بلوق مستخدم: Karim Mansour
Relevant to the following CISI qualifications: ICWIM, ICAWM, Derivatives, IISI
DEFINITION
Derivatives markets attract three main types of participants: hedgers, speculators, and arbitrageurs. Hedgers reduce the risk that they face in terms of asset prices by using futures or options markets. Speculators focus on future price movements, for which futures and options contracts provide them with extra leverage. Such investors speculate on potential gains and losses and help to make the market more liquid.
Arbitrageurs, on the other hand, take advantage of price differences in different markets. For example, they use the discrepancy between cash prices and future prices to make a profit.
The derivatives market can be seen as providing a number of economic benefits. Being speculative in nature, it provides the investor with a perception of the market not only in terms of current prices, but also in terms of the future. A further function is hat derivatives markets transfer risks from those who have no appetite for them to those who do. Finally, the underlying cash market enjoys higher trading volumes from more players as a result of risk mitigation.
ADVANTAGES
• The derivatives market is a thoroughly exciting one for certain types of investor. It attracts creative, educated, vibrant, and intelligent investors who make optimal use of the opportunities offered and transfer their enthusiasm to new entrants as well. This perpetuates the entrepreneurial spirit within the economy, and not only creates better and new products but also has a positive effect on the job market.
• Importantly, derivatives markets can be extremely beneficial for both individuals and the overall economy of a country. Entrepreneurial players are energized to create new businesses, products, and concomitant employment opportunities from the profits they make from the derivatives markets. In addition, derivatives markets then also increase savings and long-term investment through the risk-transferring function. In this way, participants in the market can expand the volume of their activity as a result of the wide variety of choices available.
DISADVANTAGES
- The main disadvantage of the derivatives markets arises from the lack of thorough investigation into how to use the risk transfer factor. This can result in difficulty when trying to margin transactions, or to monitor various participants’ activities and tailor one’s own activity accordingly.
- A lack of thorough research and sound investment may lead to investment losses for which the investor is not prepared. The risk transfer factor therefore needs to be applied in a targeted way in order to ensure that the investor does not take unnecessary risks.
- Several risks may be involved for those who are not thoroughly familiar with speculative markets. Even though risks can be transferred, remember that the derivatives market operates on a paradigm of uncertainty. An investor who is not comfortable with uncertainty in investment might be more comfortable taking on a different type of investment structure.
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Tadawul Academy is an Accredited CISI Training Partner that delivers training in English and Arabic. You can learn more at www.tadawul.academy
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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Relevant to the following CISI qualifications: ICWIM, ICAWM, Risk in Financial Services
DEFINITION
Corporate governance is the system by which organizations are directed and controlled. The defects of poor corporate governance have recently been very visible in financial institutions around the world. Since the endorsement of Sarbanes–Oxley, companies have set up audit committees, added financial experts to their boards, improved financial whistle-blowing capacity, and enhanced corporate transparency in financial statements and shareholder disclosures. However, are there any benefits from all of these requirements and best practices, and do they pay any dividends?
For good corporate governance to work, open and honest communication is necessary, with transparent policies and practices, clear lines of authority, and strong internal controls and audit functions, backed by a board that can act with clear independence from management.
A board has to identify with the business and its competition, focus on strategic problems and risk management, and establish high, yet pragmatic, standards of performance. The board directs the plans of the company but does not manage the company. The board must pick first-rate people to run the business while retaining its role to confront, evaluate, and hold managers accountable.
To do this, the board must develop and approve a strategic plan, establish specific and measurable goals, establish risk parameters (which should be reviewed regularly in light of the strategic objectives), encourage and preserve open lines of communication, select competent management, measure managers’ performance, and hold management responsible using compensation and continued employment.
In contrast, management has the responsibility to implement the board’s strategy, risk tolerances, and policies; keep directors fully informed; deal with the day-to-day operations of the business and its staff; and operate the information systems, procedures, and reports that keep the lines of communication open.
The costs of poor corporate governance have been very evident in the present financial crisis. Firms that engage in unscrupulous and risky behavior will generally fail, while those that have enhanced corporate governance will have higher valuations, greater profitability, and better sales. The recent market turmoil suggests that buying shares in firms that score highly in corporate governance may yield positive returns.
ADVANTAGES
• Good corporate governance is part of good risk management. It brings problems and concerns to light, allowing them to be addressed promptly.
• Good corporate governance helps businesses to focus on strategic issues and risk management, and establishes realistic standards of performance.
• Decision-making is improved by thorough analysis under good corporate governance. Management is held accountable, and management compensation is linked to shareholder value.
• The board can select good managers to run the business while maintaining its role to challenge, measure, and hold managers responsible.
DISADVANTAGES
- A board that lacks independence may not be willing to address poor performance by a line of business or even hold the management accountable.
- The dual loyalty that many board members feel to the management and to the institution is normally resolved in favor of the institution.
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Tadawul Academy is an Accredited CISI Training Partner that delivers training in English and Arabic. You can learn more at www.tadawul.academy
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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Other exam articles that you might find useful:
An Overview of Shariah-Compliant Funds
Understanding Key Financial Terms and Statements
Managing the Time Value of Money
Identifying and Managing Exposure to Interest and Exchange Rate Risks
The Structure and Function of the Foreign Exchange Market
Inflation, Interest Rates & Forex
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Relevant to the following CISI qualifications: ICWIM, ICAWM, Securities
DEFINITION
Publicly traded companies are under an obligation to deliver regular trading updates to the market, ensuring that at all times they present a reasonable reflection of their actual trading performance. However, the terms commonly used in trading statements range from the readily understood, such as “sales” to the more complex and obscure such as “EBITA.” While audited accounts are intended to ensure that the company’s interim and full-year trading statements provide a truthful assessment as to how the company has fared during the specified trading period,
investors frequently pay particular attention to the “outlook” or “prospects” section of a company review, on the basis that stock valuations are heavily geared to perceptions of future earnings. Given that many stocks typically trade on multiples of 10 or more of earnings, stocks are, therefore, highly sensitive to the perception of how future earnings could vary from existing market forecasts. How a company’s results compare to the market’s consensus expectations is usually the major driver for the stock’s direction following a trading update. For example, should a company announce record results, the stock is actually likely to decline should even these results fail to match the market’s even more optimistic expectations.
When reporting their performance, companies present four kinds of financial statements:
1 balance sheet—a breakdown of the company’s assets and its liabilities at a fixed date;
2 income statement—details of how much money the company earned and what it spent during the period;
3 cash flow statement—how cash moved in and out of the company during the period;
4 stockholders’ equity statement—a statement summarizing the opening balance, additions to and deductions
from, and the closing balance of the stockholders’ equity account, over a stated period.
While the purpose of each of these statements is relatively easy to understand, some of the terminology contained in company reports can be confusing without some accountancy knowledge. The following paragraphs present a small selection of examples of commonly misunderstood terms used by companies in their trading updates:
• EPS—Earnings per stock. The figure represents the company’s total net income during the period, minus dividends
to be paid to preferred stockholders (i.e. guaranteed dividends), divided by the number of stocks in issue. As the latter can change during the review period, many companies use a weighted average stock count figure for
the review period as a whole.
• EBIT—Earnings before interest and tax. This figure represents the total income from all sources before interest payments and taxes are taken into account.
• Working capital—Trading current assets less trading current liabilities.
• Retained earnings—This figure refers to the total of net earnings—revenues after all expenses, taxes, and interest deductions— that the company has built up.
• Return on capital employed—Also known as ROCE, this is a measure of the returns that a business is achieving from
the capital employed, usually expressed in percentage terms. Typically used as a guide as to how efficiently a company is using the money invested in it, ROCE can be expressed as the ratio of operating profits achieved to the total amount of operating capital invested (i.e. both equity and debt) in the business.
ADVANTAGES
• Understanding financial terms and statements helps investors to make more informed decisions.
• During extended periods of volatility in financial markets, investment news becomes mainstream news, so an understanding of the terms used becomes even more beneficial.
DISADVANTAGES
- Some of the terminology used in finance and investment can be complex.
- Detailed analysis of statements and company-specific financial number crunching requires knowledge and considerable resources, so it is best left to expert analysts. Also important to note is that a company may have trouble sustaining earnings growth if free cash flow is poor, and it may be forced to increase its debt. In the worst-case scenario, insufficient free cash flow could tip a company into a situation of illiquidity.
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Tadawul Academy is an Accredited CISI Training Partner that delivers training in English and Arabic. You can learn more at www.tadawul.academy
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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An Overview of Shariah-Compliant Funds
Relevant to the following CISI qualifications: Islamic Finance Qualification
DEFINITION
Shariah-compliant funds are investment vehicles which are fully compliant with the principles of Islam. The funds are prohibited from making investments in industries categorized as morally deficient, such as those related to gambling or alcohol.
Because Islam does not permit any form of exploitation, any kind of investment in conventional banking is outlawed. With the concept of debt also contrary to the principles of Islam, investment in highly leveraged companies is also not permitted for shariah-compliant funds. The exclusions extend to potential investments in other funds which offer guaranteed returns. Any use of futures and options, either by the fund managers or by companies in which the funds invest, is also likely to attract close scrutiny by the funds’ supervisory shariah boards.
Due to the rapid growth in Islamic finance over recent years, the available range of shariah-compliant funds has expanded as financial services providers seek to tap into the increasing demand for investment products which respect the principles of Islam. The most common forms of shariah-compliant funds are described below.
IJARAH
Ijarah (also transliterated ijara) is a leasing-type fund that acquires assets such as real estate or equipment and then leases them out to another party in return for a regular rental payment. In all cases the fund retains ownership of the asset and must ensure that usage of the asset is at all times in accordance with Islamic principles.
MURABAHAH
Murabahah (or murabaha) is a kind of development fund that acquires assets and then sells them to a client at a predetermined price which reflects the fund’s cost of acquiring the asset plus a profit margin. Sometimes described as “cost-plus” funds, murabahah investment vehicles do not hold long-term ownership of the assets, but instead generate a financial return from the payment obligations taken on by clients for a pre-agreed period.
EQUITY
Equity funds invest directly in companies through the purchase of shares. Given the difficulties involved in scrutinizing every aspect of how a company operates to verify shariah-compliance, this new, more progressive attitude allows investment in companies that operate in permitted industries, with the proviso that a proportion of the returns generated for the fund from any interest-bearing deposits held by the company must be donated to charity.
COMMODITY
Commodity funds invest in physical commodities, although speculative activities such as short selling are not permitted. However, the fund manager may make use of istisna’a contracts, pre-agreeing the price of goods to be manufactured and delivered at a specified future date, with the manufacturer benefiting from advance receipt of the agreed sale price. Commodity fund managers can also use bay al-salam contracts. These can be compared to conventional forward contracts, though the key shariah-compliant differentiator is that the seller’s position is protected because payment is passed to the seller on agreement of the contract rather than on its completion.
However, in return for the effective transfer of contract risk, the buyer is compensated by the fact that the agreed delivery price is set at a discount to the physical spot price.
ADVANTAGES
• Shariah-compliant investment funds provide a means of investing while still honoring the high morals and principles of Islam.
• Shariah-compliant funds promote largescale investment along lines similar to the niche ethical funds available to Western consumers.
DISADVANTAGES
• The funds can be more expensive to develop and administer than mainstream funds due to the need for greater verification of compliance with shariah principles.
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Tadawul Academy is an Accredited CISI Training Partner that delivers training in English and Arabic. You can learn more at www.tadawul.academy
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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Relevant to the following CISI qualifications: ICWIM, ICAWM, Securities, Risk in Financial Services
DEFINITION
The time value of money is based on the premise that most people would choose to receive, say, $10,000 now, rather than the same sum in five years’ time. Why? Firstly, because any rational person knows that the $10,000 will almost certainly buy you less in five years’ time than it will today. Secondly, there is no certainty that you will actually receive the money five years from now. As the proverb says, a bird in the hand is worth two in the bush.
Businesses use time-value-of-money formulae to make rational decisions on future expectations.
Discounting allows us to understand what we would need to invest today if we wanted to receive a certain amount in the future. Compounding helps us to calculate the sum that we will receive in the future if we invest a certain amount today.
Several other equations can be used to calculate loans, mortgages, the future values of annuities, etc. These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payment: a stream of coupon payments similar to an annuity, and a lump-sum return of capital when the bond matures—that is, a future payment. The two formulae can be combined to determine the present value of the bond.
For an annuity that makes one payment per year, there is an annual interest rate. However, the time frame in years must be converted into the number of periods consistent with the compounding frequency of the rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, if a mortgage requires monthly payments, the interest rate has to be divided by twelve.
The rate of return in these calculations can be either the variable solved or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt, or any number of similar concepts. The choice of the suitable rate is vital to the exercise, and the use of an incorrect discount rate will make the results worthless.
For calculations involving annuities, you must decide whether the payments are made at the end of each period (i.e. ordinary annuity) or at the beginning of each period (i.e. annuity due).
Most formulae are available on financial calculators or can be set up on a spreadsheet.
ADVANTAGES
Time-value-of-money formulae are generally easy to understand and are widely used.
• The data used by the formulae are readily available.
• Discounting tells us what we would need to invest today if we wanted to receive a certain amount in the future.
• Compounding helps us to calculate the sum that we will receive in the future if we invest a certain amount today.
DISADVANTAGES
• It can often be difficult to identify the appropriate formula without expert help.
• The data on which the initial investment was made often change over the lifetime of the investment.
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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
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives
DEFINITION
The successful management of a portfolio includes maximizing returns from shifts in exchange and interest rates, which in turn requires an appreciation of the associated exposures. Not knowing the exposure can leave the portfolio open to significant risk.
Exchange rate risk is the risk arising from a change in the price of one currency against another. Companies or institutions that trade internationally are exposed to exchange rate risk if they do not hedge their positions. There are two main risks associated with exposure to exchange rates.
- Transaction risk arises because exchange rates may change unfavorably over time. The best protection is to use forward currency contracts to hedge against such changes.
- Translation risk concerns the accounts, and the level of risk is proportional to the amount of assets held in foreign currencies. Over a period of time, changes in exchange rates will cause the accounts to become inaccurate. To avoid this, assets need to be offset by borrowings in the affected currency.
The significance of the exposure will depend on the portfolio’s weightings and operations. Identifying the level of risk in the above exposures should help with selecting a suitable defense strategy.
Interest rate risk relates to changes in the floating rate. Failure to understand exposure to interest rates can lead to substantial risk. The two main areas of concern here should be borrowings and cash investments. The best way of appreciating exposure to changing interest rates is to stress-test various scenarios. How, for example, would a change in rate from 4% to 6% affect your ability to borrow?
MITIGATING THE RISK
EXCHANGE RATE EXPOSURE
Other than the two strategies mentioned above, good strategies for minimizing exchange rate exposure involve employing one or more of the following products.
- Spot foreign exchange: An obligation to buy/sell a specified quantity of currency at the current market rate to be settled in two business days.
- Structured forwards: Exchange forwards embedded with, generally, more than one currency option. This adaptation allows a more effective hedge and should improve the exchange rate within the client’s perception of the market.
- Currency options: An option to the right to buy/sell a certain amount of currency at a specific exchange rate on or before a specific future date.
INTEREST RATE EXPOSURE
Once identified, the risks can be minimized using the following methods:
- Interest rate swap: A method for changing the interest rate you earn/pay on an agreed amount for a specified time period.
- Cross-currency swap: An exchange of principal and interest payments in separate currencies.
- Forward rate agreement: Two parties fix the interest rate that will apply to a loan or deposit.
- Interest rate caps: The seller and borrower agree to limit the borrower’s floating interest rate to a specified level for a period of time.
- Structured swap: An interest rate/cross-currency swap embedded with one or more derivatives. This allows the client to minimize his exposure on his perception of the market.
ADVANTAGES
The one key advantage to identifying exposure to interest and exchange rate fluctuations is the ability to minimize possible losses in the event that your view of the market is wrong. This approach will also minimize the chance of unexpected events disrupting the investment strategy.
DISADVANTAGES
As with any hedge strategy, minimizing possible losses also reduces potential gains. Only those who are supremely confident in their forecasts and with a cushion to absorb losses should consider taking any extra risk to maximize returns.
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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
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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
Tadawul owns and operates the first bilingual learning portal for CISI in the world: www.TadawulExams.com
Tadawul delivers CISI training in Dubai, Abu Dhabi, Oman Qatar, Kuwait, Bahrain and Saudi Arabia.
Tadawul’s portfolio includes: CISI IISI, CISI ICWIM, CISI ICAWM, CISI IFQ, CISI Securities, CISI Risk, CISI Derivatives, and many more.
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/
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/
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/