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N.

A- HE22- FRM- 1

INTEREST RATE RISK

How to manage interest rate risks?

1. Balance sheet immunisation


2. Using KLIBOR futures to hedge interest rates risk
a. Lender risk: rising interest rates
b. Borrower risk: declining interest rates (to hedge interest rates risk)

Hedging

 Using futures contract -equity risk FKLI -interest rates risk KLIBOR
 Using option contract - equity risk FKLI -foreign exchange rate risk
 Using credit derivatives -credit risk
 Using swaps -foreign exchange rates risk -credit risk

Futures Contract: an agreement between buyer and seller

Hedging: Protecting interest income/ revenue

As a credit office of a large Malaysia bank you have agreed to provide an important institutional customer
with a fixed rate, 3-month, RM20 million loan 90 days from today. You had price the loan at 12% annual
interest rate. Assuming your cost of funds is the KLIBOR rate and the following quotes are now available.

3-month KLIBOR = 9%
3-month KLIBOR futures = 90.0 (matures in 90 days)

Note that the KLIBOR futures priced at 90.0 is yielding 10%, since your priced the loan at 12%, you have
essentially priced in a 2% profit margin.

How would you protect yourself from a rise in interest rates? Once again, since a rise in interest rates will
hurt by squeezing the profit margin, the appropriate hedge strategy would be short the KLIBOR futures.
Hedge strategy: Short, 20, 3-month KLIBOR futures contracts.

To see if the above hedge strategy would indeed enable you to lock-in the 2% interest spread, let us
assume that interest rates rise 2% over the next 90 days. Would your interest spread be protected?

With interest rate increase by 2%


At maturity,
3-month KLIBOR = 11% (increased by 2%)
3-month KLIBOR futures = 89.0 (convergence implies 11% yield)

Without hedging, with spot rate at 11%, your profit spread would have reduced from 2% to 1% (12%-
11%).

Result of the hedge


Profit from the futures = (90 − 89) × (RM25 × 100) × 20 contracts = RM50,000.
Interest spread (price − cost) = (0.12 − 0.11)
3
Interest earned = [(0.01) × RM20,000,000] × = RM50,000.
12
Total earning = RM50,000 + RM50,000 = RM100,000.
RM100,000
% earning = ( ) × 100 = 0.50% for 3 months
RM20,000,000
Annualised % = 0.50% × 4 = 2%.
N.A- HE22- FRM- 2

Interest Rate Risk Management: 3-month KLIBOR futures: Application


Hedging Interest Rate Risk: Locking-in the cost of borrowing

Example:

Your company has just signed an agreement, with a foreign supplier. The agreement calls for your
company to pay RM10 million in 3 months for goods from the supplier. As you do not have the needed
finds, you have arranged with you banker for a 3-month RM10 million loan. Your banker has agreed to
provide the loan at an interest rate of KLIBOR +2%. You now fear that an increase in interest rates
between now and the loan is taken might increase your cost of funds and thereby erode your profits. Is
there any way by which you could use KLIBOR futures to lock-in the interest rate on your forthcoming
loan?

Assume it is now 25 June. Loan will be taken in September (exactly 90 day from 25 June). The following
quotations are available on 25 June.

 3-month KLIBOR = 7.00%


 September KLIBOR futures = 92.00

Given the above quotes, the target interest cost you would want to ’lock-in’ is the yield (25 June0 on the
KLIBOR futures +the 2% premium, i.e. 10% since the KLIBOR futures is yielding 8%; (8%+2%) =10%.

What should the right strategy be? Should we go long or short the KLIBOR futures contract? One could
arrive at the right hedge strategy by thinking in terms of the directional movement in interest rates that
would hurt you. Clearly, a rise in interest rates would hurt, since you are borrowing. Thus, you need to
create a futures position that will profit if rates rise. We know in earlier section that interest rates and
futures prices are inversely related. This means that a rise in interest rates will cause KLIBOT futures
prices to fall. To profit from falling futures prices, the right strategy is to go short. Since you need to hedge
RM10 million od borrowings, you need 10 contracts.

Hedge strategy: Short, 10 September KLIBOR futures contracts

To see if the hedge strategy does indeed ‘lock-in’ the cost, we examine two interest rate scenarios.

Scenario 1: Interest rates rise over the period by 1.5%

As such, 25 September the quotes would be:

3-month KLIBOR = 8.5% (higher by 1.5%)


September KLIBOR futures = 91.50 (since the futures matures on that day, the implied rate is 8.5%;
same as spot due to convergence.

Result of hedge
Profit from futures = (92.00 − 91.50) × (RM25 × 100) × 10 contracts = RM12,500.00
90
Interest on loan = (8.5% + 2%) × × RM10 million = RM262,500.
360
Net interest cost = RM262,500 − RM12,500 = RM250,000.
Effective interest rate with hedge = RM250,000 for 3 months, which is 2.5% of RM10 million
Annualised interest rate = 2.5% × 4 = 10%

This equals exactly 8% + 2%. (KLIBOR futures was 8% in June). As a result of the hedge, you were able to
borrow at the futures rate in June of 8.00 + 2% instead of 8.5% + 2% which you would have had to pay in
September if you had not hedged. Thus you saved 0.5%.
N.A- HE22- FRM- 3

Note:
1. The saving came from the profit of RM12,500 from futures.
2. The price at maturity of the KLIBOR September futures must be 91.50 because of convergence.
3. In determining profit from futures, we multiply the net of the entry minus exit prices by RM25
since that is the value per tick, which is in turn multiply by 100 since each tick is one basis point
1
which is 100 of 1%.

Scenario 2: Interest rates fall by 1.5%

With the fall in interest rates, the quotes on 25 September would be:
3-month KLIBOR = 5.50% (lower by 1.5%)
September KLIBOR futures = 94.50 (same as spot since it is maturity day for futures;
convergence).

Result of hedge
Profit from futures = (92.00 − 94.50) × (RM25 × 100) × 10 contracts = RM62,500.00
90
Interest on loan = (5.5% + 2%) × × RM10 million = RM187,500.
360
Net interest cost = RM187,500 + RM62,500 = RM250,000.
RM250,000
Effective interest rate with hedge = ( ) × 10 = 2.5% for 3 months
RM10,000,000
Annualised interest rate = 2.5% × 4 = 10%

Once again, the effective interest rate has been locked-in at 8% + 2%. Notice that regardless of whether
interest rates go up or down, you have locked-in the 10% cost of borrowing.
N.A- HE22- FRM- 4

FOREIGN EXCHANGE RATE RISK

Definition of Foreign Exchange Rate Risk:

 We change money between another countries.


 FOREX is price of money internationally, while interest rate is price of money domestically.
 FOREX is also known as de-currency risk.
 Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a
financial risk that exists when a financial transaction is denominated in a currency other than that
of the base currency of the company.
 Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial
statements in a currency other than the reporting currency of the consolidated entity.
 The risk is that there may be an adverse movement in the exchange rate of the denomination
currency in relation to the base currency before the date when the transaction is completed.
 Investors and businesses exporting or importing goods and services or making foreign
investments have an exchange rate risk which can have severe financial consequences; but
steps can be taken to manage (i.e. reduce) the risk.

MALAYSIA (home currency)

RM/USD = 4.19/USD - Direct quotation


USD/RM = 1/4.19/RM Indirect quotation

Slide 1: Currency exchange rates


Exchange rate conventions (Important terminology)
 Nominal vs. Real exchange rates  Currency cross-rates
 Spot vs. Forward exchange rates  Forward rate quotations (discounts and
 Foreign exchange market (Participants premiums) – Calculating forward rates
and purposes & Foreign exchange  Exchange rates regime
products)  Exchange rates, international trade and
 Direct quotation vs. Indirect quotation capital flows
 Appreciating or depreciating  Conclusions and summary

1. INTRODUCTION
The foreign exchange (FX) market is the market for trading currencies against each other.
- The FX market is the world’s largest market.
- The FX market facilitates world trade.
- The FX participants buy and sell currencies needed for trade, but also transact to reduce risk
(hedge) and speculate on currency exchange rates.
 An exchange rate is the price of a country’s currency in terms of another country’s currency.

2. THE FOREIGN EXCHANGE MARKET


 Currencies are referred by their ISO code (e.g. USD, CHF, EUR)
 Exchange rate: The number of units of one currency (the price currency) that one unit of another
(the base currency) will buy.
 Convention for exchange rate:
A/B =Number of units of A that one unit of B will buy.
A =Price currency
B =Base currency
N.A- HE22- FRM- 5

Example: INR/USD =66.9100

 This means that one US dollar will buy 66.91 Indian rupees.
 If this exchange rate falls to 65, the dollar will buy fewer Indian rupees. In other words,
- The US dollar is depreciating relative to the rupee or
- The rupee is appreciating relative to the US dollar.

Important note: There are many different conventions that are used around the world, but this
presentation is using the conventions displayed by the authors in the chapters’ examples.

REAL EXCHANGE RATES


 A real exchange rate is an exchange rate that has been adjusted for the relative purchasing power
of the two currencies’ home countries.
- Quoted exchange rates are nominal exchange rates.
- We calculate a real exchange rate by adjusting the exchange rates for the relative price levels of
the countries in the pair.
 The real exchange rate, using AUD and USD, is the spot rate adjusted for the relative price levels:
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 × 𝑃𝑈𝑆𝐷 𝑃𝑈𝑆𝐷
Real exchange rate𝐴𝑈𝐷/𝑈𝑆𝐷 = = 𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 ×
𝑃𝐴𝑈𝐷 𝑃𝐴𝑈𝐷
Where,
𝑃𝑈𝑆𝐷
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 is the nominal or spot exchange rate and is the relative price level.
𝑃𝐴𝑈𝐷

SPOT AND FORWARD RATES


 A spot exchange rate is an exchange rate for an immediate delivery (that is, exchange) of
currencies.
 A forward exchange rate is an exchange rate for the exchange of currencies at some specified,
future point in time.

THE FX MARKET
Participants and Purposes Types of FX Products
 Companies and individuals transact for the  Currencies for immediate delivery (spot
purpose of the international trade of goods market).
and services.  Forward contracts, which are agreements
 Capital market participants transact for the for a future exchange at a specified exchange
purpose of moving funds into or out of rate.
foreign assets.  FX swaps, which are a combination of a spot
 Hedgers, who have an exposure to exchange contract and a forward contract, used to roll
rate risk, enter into positions to reduce thus forward contract a position in a forward
risk. contract.
 Speculators participate to profit from future  FX options, which are options to enter into
movements in foreign exchange. an FX contract some time in the future at a
specified exchange rate.

FX PARTICIPANTS
BUY SIDE  Retails accounts
 Corporations  Governments
 Real money accounts  Central banks
 Leverage accounts  Sovereign wealth funds
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SELL SIDE
 Large dealing banks
 Others financial institutions

3. CURRENCY EXCHANGE RATE QUOTES


 A direct currency quote uses the domestic Example:
currency as the price currency and the Consider the quote BRL/USD =3.1912
foreign currency as the base currency
 An indirect currency quote uses the - The base currency is the US dollar (USD).
domestic currency as the base currency and - The price currency is the Brazilian real
the foreign currency as the price currency. (BRL).
- BRL/USD is a direct currency quote from
the Brazilian perspective.
- BRL/USD is an indirect currency quote from
the US perspective.
From the Brazilian perspective, we can convert
the BRL/USD into indirect quote of USD/BRL by
1
inverting: 𝑈𝑆𝐷/𝐵𝑅𝐿 = 3.1912 = 0.3134
IN PRACTICE
 There are a number of conventions, which simply refer to a particular exchange rate [see Exhibit
9-6 for a more comprehensive list].
FX Rate Quote Name Price currency
Actual Ratio ( )
Convention Convention Base currency
EUR euro USD/EUR
JPY dollar-yen JPY/USD
GBP sterling USD/GBP

 Dealers will quote a bid (at which the dealer will buy) and an offer price (at which the dealer will
sell). [Note: bid < offer]

APPRECIATING OR DEPRECIATING
Appreciating or depreciating is with respect to the base currency relative to the price currency.
 Appreciation is a gain in value of one currency relative to another currency.
 Depreciation is the loss in value of on currency relative to another currency.
N.A- HE22- FRM- 7

The percentage change is the ratio of the exchange rates minus one:
(A⁄B)
New
% change = −1
A
( ⁄B)
Old

Example: Suppose CZK/USD is 24.20 and increases to 24.40.


 The percentage change is
24.4000
− 1 = 0.8264%
24.2000
 This means that the US dollar (USD), the ‘base’ currency in the quote, has appreciated 0.8264%
against the Czech koruna.
- It takes fewer US dollars to buy each koruna.
 This also means that the Czech koruna (invert the rate and treat CZK as the ‘base currency’)
depreciate by
1⁄
24.40 − 1 = 0.04098 − 1 = −0.822
1⁄ 0.04132
24.20
relative to the US dollar.

CURRENCY CROSS-RATES
Given three currencies, a currency cross-rate is the implied exchange rate of a third country pair
given the exchange rates of two pairs of three currencies that have a common currency.
- If arbitrage is possible, cross-rates will be consistent.

Example 1: Suppose you have the following quotes:


DKK/USD = 6.6630 USD/AUD = 0.7685
What is the DKK/AUD exchange rate?
DKK USD DKK
× = = 6.6630 × 0.7685 = 5.1205
USD AUS AUD

Example 2: Suppose you have the following quotes:


ILS/USD = 3.8105 NOK/USD = 8.2210
What is the ILS/NOK exchange rate?
ILS USD ILS
× = = 3.8105 × 8.2210 = 0.4635
USD NOK NOK

FORWARD RATE QUOTATIONS


 Forward exchange rates are quoted in terms of points (pips: points in percentage).
If forward rate > spot rate, the base currency is trading at a forward premium.
If forward rate < spot rate, the base currency is trading at a forward discount.
 Points are 1: 10,000 (move the decimal place four places).
 Forward quotes can be specified as the number of pips from the spot rate or as percentage of spot
rate.
Example: Using pips
Suppose that the USD/EUR spot rate 1.1200 and that the one-month forward premium is 47 pips.
Therefore, the forward rate is

Forward rate = 1.1200 + 47⁄10,000 = 1.1200 + 0.0047 =1.1247


N.A- HE22- FRM- 8

Example: Using a percentage


Suppose that the spot rate of MXN/USD is 18.1000 and the one-month forward premium as a
percentage of the spot rate is 0.4%. the one-month forward rate is

Forward rate = 18.1000 × 1.0040


=18.1724

FORWARD DISCOUNTS AND PREMIUMS


Consider the relationship between forward and spot rates: Forward exchange rates are quoted in
terms of points (pips: points in percentage).
𝑖𝑓 − 𝑖𝑑
𝐹𝑓/𝑑 − 𝑆𝑓/𝑑 = 𝑆𝑓/𝑑 ( )𝜏
1 + 𝑖𝑑 𝜏
Where
𝐹𝑓/𝑑 = forward rate
𝑆𝑓/𝑑 = spot rate
𝑖𝑑 = domestic interest rate
𝑖𝑓 = foreign interest rate
𝜏 = time (in years)
This means that any premium or discount is a function of the interest rates (domestic, 𝑖𝑑 , and
foreign, 𝑖𝑓 ) and time, 𝜏.

Example:
Suppose that the AUD/USD spot rate is 1.3012 and that the one-month forward rate 1.2985.

Therefore,
 𝐹𝑓/𝑑 = 1.2985,
 𝑆𝑓/𝑑 = 1.3012,
 𝜏 = 30/360
There is a forward discount of 1.2985 − 1.3012 = −0.0027 or 27 pips, so 𝑖𝑓 < 𝑖𝑑 .

CALCULATING FORWARD RATES


𝑖 −𝑖
𝑓 𝑑
Using 𝐹𝑓/𝑑 − 𝑆𝑓/𝑑 = 𝑆𝑓/𝑑 (1+𝑖 𝜏
) 𝜏, we can calculate a forward rate based on 𝑆𝑓/𝑑 , 𝑖𝑓 , 𝑖𝑑 , and 𝜏.
𝑑

Example:
Suppose we have the spot exchange rate of the CAD/USD of 1.2923. If the one-year T-bill interest
rate in the United States is 0.55% and the Canadian one-year Treasury rate is 0.95%, what is the one-
year forward rate?
𝑖𝑓 − 𝑖𝑑 0.0095 − 0.0055
𝐹𝑓/𝑑 = 𝑆𝑓/𝑑 + 𝑆𝑓/𝑑 ( ) 𝜏 = 1.2923 + [1.2923 ( ) 1]
1 + 𝑖𝑑 𝜏 1 + 0.0055 × 1
= 1.2923 + 0.0051 = 1.2974
The estimated forward rate is 1.2974, representing a forward rate premium of 1.2974 –
1.2923=51 pips.
N.A- HE22- FRM- 9

4. EXCHANGR RATE REGIMES


 An exchange rate regime is the policy framework for foreign exchange.
 The ideal currency regime (which does not exist) would consist of the following circumstances:
i. Exchange rate is credible and fixed.
ii. All currencies are fully convertible.
iii. All countries able to undertake independent monetary policy for domestic objectives.

Exchange rate regime choice:

Regime Type Description


No separate legal Fixed Dollarization: Use another nation’s currency as the medium
tender of exchange (USD).
Shared currency Fixed Monetary union: Use a currency of a group of countries as
the medium of exchange.
Currency board system Fixed Use another currency in reserve as the monetary base,
maintaining a fixed parity.
Fixed parity or fixed Fixed Use another currency or basket of currencies in reserve, but
rate system with some discretion (parity bands).
Target zone Fixed Fixed parity (peg) with fixed horizontal intervention bands.
Active and passive Peg Adjust the exchange rate against a single currency, with
crawling pegs adjustments for inflation (passive) or announced in advance
(active).
Fixed parity with Peg Similar to target zone, but bands can be widened.
crawling bands
Managed float Float Allow exchange rate to float but intervene to manage it
toward targets.
Independently floating Float Exchange rate is market determined (supply and demand).
rates

5. EXCHANGE RATES, INTERNATIONAL TRADE, AND CAPITAL FLOWS


 The net effect of imports and exports affects a country’s capital flows:
Trade deficit → Capital account surplus
Trade surplus → Capital account deficit
 Using the national accounts relationship, we see the relationship between trade and
expenditures/savings and taxes/government spending:
X–M = (S – I) + (T – G)

Exports less imports Saving less investment Taxes less government spending

Trade surplus or deficit Fiscal surplus or deficit


N.A- HE22- FRM- 10

 The potential flow of financial capital in or out of a country is mitigated by changes in asset prices
and exchange rates.

EXCHANGE RATES AND TRADE


There are two theories on the exchange rate/trade relationship:
1. Marshall–Lerner theory
 The effectiveness of currency devaluations or depreciation on trade depends on the price
sensitivities (that is, price elasticities) of the goods and services.
 If the goods and services are highly elastic, trade responds to devaluation or depreciation,
improving the trade balance.
 If the demand for exports and imports is price inelastic, trade is less responsive to devaluation
or depreciation.
2. The Absorption Approach
 Devaluation or depreciation of the exchange rate must decrease expenditure relative to income
to improve the trade balance.
 This affects national income through the wealth effect: reduced purchasing power of domestic
currency-denominated assets leads to lower expenditure and increased saving.

6. CONCLUSION AND SUMMARY


 The foreign exchange market is by far the largest financial market in the world. It has important
effects, either directly or indirectly, on the pricing and flows in all other financial markets.
- There is a wide diversity of global FX market participants that have a wide variety of motives
for entering into foreign exchange transactions.
 Individual currencies are usually referred to by standardized three-character codes. These
currency codes can also be used to define exchange rates (the price of one currency in terms of
another). There are a variety of exchange rate quoting conventions.
- A direct currency quote takes the domestic currency as the price currency and the foreign
currency as the base currency.
- An indirect quote uses the domestic currency as the base currency.
- To convert between direct and indirect quotes, invert the quote.
- FX markets use standardized conventions for quoting exchange rate for specific currency
pairs.
 Currencies trade in foreign exchange markets based on nominal exchange rates. An increase in
the exchange rate, quoted in indirect terms, means that the domestic currency is appreciating
versus the foreign currency.
 The real exchange rate measures the relative purchasing power of the currencies. An increase in
the real exchange rate implies a reduction in the relative purchasing power of the domestic
currency.
 Given exchange rates for two currency pairs—A/B and A/C—we can compute the cross-rate
(B/C) between currencies B and C.
 Spot exchange rates are for immediate settlement (typically, T + 2), whereas forward exchange
rates are for settlement at agreed-on future dates.
 Forward rates can be used to manage foreign exchange risk exposures or can be combined with
spot transactions to create FX swaps.
 The spot exchange rate, the forward exchange rate, and the domestic and foreign interest rates
must jointly satisfy an arbitrage relationship that equates the investment return on two
alternative but equivalent investments.
N.A- HE22- FRM- 11

 Forward rates are typically quoted in terms of forward points. The points are added to (or
subtracted from) the spot exchange rate to calculate the forward rate.
 The base currency is said to be trading at a forward premium if the forward rate is higher than
the spot rate (that is, forward points are positive). Conversely, the base currency is said to be
trading at a forward discount if the forward rate is less than the spot rate (that is, forward points
are negative).
 The currency with the higher interest rate will trade at a forward discount.
 Points are proportional to the spot exchange rate and to the interest rate differential and
approximately proportional to the term of the forward contract.
 Empirical studies suggest that forward exchange rates may be unbiased predictors of future spot
rates, but the margin of error on such forecasts is too large for them to be used in practice.
 Virtually every exchange rate is managed to some degree by central banks. The policy framework
that each central bank adopts is called an “exchange rate regime.”
 An ideal currency regime would have three properties:
1. The exchange rate between any two currencies would be credibly fixed;
2. All currencies would be fully convertible; and
3. Each country would be able to undertake fully independent monetary policy in pursuit of
domestic objectives, such as growth and inflation targets.
 The IMF identifies the following types of regimes: dollarization, monetary union, currency board,
fixed parity, target zone, crawling peg, crawling band, managed float, and independent float.
- Most major currencies traded in FX markets are freely floating, albeit subject to occasional
central bank intervention.
 Any factor that affects the trade balance must have an equal and opposite impact on the capital
account, and vice versa.
 The impact of the exchange rate on trade and capital flows can be analyzed from two perspectives.
1. The elasticities approach focuses on the effect of changing the relative price of domestic and
foreign goods. This approach highlights changes in the composition of spending.
2. The absorption approach focuses on the impact of exchange rates on aggregate
expenditure/saving decisions.
 The elasticities approach leads to the Marshall–Lerner condition, which describes combinations
of export and import demand elasticities such that depreciation of the domestic currency will
move the trade balance toward surplus and appreciation will lead toward a trade deficit.
 The idea underlying the Marshall–Lerner condition is that demand for imports and exports must
be sufficiently price sensitive so that an increase in the relative price of imports increases the
difference between export receipts and import expenditures.
- If there is excess capacity in the economy, then currency depreciation can increase
output/income by switching demand toward domestically produced goods and services.
- If the economy is at full employment, then currency depreciation must reduce domestic
expenditure to improve the trade balance.

Slide 2: Currency Swap


How do we use currency swap to manage foreign risk exposure?
N.A- HE22- FRM- 12

CREDIT RISK MANAGEMENT

WHAT IS CREDIT RISK?


1. Possibility of losses associated with decline in the credit quality of borrowers or counterparties.
2. Default due to inability or unwillingness of a customer or counterparty to meet commitments in
relation to lending, trading, settlement and other financial transactions.
3. Loss from reduction in portfolio value (actual or perceived).
4. Possibility that a borrower may not meet their obligation in terms of the loan agreed terms and
conditions.
5. Probability of loss from a credit transaction.

FORMS OF CREDIT RISK


1. Non-repayment of the interest on loan or loan principal.
2. Inability to meet contingent liabilities such as letters of credit, guarantees issued by the bank on
behalf of the client.
3. Default by the counterparties in meeting the obligations in terms of treasury operations.
4. Not meeting settlement in terms of security trading when it is due.
5. Default from the flow of foreign exchange in terms of cross-border obligations.
6. Default due to restrictions imposed on remittances out of the country.

COMPONENTS OF CREDIT RISK


1. Default risk – Risk that a borrower or counterparty is unable to meet its commitment.
2. Portfolio risk – Risk which arises from the composition or concentration of bank’s exposure to
various sectors. Two factors affect credit risk
3. Internal factors – Bank specific.
Managing internal factors
Adopting proactive loan policy.
 Good quality credit analysis.
 Loan monitoring.
 Sound credit culture.

4. External factors – State of economy, size of fiscal deficit etc.

Managing external factors


 Diversified loan portfolio.
 Scientific credit appraisal for assessing financial and commercial viability of loan proposal.
 Norms for single and group borrowers.
 Norms for sectoral deployment of funds.
 Strong monitoring and internal control systems.
 Delegation and accountability.
 Measurement of risk through credit scoring.
 Quantifying risk through estimating loan losses.
 Risk pricing – Prime lending rate which also accounts for risk.
 Risk control through effective Loan Review Mechanism and Portfolio Management.

ASSESSMENT OF CREDIT RISK


1. Credit rating - Income, debt, assets & family status
N.A- HE22- FRM- 13

HOW CREDIT RISK IS MANAGED?

1. How credit default swap works?

What is a 'Credit Default Swap - CDS'


A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed
income products between two or more parties. In a credit default swap, the buyer of the swap makes
payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees
that, in the event that the debt issuer defaults or experiences another credit event, the seller will pay
the buyer the security’s premium as well as all interest payments that would have been paid between
that time and the security’s maturity date.

2. A credit default swap is the most common form of credit derivative and may involve municipal
bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

3. A credit default swap is also often referred to as a credit derivative contract.

Types of credit default swap


a. Regular credit default swap: Payoff = notional amount (1-recovery rate)
b. Binary credit default swaps: Payoff = notional amount

Both provide insurance against a particular company defaulting during a period of time. In a credit default
swaps, the payoff is the notional principal amount multiplied by one minus the recovery rate. In a binary
swap the payoff is the notional principal.

Example:
 Principal = RM300 million
 CDS cash-settled
 Default occurs after four years and two months 2/12 = 0.1667
 Cheapest deliverable bond is 40% of its face value
 List cashflows & timings for the seller of the CDS

Cash flow for the protection Seller/Buyer

Receive/Pay Pay/Receive
0
0.5 300,000,000*0.006*0.5 = RM900,000
1 300,000,000*0.006*0.5 = RM900,000
1.5 300,000,000*0.006*0.5 = RM900,000
2 300,000,000*0.006*0.5 = RM900,000
2.5 300,000,000*0.006*0.5 = RM900,000
3 300,000,000*0.006*0.5 = RM900,000
3.5 300,000,000*0.006*0.5 = RM900,000
4 300,000,000*0.006*0.5 = RM900,000
4.1667 300,000,000*0.006*0.1667 = RM300,000 300,000,000*(1 - 0.4) = 180,000,000.00
N.A- HE22- FRM- 14

CREDIT DEFAULT SWAPS

 A Credit Default Swap (CDS) is a contract in which a buyer pays a payment to a seller to take on the
credit risk of a third party.
 In exchange, the buyer receives the right to a payoff from the seller if the third party goes into default
or on the occurrence of a specific credit event named in the contract (such as bankruptcy or
restructuring).

EXAMPLE:
Say there is a person A who lends Rs. 1000 to person B on Monday. Person B promises to pay him
back on Friday. But there is a possibility that person B may default in paying back person A in the
event of a bankruptcy etc.
• Therefore, person A gets into a contract with a person C to take over the credit risk of this
transaction, in case person B defaults.
• According to the contract, person A pays a onetime premium of Rs. 100 to person C.

SITUATION:
 Situation A: Person B pays back Rs. 1000 to person A. Since person B has not defaulted, the
transaction ends between persons A & B, and also between persons A & C.
 Situation B: Person B defaults in his payment to person A. Now, according to the contract
between persons A & C, It becomes the obligation of person C to pay back Rs. 1000 to person A.

Person B
(borrows money from A)

Person C Person A
(takes on the credit risk of B) (lends money to B & enters into a
contract with C)

 This contract, which:


- Transfers the ‘credit’ risk from one person to another
- Is exercised when one party ‘defaults’ in its payment
- Consists of a ‘swap’ of a buyer and a seller (in our example, person A is a seller to person B
and a buyer to person C)
is called a Credit Default Swap.

~ One party of the CDS contract is called the protection buyer while the other party is called the protection
seller.
~ Protection Buyers are mostly banks and financial institutions, but Protection Sellers could be
anybody with an appetite for risk, such as hedge funds and insurers in the US.
~ In all CDS contracts, a protection buyer transfers his Credit Risk of a third-party transaction to a
protection seller.
So, what is credit risk?
~ Credit risk is the risk involved in all transactions of borrowing and lending. If you lend money, what are
the chances that the borrower will make the repayment?
~ In case the borrower is likely to promptly return the money, then you have a low credit risk, and in case
there is a high probability of default then you have a high credit risk.
~ So, each borrowing and lending has its own element of risk involved.
N.A- HE22- FRM- 15

So,
~ A credit default swap resembles an insurance policy. You pay the premium and the insurance company
undertakes to make good your loss.
~ So, everything depends on the happening of the credit event. If no default occurs then the protection
seller would not make any payment.

A Common Credit Default Swap Transaction

Protection Seller Protection Buyer

Does not usually own Payment only occur if Tends to own underlying
underlying credit credit event occurs credit asset

Selling credit Purchasing credit


protection Credit Default Swap protection
Premium Paid Periodically
Long credit exposure Short credit exposure

Also,
~ Like any other Over The Counter (OTC) derivatives contract, CDS contracts are negotiated directly
between the two parties.
~ But most of these contracts follow the standard terms and conditions of the International Swaps and
Derivatives Association (Isda), which makes them look like a standardized product.
To sum up:
~ A Credit Default Swap (CDS) is a credit derivative contract between two counterparties, whereby the
"buyer" pays periodic payments to the "seller" in exchange for the right to a payoff if there is a default
or credit event in respect of a third party.
~ They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks,
hedge funds and others.
~ Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit
risk, or to speculate on changes in credit spreads.
EXERCISE 1:
What is the credit default swap spread in Problem 24.8 if it is a binary CDS?
If the swap is a binary CDS, the present value of expected payoffs is calculated as follows:

Time (years) Probability of Expected Payoff Discount Factor PV of expected


Default Payoff
0.5 0.0300 0.0300 0.9656 0.0290
1.5 0.0291 0.0291 0.9003 0.0262
2.5 0.0282 0.0282 0.8395 0.0237
3.5 0.0274 0.0274 0.7827 0.0214
4.5 0.0266 0.0266 0.7298 0.0194
0.1197
The credit default swap spread s is given by: 37364 s  00598s  01197
It is 0.0315 or 315 basis points.
N.A- HE22- FRM- 16

EXERCISE 2:
Show that the spread for a new plain vanilla CDS should be 1 – R times the spread for a similar new binary
CDS where R is the recovery rate.

The payoff from a plain vanilla CDS is 1  R times the payoff from a binary CDS with the same principal.
The payoff always occurs at the same time on the two instruments. It follows that the regular payments
on a new plain vanilla CDS must be 1  R times the payments on a new binary CDS. Otherwise there
would be an arbitrage opportunity.

What is Derivatives Market? Value that can be derive from equity, so, that we can have option, futures,
forward and swaps.
Derivatives: Financial instruments whose payoffs derive from other, more primitive financial variables
such as a stock price, a commodity price, an index level, an interest rate, or an exchange rate.
How can derivatives be used?
~ Forwards and futures: to hedge an existing market exposure.
~ Options: to obtain downside protection to an exposure even while retaining upside potential.
~ Swaps: to transform the nature of an exposure.
~ Credit derivative: to obtain insurance against events such as default.
What’s a credit derivative? Derivatives written on the credit risk of an underlying reference entity.
Isolate credit risk from other risks present in an asset. Are off-balance-sheet instruments.
Types of credit derivatives:  Secured loan Credit Default Swap
 Credit Default Swap (CDS)  Credit Default Swap on Asset Backed
 Total Return Swap Securities
 Constant Maturity Credit Default Swap  Credit Default Swaption
(CMCDS)  Recovery lock transaction
 First to Default Credit Default Swap  Credit Spread Option
 Portfolio Credit Default Swap  CDS index products
CDS: definition: A Credit Default Swap (CDS) is a kind of insurance against credit risk.
How does a CDS work?
Bp per annum
Protection buyer Protection seller
(short position) (long position)
Contingent
Buy municipal bond payment
($900)
Credit event

 Municipal bonds (issue) Borrow money


Reference entity  Emerging market bonds (borrow $900)
 Mortgage-backed securities
 Corporate debt
N.A- HE22- FRM- 17

Lessons for ALL Users of Derivatives


 Risk must be quantified, and risk limits defined  Beware of potential liquidity problems when
 Exceeding risk limits not acceptable even when long-term funding requirements are financed
profits result with short-term liabilities
 Do not assume that a trader with a good track  Market transparency is important
record will always be right  Mange incentives
 Be diversified  Never ignore risk management, even when
 Scenario analysis and stress testing is times are good
important  It is important to fully understand the products
 Do not give too much independence to star you trade
traders  Beware of hedgers becoming speculators
 Separate the front middle and back office  It can be dangerous to make the Treasurer’s
 Models can be wrong department a profit center
 Be conservative in recognizing inception profits  Liquidity risk is important
 Do not sell clients inappropriate products
 There are dangers when many are following the
same strategy
N.A- HE22- FRM- 18

RISK MANAGEMENT

Managing Financial Risk Using Options


 What is options contract?
Call: right to buy (long-buy)/(short(sell)
 Types of options contract
 Delta neutrality Buy: right to sell (long-buy)/(short(sell)
 Delta hedging
 Gamma hedging  Call option (buy): Buy right to buy (LC)
 Vega hedging Sell right to buy (SC)
 Theta hedging
 Rho hedging  Put option (sell): Buy right to sell (LP)
Sell right to sell (SP)
A trader’s Gold Portfolio. How should risks be hedged?

Delta
~ Delta of a portfolio is the partial derivative of a portfolio with respect to the price of the
underlying asset (gold in this case)
~ Suppose that a $0.1 increase in the price of gold leads to the gold portfolio decreasing in value by
$100
~ The delta of the portfolio is −1000
~ The portfolio could be hedged against short-term changes in the price of gold by buying 1000
ounces of gold. This is known as making the portfolio delta neutral

Linear VS Nonlinear Products


 When the price of a product is linearly - How does the bank hedge its risk to lock
dependent on the price of an underlying asset in a $60,000 profit?
a ``hedge and forget’’ strategy can be used
 Non-linear products require the hedge to be
rebalanced to preserve delta neutrality
 Example of hedging a Nonlinear Product
- A bank has sold for $300,000 a European
call option on 100,000 shares of a non-
dividend paying stock
- S0 = 49, K = 50, r = 5%, s= 20%,
T= 20 weeks, m= 13%
- The Black-Scholes-Merton value of the
option is $240,000
N.A- HE22- FRM- 19

Delta Hedging
~ Initially the delta of the option is 0.522
~ The delta of the position is -52,200
~ This means that 52,200 shares must purchased to create a delta neutral position
~ But, if a week later delta falls to 0.458, 6,400 shares must be sold to maintain delta neutrality
Tables 7.2 and 7.3 (pages 142 and 143) provide examples of how delta hedging might work for
the option.

Where the costs come from


~ Delta hedging a short option position tends to involve selling after a price decline and buying after
a price increase
~ This is a “sell low, buy high” strategy.
~ The total costs incurred are close to the theoretical price of the option

Gamma
 Gamma () is the rate of change of delta () with respect to the price of the underlying asset
 Gamma is greatest for options that are close to the money
 Gamma measures the delta hedging errors caused by curvature

Interpretation of Gamma
- For a delta neutral portfolio, P t ½ S

Positive Gamma Negative Gamma


Vega
~ Vega () is the rate of change of the value of a derivatives portfolio with respect to volatility
~ Like gamma, vega tends to be greatest for options that are close to the money
N.A- HE22- FRM- 20

Gamma and Vega Limits


 In practice, a traders must keep gamma and vega within limits set by risk management

Managing Delta, Gamma and Vega


~  can be changed by taking a position in the underlying
~ To adjust  it is necessary to take a position in an option or other derivative

Theta
 Theta () of a derivative (or portfolio of derivatives) is the rate of change of the value with
respect to the passage of time
 The theta of a call or put is usually negative. This means that, if time passes with the price of the
underlying asset and its volatility remaining the same, the value of the option declines

Rho: the partial derivative with respect to a parallel shift in all interest rates in a particular country

Hedging in Practice
~ Traders usually ensure that their portfolios are delta-neutral at least once a day
~ Whenever the opportunity arises, they improve gamma and vega
~ As portfolio becomes larger hedging becomes less expensive

Chapter 7: How Traders Manage Their Risks


1. The gamma and vega of a delta-neutral portfolio are 50 per $ per $ and 25 per %, respectively.
Estimate what happens to the value of the portfolio when there is a shock to the market causing the
underlying asset price to decrease by $3 and its volatility to increase by 4%.

With the notation of the text, the increase in the value of the portfolio is

0.5  gamma  (S ) 2  vega  

This is 0.5 × 50 × 32 + 25 × 4 = 325

The result should be an increase in the value of the portfolio of $325.

2. A financial institution has the following portfolio of over-the-counter options on sterling:

Type Position Delta of Option Gamma of Option Vega of Option


Call −1,000 0.50 2.2 1.8
Call −500 0.80 0.6 0.2
Put −2,000 −0.40 1.3 0.7
Call −500 0.70 1.8 1.4

A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.

(a) What position in the traded option and in sterling would make the portfolio both gamma
neutral and delta neutral?

(b) What position in the traded option and in sterling would make the portfolio both vega neutral
and delta neutral?
N.A- HE22- FRM- 21

The delta of the portfolio is −1, 000 × 0.50 − 500 × 0.80 − 2,000 × (−0.40) − 500 × 0.70 = −450
The gamma of the portfolio is −1, 000 × 2.2 − 500 × 0.6 − 2,000 × 1.3 − 500 × 1.8 = −6,000
The vega of the portfolio is −1, 000 × 1.8 − 500 × 0.2 − 2,000 × 0.7 − 500 × 1.4 = −4,000

(a) A long position in 4,000 traded options will give a gamma-neutral portfolio since the long
position has a gamma of 4, 000 × 1.5 = +6,000. The delta of the whole portfolio (including traded
options) is then:

4, 000 × 0.6 − 450 = 1, 950

Hence, in addition to the 4,000 traded options, a short position in £1,950 is necessary so that the
portfolio is both gamma and delta neutral.

(b) A long position in 5,000 traded options will give a vega-neutral portfolio since the long position
has a vega of 5, 000 × 0.8 = +4,000. The delta of the whole portfolio (including traded options) is
then

5, 000 × 0.6 − 450 = 2, 550

Hence, in addition to the 5,000 traded options, a short position in £2,550 is necessary so that the
portfolio is both vega and delta neutral.
N.A- HE22- FRM- 22

RISK MEASUREMENTS- VALUE AT RISK (VaR) AND EXPECTED SHORTFALL (ES)

VaR: It is the loss level: RM1,000,0000 over N=10days days that we are X%=99% certain will not be
exceeded.
How bad can things get bad?
ES: Whereas VaR asks how bad can thing get, expected shortfall asks: "If things do get bad, what is the
expected loss?"

 ADVANTAGES OF VaR
~ It captures an important aspect of risk in a single number
~ It is easy to understand
~ It asks the simple question: “How bad can things get?”

 VaR VS Expected Shortfall


~ VaR is the loss level that will not be exceeded with a specified probability
~ Expected shortfall is the expected loss given that the loss is greater than the VaR level (also called
C-VaR and Tail Loss)
~ Two portfolios with the same VaR can have very different expected shortfalls
~ VaR satisfies the first three conditions but not the fourth one
~ Expected shortfall satisfies all four conditions.

 Distributions with the Same VaR but Different Expected Shortfalls

Chapter 9: Value at Risk


1. Suppose that each of two investments has a 4% chance of a loss of $10 million, a 2% chance of a loss of
$1 million, and a 94% chance of a profit of $1 million. They are independent of each other.

(a) What is the VaR for one of the investments when the confidence level is 95%?
(b) What is the expected shortfall when the confidence level is 95%?
(c) What is the VaR for a portfolio consisting of the two investments when the confidence level is 95%?
(d) What is the expected shortfall for a portfolio consisting of the two investments when the
confidence level is 95%?
(e) Show that, in this example, VaR does not satisfy the subadditivity condition whereas expected
shortfall does.

ANSWER:

(a) A loss of $1 million extends from the 94 percentile point of the loss distribution to the 96 percentile
point. The 95% VaR is therefore $1 million.

(b) The expected shortfall for one of the investments is the expected loss conditional that the loss is in
the 5 percent tail. Given that we are in the tail there is a 20% chance than the loss is $1 million and
an 80% chance that the loss is $10 million. The expected loss is therefore $8.2 million. This is the
expected shortfall.
N.A- HE22- FRM- 23

(c) For a portfolio consisting of the two investments there is a 0.04 × 0.04 = 0.0016 chance that the loss
is $20 million; there is a 2 × 0.04 × 0.02 = 0.0016 chance that the loss is $11 million; there is a 2 ×
0.04 × 0.94 = 0.0752 chance that the loss is $9 million; there is a 0.02 × 0.02 = 0.0004 chance that the
loss is $2 million; there is a 2 × 0.2 × 0.94 = 0.0376 chance that the loss is zero; there is a 0.94 × 0.94
= 0.8836 chance that the profit is $2 million. It follows that the 95% VaR is $9 million.

(d) The expected shortfall for the portfolio consisting of the two investments is the expected loss
conditional that the loss is in the 5% tail. Given that we are in the tail, there is a 0.0016/0.05 = 0.032
chance of a loss of $20 million, a 0.0016/0.05 = 0.032 chance of a loss of $11 million; and a 0.936
chance of a loss of $9 million. The expected loss is therefore $9.416.

(e) VaR does not satisfy the subadditivity condition because 9 > 1 + 1. However, expected shortfall does
because 9.416 < 8.2 + 8.2.

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