DERIVATIVES IN FINANCIAL RISK MANAGEMENT QUESTION AND ANSWERS

QUESTION 1
(a) Explain how currently swaps could be used to hedge against the foreign exchange
operating exposure of a firm.

(a) The term swap is widely used to describe a foreign exchange agreement between two
parties to exchange a given amount of one currency for another and, after a period
of time, to give back the original amounts swapped. Care should be taken to clarify
which of the many different swaps is being referred to in a specific case.





A typical currency swap first requires two firms to borrow funds in the markets and
currencies in which they are best known. For example, a Japanese firm would
typically borrow Yen on a regular basis in its home market. If however, the Japanese
firm were exporting to the United States and earning US dollars, it might wish to
construct a matching cash flow hedge, which would allow it to use the US dollars
earned to make regular debt service payments on US dollar debt. It however, the
Japanese firm is not well known in the US financial markets, it may have no ready
access to the US dollar debt.
One way in which it could swap its Yen denominated debt service agreement with
another firm that has US dollar debt service payments. The swaps could have the
Japanese firm paying dollars and receiving Yen.


(b) Shortcomings of the Black-Scholes Option pricing Model:
This model can only be applied to value European options which can only be
exercised at the maturity time. This model cannot value American options which can
be exercised at any time during the option period.
The assumption that no dividends are payable during the option period is not
realistic
The assumption that the volatility of returns is known and will remain constant is
unrealistic.
The assumption that the risk free rate is known and will remain constant is not
realistic.


ANSWER 2
(a) Four techniques a company might use to hedge against the Foreign Exchange
risk are:


Future market hedges;-
Exporter opens up a position on the futures market such that
any profits or losses made on the futures when the position is subsequently closed out
approximately offsets the loss or gain on the invoiced amount arising out of a movement
on exchange rates over the credit period.


Options market hedge;-This guarantees the company a minimum rate of exchange for
its future foreign currency receipt known as the option exercise or strike price. When
the foreign currency is received from the customer, if a better rate of exchange is
available on the spot market then the option is allowed to lapse and the currency is sold

on the spot market. If the spot market provides a less favorable rate of exchange, then
the option is exercised to take advantage of its guaranteed minimum rate of exchange.
Forward market hedge;-The exporter who is due to receive payment in a foreign
currency arranges with a bank to sell that currency at a specific rate of exchange for
delivery on a specific future date which coincides with the expected payment of the
invoice.
Money market hedge;-An exporter would borrow an amount of money in the foreign
currency for the period of the credit granted to the customer such that the principal
sum plus the accumulated interest at the end of the loan term would exactly equal the
amount of foreign currency due from the customer. The amount borrowed is spot and
represents the outcome of the export deal.


QUESTION 3




a) The main driver of option valuation is the volatility of returns of the associated asset.
Support the above statement.
b) Explain how triangular arbitrage ensures that currency values are essentially the
same in different markets around the world at any given moment.

ANSWER 4


a) Usually, the most important factor in the valuation of options is the price volatility
of the underlying security. Notably, the greater the possibility of extreme variables,
the greater the value of the option to the holder. This shows a positive association
between option value and the standard deviation of returns of the underlying
security.
If a stock is not likely to change much in price, an option on it is worth little. It is
the variance or volatility of the stock price that is important.


b)
How triangular arbitrage ensures that currency values are essentially the same
in different markets around the world at any given moment.
If exchange rate quotations between different markets are not consistent with each
other, traders will buy a currency in the market where its price is low and sell it in the
market where the price is high making a profit and helping the market move back
towards equilibrium the market with a lower price will attract higher demand which will
push up the prices hence the equilibrium, the point of same prices will be attained.


c)
(i) Forward contract and money market hedge

FAST FORWARD
Under forward contract hedge two things are needed;-

(i) The forward exchange rate
(ii) The amount to be exchange

ANSWER 6
b) Difference between “open-end funds” and “closed-end funds”.


Open end funds have no predetermined limits. Under open funds model old shares
issued can be bought back or new shares can be issued at any point. The price of
the share is not determined by demand but by an estimate of the current market
value of the fund’s net assets per share.

Closed end fund shares are publicly traded and normally a specific number of shares
are issued at once.
Under the closed end fund, new shares cannot be issued subsequent the initial
public offer and the shares trading can’t be repurchased by the primary issuer.
Nevertheless, if there are investors who would wish to quit or acquire new shares,
they can do so at the secondary market where the prevailing market price is used
for trading purposes.


QUESTION 7
a) Differentiate between ‘futures contracts’ and ‘forward contracts’.
b) Evaluate the wisdom or hedging interest rate risk using an interest rate collar instead
of an option.
c) Explain how “basis risk” arises.

(a) Differences between futures and forwards;-

Futures Forwards
1 Denominated in dollars Denominated in other currencies other
than dollars
2 Futures are traded on an organized
exchange
Forwards are traded on an over the
counter market.
3 Futures have standardised contract
site.
Forwards involve negotiated contract
terms which could take any site.
4 There is need for a third party who
will act as a guarantor.
There is no third party guaranteed for
forwards.
5 Futures are marked to market on a
daily basis.
No cash flows accrue until delivery date.

(b) The wisdom or hedging interest rate risk using an interest rate collar instead
of an option.
An interest rate collar is an investment strategy that uses derivatives to hedge an
investor’s exposure to interest rate variations the investor acquires an interest rate
ceiling for a premium which is offset by selling an interest rate floor. The major
advantage of an interest collar is significant reduction on premium payable. A collar
involves the simultaneous purchase and sell of options for instance when a borrower
buys a collar, he is buying a cap at one at one strike rate but at the same time is
selling a floor at lower rate. Hence, the cost of a collar is the difference between
premium payable on the cap and premium receivable from selling the floor.




 

HINT
If the cost of the cap is offset exactly by the sale value of the floor, then the collar is
known as zero cost collar.

(c) How “basis risk” arises.
Basis risk arises from the fact that the price of a futures contract could be different in

relation to the price of the instrument being hedged.
Basis changes do occur and thus represent potential profit/losses to investors. Basis
risk is the difference between spot and futures.
Basis risk arises when there’s a variation between hedge (futures) relative price and the
cash (spot) price of the hedged instrument.


QUESTION 8
Briefly explain the meaning and importance of the following terms in relation to option
pricing:
(i) Delta
(ii) Theta
(iii) Vega

(i) Delta = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
Change in price of the shares
This measures the gradient of the option value at any point in time or price point. The
delta value is directly proportional to the price of a share i.e. as the share price falls
towards zero, delta should also fall towards zero. The delta calculation is useful in
determination of the amount of the underlying shares that the writer of the option
position should hold in order to hedge the risk of an option position.


(ii) Theta
It is a measure of the rate of decline in the value of an option due to the passage of time.
It is also referred to as the time decay value of an option. Theta is useful in terms of
ascertainment of option prices as maturity approaches.


(iii) Vega
Options Vega is a measure of the impact of changes in the underlying volatility on the
option price. Specifically, the Vega of an option expresses the change in the price of the
option for every 1% change in underlying volatility.


QUESTION 9
a) Define the following types of foreign currency risk exposure:
i) Transaction exposure
ii) Translation exposure
iii) Economic exposure
b) Explain two ways in which a firm can hedge against a currency transaction
exposure

a)
i) Transaction exposure
This relates to the gains or losses to be made when settlement takes place at some future
date of a foreign currency denominated contract that has already been entered into. It
arises due to credit imports and exports denominated in a foreign currency.
ii) Translation exposure

This arises from the need to consolidate worldwide operations according to
predetermined accounting rules. Assets, liabilities, revenues and expenses must be
restated in home currency terms in order to be consolidated into group accounts. The
depreciation of host currency will reduce value of consolidated assets and liabilities.
iii) Economic exposure


This relates to the possibility that the value of the company (the present value of all
future cash flows) will change due to unexpected changes in future exchange rates. The
volatility of exchange rate will affect the magnitude and uncertainty of future cashflows.
b) Hedging a transaction exposure

(i) Invoicing in home currency. A company exporting goods or services may invoice
in its local currency so that payments made by the buyer are fixed and not affected
by exchange rate fluctuations.
Leading and lagging;-Leading refers to an immediate payment or the granting of
(ii)

very short term credit. Lagging refers to the granting of long term credit.
(iii) Multi-lateral netting and matching
(iv) Forward contracts
(v) Money market hedges
(vi) Currency futures
(vii)Currency options
(viii) Currency swaps


QUESTION 10


The financial manager of Town Ltd. is concerned about the volatility of interest rates.
His company needs to borrow Sh. 100 million in six months’ time for a period of two
years. Current interest rates are 15% per year for the type of loan that Town Ltd.
needs. The financial manager does not wish to pay an interest rate higher than this.
He is considering using different alternatives. For the following four alternatives,
briefly explain how each could be useful to the financial manager:


(i) Forward rate agreement.
(ii) Interest rate futures
(iii)Interest rate options.
(iv) Interest rate swaps.

(a)
(i)Forward rate of agreement (FRA)
This is a contract between a bank and a company to lend or borrow a given amount of
money at an agreed future interest rate.
In case of borrowing the Bank will loose if lending rate at the time of borrowing by the
borrower is higher than the agreed interest rate
FRA involve one year borrowing and the borrowing is in batches of UK ƒ500,000

(ii)Interest rate futures
This is a contract to borrow or lend a fixed amount of money at a given rate and
within a specified future period typically 3 months.
Futures are closed out and people can buy or sell the futures e.g. the purchase of a
interest rate futures entitle the buyer to receive interest which the sale of futures
involve obligations to pay interest charges.
Interest rate futures are closed out by reversing earlier e.g if one sold the
contract today, he will buy it at a future date. Initial deposits called margins are
required
The contracts must be in whole.




(iii)Interest rate options
This are also called interest rate Guarantee (IRG) and involve the right to borrow
or lend at a guaranteed interest rate at a fixed future date.
If on exercise date the interest rate guaranteed turns out to be unfavourable, the
borrower/depositor will allow the option to lapse
A cost called premium is paid to buy options.


(iv)Interest rate Swaps
an agreement to exchange interest rate obligations between two parties where one
party has a fixed interest rate bond but anticipate decline in interest rate while
another has floating interest bond but anticipate increase in interest rate. Both
parties would swap the interest obligations to take advantage of anticipated
charges in interest rates. It does not involve actual cash flow of the principal loan
The loan, interest rate and period of loans must be equal.

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