Group 3 (WordFinal)

FINANCIAL
MANAGEMENT
Submitted by: Joseph P. Docto

Riea Clanza
Jhanen F. Colbe
CHAPTER 21: RISK MANAGEMENT
Innovations in Risk Management
I. Futures Contract: a contract to buy or sell a stated commodity or financial
claim at a specified price at some specified future time.
 Futures: A Simple Example
Suppose a farmer plans to harvest 10,000 bushels of corn in six months. The
current price is $2.50 per bushel. The farmer sells a futures contract, which will
allow him to sell corn at 2.50 per bushel in six months.
If the price of corn falls to $2.00 per bushel, the farmer loses $5,000 ($0.50
x10.000 bushels) on his corn, but wing $5,000 on his futures contract.
If the price of corn rises to $3 per bushel, the farmer gets $5,000 more for his
corn, but loses $5,000 on the futures contract.
The farmer has effectively locked in a price of $2.50 per bushel and has
hedged his risk.
 Futures Trading Requires:

1. An Organized Exchange – the Chicago Board of Trade is the oldest and
largest futures exchange.
2. Standardized Contracts – for more frequent trades and greater liquidity.
3. A Futures Clearinghouse – stands between all buyers and sellers to
guarantee that all trades are honored.
4. Daily Resettlement of Contracts – An initial margin of 3% to 10% of the
contract’s value is paid up front.
A maintenance margin is required. Any end-of-da) losses must be
replenished by the contract holder.
 Types of Futures Contracts

1. Commodity Futures – agricultural commodities (corn, wheat, orange juice,
etc.) as well as metals, wood products, and fibers.
2. Financial Futures – futures contracts on Treasury bills, notes and bonds,
GNMAs, CDs,Eurodollars, foreign currencies, and stock indices.
Types Financial Futures

1) Interest Rate Futures – used to hedge risks associated with
interest rate fluctuations.
Example: Treasury bond futures may allow a firm to lock in an
interest rate for their bond issue.
2) Foreign Exchange Futures - used to hedge risks associated with
exchange rate fluctuations.
A firm can use a foreign exchange futures contract to lock in an
exchange rate for a future transaction.
3) Stock Index Futures - used to hedge risks associated with equity

market fluctuations.
Investors can buy and sell contracts based on the S&P 500 and
other market indices.
I. Option Contract: gives the owner the right to buy or sell a fixed number of
shares of stock at a specified price over a limited time.
 Types of Option Contracts
 Call Option: gives the owner the right to buy a fixed number of shares of
stock at a specified price over a limited time.
If you buy a call option on IBM stock, and the stock price rises enough,
you can profit on the call option contract.
If the stock price does not rise enough, or falls, your call option contract
expires worthless.
 Put Option: gives the owner the right to sell a fixed number of shares of
stock at a specified price over a limited time.
If you buy a put option on IBM stock, and the stock price falls enough,
you can profit on the put option contract.
If the stock price does not fall enough, or rises, your call option contract
expires worthless.
 Chicago Board Options Exchange
 Established in 1973 to provide exchange-listed option trading.
WHY?
 Standardization of option contracts.
 A regulated central marketplace.
 An options clearinghouse corporation.
 Certificateless trading.
 A liquid secondary market.
 Innovations in Options
 Option contracts can be written on:
 Common stocks
 Stock Indices
 Interest rates
 Foreign currency
 Treasury bond futures
II. Currency Swaps: An exchange of debt obligations in different currencies.

 A Simple Example
An American firm and a British firm agree to pay each other’s debt
obligation.
 This allows long-term exchange rate risk hedging.
Other Innovations
Long-term Equity Anticipation Securities (LEAPS)
These are long-term options, both calls and puts, which may not expire for as long as
three years.
Can be used to hedge against longer term movements in stocks.
CHAPTER 22: INTERNATIONAL BUSINESS FINANCE
I. Exchange Rates are the price of one currency in terms of another.
 Exchange rates affect our economy and each of us because:
1) When the dollar appreciates (strong dollar), the dollar becomes more valuable
relative to other currencies.
 Foreign products become cheaper to us.

 U.S. products become more expensive overseas.
2) When the dollar depreciates (weak dollar), the dollar falls in value relative
to other currencies.
 Foreign products become more expensive for us.

 U.S. products become cheaper overseas.
 What Determines Exchange Rates?

1. Floating Rate Currency System: Since 1973, the world has allowed exchange
rates to change daily in response to market forces.
2. Exchange rates are affected by:
 Foreign investors
 Speculators
 Political conditions here and overseas
 Inflation
 Trade policies (tariffs and quotas) and Supply and Demand for
currencies!
Let’s consider the £ / $ market.
Suppose the British increase demand for U.S. products.
 British importers buy the US. products to sell in England. They buy
dollars with pounds, so they can pay U.S. firms in dollars.
 The demand for dollars increases and forces up the £ / $ exchange rate,
which makes U.S. products more expensive in England.
Another example:
Let’s consider the ¥ / $ market.
Suppose American demand for Japanese cars and stereos

increases rapidly.
 American importers buy the Japanese products to sell in the US.

They buy yen with dollars, so they can pay Japanese firms in yen.
 The supply of dollars increases, and forces down the ¥ / $
exchange rate, which makes Japanese products more expensive in
the US.
Foreign Exchange Markets
Different exchange rates are used for different types of transactions:
1) Spot Exchange Market: deals with currency for immediate delivery.
 The exchange rate used in spot transactions is called the spot

exchange rate.
 If you need 50,000 francs to buy imports, and the spot exchange rate is
.1457, you would pay your bank $72,850.
2) Forward Exchange Market: deals with the future delivery of foreign

currency.
 You can buy or sell currency for future delivery, usually in one, three, or
six months.
 The exchange rate for forward transactions is called the forward
exchange rate.
 Forward exchange contracts allow you to hedge foreign exchange risk!
Forward Market Hedge

Example: You will import wine from France, to be delivered and paid for in six
months.
 You have agreed to a price of 500,000 francs. With the spot exchange rate
of .1457, this comes to $72,850.
 Suppose the dollar weakens over the next six months, and the SIF
exchange rate rises to .20.
 The wine would cost you $100,000. This in an example of foreign
exchange risk!
You decide to hedge your risk with a forward exchange contract!
 The six-months $/F forward exchange rate is .1476. By agreeing to this

forward rate with your bank, you lock in a price of $73,800 for 500,000
francs, six months from now.
 Now it doesn’t matter what happens to the $/F exchange rate over the
next six months.
Money Market Hedge
For the previous problem, another potential solution is the money market
hedge.
1. Borrow $72,850 from your bank.

2. Buy the 500,000 francs now (at the current spot exchange rate of .1457)
for $72,850.
3. Invest the 500,000 francs in interest-bearing French securities.
4. Complete your transaction after six months.
[Borrowing and investment rates determine the cost of the hedge.]
Forward-Spot Differential
 If the forward rate > the spot rate, the forward is trading at a premium.
 If the forward rate < the spot rate, the forward is trading at a discount.
For our example,
II. Interest Rate Parity Theory

Links the forward exchange market with the spot exchange market. The idea:
 The annual percentage difference between the forward rate and the spot rate
(forward premium or discount) is approximately equal to the difference in
interest rates between the two countries.
 Arbitrage in the forward and spot markets helps to hold this relationship in
place.
III. Purchasing Power Parity

Links changes in exchange rates with differences in inflation rates and the
purchasing power of each nation’s currency.
 In the long run, exchange rates adjust so that the purchasing power of each
currency tends to be the same.
 Exchange rate changes tend to reflect international differences in inflation rates.
 Countries with high inflation tend to experience currency devaluation.
The Law of One Price

In competitive markets where there are no transportation costs or barriers to
trade, the same goods sold in different countries sell for the same price if all the
different prices are expressed in terms of the same currency.
 This proposition underlies the PPP relationship.

 Arbitrage allows the law of one price to hold for commodities that can be
shipped to other countries and resold.
IV. Exposure of Exchange Rate Risk

 Translation exposure - foreign currency assets and liabilities that, for
accounting purposes, are translated into domestic currency using the exchange
rate, are exposed to exchange rate risk.
o However, if markets are efficient, investors know that any translation
losses are “paper” losses and are unrealized.
 Transaction exposure - refers to transactions in which the monetary value is
fixed before the transaction actually takes place.
o Example: your firm buys foreign goods to be received and paid for at a
later date. The exchange rate can change, which can affect the price
actually paid.
V. Multinational Working-Capital Management

Leading and Lagging
 Lead: dispose of a net asset position in a weak currency.
Pay a net liability position in a weak currency.
 Lag: Delay collection of a net asset position in a strong currency.
Delay payment of a net liability position in a weak currency.
VI. Direct Foreign Investment
Risks
 Business Risk - firms must be aware of the business climate in both the U.S. and
the foreign country.
 Financial Risk - not much difference between financial risks of foreign
operations and those of domestic operations.
 Political Risk - firms must be aware that many foreign governments are not as
stable as the U.S.
 Exchange Rate Risk - exchange rate changes can affect sales, costs of goods
sold, etc. as well as the firm’s profit in dollars.

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FINANCIAL

Submitted by: Joseph P. Docto

 Futures Trading Requires:

 Types of Futures Contracts

Types Financial Futures

3) Stock Index Futures - used to hedge risks associated with equity

II. Currency Swaps: An exchange of debt obligations in different currencies.

 Foreign products become cheaper to us.

 Foreign products become more expensive for us.

 What Determines Exchange Rates?

Suppose the British increase demand for U.S. products.

Let’s consider the ¥ / $ market.

Suppose American demand for Japanese cars and stereos

 American importers buy the Japanese products to sell in the US.

1) Spot Exchange Market: deals with currency for immediate delivery.

 The exchange rate used in spot transactions is called the spot

2) Forward Exchange Market: deals with the future delivery of foreign

Forward Market Hedge

You decide to hedge your risk with a forward exchange contract!

 The six-months $/F forward exchange rate is .1476. By agreeing to this

1. Borrow $72,850 from your bank.

For our example,

II. Interest Rate Parity Theory

III. Purchasing Power Parity

The Law of One Price

 This proposition underlies the PPP relationship.

IV. Exposure of Exchange Rate Risk

V. Multinational Working-Capital Management

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