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STFMChapter 17 ECM Chapter 14 Managing Financial Risk

Learning Objectives. Understand the basic difference between hedging and speculatingDiscern between two types of hedging strategies using futures, options, swaps, and products such as interest rate ceiling, floor, and collarsDevelop appropriate interest rate hedging strategies. Financial Risk Management .

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STFMChapter 17 ECM Chapter 14 Managing Financial Risk

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    1. STFMChapter 17 ECM Chapter 14 Managing Financial Risk

    2. Learning Objectives Understand the basic difference between hedging and speculating Discern between two types of hedging strategies using futures, options, swaps, and products such as interest rate ceiling, floor, and collars Develop appropriate interest rate hedging strategies

    3. Financial Risk Management Identification Measurement Hedging Monitoring

    4. Financial Risk Financial leverage Changes in interest rates foreign exchange rates commodities prices

    5. Risk Profile Attitude towards risk for each potential exposure. Risk-return tradeoff. Basis for financial risk management.

    6. Objectives of Financial Risk Management Determine Risk Profile Value at Risk(VAR) Set Basic Goals Identify and Measure the Level of Risk Exposure Manage Exposure Monitor Exposure

    7. Hedging vs. Speculating A hedger has a cash position or an anticipated cash position that he or she is trying to protect from adverse interest rate movements A speculator has no operating cash flow position to protect and is trying to profit solely from interest rate movements

    8. Some Important Terms Hedger Speculator Arbitrage Perfect vs imperfect hedge Pure vs anticipatory hedge Partial and cross hedge Long (buy) and short (sell) hedge Mark to market

    9. Hedger

    10. Speculator

    11. Arbitrage

    12. Perfect vs Imperfect Hedge

    13. Pure vs Anticipatory Hedge

    14. Partial and Cross Hedge

    15. Long (buy) and Short (sell) Hedge

    16. Mark to Market

    17. Forwards A contractual obligation to deliver the underlying asset at a specific future date at a predetermined price. Advantage-can be custom-tailored to the needs of the company. Disadvantage-cost of negotiating contracts. Delivery of the underlying asset takes place at maturity.

    18. Futures Similar to forward contracts Contracts are standardized Traded on organized exchanges Requires margin accounts Contracts are “marked to market” Margin calls are made when value of contract falls below a specified level Normally contracts are closed out prior to maturity.

    19. Buy vs. Sell Hedge Type of hedge should depend on the nature of the cash flow position being hedged, not on the anticipated direction of interest rates. Buy Hedge: A future investment or retiring a liability prior to maturity Sell Hedge: Issue a liability in the future or sell an investment prior to its maturity

    20. Why Hedges Are Not Perfect Futures contract in general have only four expiration dates per year. (Note T-bills: Mar, June, Sept, and Dec. Correlation coefficient of spot rates and futures rates is less than 1.0

    21. Options A contract which gives the purchaser the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) during, or at the end of a future time period. Call options give the holder the right to buy. Put options give the holder the right to sell.

    22. Options (continued) Options provide protection from adverse price movements. Options provide potential for unlimited gains. No obligation to deliver or take delivery of the underlying asset.

    23. Interest Rate Swaps An agreement between two parties to exchange an underlying asset (or the stream of cash flows) for a specific period of time. Based on notional amounts. Financial intermediaries act as counter parties or swap dealers.

    24. Types of Swap Arrangements Interest Rate Swaps Currency Swaps Commodity Swaps

    25. Interest Rate Swaps

    26. A Swap Diagram (Fixed-for-Floating Liability Swap)

    27. Liability Swap k swap = fr + so - si + fee fr = financing rate so = swap outflow si = swap inflow fee = intermediary fee

    28. Other Hedging Instruments Interest rate caps Purchaser pays a premium and receives cash payments from the cap seller when the reference rate exceeds strike rate. Interest rate floors Purchaser pays a premium for the rate floor contract, receives cash payment when reference rate falls below strike rate. Interest rate collars Purchase a rate cap and sell or issue a rate floor. Pay a premium for the cap and receive a premium for the floor.

    29. Types of Foreign Exchange Exposure Transaction Exposure Translation Exposure Economic Exposure

    30. Foreign Exchange Markets Spot Market and the Spot Foreign Exchange Rate Forward Market and the Forward Exchange Rate Forward Exchange Rate and Interest Rate Parity

    31. Type of FX Contracts Forwards Futures Currency Swaps Options

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