User blog: Karim Mansour

Anyone in the world

Relevant to the following CISI qualifications: Risk in Financial Services

DEFINITION

The concept of “liquidity risk” tends to be very loosely defined. It is used most commonly with reference to the banking and finance industry, but it is an important issue for all companies. Broadly, liquidity risk is the danger that it will be difficult or impossible for an organization to sell an asset in order to provide capital to meet short-term financial demands.

A company needs to remain solvent; the liquidity risk is in the secondary market for its assets, which may not be sellable in time to meet short-term financial commitments, or will be sold at a price considerably below the perceived current market value. The problem may arise as the result of a liquidity gap or mismatch. This means that the dates for inflow and outflow of funds do not match up, creating a shortage.

Systemic liquidity risks arise from external factors. National or international recessions and credit crunches have the largest general impact on liquidity. Capital market disruptions, however, are more common. The collapse of the Russian ruble in 1998, for instance, created a global liquidity crisis, with a capital flight to quality away from the highly speculative Russian stock market.

Generally, liquidity is abundant during times when the economy is booming. During a downturn the impact on companies may increase if they continue with strategies based on the assumption that the high liquidity will continue indefinitely.

CASE STUDIES

A company has outgoings of $8,000,000 a month against income from sales of $10,000,000. It faces a number of threats to its liquidity: for example, the price of the commodity it sells has fallen by 25%, leaving its income at $7,500,000 against $8,000,000 outgoings, and it has to find a way to raise the additional $500,000.

Some major customers have axed or cut their orders, leaving the company with a surplus of products to sell on the market. It has lost $4,000,000 in “normal” monthly sales and now has to offload products it is forced to sell, below cost, at 50% of the expected price simply to pay its bills ($6,000,000 in expected sales plus $2,000,000 to meet monthly obligations of $8,000,000).

The company chose to secure its position and iron out liquidity problems in the following ways:

  • It held cash to cover some of the shortfall, but it lost the potential income from this capital.
  • It set up a line of credit with its bank to help cover the shortfall.
  • It sold off some assets in order to meet its financial obligations. This is risky as assets that have to be sold in a hurry may not realize their book price.

All this assumes that the company assessed its liquidity risks accurately and market conditions did not change.

STRATEGIES

Threats to a company’s liquidity seldom happen in isolation but are intertwined with other financial risks. If, for example, a company fails to receive a payment, it may be forced to raise cash elsewhere or default on its payments. In this scenario, credit risk and liquidity risk are linked.

The aim of a liquidity management strategy is to minimize the cost of capital, allowing efficient access to capital and money markets at competitive prices during times of “normal” activity. Concurrently, the strategy should provide high levels of liquidity during periods when the financial markets are impaired.

The latter part of the strategy is often described as “life insurance.” At a simple level this can mean organizing lines of credit well in advance of market turmoil, which is the cheapest option. However, the activities of a company and the market it operates in are dynamic. There will be periods when it is cash-rich and others when it is cash-poor. As cash is the ultimate liquid asset, there will be periods when it can “self-insure” and times when it will need to approach an external source for insurance.

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Tadawul Academy is a CISI-Accredited Training Partner delivers training in English and Arabic. You can learn more at www.tadawul.academy

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Anyone in the world

Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives, ICAWM

DEFINITION

Risks arise from the way the value of an investment changes with the level of interest rates. This is most clearly seen in the value of fixed-rate investments such as bonds. If interest rates rise, the opportunity cost from holding the bond falls as it becomes more advantageous to switch to other investments.

Alternatively, a company with a loan at a variable rate of interest may want to adapt its payments to avoid the risk arising from a rise in interest rates. It may also want to aid its financial planning by creating a more even pattern of repayment.

A number of instruments exist to hedge against the risks posed by changing interest rates. For a company that decides to reduce its exposure to rising interest rates associated with variable rate funding there are two main types of derivative.

A cap will ensure that the company does not have to find more than a maximum agreed level of interest. The company will benefit if interest rate levels stay below that level. A cap is paid for up-front. A variation on this instrument is the cap and collar, whereby the company will pay the seller of the product if interest rates fall below an agreed level.

Swaps allow the company to exchange variable-rate payments for a guaranteed fixed rate. Swaps do not generally require any advance payment to the seller.

There are a huge variety of swap instruments, reflecting the international nature of the debt market. For instance, although there would be no advantage in swapping a fixed rate for another fixed rate within the same currency, as the outcome would be known, it may be desirable to swap fixed rates between two currencies. Every variable of currency, floating and fixed exchange rate can be swapped.

CASE STUDIES

Vanilla Interest Rate Swap

A company enters into a vanilla interest rate swap with a bank to reduce the risk from fluctuations on a $10 million loan it has taken out on a floating rate. The bank agrees to a fixed rate of, for example, 6% over five years, while the floating rates are based on the six-monthly Libor (London Interbank Borrowing Rate) plus 2%. If the Libor is 4% at the start of the agreement, the amount payable is 6% in both cases, although any percentage could be agreed.

If the Libor rises to 6%, the amount payable every six months would be 8% of $10 million divided by two, or $400,000. The company’s agreement with the bank is for a rate of 6%, or a payment of $300,000 in this case. The company will receive the difference of $100,000 from the bank.

The amount of the loan does not change hands and the company may continue to make the variable payments. It will receive cash if interest rates rise, and pay the bank if they fall. The net effect on the company is the same as if it had taken out a fixed-rate loan. Although the obvious route would be for a company to take out a fixed-rate loan, initially this may not be available or it may be too expensive.

Moreover, because the amount of the swap is notional, it is not necessary for the company to match the whole amount of the loan or to ensure that its entire life is covered. There may well be occasions when risk managers expect interest rate rises over the short to medium term. Continuing with a swap arrangement after the rises have peaked could wipe out initial gains.

ADVANTAGES

  • A swap is flexible, allowing a company to adjust its maturity, payment frequency, and principal to suit its ongoing financial arrangements.
  • Interest rates can be managed independently of financing arrangements.
  • There is no requirement for a payment up-front.

DISADVANTAGES

  • The arrangement locks the company into a fixed rate that may not be advantageous.
  • Early termination may incur a cost.
  • There is a slight additional risk of failure from involving an additional financial institution in the swap arrangement.

This article was originally published on Tadawul Academy’s website:

https://www.tadawul.academy/2018/12/03/cisi-exam-prep-hedging-interest-rate-risk/


 
Anyone in the world

Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives, ICAWM

DEFINITION

A company that imports raw materials, exports finished goods, or has overseas assets or subsidiaries is exposed to fluctuations in exchange rates. Adverse movements can wipe out export profits, while positive changes can increase the price of its products in the foreign market. Equally, the company could benefit from windfall profits as a result of exchange rate fluctuations.

A company trading across national borders therefore has a number of choices. It can take a chance with spot rates, buying currency when required. This leaves it totally at the mercy of exchange rates. The risk can be removed if it books a forward exchange contract that fixes the rate for the date on which it will be needed for a transaction. If the rate improves, however, the company will not be able to take advantage of the improvement.

Using a combination of flexible products allows the company to protect itself against adverse movements while still giving it the ability to profit from improvements. A wide variety of instruments are available that allow companies to pursue this strategy.

Which is chosen depends partly on the level of risk and also on the ease of converting the currencies.

 

CASE STUDIES

The Participating Forward

This product is similar to a forward exchange contract in that it limits risk by offering a worst-case exchange rate for a transaction. If, however, there is a favorable move in exchange rates, the company can take advantage—generally with half its currency. There is usually no premium payable for this product.

Example

A company imports Cava wine from Spain to the United Kingdom. It is April, and a supplier has to be paid €4 million in October in time to catch the Christmas market.

The forward rate is 1.2100, and the company wants the certainty of a worst-case rate but doesn’t want to lose out if the rate goes up. The foreign exchange broker offers a rate of 1.1800, with the option to buy half the currency on the spot market two days before completion of the transaction.

Possible Outcomes

Sterling strengthens against the euro and the rate rises to 1.2500. The customer pays £1,694,915 for the first €2,000,000 at the low rate agreed in advance and £1,600,000 for the second €2,000,000 at the spot rate.

The average rate is therefore 1.215, slightly better than the forward rate, but not as good as the spot rate.

Alternatively, the euro strengthens against sterling and the spot rate is 1.1600. The company then pays the rate of 1.1800 for the whole transaction. The advantages of a participating forward are: a guaranteed worst-case rate; total protection against currency falls; a partial benefit from currency gains; and no premium.

The disadvantages are: if the currency weakens the rate will not be as good as a forward exchange contract; and the spot rate will be better if there is a positive move in currency.

 

The Protection Option

With this service a company pays a premium for an option to exchange currency on a fixed forward date at a predetermined rate. If the spot rate on that date is better than the predetermined rate, the company can decide not to exercise its option to sell at the predetermined rate.

Example

A UK company is selling dresses to a customer in the United States. In six months it will receive $4,000,000. The current forward rate for this date is 2.0000. Fearing that sterling is going to strengthen against the dollar, the company opts to buy a protection option at the forward rate.

Possible Outcomes

Sterling does strengthen against the dollar, taking the rate to 2.1500. The company then exercises its right to sell dollars at 2.0000.

The dollar strengthens against sterling. The rate is now 1.85000. The company takes the better rate on the spot market.

The advantages of the protection option are: a guaranteed worst-case rate; total protection against negative currency fluctuations; and the ability to take full advantage of positive currency movements.

The disadvantage is that a premium is payable to the foreign exchange trader.

 

OTHER HEDGING PRODUCTS

There are many other ways for companies to hedge against currency variations using derivatives. Currency markets are extremely volatile, and it makes sense for any organization trading across national borders to protect itself from these fluctuations.


This article was originally published on Tadawul Academy’s website:

https://www.tadawul.academy/2018/11/24/cisi-exam-prep-hedging-foreign-exchange-risk/


 
Anyone in the world

CISI Exam Prep: Hedging Credit Risk – Case Studies and Strategies

Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives, ICAWM

DEFINITION

Credit risk is the uncertainty about the ability of a debtor or the counterparty in an agreement to make a payment. Strategies for managing credit risk use traditional credit analysis techniques to screen counterparties and may also take advantage of hedging via derivatives.

Corporations frequently need to estimate the likelihood of defaults, the exposure, and the severity of loss from a default event. Taking into account these factors and market-based inputs, it is possible to estimate both expected and unexpected losses across a portfolio.

Expected credit losses can be statistically estimated over a period of time. Risk-adjusted credit loss provisions can then be set and factored into pricing as part of the normal cost of doing business. Unexpected losses form the basis for the credit risk capital-allocation process.

INSTRUMENTS

There are three main structures of derivative that enable an organization to manage credit risks more effectively.

With a credit default swap (CDS), a buyer purchases a contract and makes regular payments to a seller of credit protection. In the event of a default, the buyer receives compensation from the seller. This is commonly seen as an insurance policy for the buyer. It can, however, be used speculatively as there is no requirement for the buyer to hold any asset or have any potentially loss-making relationship with the so-called “reference entity.”

Total return swaps are similar to interest rate swaps. One side makes payments based on the total return from an asset. The other makes floating or fixed payments. The notional amount of the underlying asset is the same for both parties.

A credit-linked note (CLN) covers a specific credit risk. Investors receive a higher yield in return for accepting risk relating to a specific event. It provides a hedge for borrowers against an explicit risk. A CLN is created through a trust using very low-risk securities as collateral. Investors are paid a floating or fixed rate throughout the period of the note. At its completion they will either receive par or, if the reference entity has defaulted, the recovery rate value of the note.

CASE STUDY

Although swaps can be used to hedge against any sort of credit risk, they are easiest to explain through a notional case study of an instrument such as a bond. A fund may, for example, hold $8,000,000 of Mega Car Company’s five-year bond, and is concerned about the possibility of default due to market conditions arising from rising oil prices, increased government regulation on emissions, or the macroeconomic climate.

The fund decides to buy a credit default swap in a notional amount of $8,000,000 to cover the potential default value. The CDS in this case trades at 150 basis points, so the fund will pay 1.5% of $8,000,000, or $120,000 annually.

If Mega Car Company does not default, the fund will simply receive the full $8,000,000. In this case, its return will not be as good as it would have been without the CDS. On the other hand, if the corporation does default after, say, two years, the fund will receive its $8,000,000 from the seller of the CDS. It could be that the seller will take the bond or pay the difference between the recovery value and the par value of the bond.

Alternatively, Mega Car Company could make a breakthrough in low-emission technology and dramatically improve its credit profile. In that case the fund might decide to reduce its outgoings by selling the remaining period of the CDS.

ADVANTAGES

  • Derivatives such as a CDS will reduce or entirely remove the risk of default.

DISADVANTAGES

  • The cost of hedging will reduce the return on investment.


This article was originally published on Tadawul Academy’s website:

https://www.tadawul.academy/2018/11/18/cisi-exam-prep-hedging-credit-risk-case/


[ Modified: Sunday, 18 November 2018, 10:45 AM ]
 
Anyone in the world

Share Capitalisation Issues: Ex-scrip price and effects on the Balance Sheet

A case study on Emirates NBD

Capitalisation issues, otherwise known as bonus issues or scrip issues, are shares issued by the company to existing shareholders free of charge.

Although mostly intended to reward shareholders, bonus issues are an effective way for a company to lower its share price in the market without the need for a stock split. Lower share prices mean more liquidity, as high prices can turn small investors away.

Bonus issues are covered in most CISI qualifications in varying depth. Level 2 qualifications introduce to students the concept of bonus issues, while Level 3 & 4 qualifications require further analysis, such as the calculation of ex-bonus price (price after bonus issue) and the effect on a company’s balance sheet (sometimes referred to as the Statement of Financial Position).

In this quick lecture, we shall use Emirates NBD as a case study.

In April 2009, Emirates NBD announced the distribution of 10% (1:10) bonus shares to existing shareholders. It was decided that April 2nd will be the ex-bonus date.

The two most popular questions you’ll get asked in a CISI exam are:

1.      What is the effect of the bonus issue on the market price?

2.      What is the effect of the bonus issue on the balance sheet?


The effect on the market price

Market prices drop after the bonus issue. The drop happens on the ex-bonus date, in the same way the price drops on ex-dividend date when there is a dividend distribution.

Before the bonus issue (cum-bonus), the share was trading at AED 3.2.

Where do we expect the price to be after the bonus issue (ex-bonus)?


               Before the bonus issue:                10 shares @ AED 3.2      =            AED 32

               During the bonus issue:                1 share @ AED 0 (free) =            AED 0

               After the bonus issue:                   11 shares                            =            AED 32

               The price of the share after the bonus issue is expected to be AED 32/11 = 2.9.

               This is referred to as Theoretical Ex-Bonus Price.

Indeed, if you see the price of the share on April 3rd, you’ll notice it dropped to AED 2.9.

Sometimes, CISI might give you the ex-bonus price, and ask you to calculate the cum-bonus (price before the bonus).

Example:

               Ex-bonus price = AED 5

               Bonus issue = 1:10

               Find cum-bonus price

Before the bonus issue:                10 shares @ AED x          =            AED x

               During the bonus issue:                1 share @ AED 0 (free) =             AED 0

               After the bonus issue:                   11 shares @ AED 5          =            AED 55


The total price for 11 shares was AED 55. The price for 10 shares will also be AED 55 because the additional share was free of charge. This means this price of the share before the bonus was AED 55/10 = AED 5.5

The cum-bonus price is AED 5.5

The effect on the Balance Sheet

A bonus issue will bring no cash to the company. This means the “Assets” side of the Balance Sheet will not change. Consequently, in order to keep the Balance Sheet balanced, the “Equity” side shouldn’t change either.

A bonus issue increases the number of shares in the market. This means an increase in capital.

This additional capital is taken from the Equity Reserves. In CISI qualifications, the reserves used are called “Share Premium Reserves”. In the Emirates NBD Balance Sheet, the reserves used were “Other Reserves”.

Before the bonus issue, Emirates NBD had 5,052,523 shares in the market. The 10% bonus issue (505,252 new shares) brought the number of shares up to 5,557,775.

The nominal value of the shares was AED 1.

Here’s how the Balance Sheet looked like before and after the bonus issue:

                               Before Bonus Issue         After Bonus Issue

Capital                         5,052,523                          5,557,775

Reserves                      3,324,385                          2,819,133

TOTAL                         8,376,908                         8,376,908                                                

The Capital account went up by AED 505,252, and the Reserves account went down by AED 505,252.

In the end, the total of both remained the same (8,376,908).

In a bonus issue, the capital increases while reserves decrease. Equity in total remains unchanged. Since assets also remain unchanged, this means the balance sheet remains balanced.


References:

Emirates NBD Corporate Actions:

https://www.dfm.ae/en/issuers/listed-securities/securities/company-profile-page?id=EMIRATESNBD


Emirates NBD Balance Sheet and financial statements:

2009 – Q1 (before the bonus issue):

https://www.emiratesnbd.com/plugins/FinanceManagement/QuaterlyReports/FinancialEng/Q2_FinancialStatements_2009_English.pdf


2009 – Q2 (after the bonus issue):

https://www.emiratesnbd.com/plugins/FinanceManagement/QuaterlyReports/FinancialEng/Q1_FinancialStatements_2009_English.pdf


This article was originally published on Tadawul Academy’s website https://www.tadawul.academy/2018/08/07/solving-cisi-exam-questions-share-bonus-issues/


[ Modified: Tuesday, 13 November 2018, 3:05 PM ]
 
Picture of Karim Mansour
by Karim Mansour - Tuesday, 13 November 2018, 2:47 PM
Anyone in the world

Inflation, Interest Rates & Forex

Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM, ICAWM.

The inter-relationship between inflation, interest rates and foreign exchange rates has always been a popular area in CISI exams – with varying difficulty across different levels.
The recent turmoil in the Turkish Lira provides an excellent case study that would help students understand how the three pillars of monetary policy influence each other.
Before we begin, it is important to seperate the factors that caused the crisis between economical factors (inflation, interest, fx) and non-economical factors (psychological and religious).

 

Economical Factors

Exports and GDP

Since July last year, the Turkish Lira has lost 35% of its value against the US dollar. This was mainly attributed to Trump’s tariffs on aluminium and steel which were imposed as a political retaliation for the imprisonment of an American pastor.

Tariffs on Turkish products will cause American importers to import less from Turkey and source their aluminium and steel from somewhere else. This means lesser exports from Turkey to the USA. If you’ve taken any CISI securities qualification, you’ll know that any adverse changes in exports have a direct effect on a country’s economy (remember: GDP = consumer spending + government spending + investments + exports – imports).

CISI exam point: negative movements in exports = negative effects on GDP = negative effects on currency

Interest rates and Inflation

Turkey’s inflation rates currently stand at an astonishing 15%. For comparison, in the USA, UK and the UAE inflation rates hover around 2%. Turkey has continuously used credit and its budget to stimulate its economy. This meant deficits in its current account and public-sector budget. These deficits were covered through foreign direct investments (FDI) and external borrowing (bond issuance). The yields on Turkish 1-year to 10-year government bonds range between 20% and 25%. Recent growth in income and GDP however was not adequate enough to cover the debt burden.

CISI exam points: Deficit in current account means imports are higher than exports. Governments cover deficits by borrowing – usually through the issuance of bonds.

With inflation at such high levels, investors and creditors expected the Turkish central bank to increase interest rates which are already high at 17.75%. Contrary to expectations, the central bank held interest rates at that level. This raised concern among investors who started to believe that the central bank is not serious about controlling inflation and stabilising the currency. These concerns grew when Erdogan appointed his son-in-law to run the Treasury and Finance Ministry.

CISI exam points: When inflation is high, central banks are expected to interfere and raise interest rates. This will cause borrowing to drop. Consequently, inflation will drop too.

Non-Economical Factors

As a conservative Muslim, Erdogan has continuously expressed his loathing for interest rates. On multiple occasions, he’s been quoted saying:

“If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates.”
“Because my belief is: interest rates are the mother and father of all evil.”

Islam considers charging interest on debts as usury, or “riba”, which is therefore prohibited. Therefore, Erdogan’s description of interest rates is literal and not figurative. Investors believe that Erdogan’s lack of understanding of how interest rates influence currency levels stems from his deep hatred for interest – which is not expected to change any time soon.


This article was originally published on Tadawul Academy’s website https://www.tadawul.academy/2018/08/16/cisi-exam-articles-inflation-interest-rates-forex/

[ Modified: Tuesday, 13 November 2018, 3:05 PM ]
 
Anyone in the world

The Structure and Function of the Foreign Exchange Market

Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM and ICAWM

DEFINITION

The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for another. Prior to 1996 the market was confined to large corporate banks and international corporations. However it has since opened up to include all traders and speculators. Today, the average daily turnover in forex markets is US$1.9 trillion, according to the Bank of International Settlement’s Triennial Survey. The market is growing rapidly as investors gain more information and develop more interest.

In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they bet correctly and collect the profit in the form of an interest rate spread when they return to the original currency. The profit margins are low compared with other fixed-income markets. Large trading volumes can, however result, in very high profits. Most forex trading takes place in London, New York, and Tokyo, with most trading activity in London, which dominates the market at 30% of all transactions. New York’s market share is 16%, and Tokyo’s has fallen to 10% due to the growing prominence of Singapore and Hong Kong. Singapore has become the fourth largest exchange market globally, and Hong Kong is the fifth, having overtaken Switzerland. The various players in the foreign exchange market include bank dealers, 16% of which are international investors and speculators. Banks account for almost two-thirds of forex transactions; of the rest, about 20% is mainly attributable to securities firms that operate in the international debt and equity markets.

One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using cash as opposed to a contract.

In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in advance. The time period ranges from days to years. Currency swaps are a popular type of forward transaction; these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later date. Another type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up and a maturity date arranged. The time schedule is about three months.

In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction depends on the availability of option contracts on an organized exchange. Otherwise, such forex deals may be carried out using an over-the-counter (OTC) contract.

ADVANTAGES

  • The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.
  • As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis part from weekends.
  • An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.
  • It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.
  • In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.

DISADVANTAGES

  • The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.
  • Investors need a lot of capital to make good profits because the profit marginson small-scale trades are very low.


This article was originally published on Tadawul Academy’s website:

https://www.tadawul.academy/2018/11/13/the-structure-and-function-of-the-foreign-exchange-market-cisi-exam-prep/


[ Modified: Tuesday, 13 November 2018, 3:06 PM ]