Management of Market

Risk
CHAPTER 5
Introduction
There are three ways of managing market risk:
[1] Diversifying: Spreading investments over a number of assets
[2] Insuring: Transfer of risk to a third party by paying a premium
[3] Hedging: Involves the use of an instrument with the object of reducing risk
Portfolio Diversification
A diversified portfolio has volatility that is generally lower than the sum of the
volatilities of the assets in the portfolio
A diversified portfolio comprises of assets whose returns are weakly or
negatively correlated with one another
The portfolio variance depends on the correlation between returns of securities
As n (the number of securities in a portfolio) tends to infinity, the portfolio risk
becomes the average of covariances
The portfolio variance can be driven to zero by increasing n, when covariances
become zero (i.e., when all risk is firm specific)
Portfolio Diversification
Consider a stock portfolio consisting of two stocks with normally distributed
returns.
Stock A has a market value of ₹100,000 with an annualized volatility of 22%.
Stock B has a market value of ₹200,000 with an annualized volatility of 25%.
The correlation coefficient between the return of two stocks is 0.3.
What is the effect of diversification?
Volatility of Stock A = ₹22,000. Volatility of Stock B = ₹50,000
Volatility of Portfolio = ₹60,366
Effect of diversification = ₹11,634
Insurance-Type Contracts
The party exposed to the risk pays a premium to eliminate the risk of loss
In insurance, the insured retains the potential for gains…
Unlike hedging where the potential for gain is given up
Examples:
◦ Options
◦ Caps
◦ Floors
Options
Drawing parallels with an insurance
◦ Premium
◦ Insurance against losses
Example: ABC Inc. of US sells electronic equipment to customers in Canada
It expects to receive CAD 1 million in 6 months
The current exchange rate is 1CAD=0.74USD
Expecting CAD to weaken over the next 6 months, ABC buys a 6-month put
option [at a strike price of USD0.74]
If after 6 months, the CAD trades at:
◦ USD 0.79, ABC lets the option expire and sells the CAD in market
◦ USD 0.69, ABC can exercise the option
Interest Rate Caps & Floors
A cap is a series of interest rate options that provide protection against rise in interest
rates
It is used by borrowers of money for protection against rise in interest rates, where the
loan bears a floating interest rate
The cap buyer pays the cap premium to the cap seller
Example: A floating rate debt of ₹15 million rolled over every quarter
Strike interest rate under the cap is 6%
The rate is reset after every quarter based on a reference rate
If at the end of a quarter, the reference rate is:
◦ 5.50%, no payoff under the cap
◦ 6.25%, compensation to cap buyer = 15mn*(6.25%-6%)*(1/4)=₹9,375
Interest Rate Caps & Floors
In the case of interest rate floor, the buyer of the floor gets protection against
fall in the interest rate below the floor strike rate
It is used by lenders of money for protection against fall in interest rates, where
the loan bears a floating rate of interest
Interest Rate Collars
Comprises of both a cap and a floor
One option is purchased, and the other option is sold
Collars are used to reduce the cost of interest rate risk protection
The option that is sold pays for whole or part of the cost of the purchased option
However, it also takes away a part of the benefits that might otherwise accrue
due to a favourable movements in the rates
Foreign Exchange Collars
A call option is purchased on a currency and a put option is sold on the same
currency
Both the options have the same expiry date
The sale of the put option serves to offset the whole or part of the premium
paid on the call option
One of the two options is exercised at maturity depending upon the exchange
rate at maturity in relation to the option strike price
Portfolio Insurance
The portfolio is protected against downside risk and it also does not forego the
upside potential
This is achieved by combining the underlying portfolio with a derivative
instrument [buying a put option]
Any loss on the portfolio is offset by gains on the long-put position
If the put options required to achieve portfolio insurance are not available, stock
index futures contracts can be used [short-sell]
Hedging
Hedging aims at finding assets or instruments whose returns have a low or
negative correlation with the returns of an existing risk exposure
Hedging, while reducing exposure to loss, entails giving up the possibility of a
gain
The main tool used for hedging market risk is derivatives
Internal hedging strategies are also available to supplement the use of
derivatives
Internal Hedges
Internal hedges for Interest Rate Risk:
Cash netting:
◦ Multi-divisional firms
◦ Excess cash/Cash deficit divisions
◦ Inter-divisional transfer of funds can reduce the amount of borrowings
Embedded options:
◦ Embedding a call option in debt instruments used for borrowing
◦ When interest rates decline, retire existing high-interest bearing debt
◦ Replace by lower-interest debt
◦ Need to offer higher coupon rate to investors for embedding call option
Internal Hedges
Internal hedges for Interest Rate Risk:
Change of payment schedules:
◦ Supplier payments may be delayed to an extent that the relationship with them is
not adversely affected
◦ Customer payment schedules may be changed to speed up collections
Asset-liability management:
◦ Very important for financial institutions
◦ Also important in the case of nonfinancial companies that offer finance to their
customers
Internal Hedges
Internal hedges for Foreign Exchange Risk:
Currency netting:
◦ Prepare a forecast of inflows and outflows for different currencies
◦ Net cash inflows and outflows: net exposures
◦ Centralize Treasury operations
◦ Proxy hedging (hedging in a different, strongly correlated currency)
Foreign currency debt:
◦ To take advantage of lower interest rate
◦ Risk may be reduced if the borrower has some assets or operations that produce
revenue in the currency of borrowing
◦ Foreign currency bank accounts (when inflows are outflows are at different timings)
Internal Hedges
Internal hedges for Foreign Exchange Risk:
Changes in purchasing/processing
◦ Locate manufacturing facilities at a place where most of the customers are located
Protection clauses
◦ Insert a protective clause in the document
◦ Allow change in the contract price when the change in the exchange rate exceeds a
specified percent change
Exchange rate risk transfer
◦ The terms of sale may include a clause that allows passing the exchange rate risk to
customers
◦ Make suppliers agree to charging fixed price or invoicing in the domestic currency
Hedging Using Forward Contracts
Forward Contract?
Forward contracts provide a perfect hedge against risk exposure
A perfect hedge is one that completely eliminates the risk.
Example: XYZ Company of India has imported some machinery from the United States
and the $100,000 invoice is due for payment in 90 days
XYZ is worried that the USD may appreciate against the INR during this period and
therefore goes to its bank for a forward cover
The bank agrees to sell USD, 90 days forward, at a price of ₹83.40 per $1
This hedge completely eliminates the exchange risk for XYZ
On the due date, it has to pay ₹8.34 million to the bank, which has to sell $100,000 at
the aforesaid price