FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

Treasury Risk Management CHAPTER TWENTY-ONE Treasury Risk Management

Learning Objectives 1. Define the term exposure, and describe how it affects effective risk management. 2. Explain why most firms use aggregate measures, and understand why they are preferable in defining exposure. 3. Identify some techniques used to quantify exposure. 4. Describe the role market efficiency plays in risk management. 5. Compare and contrast on-balance-sheet hedging and off-balance-sheet hedging.

Introduction Treasury management is concerned with managing the firm’s exposure to changes in: interest rates foreign exchange rates price of commodities that firm buys or sells has gained more attention because of: price volatility in the financial markets globalization of business

Measuring Exposure Exposure to foreign exchange and interest rates is measured by: how financial variables affect operating performance reflected in profits how they influence the firm’s value as reflected in share prices Profit reflects performance over a given time period and is a flow variable Flow variable – measures how much income flows into the business during a particular time span Stock variable – measures economic value at a point in time

Measuring Exposure Primary concern of risk management is to protect value reflected in share prices Two methods used to measure how a firm’s share price reacts to a change in interest or exchange rates are: 1. regression analysis

Measuring Exposure where: = the percentage change in the value of the firm’s shares = the percentage change in various financial prices bi = the regression coefficient that measures the sensitivity of the firm’s stock prices to changes in the i th factor price

Measuring exposure Gap Analysis 2. Estimate how changes in financial prices will affect the firm’s assets and liabilities Gap Analysis “Gap” – the difference between the values of interest-rate-sensitive assets and interest rate liabilities Measuring gap allows one to control the direction of exposure to interest rate risk. Gap analysis is limited to its rough binary classifications Duration is used to deal with value sensitivity of specific assets, liabilities, or portfolios to changes in interest rates

Risk Management - General Concepts Market efficiency and risk attitudes Faced with volatile financial prices a company has three fundamental approaches: 1. Opportunistic – tries to take advantage of market swings through timing 2. Passive – business is conducted without regard to potential changes in prices 3. Defensive – seeks to limit risk through hedging some firms compromise between a defensive and opportunistic approach is called benchmarking, which involves moving in and out of hedged positions

Risk Management at the Shareholder Level Shareholders can also manage risk through: options futures contracts swaps In perfect markets with full information and no transaction costs individuals should manage their own risk In markets with information asymmetries and transaction costs, its more advantageous for the firm’s management to control treasury risk management

On-Balance Sheet Hedging Traditional hedging involves matching assets and liabilities, and revenues and costs such as: maturity dates between short-term assets and short-term liabilities currencies in which the assets and liabilities are denominated the sensitivity of asset and liability values to changes in interest rates.

On-Balance Sheet Hedging Innovations in Securities innovative financial instruments firms can use to raise funds include: Floating-rate debt – debt with interest rates that rise and fall (float) in response to market shifts in interest rates Real interest rate debt – debt that protects the investor from inflation Commodity-linked debt – debt with interest payments linked to the price of a commodity

On-Balance Sheet Hedging Debt with interest rate, floors, and collars – caps and floors place upper and lower limits on the interest rate to be paid on floating-rate debt Zero coupon bonds – bonds that are sold at a discount with no periodic interest payments Index-linked debt – securities that attempt to offer the security of bonds with the potential return of stock

Off-Balance Sheet Hedging Side contacts that are not an inherent part of the firms primary outside financing Swaps the most common side contract available to companies How do swaps work? two parties exchange their future cash flow commitments on loans with identical principal outstanding. each find the forms of the other party’s obligation to be more attractive financial intermediary arranges the swap and for a fee may guarantee the future performance under the deal

Swaps Schematic Diagram of Interest Rate Swap

Using Derivative Securities: Options and Futures Options and futures contracts can both be used to hedge financial risk Options provide greater flexibility than forwards contracts Direct hedge – where the underlying asset is the same as that of the original transaction being hedged Cross Hedge – derivative securities denominated in an asset with a value that is highly correlated with the asset of the original transaction

Using Derivative Securities: Options and Futures Combining Derivative Securities Combining different types of derivative products it is possible to provide almost any payoff pattern Two of the most common patterns include: 1.The Straddle: Straddle – combines a put and a call on the same underlying asset with the same strike price, and with the same expiration date

Using Derivative Securities: Options and Futures Who uses straddles? Speculators – to bet on either an upward or a downward movement in the price of an underlying asset Intermediaries – to transfer commodities from producers to purchasers

Using Derivative Securities: Options and Futures 2. The Butterfly Spread: Butterfly spread – combines several call options to obtain payoffs only if the price of the underlying asset remains within a given range. The combination involves: buying an option with a very low strike price writing two options with mid-range strike prices buying an option with a high strike price

Using Derivative Securities: Options and Futures Other combinations and contracts include: Caps Floors Collars Captions Swaptions

Summary 1. Treasury risk management activity has become increasingly important as volatility in financial markets increases. Financial markets and institutions have responded with new vehicles for apportioning risk, reducing taxes and issuance costs, or otherwise enhancing efficiency and value.

Summary 2. Effective risk management requires systematic and reasonably accurate measurement of exposure. Exposure is defined as the variability in a firm’s value or cash flows that results from changes in financial variables such as interest rates, exchange rates, and commodity prices. 3. Regression analysis and computer simulation can be used to quantify aggregate exposure. Other techniques commonly used by financial institutions include gap and duration analysis.

Summary 4. Optimal risk management is closely related to beliefs about market efficiency. 5. On-balance sheet hedging entails the matching of assets and liabilities, and revenues and costs, on the basis of maturities, currencies, and value sensitivity to changes in interest rates or commodity prices.

Summary 6. Off-balance sheet hedging relies on derivative securities whose usage does not directly affect the firm’s financial statements. Swaps, options, and futures, alone or in various combinations, allow for the design of a variety of creative solutions to risk management.