Analyse and discuss the most common hedging techniques and how they can be used to mitigate interest rate, foreign exchange and commodity price risk to a multinational corporation. In what instances would one type of hedge be preferred to another?

Risk Management and Ethics Week 7: Other Areas of Treasury Management I This week's readings focus on risk management, or protecting the firm from losses due to variation in financial asset and commodity prices, operational issues, and accidents. The materials start with financial risk management, covering processes for identification and measurement of financial risk, focusing on interest rate, foreign exchange, and commodity price risk. This is followed by discussion of hedging instruments including futures, forwards, options, and swaps. The week's material explores Enterprise Risk Management (ERM) and operational risk, control techniques, and insurance requirements, standard policies, and procurement. The week concludes with a review of disaster recovery and business continuity planning from a treasury management perspective. Overview of financial risk management Financial risk is defined as the risk of loss due to the uncertainty of the future level of interest rates, foreign exchange rates, commodity prices, and the adverse consequences that may arise with a highly leveraged capital structure (i.e. debt default). Financial risk management, the responsibility of the treasury function, involves actions designed to mitigate these risks. The financial risk management process involves five important steps: 1. 2. 3. 4. 5. Determining an organisation's risk appetite; Identifying exposures; Measuring exposures; Implementing appropriate risk management strategies; and Monitoring exposures to evaluate and measure strategy effectiveness. Each topic is discussed more fully below. The firm's risk appetite should be clearly defined and incorporated into a risk management policy that is preferably endorsed by senior management and the Board of Directors. This policy should define the firm as risk-seeking or risk-averse (or more likely somewhere in between), contain a concise statement of the firm's risk management goals, identify important exposures needing management, define hedge techniques and approved instruments, outline the strategy approval process and monitoring methods, and specifically allocate authority and responsibilities to staff. Exposure identification involves qualitative and quantitative assessments of the effects of interest rate, foreign currency, and commodity price variability on the firm's financial position. The qualitative assessment covers definition of the economic exposure (how changes in prices affect business competitiveness, cash flows, and equity value of the firm) and the accounting exposure (how changes in prices affect balance sheet and income statement items, e.g. foreign currency translation of assets and liabilities into the firm's functional currency). Use of the operating cycle can facilitate this analysis. The quantitative assessment follows from the qualitative analysis, and involves measuring the materiality of the exposure and the identification of key risk drivers. Risk measurement provides management with the information necessary to determine whether the organisation can tolerate the risk, or if risk mitigation strategies should be implemented. Implementation may include a variety of strategies such as balance sheet composition (e.g. matching of foreign currency assets and liabilities) or the use of derivatives (e.g. futures, options, and swaps). Monitoring involves periodic evaluation of exposures and strategy, as well as frequent review of exposure changes and hedging effectiveness. This begins the feedback loop for re-evaluation of the five steps in the process. The methods employed to evaluate the risk impact on the firm are summarised as follows: Value at risk (VAR) - developed for frequent trading, VAR is based on the probability distribution of daily trading gains and losses, derived from historical firm trading records and daily profit and loss statements. Sensitivity analysis - a what-if method that models the sensitivity of the firm's cash flow and/or income to a change in a variable. Useful in identifying the most important, material exposures. Scenario analysis - similar to sensitivity analysis, but with changes in multiple variables analysed. May include best case, mid case, and worst case scenarios. Monte Carlo simulation - Estimates a probability distribution of a defined variable (e.g. net income, cash flow, firm value) based upon the probability distribution of key inputs (e.g. FX rates, commodity prices, interest rates). Financial risk management may involve three alternative trading strategies: hedging, speculation, and arbitrage. Each is defined below: Hedging - primary goal is to actively offset the risk of loss associated with a defined risk exposure. For example, an investor owning long term bonds (the \"cash position\") may want to counter the risk that bond prices decline when interest rates rise, and enter a hedging transaction that offsets gains or losses on the cash position. Hedging is a primary function for treasury managers. Speculation - primary goal is to take outright positions seeking to profit from changes in prices, also exposing the firm to the risk of loss. This is usually not a treasury function. Arbitrage - involves purchasing an asset in one market and simultaneously selling it in another market at a profit. This is also rarely a treasury management function. Use of derivative instruments as risk management tools Risk management is a key treasury function, and a fundamental understanding of derivatives, and their behaviour, is a necessary pre-condition to the topics that follow, notably interest rate risk management, foreign exchange exposure, and commodity price risk. The most common types of derivatives (swaps, forwards, futures, and options) have similar return characteristics across asset classes (interest rates, currencies, and commodities). The following discussion provides a high level overview of the price and payment characteristics of these derivative contracts. Forwards and futures have similar payout profiles, with the primary difference being that forwards are private, customisable contracts, while futures are standardised exchange traded contracts. There is a buyer (long position) and seller (short position) for each futures or forward contract. Buyers and sellers are collectively referred to as \"counterparties\". The contract specifies delivery of an asset (the \"underlying asset\") by the seller, to be purchased by the buyer, upon contract expiration at a defined date in the future (the \"settlement date\"). The price at which the trade is executed (the \"trade price\") sets the price at which the counterparties exchange assets at the settlement date (i.e. buyer delivers cash, seller delivers underlying asset). Gains and losses on futures and forward contracts are a zero-sum game between the two counterparties. In practice, traders in futures contracts do not hold until settlement date, often entering offsetting transactions prior to contract expiration. Forwards, on the other hand, more frequently result in delivery of the underlying asset. For example, the Chicago Mercantile Exchange (CME, http://www.cmegroup.com/) trades US$ / Euro currency futures contracts. Buying (the long position) a futures contract with a settlement date in December (the third Wednesday of the month is standard) entitles the trader with the long position to buy EUR 125,000 from the trader with the short position at the settlement date in exchange for US$, at the trade price. Over the intervening period between the trade date and settlement date, positions are marked-to-market daily, and gains and losses are posted to each party's account. A minimum cash balance (the \"margin\" balance) must be maintained in each trader's account. If the margin balance dips below the minimum, additional margin must be posted or the position closed. This protects traders from counterparty default. From a treasury risk management perspective, consider the example of a company that uses the Euro () as its functional currency (i.e. the currency of its published financial statements) that has sold product in a Yen denominated transaction for 100 million. The sale will close 3 months later. In this situation, the company will have a 100 million cash inflow in three months, but is exposed to changes in the / exchange rate over the period. To hedge this risk, the company can enter a forward contract to sell 100 million in exchange for in three months, at a rate established on the trade date. Assume the trade exchange rate is 110 per 1. By doing so, the company has locked in the Euro value of this sale at 909,090.91. At settlement date, the firm delivers 100 million and receives 909,090.91. To illustrate the nature of this risk, assume over this timeframe that the weakens against the (in other words, it costs more to buy 1) to 120 per 1. If the company did not enter the forward transaction, it would receive the equivalent of 833,333.33 when the sale closed, 75,757.58 less than under the hedged transaction. Unlike futures and forwards, where counterparties are obligated to deliver specific assets on the settlement date, options give purchasers' rights rather than imposing obligations. A purchaser of the call option has the right, but not the obligation, to purchase the underlying asset at the pre-determined price (the \"strike price\") on a given date (a European style option) or alternatively on or before a given date (an American style option). The purchaser pays the seller an amount (the \"premium\") for this right. Inversely, the seller of the option (which collects the premium) is obligated to deliver the underlying asset at the strike price if the purchaser exercises their right to purchase the underlying asset (e.g. \"exercises\" the option). If the option purchaser does not exercise, the option expires, and is worthless. A put option is essentially the opposite of a call option. A purchaser of the put option has the right, but not the obligation, to sell the underlying asset at the strike price on a given date (a European style option) or alternatively on or before a given date (an American style option). The purchaser pays the seller a premium for this right. The option seller is obligated to buy the underlying asset at the strike price if the purchaser exercises the option. Continuing with the sales transaction discussed above, there is an alternative strategy using options that will allow the company to protect itself from changes in the / rate, but also benefit if the rate moves in its favour. To recap the situation, the firm will receive 100,000,000 in three months, and hence will want to sell the in exchange for or put differently, to buy in exchange for . It can enter into a call option to buy 909,090.91 for in three months at a strike price of 110 per 1. Assume the premium the firm pays for this option is 30,000. As with the above example, over this period the weakens to 120 per 1. Under this scenario, the firm will exercise its option to buy 909,090.91 for 100,000,000. In this instance, the net proceeds to the firm in will be 879,090.91, which is the received under the option contract exercise minus the option premium paid. If, on the other hand, the strengthens against the to 100 per 1, the firm will choose to sell its in the open market, received 1,000,000, and not exercise its option. After deducting the option premium paid, the net proceeds are 970,000. In this scenario, the firm is better off than under the forward contract by 60,909.09 (or 970,000 less 909,090.91). [Please note, this is a very simplified analysis of an option hedging scheme. It assumes that the firm can enter a private option contract with a counterparty, such as a bank. Most active exchange traded options are in stocks rather than currencies or interest rate instruments. Hence, option hedging may be difficult to execute in practice, especially if relying on exchange-traded contracts.] Interest rate swaps are a common method to transform the interest income or expense characteristics of an investment portfolio or debt outstanding, respectively. Under a \"plain vanilla\" interest rate swap contract, two counterparties agree to exchange one form of interest payment (e.g. fixed) for another (e.g. floating) on an agreed underlying amount (the \"notional\" amount) for a specified period (the \"term\"). Over the term of the contract, amounts due under the swap are calculated periodically (e.g. quarterly), and a net payment is made between the counterparties (net in that rather than each counterparty making its required payment, the two payments are netted, and the party with the higher amount due makes a payment equal to the higher less the lower amount due). For example, consider two companies, X and Y. X can borrow in the long-term bond market at an attractive fixed rate for 5 years. However, it prefers to borrow on a floating rate basis. This may be due to their view that economically, floating rates are a better match with its revenue stream, which tends to have a boom and bust profile (eg: timber company). Strong economic growth is associated with high firm earnings and also rising short-term interest rates, while weakening economic growth reduces firm earnings, and is also associated with declining short-term interest rates. Economically, the firm is willing to incur higher interest expense during boom periods, when earnings are high, in order to benefit from the buffer of lower interest expense in bust periods, when earnings are declining. Assume Y can borrow at attractive short-term rates, but prefers to pay fixed term interest rates. This is because the firm is an electric utility, with a very stable, predictable revenue stream that does not vary meaningfully with the economic cycle. X and Y, taking advantage of their unique borrowing strengths, can swap with one another, transforming their interest expense profile in a manner that better matches their earnings profiles and risk appetite. So, X and Y enter an interest rate swap on 100,000,000 of notional, whereby X pays a floating rate (say Interbank offered rate, or EURIBOR) plus a spread of 1%, and Y pays a fixed rate of 5% (both are annualized rates). In the first quarter of the swap term, assume EURIBOR is 1%, plus a spread of 1%, means that X is owes 2% annualized, or 0.5% of the notional of 100,000,000, or 500,000. Y owes 5% annualized, or 1.25% of the notional of 100,000,000, or 1,250,000. Y pays X the net amount of 750,000. Now, assume it is four years later, and short-term interest rates have risen. EURIBOR is 6%, plus a 1% spread, means that X owes Y 7% annualized, or a quarterly payment of 1.75% of 100,000,000 or 1,750,000. Y still pays 5% per annum, and owes a quarterly payment to X of 1,250,000. Hence, in this quarter, X pays Y 500,000. Interest rate and foreign exchange exposure Interest rate risk covers the change in value of a security (e.g. bond, money market instrument) that is related to a change in interest rates, as well as the impact changing rates have on the firm's income, cash flows, and value. Firms that borrow at short term floating interest rates benefit when rates fall (lower interest expense and higher net income), but are exposed if interest rates rise (higher interest expense reduces net income). Alternatively, firms borrowing at long-term interest rates will have lower periodic volatility in interest expense and hence earnings, but are likely to pay generally higher interest rates than firms borrowing short term, since the yield curve is normally upwardly sloping. Derivatives can be used to transform the nature of the firm's interest rate exposure, with the most important instruments as follows: Interest rate swaps are generally private transactions between two counterparties (such as a bank or dealer, and a corporation) allowing for some level of customisation. Interest rate futures are exchange traded, standardised contracts available in a variety of short-term rates (e.g. LIBOR, Federal Funds, Treasury bills) and long-term rates (Government bond yields, swaps). Forward rate agreements (FRA) are similar to futures but are private transactions between two counterparties rather than exchange traded. They have a return profile similar to that of futures contracts. Interest rate options can be standard exchange traded contracts or private transactions with dealers. The return characteristics of put and call options are discussed above under \"Use of derivative instruments as risk management tools\". There are interest rate caps, floors, and collars: o Caps are a form of call option under which the purchaser of the call will benefit if the floating rate underlying the option rises above the agreed rate. For example, the floating rate borrower currently paying 3% may purchase a cap that sets a ceiling on its floating rate at 4%, yet it will still benefit if rates decline. o Floors are a form of put option whereby the purchaser is assured that the rate they receive will go no lower than an agreed rate. For example, the lender in the foregoing example may purchase a floor with a strike of 2%, meaning that the minimum yield on the loan will be protected in the event rates fall below 2%. o Collars are a combination of a cap and floor. Continuing with the prior example, the lender and borrower may agree to a \"cashless\" collar whereby the borrower is \"buying\" a cap at 4%, and simultaneously \"selling\" a 2% floor to the lender. The premium payable to the borrower for selling the floor offsets the premium payable by the borrower for purchasing the cap, hence \"cashless\". Meanwhile, the borrower is assured that its borrowing costs will be no more than 4%, and no less than 2%. Foreign exchange (FX) exposure, from the perspective of the firm, has three categories: transaction, translation, and economic. Each is summarised as follows: Transaction exposure exists when receivables and/or payables are in different currencies than the firm's functional currency and hence the functional currency value will be affected by changes in FX rates. An explicit transaction exposure exists from the point the payable or receivable is created until it is settled in cash. There is an implicit transaction exposure when prices are established, prior to any sales actually occurring. Since established prices reflect the then current FX rate, there is an implicit risk since the FX rates may change, while the product price remains constant. Translation exposure relates to the accounting impact of consolidating financial statements of foreign subsidiaries, denominated in their local currency, within the firm's consolidated financial statements. The primary method to deal with translation risk is to match the value of foreign currency denominated assets and liabilities, so gains and losses offset one another. Economic exposure is the long term influence that changing FX rates have on the present value of future cash flows and firm value. Common instruments used to hedge FX exposure are forwards, futures, swaps, and options, summarised as follows: FX futures are exchange-traded contracts under which 2 counterparties agree to exchange currencies in the future at a set rate upon expiration of the contract. FX forwards are similar to futures but are instead private contracts between 2 counterparties, usually between banks and corporations, allowing for customisation. FX Swaps are a variation of the standard interest rate. Under an FX swap, interest payments in different currencies are exchange over the contract life, and principal in different currencies are exchanged at the end of the contract. FX Options are calls or puts exercisable into a fixed amount of foreign currency on or before a specific date. Commodity price exposure The primary risk faced by companies is the impact of an unforeseen change in the price of a commodity. For firms selling commodities (e.g. gold), there may be a desire to hedge the price of future delivery of the good in order to create some predictability to the firm's revenue stream. Alternatively, firms that purchase commodities as a production input may want to lock-in today the future price of that input (e.g. jet fuel for airlines) in order to protect profit margins against unanticipated changes in the input price. Commodity price risk can be managed through a variety of instruments, much like currency and interest rate risk, such as forwards, futures, swaps, and options. For firms concerned with the reliable supply of a commodity, a long-term supply contract may be appropriate. For example, airlines consume a high volume of jet fuel, making it one of the largest components of the carrier's cost base. Since tickets are priced and sold in advance of the actual day of travel, variation in jet fuel prices presents a significant earnings risk as prices may rise between the point the tickets are sold and the flight. Some airlines hedge jet fuel prices with futures and options in order to lock in the future jet fuel price, thereby protecting revenue. A good description is included in \"Thai Airways jet fuel hedging activity up more than 50% since Q1\