Slide 2:
1. Identification
• Market risk:
- Price risk
- Interest risk: Use duration (gap), when talking for a bond this is more interest sensitive
when the maturity is longer but must be adjusted if there are intermediate payments
- Currency risk
- Credit risk: Credit rating
Liquidity risks (most important one)
2. step Valuation. Value at risk (VAR):
- Markovits portfolio theory
- Risk of financial instrument is measured by its SD
- Risk of portfolio: variance = sum of all SD / correlation diversification
What is the value?
Maximum loss on a portfolio during a certain period with a certain probability
Example: 1M in KBC
SD = 2%
1-week VAR on portfolio with 97,72% probability
E.g. 100 weeks, in 98 weeks you cannot lose more
Normal distribution: probability range, mean is 95,45% and 2 SD = 2,28
Probability that you are at the range right of the lower boundary : 97,72%
=> 2 x 2% (SD KBC shares) x 1M = 40.000 EUR
If American portfolio: SD of KBC shares / SD of the dollar/euro rate / correlation between
KBC shares and dollar/euro rate
e.g. 1%
Benefit VAR: include different risks and results in EUR or USD
Big problem VAR reporting: if you only keep in mind that for the given probability that
you need to take 2 SD than that is not the right conclusion, you can calculate it in this
way if you have a normal distribution! (if other distribution, you have to calculate this
in another way)
= statistical story (not financial)
3. Financial risk strategy
- Risk tolerance
- Decentralised or centralized structure: e.g. decentralized because of tax
differences
- Cost – profit (using benchmark)
- List of instruments, at least someone of the board that understands the financial
techniques in that area, level of knowledge is not in the details (e.g. transaction
costs, …)
4. Management
Strategic financial risk management: e.g. reducing currency risk: sales are in
USD, but cost plant in EUR => closing plant and setup one in America
Operational financial risk management :
- Internal technique to avoid currency risk
- send invoice in own currency, invoice to US with payment in EUR
- Cash net: Netting: e.g. three countries Swiss, UK, Belgium all countries
with companies of the same group
,Without netting: Belgium receiving € and paying £ and CHF, UK receiving £ and paying
CHF and €, Swiss receives CHF and pays €, £ => international payments are
expensive! And inefficient CRM
With netting: create netting centre, difference between net receiver countries and net payer
countries taking into account the currency rate => calculate the net payment of net
receivement and only does pay/receive this result to/off the netting centre in own
currency decrease the nor of payments! make agreement with one bank (better
terms in this scale) => currency trade risk disappears, and it becomes cheaper
INTRAGROUP
Matching: netting structure where you also include the payments of clients and towards
suppliers
You need the scale to create this, but when you have this you created your own inhouse
bank => Can you buy x dollars but!! bank regulation!! cheaper terms
cash pooling: ask the bank to take all your accounts together and count the
interest on the total sum of the accounts together => optimizing the interest income
- External techniques:
- Traditional techniques:
credit risk credit insurance (credento)
Currency risk: money market hedge
e.g.
T0: 1$ = 1€ and Production cost is 90 EUR
T1: selling price is 110$, if you don’t hedge and 1$ = 2€ profit is +130 EUR but if 1$
= 0.50€ profit is -35 (loss)
If you’d hedge:
Step 1: Calculate PV at T0 of the receivable = 110/1,10 = 100$
Step 2: borrow at T0 PV of receivable (=100$-)
Step 3: at T0 convert $ into EURO at spot rate => 100 € profit = 10€
Step 4: at T1 repayment (110$) to the bank, with the money received from the client
Problem if client is not paying -> e.g. credit insurance
1. Derivatives
For each traditional technique, you’ll have a derivative simpler and cheaper
- credit insurance CDS (credit default swap)
- Money market hedge currency forward
Money market hedge is not used anymore, why should they if they could use a simple
method as currency forward
Financial instrument is a derivative if the value is based on the value of another financial
instrument (of the underlying asset)
Are shares and bonds derivatives?
- shares: underlying asset is the company -> only if the company is making money
If you’re the only shareholder, you have the right on all the value of the company after
debt repayment
VALUATION:
- use: why can you buy and sell derivatives
- trading objective: make profit by taking risk
- Arbitrage: making profit without taking risks = here you don’t believe
in an efficient market “you can’t make profit without taking risks” =>
make money on market inefficiencies
- Hedging: create certainty
- How to understand derivatives
, Lego approach: building block approach, split up all the instruments
- Swaps: combining the other two, combination of forwards and options
=> only two building blocks, stream of forwards
- Futures – Forwards: specific combination of options
- Options
- EVERYTHING IS AN OPTION
Once you know the pricing and basics on reporting on the building blocks => easy to
include these
Pricing: if you understand the instrument = price goes down, if you don’t understand the
instrument = price will be lower
Trend: big companies don’t accept every amount charged by the bank, checking,
controlling, … => check for fair pricing
Slide 4:
IRM = interest risk management
Building blocks in interest risk management
SWAP (H8) = exchange
- Interest payments = Interest rate swap (IRS)
- Very simple IRS = plain vanilla
Buy IRS paying the fixed interest, receiving the floating interest Payers IRS: if you
buy an IRS
Sell IRS pay the floating interest, receive the fixed interest Receivers IRS: if you
sell IRS
Look at what happens with the fixed
Hedging: creating certainty
How to use IRS for hedging? (look at paper: “IRS as hedge instrument”) DEPOSIT
Required: 60.000 €/ year
Expected spot rates = forward rate
PV IRS 4 years, end of each year
Floating: 1y EURIBOR
Fixed: 5%
A: 8% 7% 5% 2%
B: problems in year 3 an 4 (< budget)
C: If you sell IRS = receivers IRS
Receive the fixed and pay the floating (5% - floating interest rates)
Requirement for a good hedge
1. Expect certainty
2. Expost = expected
How to use IRS for hedging? (look at paper: “IRS as hedge instrument”) BORROW
You borrow 1M at 1y EURIBOR + 2% to invest in a project with IRR = 11%
Situation: you pay floating interest you want to pay fixed interest (certainty) buy
IRS
Problem in year 3 and 4
If you want to hedge your interest income => sell IRS
If you want to hedge your interest expense => buy IRS
Q6: What if they don’t offer you a plain vanilla IRS but an IRS in Arrears (sth magic)
Normally with plain vanilla IRS: Fixing: standard practice = in the beginning of the period
you fix the interest rate, and pay it at the end of the period
1. Identification
• Market risk:
- Price risk
- Interest risk: Use duration (gap), when talking for a bond this is more interest sensitive
when the maturity is longer but must be adjusted if there are intermediate payments
- Currency risk
- Credit risk: Credit rating
Liquidity risks (most important one)
2. step Valuation. Value at risk (VAR):
- Markovits portfolio theory
- Risk of financial instrument is measured by its SD
- Risk of portfolio: variance = sum of all SD / correlation diversification
What is the value?
Maximum loss on a portfolio during a certain period with a certain probability
Example: 1M in KBC
SD = 2%
1-week VAR on portfolio with 97,72% probability
E.g. 100 weeks, in 98 weeks you cannot lose more
Normal distribution: probability range, mean is 95,45% and 2 SD = 2,28
Probability that you are at the range right of the lower boundary : 97,72%
=> 2 x 2% (SD KBC shares) x 1M = 40.000 EUR
If American portfolio: SD of KBC shares / SD of the dollar/euro rate / correlation between
KBC shares and dollar/euro rate
e.g. 1%
Benefit VAR: include different risks and results in EUR or USD
Big problem VAR reporting: if you only keep in mind that for the given probability that
you need to take 2 SD than that is not the right conclusion, you can calculate it in this
way if you have a normal distribution! (if other distribution, you have to calculate this
in another way)
= statistical story (not financial)
3. Financial risk strategy
- Risk tolerance
- Decentralised or centralized structure: e.g. decentralized because of tax
differences
- Cost – profit (using benchmark)
- List of instruments, at least someone of the board that understands the financial
techniques in that area, level of knowledge is not in the details (e.g. transaction
costs, …)
4. Management
Strategic financial risk management: e.g. reducing currency risk: sales are in
USD, but cost plant in EUR => closing plant and setup one in America
Operational financial risk management :
- Internal technique to avoid currency risk
- send invoice in own currency, invoice to US with payment in EUR
- Cash net: Netting: e.g. three countries Swiss, UK, Belgium all countries
with companies of the same group
,Without netting: Belgium receiving € and paying £ and CHF, UK receiving £ and paying
CHF and €, Swiss receives CHF and pays €, £ => international payments are
expensive! And inefficient CRM
With netting: create netting centre, difference between net receiver countries and net payer
countries taking into account the currency rate => calculate the net payment of net
receivement and only does pay/receive this result to/off the netting centre in own
currency decrease the nor of payments! make agreement with one bank (better
terms in this scale) => currency trade risk disappears, and it becomes cheaper
INTRAGROUP
Matching: netting structure where you also include the payments of clients and towards
suppliers
You need the scale to create this, but when you have this you created your own inhouse
bank => Can you buy x dollars but!! bank regulation!! cheaper terms
cash pooling: ask the bank to take all your accounts together and count the
interest on the total sum of the accounts together => optimizing the interest income
- External techniques:
- Traditional techniques:
credit risk credit insurance (credento)
Currency risk: money market hedge
e.g.
T0: 1$ = 1€ and Production cost is 90 EUR
T1: selling price is 110$, if you don’t hedge and 1$ = 2€ profit is +130 EUR but if 1$
= 0.50€ profit is -35 (loss)
If you’d hedge:
Step 1: Calculate PV at T0 of the receivable = 110/1,10 = 100$
Step 2: borrow at T0 PV of receivable (=100$-)
Step 3: at T0 convert $ into EURO at spot rate => 100 € profit = 10€
Step 4: at T1 repayment (110$) to the bank, with the money received from the client
Problem if client is not paying -> e.g. credit insurance
1. Derivatives
For each traditional technique, you’ll have a derivative simpler and cheaper
- credit insurance CDS (credit default swap)
- Money market hedge currency forward
Money market hedge is not used anymore, why should they if they could use a simple
method as currency forward
Financial instrument is a derivative if the value is based on the value of another financial
instrument (of the underlying asset)
Are shares and bonds derivatives?
- shares: underlying asset is the company -> only if the company is making money
If you’re the only shareholder, you have the right on all the value of the company after
debt repayment
VALUATION:
- use: why can you buy and sell derivatives
- trading objective: make profit by taking risk
- Arbitrage: making profit without taking risks = here you don’t believe
in an efficient market “you can’t make profit without taking risks” =>
make money on market inefficiencies
- Hedging: create certainty
- How to understand derivatives
, Lego approach: building block approach, split up all the instruments
- Swaps: combining the other two, combination of forwards and options
=> only two building blocks, stream of forwards
- Futures – Forwards: specific combination of options
- Options
- EVERYTHING IS AN OPTION
Once you know the pricing and basics on reporting on the building blocks => easy to
include these
Pricing: if you understand the instrument = price goes down, if you don’t understand the
instrument = price will be lower
Trend: big companies don’t accept every amount charged by the bank, checking,
controlling, … => check for fair pricing
Slide 4:
IRM = interest risk management
Building blocks in interest risk management
SWAP (H8) = exchange
- Interest payments = Interest rate swap (IRS)
- Very simple IRS = plain vanilla
Buy IRS paying the fixed interest, receiving the floating interest Payers IRS: if you
buy an IRS
Sell IRS pay the floating interest, receive the fixed interest Receivers IRS: if you
sell IRS
Look at what happens with the fixed
Hedging: creating certainty
How to use IRS for hedging? (look at paper: “IRS as hedge instrument”) DEPOSIT
Required: 60.000 €/ year
Expected spot rates = forward rate
PV IRS 4 years, end of each year
Floating: 1y EURIBOR
Fixed: 5%
A: 8% 7% 5% 2%
B: problems in year 3 an 4 (< budget)
C: If you sell IRS = receivers IRS
Receive the fixed and pay the floating (5% - floating interest rates)
Requirement for a good hedge
1. Expect certainty
2. Expost = expected
How to use IRS for hedging? (look at paper: “IRS as hedge instrument”) BORROW
You borrow 1M at 1y EURIBOR + 2% to invest in a project with IRR = 11%
Situation: you pay floating interest you want to pay fixed interest (certainty) buy
IRS
Problem in year 3 and 4
If you want to hedge your interest income => sell IRS
If you want to hedge your interest expense => buy IRS
Q6: What if they don’t offer you a plain vanilla IRS but an IRS in Arrears (sth magic)
Normally with plain vanilla IRS: Fixing: standard practice = in the beginning of the period
you fix the interest rate, and pay it at the end of the period
