Financial Risk Management - Assignment Example

Financial Risk Management by Student’s Name Course code+name Professor’s name University name City, State Date of submission Financial Risk Management Part A Foreign exchange risk - GMFL has high investment in foreign currency. Incase of $ US currency, the company faces risk associated with exchange between $ US and A$. The exchange rate is been influenced by the demand of Australian commodities or demand by central banks around the world. It’s favorable for the company to invest in Hong Kong where the exchange rate between HK$ and US$ is relatively fixed. Credit risk - GMFL may be unable to make payments to its shareholder’s in form of dividends in the long run and also meet the company’s financial obligation. The company is highly geared i.e. the ratio between debt and equity is high. Liquidity risk - GMFL may be unable to buy or sell its assets if it holds on to its gold reserves at the Australian current market price. The company may be unable to meet its short-term obligations considering the amount of funds held in short term bearing securities to meet its liquidity needs is small compared to the amount held in equities and gold. Also the company cannot be able to access short term credit from financial institutions because it is highly geared. The financial institutions e.g. banks are likely to shy off due to the high gearing of the company. Market risk - There is an exchange rate risk due to dealing in foreign currency and fluctuating in interest rates. The Australian dollar is overvalued this means that commodities are very expensive leading to low demand hence commodity prices are likely to fall. When the interest rate is cut the returns generated from short term interest bearing securities will go down. There are speculations regarding the fall of interest rates in Australia where the company is based. This leads to uncertainty in the market. The investments are financed using debt and equity instruments. The debt instruments are fixed and variable amounting to A$164.56m. The equity instruments amount to A$260m which are invested as securities in the stock market of Australia. Part B In order for the company to avoid the risk of plunging into bankruptcy and severe losses I have recommended hedging against the following risks: Foreign exchange risks Credit risks Market risks Foreign exchange risks are associated with adverse currency rate fluctuations. This exchange risk can also affect borrowers and lenders in that borrow rate volatility can translate into severe losses, even bankruptcy for institutions and individuals. Exchange rate hedges are tailored to lower this volatility by creating predictable cash flows. This enables corporate entities, individuals and government to be able to make better budgeting decisions and financial planning. GFML is a multi- national investment company and deals with foreign currency in various denominations. This makes the company susceptible to foreign exchange risk hence the need to hedge against the risk. Market risks are associated with fluctuating interest rates and stock prices which can incur the investor huge losses if hedging is not undertaken prior to entering into a contract. The stock prices are subject to the prevailing forces of demand and supply in the market and are subject to huge fluctuations depending on the market trading price of the stock and the willingness of buyers to invest in the company shares. There is need to hedge against the speculations in the market regarding changes in interest rate in Australia and those expected in the US in the near future. Credit risk – there is need to hedge against credit risk so that the company is not declared bankruptcy in case it’s unable to pay its debts. Part C Foreign exchange risk is hedged by company’s owners who take out loans in foreign denomination and find repayment difficult. Also, the foreign exchanges undergo currency derivatives such as options, futures and forwards and swap contracts. Currency derivative applies the method of locking in set exchange rates for specific periods of time. In exchange for the costs of option premiums, options give opportunities to the holders to make a choice whether to accept or decline foreign exchange at certain rates. Futures on the other hand are binding contracts between parties to exchange currencies at preset rates. Forwards are private agreements between trading partners to figure out exchange rates at a later point in time. Swap contracts are similar to forward contracts with interim payments occurring along the way. I recommend the company to use currency derivative for locking exchange rates for a specific period, this will mitigate against losses in case of fluctuations in foreign currency. Market risks can best be hedged using the interest rate swap whereby an agreement between two parties is reached where one stream of future interest payments is swap for another based on a certain principal amount. Companies will in most cases use interest rate swaps to influence their exposure to fluctuations in interest rates or to in order to obtain a marginally lower interest rate than it would have likely gotten without the swap. Credit risk can be best hedged using debt equity swaps. This involves the company converting debt to equity incase its unable to meet some of its obligations in repayment of such debts. This also assists the company to have a low gearing ratio. Part D Hang Seng Index Options Last Updated: 16/10/2012 17:15 All data delayed at least 15 minutes Type Expiry Strike Sort By Sort Order Contract Bid Ask Last Traded High Low Volume Prev. Day Settlement Price Net Change Prev. Day Open Interest C Dec-15 - 15000 - - - - - 0 5,314 N/A 0 C Dec-15 - 15800 - - - - - 0 4,750 N/A 0 C Dec-15 - 16600 - - - - - 0 4,218 N/A 0 C Dec-15 - 17400 - - - - - 0 3,720 N/A 0 C Dec-15 - 18200 - - - - - 0 3,256 N/A 0 C Dec-15 – 19000 - - - - - 0 2,826 N/A 0 C Dec-15 - 20000 - - - - - 0 2,338 N/A 50 C Dec-15 - 21000 - - - - - 0 1,905 N/A 0 C Dec-15 - 22000 - - - - - 0 1,526 N/A 0 C Dec-15 - 23000 - - - - - 0 1,198 N/A 0 C Dec-15 - 24000 - - - - - 0 921 N/A 0 C Dec-15 - 25000 - - - - - 0 691 N/A 0 C Dec-15 - 26000 - - - - - 0 505 N/A 0 (i) The exposures to be hedged are: Foreign exchange risk credit risk market risk (ii) Beta indicates the responsiveness of a return of a given security to changes in market portfolio returns. Beta of 1.3 means that a 1% change in market portfolio returns will cause a 1.3% change in security returns. The percentage proportion of the exposure to be hedged is as follows: Foreign exchange risk (1.3/3.3) = 39.4% Market risk (1/3.3) = 30.3% Credit risk (1/3.3) = 30.3% (iii). For the case foreign exchange risk, I recommend we use currency derivatives where the exchange rate is fixed in certain period so as to mitigate against foreign exchange losses during fluctuations. We can also enter into call options contract with a financial institution and agree to buy certain type or a given currency at a given fixed price. Also we can enter into a put options contract where we agree to sell a given currency at a given price. In the process of combating market risk, companies will in most cases use interest rate swaps. I recommend our company uses the same as it influences a firm’s exposure to fluctuations in interest rates. In addition, it helps firms obtain a marginally lower interest rate than it would have likely realized without the interest rate swap. An effective derivative that can be applied against credit risk is debt equity swaps. This involves the company converting its debts to equity. This gives its creditors an opportunity to own shares in the company. (iv) Foreign exchange risk – Currency derivatives contracts will be used together with call and put options contracts. Market risk – interest rate swaps Credit risk - debt equity swaps (v). Foreign exchange risk Currency derivative = 3 months Call and put options = 2 months Market risk Interest rate swaps = 2 months (vi) From the research carried out the prices are as follows: Future prices, AUD/USD=1.0181, S&P 500=1426.30, Gold=1735.3×100=173,530 as the contractual price. Options 90 day bank bills 96.90,97.00,97.10,97.20,97.30,97.40,97.50,97.60,97.70,97.80,97.90,98.00,98.10 Options on SPI 200 43.25×100,43.50×100,43.75×100,44.00×100,44.25×100,44.50×100,44.75×100,45.00×100,45.25×100,45.50×100,45.75×100,46.00×100 and 46.25×100. The choice of strike price is based on the need to estimate the price for all contracts within a period of 2 months. Putting into consideration the maturity time will be on 15th December. Hang Seng Index Futures Last Updated: 16/10/2012 17:15 All data delayed at least 15 minutes Contract Month Bid Ask Last Traded High Low Volume Prev. Day Settlement Price Net Change Prev. Day Open Interest Chart Oct-12 21,195 21,197 21,197 21,291 21,091 52,421 21,106 +91 111,588 Intraday Historical Nov-12 21,181 21,198 21,187 21,255 21,093 1,269 21,100 +87 3,656 Intraday Historical Dec-12 21,190 21,238 21,201 21,255 21,095 274 21,109 +92 8,725 Mar-13 21,050 21,190 21,154 21,193 21,078 53 21,069 +85 1,558 References CHRISTOFFERSEN, P. F. (2003). Elements of financial risk management. Amsterdam, Academic Press. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=104 701. EALES, B. A. (1995). Financial risk management. London, McGraw-Hill Book Co. GREUNING, H. V., & BRAJOVIC BRATANOVIC, S. (2000). Analyzing banking risk a framework for assessing corporate governance and financial risk management. Washington, D.C., World Bank. http://site.ebrary.com/id/10290041 REDHEAD, K., & HUGHES, S. (1988). Financial risk management. Aldershot, Hants, England, Gower. SCHÖNBORN, J. (2010). Financial Risk Management. Hamburg, Diplomica Verlag. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=673458. SHARMA, N. K. (2010). Business finance. Jaipur, India, ABD Publishers. http://site.ebrary.com/id/10415706. Read More