contract differs from a forward contract in that the futures contract is a standardized
contract written by a clearing house that operates an exchange where the contract can be bought
and sold; the forward contract is a non-standardized contract written by the parties themselves.
Futures contracts are standard sized, traded hedging instruments. The aim of a currency futures
contract is to fix an exchange rate at some future date.

Key features of Futures Contracts are:

1. Terms and conditions are standardized.

2. Trading takes place on a formal exchange wherein the exchange provides a place to engage
in these transactions and sets a mechanism for the parties to trade these contracts.

3. There is no default risk because the exchange acts as counterparty, guaranteeing delivery
and payment by use of a clearing house.

4. The clearing house protects itself from default by requiring its counterparties to settle gains
and losses or mark to market their positions on a daily basis.

5. Futures are highly standardized, have deep liquidity in their markets and trade on an
exchange.

6. An investor can offset his or her future position by engaging in an opposite transaction
before the stated maturity of the contract.

Standardization of Futures
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
 The underlying asset or instrument. This could be anything from a barrel of crude oil to a
short term interest rate.
 The type of settlement, either cash settlement or physical settlement.
 The amount and units of the underlying asset per contract. This can be the notional amount
of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount
of the deposit over which the short term interest rate is traded, etc.
 The currency in which the futures contract is quoted.
 The grade of the deliverable. In the case of bonds, this specifies which bonds can be
delivered.
 The delivery month.
  The last trading date
3. Forwards

A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to
buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later
time, but the price is determined at the time of purchase. Forwards are tailored contracts between
two parties, where payment takes place at a specific time in the future at today's pre-determined
price.

Key features of forward contracts are:

 Highly customized - Counterparties can determine and define the terms and features to fit
their specific needs, including when delivery will take place and the exact identity of the
underlying asset.
 All parties are exposed to counterparty default risk - This is the risk that the other party
may not make the required delivery or payment.
 Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
 Underlying assets can be stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
 They tend to be held to maturity and have little or no market liquidity.
 Any commitment between two parties to trade an asset in the future is a forward contract.
Example: Forward Contracts

Let’s assume that you have just taken up sailing and like it so well that you expect you might buy
your own sailboat in 6 months. Your sailing buddy, John, owns a sailboat but expects to upgrade
to a newer, larger model in 6 months. You and John could enter into a forward contract in which
you agree to buy John's boat for sh.1,500,000 and he agrees to sell it to you in 6 months for that
price.

In this scenario, as the buyer, you have entered a long forward contract. Conversely, John, the
seller will have the short forward contract. At the end of one year, you find that the current market
valuation of John's sailboat is sh.1, 650,000. Because John is obliged to sell his boat to you for
only sh.1500, 000, you will have effectively made a profit of sh.150, 000. (You can buy the boat
from John for $150,000 and immediately sell it for sh.1650, 000.) John, unfortunately, has lost
sh.150, 000 in potential proceeds from the transaction.
Futures versus Forwards

Futures differ from forwards in several instances:

 A forward contract is a private transaction - a futures contract is not. Futures contracts are
reported to the future's exchange, the clearing house and at least one regulatory agency.
The price is recorded and available from pricing services.
 A future takes place on an organized exchange where the all of the contract's terms and
conditions, except price, are formalized (standardized). Forwards are customized to meet
the user's special needs. The future's standardization helps to create liquidity in the
marketplace enabling participants to close out positions before expiration.
 Forwards have credit risk, but futures do not because a clearing house guarantees against
default risk by taking both sides of the trade and marking to market their positions every
night. Mark to market is the process of converting daily gains and losses into actual cash
gains and losses each night. As one party loses on the trade the other party gains, and the
clearing house moves the payments for the counterparty through this process.
 Forwards are basically unregulated, while future contract are regulated at the federal
government level. The regulation is there to ensure that no manipulation occurs, that trades
are reported in a timely manner and that the professionals in the market are qualified and
honest.
4. Swaps
A currency swap (or a cross currency swap) is a foreign exchange derivative between two
institutions to exchange the principal and/or interest payments of a loan in one currency for
equivalent amounts, in net present value terms, in another currency.
Characteristics of swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then
reswap them at the end of the period at an agreed swap rate. The swap rate and amount of currency
is agreed between the parties in advance. Thus it is called a "fixed rate/fixed rate" swap.
The main objectives of a forex swap are:
1. To hedge against forex risk, possibly for a longer period than is possible on the
forward market.
2. Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have exchange controls and/or
volatile exchange rates. Swaps can basically be categorized into the following types:
 Interest rate swap: These basically necessitate swapping only interest associated cash
flows in the same currency, between two parties.
  Currency swap: A currency swap involves exchanging principal and fixed rate interest
payments on a loan in one currency for principal and fixed rate interest payments on an
equal loan in another currency. Just like interest rate swaps, the currency swaps are also
motivated by comparative advantage. Currency swaps entail swapping both principal and
interest between the parties, with the cashflows in one direction being in a different
currency than those in the opposite direction. It is also a very crucial uniform pattern in
individuals and customers.
 A commodity swap is an agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period. The vast majority of commodity swaps
involve crude oil.
 Credit default swaps; A credit default swap (CDS) is a contract in which the buyer of the
CDS makes a series of payments to the seller and, in exchange, receives a payoff if an
instrument - typically a bond or loan- goes into default(fails to pay). Less commonly, the
credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy
or even just having its credit rating downgraded.
Illustration

For example, assume that a corporation needs to borrow $10 million euros and the best rate it can
negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a comparable loan. The
corporation could take the U.S. loan and then find a third party willing to swap it into an equivalent
euro loan. By doing so, the firm would obtain its euros at more favorable terms. Cash flow streams
are often structured so that payments are synchronized, or occur on the same dates. This allows
cash flows to be netted against each other (so long as the cash flows are in the same currency).
Typically, the principal (or notional) amounts of the loans are netted to zero and the periodic
interest payments are scheduled to occur on that same dates so they can also be netted against one
another.

INTEREST RATE RISKS

Financial managers face risk arising from changes in interest rates, i.e. a lack of certainty about
the amounts or timings of cash payments and receipts. Many companies borrow, and if they do
they have to choose between borrowing at a fixed rate of interest (usually by issuing bonds) or
borrow at a floating (variable) rate (possibly through bank loans). There is some risk in deciding
the balance or mix between floating rate and fixed rate debt. Too much fixed-rate debt creates an
exposure to falling long-term interest rates and too much floating-rate debt creates an exposure to
a rise in short-term interest rates.

In addition, companies face the risk that interest rates might change between the point when the
company identifies the need to borrow or invest and the actual date when they enter into the
transaction. Managers are normally risk-averse, so they will look for techniques to manage and
reduce these risks. Interest rate risk is the risk that an investment's value will change due to a
change in the absolute level of interest rates, in the spread between two rates, in the shape of the
yield curve or in any other interest rate relationship. Such changes usually affect securities
inversely and can be reduced by diversifying (investing in fixed-income securities with different
durations) or hedging (e.g. through an interest rate swap).

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility
of a change in the asset's value resulting from the variability of interest rates. A company might
borrow at a variable rate of interest, with interest payable every six months and the amount of the
interest charged each time varying according to whether short-term interest rates have risen or
fallen since the previous payment. Some companies borrow by issuing bonds. If a company
foresees a future requirement to borrow by issuing bonds, it will have an exposure to interest rate
risk until the bonds are eventually issued.

Some companies also budget to receive large amounts of cash, and so budget large temporary cash
surpluses that can be invested short-term. Income from those temporary investments will depend
on what the interest rate happens to be when the money is available for depositing. Some
investments earn interest at a variable rate of interest (e.g. Money in bank deposit accounts) and
some short-term investments go up or down in value with changes in interest rates (for example,
Treasury bills and other bills). Some companies hold investments in marketable bonds, either
government bonds or corporate bonds. These change in value with movements in long-term
interest rates.

Interest rate risk can be significant. For example, suppose that a company wants to borrow sh.100
million for one year, but does not need the money for another three weeks. It would be expensive
to borrow money before it is needed, because there will be an interest cost. On the other hand, a
rise in interest rates in the time before the money is actually borrowed could also add to interest
costs. For example, a rise of just 0.25% in the interest rate on a one-year loan of sh.100 million
would cost an extra sh.250, 000 in interest over the course of a year.

TERM - STRUCTURE OF INTEREST RATES

The term structure reflects expectations of market participants about future changes in interest
rates and their assessment of monetary policy conditions. The term structure of interest rates is
also known as a yield curve and it plays a central role in an economy. It is the relationship between
interest rates or bond yields and different terms or maturities.
There are three main theories that try to describe the future yield curve:

Pure Expectation Theory: Pure expectation is the simplest and most direct of the three theories.
The theory explains the yield curve in terms of expected short-term rates. It is based on the idea
that the two-year yield is equal to a one-year bond today plus the expected return on a one-year
bond purchased one year from today. The one weakness of this theory is that it assumes that
investors have no preference when it comes to different maturities and the risks associated with
them.

Liquidity Preference Theory: This theory states that investors want to be compensated for
interest rate risk that is associated with long-term issues. Because of the longer maturity, there is
a greater price volatility associated with these securities. The structure is determined by the future
expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk
increases with maturity, the yield premium will also increase with maturity. Also known as the
Biased Expectations Theory.

Market Segmentation Theory: This theory deals with the supply and demand in a certain
maturity sector, which determines the interest rates for that sector. It can be used to explain just
about every type of yield curve an investor can came across in the market. An offshoot to this
theory is that if an investor wants to go out of his sector, he'll want to be compensated for taking
on that additional risk. This is known as the Preferred Habitat Theory.

HEDGING INTEREST RATE RISKS

The common tools for hedging interest rate risk are;-

1. Forward rate agreement

2. Interest rate futures

3. Interest rate swaps

4. Interest rate options

 Forward Rate Agreements (FRAs)

An FRA is based on the idea of a forward contract, where the determinant of a gain or loss is
interest rate. Under this agreement, one party pays a fixed interest rate and receives a floating
interest rate equal to a reference rate. The actual payments are calculated based on a notional
principal amountand paid at intervals determined by the parties. Only a net payment is made - the
loser pays the winner, so to speak. FRAs are always settled in cash. FRA users are typically
borrowers or lenders with a single future date on which they are exposed to interest rate risk. A
series of FRAs is similar to a swap (discussed below); however, in a swap all payments are at the
same rate. Each FRA in a series is priced at a different rate, unless the term structure is flat.
  Interest rate futures
An interest rate future is a financial derivative (a futures contract) with an interest-bearing
instrument as the underlying asset. It is a particular type of interest rate derivative.
There are two broad types of interest rate futures:
1. Short-term interest rate futures (STIRs). These are standardized exchange-traded forward
contracts on a notional deposit (usually a three-month deposit) of a standard amount of
principal, starting on the contract's final settlement date.
2. Bond futures. These are contracts on a standard quantity of notional government bonds. If
they reach final settlement date, and a buyer or seller does not close his position before then,
the contracts must be settled by physical delivery.
 Interest rate swaps
An interest rate swap is an agreement whereby the parties agree to swap a floating stream of
interest payments for a fixed stream of interest payments and via versa. There is no exchange of
principal:
1. The companies involved are termed 'counter-parties'.
2. Swaps can run for up to 30 years.
3. Swaps can be used to hedge against an adverse movement in interest rates. Say a company
has a $200m floating loan and the treasurer believes that interest rates are likely to rise over
the next five years. He could enter into a five-year swap with a counter party to swap into a
fixed rate of interest for the next five years. From year six onwards, the company will once
again pay a floating rate of interest.
4. A swap can be used to obtain cheaper finance. A swap should result in a company being
able to borrow what they want at a better rate under a swap arrangement, than borrowing it
directly themselves.