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					  BUFN 722


    ch-10
  Market Risk


BUFN722- Financial Institutions   ch10 - 1
                      Overview


• This chapter discusses the nature of market risk
  and appropriate measures
  Dollar exposure
  RiskMetrics
  Historic or back simulation
  Monte Carlo simulation
  Links between market risk and capital requirements


                  BUFN722- Financial Institutions   ch10 - 2
                Market Risk:

• Market risk is the uncertainty resulting from
  changes in market prices . It can be
  measured over periods as short as one day.
• Usually measured in terms of dollar
  exposure amount or as a relative amount
  against some benchmark.



                BUFN722- Financial Institutions   ch10 - 3
         Market Risk Measurement

• Important in terms of:
  Management information
  Setting limits
  Resource allocation (risk/return tradeoff)
  Performance evaluation
  Regulation




                 BUFN722- Financial Institutions   ch10 - 4
       Calculating Market Risk Exposure

• Generally concerned with estimated
  potential loss under adverse circumstances.
• Three major approaches of measurement
  JPM RiskMetrics (or variance/covariance
   approach)
  Historic or Back Simulation
  Monte Carlo Simulation



                BUFN722- Financial Institutions   ch10 - 5
    JP Morgan RiskMetrics Model

Idea is to determine the daily earnings at risk =
 dollar value of position × price sensitivity ×
 potential adverse move in yield or,
DEAR = Dollar market value of position × Price
 volatility.
Can be stated as (-MD) × adverse daily yield
 move where,
  MD = D/(1+R)
Modified duration = MacAulay duration/(1+R)

               BUFN722- Financial Institutions   ch10 - 6
          Confidence Intervals

If we assume that changes in the yield are
 normally distributed, we can construct
 confidence intervals around the projected
 DEAR. (Other distributions can be
 accommodated but normal is generally
 sufficient).
Assuming normality, 90% of the time the
 disturbance will be within 1.65 standard
 deviations of the mean.

               BUFN722- Financial Institutions   ch10 - 7
       Confidence Intervals: Example

Suppose that we are long in 7-year zero-coupon bonds
 and we define “bad” yield changes such that there is
 only 5% chance of the yield change being exceeded in
 either direction. Assuming normality, 90% of the time
 yield changes will be within 1.65 standard deviations
 of the mean. If the standard deviation is 10 basis
 points, this corresponds to 16.5 basis points. Concern is
 that yields will rise. Probability of yield increases
 greater than 16.5 basis points is 5%.

                   BUFN722- Financial Institutions   ch10 - 8
      Confidence Intervals: Example

• Price volatility = (-MD)  (Potential
  adverse change in yield)
  = (-6.527)  (0.00165) = -1.077%
DEAR = Market value of position  (Price
  volatility)
      = ($1,000,000)  (.01077) = $10,770

Note if MD = -6.527, what is R?
               BUFN722- Financial Institutions   ch10 - 9
      Confidence Intervals: Example

• To calculate the potential loss for more than
  one day:
  Market value at risk (VAR) = DEAR × N
• Example:
     For a five-day period,
     VAR = $10,770 × 5 = $24,082.45



                BUFN722- Financial Institutions   ch10 - 10
      Foreign Exchange & Equities

• In the case of Foreign Exchange, DEAR is
  computed in the same fashion we employed
  for interest rate risk.
• For equities, if the portfolio is well
  diversified then
  DEAR = dollar value of position × stock
  market return volatility where the market
  return volatility is taken as 1.65 sM.

               BUFN722- Financial Institutions   ch10 - 11
         Aggregating DEAR Estimates


• Cannot simply sum up individual DEARs.
• In order to aggregate the DEARs from individual
  exposures we require the correlation matrix.
• Three-asset case:
  DEAR portfolio = [DEARa2 + DEARb2 + DEARc2
  + 2rab × DEARa × DEARb + 2rac × DEARa ×
  DEARc + 2rbc × DEARb × DEARc]1/2

                  BUFN722- Financial Institutions   ch10 - 12
        Historic or Back Simulation

• Advantages:
  Simplicity
  Does not require normal distribution of returns
   (which is a critical assumption for RiskMetrics)
  Does not need correlations or standard
   deviations of individual asset returns.




                 BUFN722- Financial Institutions   ch10 - 13
        Historic or Back Simulation

• Basic idea: Revalue portfolio based on
  actual prices (returns) on the assets that
  existed yesterday, the day before, etc.
  (usually previous 500 days).
• Then calculate 5% worst-case (25th lowest
  value of 500 days) outcomes.
• Only 5% of the outcomes were lower.


                BUFN722- Financial Institutions   ch10 - 14
           Estimation of VAR: Example


• Convert today’s FX positions into dollar
  equivalents at today’s FX rates.
• Measure sensitivity of each position
  Calculate its delta.
• Measure risk
  Actual percentage changes in FX rates for each of past
   500 days.
• Rank days by risk from worst to best.
                     BUFN722- Financial Institutions   ch10 - 15
               Weaknesses

• Disadvantage: 500 observations is not very
  many from statistical standpoint.
• Increasing number of observations by going
  back further in time is not desirable.
• Could weight recent observations more
  heavily and go further back.



               BUFN722- Financial Institutions   ch10 - 16
          Monte Carlo Simulation

• To overcome problem of limited number of
  observations, synthesize additional
  observations.
  Perhaps 10,000 real and synthetic observations.
• Employ historic covariance matrix and
  random number generator to synthesize
  observations.
  Objective is to replicate the distribution of
   observed outcomes with synthetic data.
                 BUFN722- Financial Institutions   ch10 - 17
               Regulatory Models


• BIS (including Federal Reserve) approach:
  Market risk may be calculated using standard BIS
   model.
     • Specific risk charge.
     • General market risk charge.
     • Offsets.
  Subject to regulatory permission, large banks may
   be allowed to use their internal models as the basis
   for determining capital requirements.
                   BUFN722- Financial Institutions   ch10 - 18
                   BIS Model

Specific risk charge:
   • Risk weights × absolute dollar values of long
     and short positions
General market risk charge:
   • reflect modified durations  expected interest
     rate shocks for each maturity
Vertical offsets:
   • Adjust for basis risk
Horizontal offsets within/between time zones

                BUFN722- Financial Institutions   ch10 - 19
         Large Banks: BIS versus RiskMetrics



In calculating DEAR, adverse change in rates defined
 as 99th percentile (rather than 95th under
 RiskMetrics)
Minimum holding period is 10 days (means that
 RiskMetrics’ daily DEAR multiplied by 10.
Capital charge will be higher of:
   • Previous day’s VAR (or DEAR  10)
   • Average Daily VAR over previous 60 days times a
     multiplication factor  3.
                  BUFN722- Financial Institutions   ch10 - 20
                       Overview
• The Corporate Treasurer’s Financial Risk
  Management Problem- Manage Risk – Not
  avoid it
  The Market Value of the Firm and Channels of Risk
• Accounting Measures of Foreign Exchange
  Exposure
  Exposure of the Balance Sheet: Translation
   Exposure
  Exposure of the Income Statement: Transaction
   Exposure
  U.S. Accounting Conventions: Reporting
                  BUFN722- Financial Institutions ch10 - 21
   Accounting Gains and Losses
                   Overview

• Economic Measures of Foreign Exchange
  Exposure
  The Regression Approach
  The Scenario Approach
• Empirical Evidence on Firm Profits, Share
  Prices, and Exchange Rates
• Arguments for Hedging Risks at the
  Corporate Level
               BUFN722- Financial Institutions   ch10 - 22
                      Overview

• Financial Strategies Toward Risk Management
  The Currency Profile and Suitable Financial
   Hedging Instruments
• Policy Issues - International Financial Managers
  Problems in Estimating Economic Exposure
  Picking an Appropriate Hedge Ratio
  The International Investor’s Currency Risk
   Management Problem
  The Value at Risk Approach
                  BUFN722- Financial Institutions   ch10 - 23
                    Overview

• Policy Issues - Public Policymakers
  Disclosure of Financial Exposure
  Financial Derivatives and Corporate Hedging
   Policies




                BUFN722- Financial Institutions   ch10 - 24
          The Corporate Treasurer’s
         Financial Risk Management Problem


• Corporate treasurers are directly responsible
  for managing the firm’s exposure to
  financial risk.
• The risks that remain are held by the
  investor, who can reduce these risks through
  a diversified portfolio of shares, or by
  applying some of the same hedging
  techniques available to the corporate
  treasurer.
                 BUFN722- Financial Institutions   ch10 - 25
• Credit risk        Types of Risk
      • Risk of default or failure of borrower or counterparty;
        unwilling to service loan; e.g., 1998 Russia 90-day
        moratorium on debt pay.
• Market risk
      • Adverse changes in market prices, rates, exchange rates
• Liquidity risk
      • Cash flows not sufficient to meet bank’s financial
        commitments
• Interest rate risk
      • Earnings & returns fluctuate with changes in interest rates
• Operational risk
      • Potential losses due to breakdown in information,
        communication, transaction processing, settlement systems,
        fraud, unauthorized transactions by employees
• Cross-border risk
                       BUFN722- Financial Institutions       ch10 - 26
           Credit Risk Management

•   Screening
•   Monitoring
•   Long-term customer relationships
•   Loan commitments
•   Collateral
•   Compensating balances
•   Credit rationing

                 BUFN722- Financial Institutions   ch10 - 27
              Market Risk Management

The Value at Risk (VAR) Approach
  The VAR approach is a relatively new approach for
   measuring the exposure of financial assets.
  It can be applied to any portfolio of assets (and
   liabilities) whose market values are available on a
   periodic basis and whose price volatilities (s) can
   be estimated.
  Assuming normal price distributions, calculate the
   loss in value of the portfolio if an unlikely (say, 5%
   chance) adverse price movement occurs. The result
   of this calculation is the value at risk.
                   BUFN722- Financial Institutions   ch10 - 28
              Value at Risk (VAR)
• Value at Risk
     • Estimates the largest expected loss to a particular
       investment position for a specified confidence
       level
• Applying Value At Risk
   Deriving The Maximum Dollar Loss
     • VAR = estimated potential loss from its trading
       business that could result from adverse
       movements in market prices.
   Common Adjustments To The Value-At-Risk
   Applications
                   BUFN722- Financial Institutions   ch10 - 29
                                            VAR
VAR is a risk measurement that estimates the largest expected loss to a
  particular investment position for a specified confidence level. This method
  became popular in the late 1990s after some mutual funds & pension funds
  experienced abrupt large losses. VAR is intended to warn investors about
  potential maximum loss that could occur. If investors are uncomfortable
  with the potential loss that could occur in a day or week, they can revise
  their investment portfolio to make it less risky.
VAR focuses on pessimistic portion of probability distribution of returns from
  the investment of concern. E.g., a port. mgr. Uses a 90% confidence level,
  which estimates the max. daily expected loss to an asset in 90% of the
  trading days over an upcoming period. The higher the confidence level
  desired, the larger the maximum expected loss that might occur for a given
  type of investment. E.g., one may expect that the daily loss from holding a
  particular asset won’t be worse than -5% when using a 90% confidence level
  & < -8% if a 99% confidence level.In essence the more confidence
  investors have that the actual loss won’t be > the expected maximum loss,
  the further they move into the left tail of the probability distribution.
VAR is also used to measure risk of a portfolio. Some assets have high risk when assessed
  individually, but low risk when part of a portfolio because the likelihood of a large loss
                                    probabilities of simultaneous losses in all ofch10 - 30
  in the port. Is influenced by theBUFN722- Financial Institutions                 the
  component assets for the period of concern.
• More precisely, VaR measures the worst possible loss that
                 Applying Value at Risk
  a bank could expect to suffer over a given time interval,
  under normal market conditions, at a given confidence
  level. E.g., a bank might calculate that the daily VaR of its
  trading portfolio is $35 million at a 99% confidence
  interval. This means that there is only 1 chance in 100 that
  a loss > $35 million would occur on any given day. Note:
  this is NOT a maximum loss; e.g., if a bank regularly
  measures VaR at the 99% confidence level, the actually
  losses should exceeds its estimate 1% of the time, or 1 day
  out of 100.
• Methods of determining the maximum expected loss
   Use of historical returns
      • Example: count the percentage of days an asset drops a certain
        level
                         BUFN722- Financial Institutions       ch10 - 31
   Use of standard deviation
          Applying Value at Risk

• Deriving the maximum dollar loss
  Apply the maximum percentage loss to the
   value of the investment
• Common adjustments to the value-at-risk
  applications
  Investment horizon desired
  Length of historical period used
  Time-varying risk
  Restructuring the investment portfolio

                BUFN722- Financial Institutions   ch10 - 32
• Easy toWidespread usage of VaR
           understand
1. BIS meeting at Basel in 1995, at which major
   central banks amended the 1988 accord requiring
   financial institutions to hold capital against their
   exposure to market risk; this created an incentive
   for banks to develop sophisticated internal risk
   measurement systems to calculate VaR and thus
   avoid more regulatory requirements. Therefore, in
   1998, large banks with substantial trading
   businesses began using their own internal measures
   of market risk to adjust their capital requirements.
   They use a VAR model, usually with a 99 percent
   confidence interval
2. JP Morgan made its RiskMetrics system available
                    BUFN722- the Institutions
   free from charge overFinancialInternet; this systemch10 - 33
            Regulation of Capital
Testing the validity of a bank’s VAR
   • Uses backtests with actual daily trading gains or
     losses
   • If the VAR is estimated properly, only 1 percent of
     the actual trading days should show results worse
     than the estimated VAR
Related stress tests
   • Bank identifies a possible extreme event to estimate
     potential losses




                 BUFN722- Financial Institutions   ch10 - 34
  Exact computation of VaR depends on
          assumptions about:
• Distribution of price changes, normal or otherwise
• Extent to which today’s change in the price of an
  asset may be correlated to past price changes
• Extent to which the characteristics of mean U and
  standard deviation (volatility) are stable over time
• Relationship between 2 or more different price
  moves
• Data series to which these assumptions apply.

• Financial managers use historical market data on
                   BUFN722- Financial Institutions ch10 - 35
  various financial asses to create their VaR model.
                 JP Morgan’s VaR

• Maximum estimated losses in the market
  value of a given position that may be
  incurred before the position is neutralized or
  reassessed.
• VaRx = Vx x dV/dP x Dpi
   Vx = market value of position x
   dV/dP = sensitivity to price move per $
  market value
  Dpi = adverse price movement over time i;
  e.g, if the time horizon is one day, then VaR
                  BUFN722- Financial Institutions ch10 - 36
  becomes daily earnings at risk
JP Morgan’s assumptions in its measure of
                 VaR
• Prices of financial instruments follow a
  stable random walk; thus, price changes are
  normally distributed
• Price changes are serially uncorrelated;
  there is no correlation between change
  today and changes in the past
• Standard deviation (volatility) of price or
  rate changes is stable over time; i.e., past
  movements may be used to characterize
  future movements.
• Interrelationships between 2 different price
  movements follow a joint normal
                 BUFN722- Financial Institutions ch10 - 37
              Drawbacks of VaR

•   Markets are NOT normal
•   Portfolios are non-linear
•   Volatility is NOT constant
•   Markets move together but no one knows
    how




                BUFN722- Financial Institutions   ch10 - 38
                  Portfolio Stress Testing
• Technique that relies on computer modeling of different
  scenarios and computation of results of those scenarios on a
  bank’s portfolio.
• E.g., Sept 11 bombing of WTC; political assassination
• E.g., Mexican peso devalued by 30%.
        • All assets in portfolio are revalued using new environment,
          creating a new estimate for the return on the portfolio
        • Many such scenarios lead to many such exercise, so that a range
          of values for return on the portfolio is derived
        • By specifying the probability for each scenario, mangers can
          then generate a distribution of portfolio returns, from which
          VaR can be measured
        • The advantage of this method is that it allows risk managers to
          evaluate possible scenarios that may be completely absent from
          historical data.
• Chase management devised an incentive package that reduced
  compensation if risk taking did not lead to appropriate rewards,
                         BUFN722- Financial Institutions      ch10 - 39
  helping it create a more conservative risk portfolio overall.
            Flaws of stress testing
• Subjective- difficult to brainstorm scenarios
  that have never occurred
• Choice of scenarios may be affected by
  bank’s portfolio position, itself – where
  portfolio is invested
• Poor handling of correlations – stress testing
  examines effect of a large movement on one
  financial variable at a time, so it is not well
  suited to large, complex portfolios such as
  those held by international banks.
• Stress testing is supplement to VaR, not a
  replacement BUFN722- Financial Institutions ch10 - 40
     BIS 2000 Study on Stress Testing

•  Financial institutions relied mostly on four
   different techniques in stress testing (technique
   and “stress test result”)
1. Simple sensitivity test
      Change in portfolio value for 1 or more shocks to a single
         risk factor
2. Scenario analysis
      Change in portfolio value if scenario were to occur
         (historical or hypothetical)
3. Maximum loss
      Sum of individual trading units’ worst case scenarios
4. Extreme value theory
                     BUFN722- Financial Institutions          ch10 - 41
      Probability distribution of extreme losses
             Operational Risks

• Most difficult to quantify
• “Rogue trader” losses
• Risk of computer or telephone outage
  disrupting operations systems in critical
  areas
• Best safeguard is internal control.



                BUFN722- Financial Institutions   ch10 - 42
• GAP = RSA – RSLInterest Rate Risk
• Repricing or funding gap
   GAP: the difference between those assets whose interest
    rates will be repriced or changed over some future period
    (RSAs) and liabilities whose interest rates will be repriced or
    changed over some future period (RSLs
• Rate Sensitivity
   the time to reprice an asset or liability
   a measure of an FI’s exposure to interest rate changes in
    each maturity “bucket”
   GAP can be computed for each of an FI’s maturity buckets
• Multiply GAP times change in interest rate reveals effect
  on bank income
• Alternative method: Duration gap analysis examines
  sensitivity of market value of financial institution’s net
                       interest rates; duration measuresch10 - 43
  worth to changes in BUFN722- Financial Institutions
      Calculating GAP for a Maturity Bucket

   DNIIi = (GAP)j Dij = (RSAj - RSLj) Dij

where
 DNIIj = change in net interest income in the ith
            maturity bucket
 GAPj = dollar size of the gap between the book
            value of rate-sensitive assets and rate-
            sensitive liabilities in maturity bucket i
  Dij = change in the level of interest rates
            impacting assets and liabilities in the
            jth maturity bucket
                    BUFN722- Financial Institutions   ch10 - 44
                 Duration Model


Duration gap - a measure of overall interest rate
  risk exposure for an FI


D = - %D in market value of a security
            D i/(1 + i)


                  BUFN722- Financial Institutions   ch10 - 45
   Policy Issues - Public Policymakers


Disclosure of Financial Exposure
  The possibility that individual firms may face
   substantial exposure to exchange rate changes,
   as well as the increased trading in financial
   derivatives in recent years, create a genuine
   concern among investors and regulators
   regarding corporate exposure to financial risks.
  Note that a firm without a financial position
   may still face substantial currency and interest
   rate risk due to its ongoing operations.
                 BUFN722- Financial Institutions   ch10 - 46
   Policy Issues - Public Policymakers


Financial Derivatives and Corporate Hedging
  Policies
  The findings of various studies were consistent
   with the notion that firms used derivatives to
   lower the variability of their cash flows or
   earnings.
  It was also found that the likelihood of using
   derivatives was positively related to foreign
   pretax income, foreign sales, and foreign-
   denominated debt.
                 BUFN722- Financial Institutions   ch10 - 47
         The Market Value of the Firm

 • The market value of a firm at time t (MVt) is
   the summation of the firm’s cash flows
   (CF) over time discounted back to their
   present value by an appropriate discount
                         T
   factor (i):                CFt
                MVt  
                       t 0   it 
                                    t
                             1
• Cash flows in each currency are discounted at
  their own appropriate interest rate and
  multiplied by a spot exchange rate.
                 BUFN722- Financial Institutions   ch10 - 48
       The Market Value of the Firm

• The sensitivity of the market value of the
  firm to a change in an exchange rate
  measures exchange rate exposure.
• For the $/€ exchange rate, the sensitivity
  measure can be expressed as:
                     MV
                     S$ / €


                BUFN722- Financial Institutions   ch10 - 49
                   Channels of Exposure to
                  Foreign Exchange Risk

Direct Economic      Home Currency                      Home Currency
   Exposure           Strengthens                         Weakens

Sales Abroad           Unfavorable                        Favorable
                   Revenue worth less                   Revenue worth
                    in home currency                        more
                         terms
Source Abroad          Favorable                         Unfavorable
                    Inputs cheaper in                    Inputs more
                     home currency                        expensive
                         terms
Profits Abroad        Unfavorable                          Favorable
                    Profits worth less                 Profits worth more
                     BUFN722- Financial Institutions              ch10 - 50
                     Channels of Exposure to
                    Foreign Exchange Risk
Indirect Economic      Home Currency                      Home Currency
    Exposure            Strengthens                         Weakens
Competitor that         Unfavorable                          Favorable
sources abroad          Competitor’s                        Competitor’s
                       margins improve                    margins decrease
Supplier that            Favorable                          Unfavorable
sources abroad       Supplier’s margins                  Supplier’s margins
                         improve                              decrease
Customer that           Unfavorable                          Favorable
sells abroad         Customer’s margins                      Customer’s
                          decrease                        margins improve
Customer that            Favorable                          Unfavorable
sources abroad       Customer’s margins                  Customer’s margins
                          improve                             decrease
                       BUFN722- Financial Institutions             ch10 - 51
    The Market Value of the Firm and Channels of Risk


• Note that virtually any firm could be exposed to
  exchange rate risk through a financial channel.
• In the long run however,
    The firm can make changes in response to an
     unexpected exchange rate change.
    Other economic events that follow the exchange rate
     change may lessen the impact on the firm.
• Nevertheless, the short-run exposure is critical
  since the firm must survive the shock to get to the
  long run.
                    BUFN722- Financial Institutions   ch10 - 52
                    Accounting Measures of
               Foreign Exchange Exposure
•     Net      = exposed – liabilities         exposed
   exposure         assets
• Accounting exposure can be subdivided into
  translation and transaction exposures.
• Translation exposure focuses on the book
  value of assets and liabilities as measured in
  the firm’s balance sheet.
• Transaction exposure focuses on the economic
  value of transactions denominated in foreign
  currency that are planned or forecast to occur
  in the next reporting period.
                   BUFN722- Financial Institutions     ch10 - 53
           U.S. Accounting Conventions
         Reporting Accounting Gains and Losses
• Under Statement 52 of the Financial Accounting
  Standards Board (FASB-52), translation gains and
  losses are accumulated in a translation adjustment
  account.
• FASB-52 focuses on a parent’s net investment in a
  foreign operation to measure the effect of
  exchange rate changes.
• Transaction gains and losses represent realized
  exchanges and are reported in current income.
• Under FASB-133, derivatives that do not qualify
  as hedges of the underlying exposures must be
  marked-to-market, with the resulting gains or
  losses included in either current or deferred
                   BUFN722- Financial Institutions ch10 - 54
  income.
              Economic Measures of
         Foreign Exchange Exposure

• Economic exposure captures the entire
  range of effects on the future cash flows of
  the firm, including the effects of exchange
  rate changes on customers, suppliers, and
  competitors.
• MV/S reflects economic exposure. Two
  approaches for measuring economic
  exposure are the regression approach and
  the scenario approach.
                BUFN722- Financial Institutions   ch10 - 55
          The Regression Approach

• The regression approach directly measures
  the exposure of a firm to exchange rate
  changes by estimating the relationship
  between the firm’s market value at time t
  (MVt)and the spot rate (St) using the
  equation:
                MVt = a + b St + et
• The coefficient b measures the sensitivity of
  the market value of the firm to the exchange
                BUFN722- Financial Institutions ch10 - 56
  rate.
               The Regression Approach
• To interpret the regression analysis, three results need
  to be examined:
    The   magnitude of b.
      • b > 0  an asset exposure in the foreign currency
      • b < 0  a liability exposure
      • b = 0  no exposure to the exchange rate
    The   t-statistic of b.
      • Statistical significance is necessary for confidence in
        the results.
    The   R2 of the regression.
      • R2 measures the percentage of variation in the market
        value explained by the exchange rate.
                           BUFN722- Financial Institutions   ch10 - 57
           The Regression Approach
• To measure the firm’s exposure to multiple exchange
  rates, a multiple regression can be estimated:
      MVt = a + b1 S$/€,t + b2 S$/£,t + b3 S$/¥,t + et
• If the firm has data on cash flows at the level of a
  subsidiary or project, the exposure of these smaller
  units can also be measured:
               CFt = a + b St + et
• Note that exposure tends to be lower in the long run
  due to PPP (which tends to hold better in the longer
  run) and the ability of firms to make adjustments in
  response to exchange rate changes.

                  BUFN722- Financial Institutions   ch10 - 58
          The Scenario Approach

• Given a scenario, we can estimate the firm’s
  cash flows (and its market value)
  conditional on an exchange rate path.
• The scenario approach is well suited to a
  spreadsheet analysis where one is
  encouraged to ask a variety of “what-if”
  questions.


                BUFN722- Financial Institutions   ch10 - 59
                                     The Scenario Approach
Consider the impact of a permanent 5% appreciation of the US$,
               holding all other factors constant.
 Present Value of Cash Flows
                (Millions)




                                                                                 A*
                                        The slope measures the
                                        exposure of the firm at
                                        the initial exchange rate.

                     $39.577
                     $35.222                                       O

                                 A
                                - 15% - 10%     - 5%             5%     10%     15%
$/A$                           $0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188
A$/$                           A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39
                                             BUFN722- Financial Institutions    ch10 - 60
                                     The Scenario Approach
Suppose the firm can pass along part of the exchange rate change
                   to its Australian customers.
 Present Value of Cash Flows
                (Millions)




                                                                                 A*
                                      The slope of BOB* is flatter
                                      than AOA* since the firm has               B*
                                      less exposure now.

                     $39.577
                     $35.222                                       O
                                 B
                                 A
                                - 15% - 10%     - 5%             5%     10%     15%
 $/A$                          $0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188
 A$/$                          A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39
                                             BUFN722- Financial Institutions    ch10 - 61
              Empirical Evidence on
      Firm Profits, Share Prices, & Exchange Rates

• During the Bretton Woods pegged-rate
  period, the general stock market index
  tended to move up (down) immediately
  after a devaluation (revaluation) of the local
  currency.
• Studies also indicated that exposure
  coefficients vary from firm to firm within
  the same industry and over time, and that
  exchange rate changes can have a
  substantial impact on the overall economy.
                   BUFN722- Financial Institutions   ch10 - 62
                       Arguments for
            Hedging Risks at the Corporate Level
• Shareholders may not favor hedging since they can select
  well-diversified portfolios to rid themselves of firm-
  specific risks.
• However, in view of transaction costs and taxes, hedging
  that reduces the volatility of cash flows may be favored.
   If the tax credits of a firm which has incurred losses over
    several successive periods cannot be carried forward to
    reduce future tax payments, then another firm with a less
    volatile pattern of earnings will enjoy greater after-tax cash
    flows and a higher market value.
   A firm with more volatile cash flows is also more open to
    the costs of financial distress.
• For the same reasons, banks and bondholders will prefer
  firms with less volatile cash flows (holding average cash
  flows equal) and reward them with greater borrowing - 63
                                                       ch10
  capacities and higher credit ratings.
              Financial Strategies
             Toward Risk Management


• An important step in the process of
  determining the appropriate financial
  hedging instruments for a firm is to analyze
  the nature of the firm’s currency cash flows.

• Note that a hedging strategy may offset
  certain risks, while leaving open or
  increasing other risks.

                BUFN722- Financial Institutions   ch10 - 64
                     Financial Strategies
                    Toward Risk Management

    Characteristics of                        Suitable Financial
   Currency Exposure                         Hedging Instruments

Frequency       Single period           Single contract (futures/options)
of cash flows
                Multiple                Sets (“strips”) of contracts/swaps
                periods                 or present value hedge

Currency        Single                  Contracts on one currency
dimension       currency
                Multiple                Contracts on an index (ECU,
                currencies              US$) or synthetic hedge

                         BUFN722- Financial Institutions           ch10 - 65
                    Financial Strategies
                   Toward Risk Management

    Characteristics of                        Suitable Financial
   Currency Exposure                         Hedging Instruments

Certainty     Certain,                  Naïve hedge to match contract
about cash    contractual               size of financial instrument and
flows         cash flows                exposure
              Uncertain,                Option hedge or dynamic futures
              estimated cash            hedge to match probability of
              flows                     cash flows




                         BUFN722- Financial Institutions           ch10 - 66
                  Policy Issues
          International Financial Managers


Problems in Estimating Economic Exposure
  Using market data presumes that financial
   markets are efficient, and that share prices
   respond quickly and appropriately to exchange
   rate changes.
  The approach is unsuitable for newly organized
   or reorganized firms for which there is not a
   large sample of consistent observations.
  For the exposure coefficient to be useful, the
   relationship between exchange rate changes and
   market value must remain stable in the future.
                 BUFN722- Financial Institutions   ch10 - 67
                    Policy Issues
            International Financial Managers

Picking an Appropriate Hedge Ratio
  If the exchange rate is expected to change favorably,
   hedging may not be desirable.
  Complete hedging may be achieved by taking offsetting
   positions (-bi ).
  Otherwise, an intermediate solution may be chosen,
   with hedge positions in between 0 and bi .
  Note that the more direct approach is to restructure the
   firm’s long-term financing, so as to permanently alter
   the firm’s financial exposure.


                   BUFN722- Financial Institutions    ch10 - 68
                  Policy Issues
          International Financial Managers


The International Investor’s Currency Risk
  Management Problem
  A portfolio’s exposure to foreign exchange risk
   can be measured using the regression approach
   in much the same way as the treasurer measures
   the firm’s exposure.
  The investor can hedge foreign exchange risk
   using forward contracts, or retain the risk using
   a risk-return decision criterion.

                 BUFN722- Financial Institutions   ch10 - 69
               Pertinent Websites

For information on the BIS framework, visit:
  Bank for International Settlements www.bis.org
Federal Reserve www.federalreserve.gov
Citigroup www.citigroup.com
J.P.Morgan/Chase www.jpmorganchase.com
Merrill Lynch www.merrilllynch.com
RiskMetrics www.riskmetrics.com

                  BUFN722- Financial Institutions   ch10 - 70

				
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