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Nov
25
Risk-Return for Options
The maximum amount that an option buyer can lose is the option price. The maximum profit that the option writer can realize is the option price. The option buyer has substantial upside return potential, while the option writer has substantial downside risk.
Notice that, unlike in a futures contract, one party to an option contract is not obligated to transact—specifically, the option buyer has the right but not the obligation to transact. The option writer does have the obligation to perform. In the case of a futures contract, both buyer and seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller an option price.
Consequently, the risk/reward characteristics of the two contracts are also different. In the case of a futures contract, the buyer of the contract realizes a dollar-for-dollar gain when the price of the futures contract increases and suffers a dollar-for-dollar loss when the price of the futures contract drops. The opposite occurs for the seller of a futures contract. Options do not provide this symmetric risk/reward relationship. The most that the buyer of an option can lose is the option price. While the buyer of an option retains all the potential benefits, the gain is always reduced by the amount of the option price. The maximum profit that the writer may realize is the option price; this is offset against substantial downside risk. This difference is extremely important because investors can use futures to protect against symmetric risk and options to protect against asymmetric risk.
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Oct
25
Options Granted to Bondholders
A bond issue may include a provision that gives either the bondholder and/or the issuer an option to take some action against the other party. The most common type of option embedded in a bond is a call feature, which was discussed earlier. This option is granted to the issuer. There are two options that can be granted to the bondholder: the right to put the issue and the right to convert the issue.
An issue with a put provision grants the bondholder the right to sell the issue back to the issuer at a specified price on designated dates. The bond with this feature is called a putable bond and the specified price is called the put price. The advantage of the put provision to the bondholder is that if after the issue date market rates rise above the issue’s coupon rate, the bondholder can force the issuer to redeem the bond at the put price and then reinvest the proceeds at the prevailing higher rate.
A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock. Such a feature allows the bondholder to take advantage of favorable movements in the price of the bond issuer’s common stock. An exchangeable bond allows the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond.
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Sep
25
Assess High Potential Candidates in Depth
Once you have narrowed your list of candidates to a handful of realistic possibilities, you will begin the detailed work of valuing each candidate and identifying your strategy for creating value. You will need a plan that more than earns back the purchase price, including a premium that you would have to pay to complete a deal. With takeover premiums running 30 percent to 40 percent and more above the pre-acquisition market values, you will want to be sure the synergies are both large and clearly identified.
When undertaking a detailed evaluation of the remaining candidates, keep in mind the distinction between the value to you and the price you will need to pay. Your obvious objective should be to maximize the former while minimizing the latter. The essential starting point is a clear understanding of the value of the company to you under your ownership. This consists of its standalone value, as operated by current management; likely net synergies from the combination, after taking into account potential lost business from disruption, and transactions costs, such as restructuring charges and deal fees. The more specific you can be in assessing each of these areas, the better prepared you will be for negotiations and subsequent integration.
Standalone value should be looked at from multiple perspectives, including average securities analyst estimates, past performance, and management pronouncements. Likewise, synergies should be categorized and quantified wherever possible. You should also assess how long it will take to capture the synergies. And don’t forget about the impact of competitor reactions to your deal that could have a financial impact on the combined firm.
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Aug
25
Overbidding
In the heat of a deal, the acquirer may bid up the price beyond the limits of reasonable valuations. It is all too easy to find benchmarks that justify a higher price or bargain away important nonprice terms that restrict the ability of the acquirer to achieve planned-for savings and growth. Remember the winner’s curse: If you are the winner in a bidding war, why did your competitors drop out (bearing in mind that they too may have scratched to find the last penny for their bid!)?
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Nov
19
MANAGING FOREIGN EXCHANGE RATE RISK
Banks are exposed to a number of potential foreign exchange risks. Foreign exchange risks may arise as a result of cash exposures or from exposures to instruments denominated in a foreign currency. Risks arise when there is a mismatch between the value of assets it owns denominated in a foreign currency and the value of what it owes in the same currency. A mismatch may also occur as a result of payments it expects to receive, or is committed to make, in a foreign currency at a future time. The former exposures are referred to as spot positions and the latter forward positions:
Long.A bank may have a long spot foreign currency position if it has foreign currency in the form of cash or owns an asset denominated in a foreign currency. It may have a long forward position if it expects to receive a future payment in a foreign currency or expects to receive an asset at a future date that is denominated in a foreign currency. Short. A bank may have a short spot foreign currency position if it owes foreign currency in the form of cash (for example, in the form of a deposit taken by a bank in a foreign currency) or a financial instrument denominated in a foreign currency. It may have a short forward position if it is committed to making a future payment in a foreign currency or to deliver an asset at a future date that is denominated in a foreign currency.
The overall spot and forward position is calculated for each foreign currency by adding up the individual spot and forward positions in that currency. It has a flat position if its assets in one currency are equal to its liabilities in both the spot and forward markets.
A US bank that has a long spot position in euros worth $100m at current exchange rates but also owes yen to the value of $100m does not have a flat position. It has a long euro position and a short yen position. If the bank also owes the equivalent of $100m in euros at current exchange rates for delivery in one month’s time the bank does have a flat euro position overall even though it is long in the spot market and short in the forward.
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Oct
03
Economic Value versus Reported Book Value
Economic value represents the net market value of the assets and liabilities at a moment in time. It represents the value if the assets were sold and used to buy back its liabilities assuming that their sale and repurchase have no direct impact on market prices:
Economic value = Market value of assets ? Market value of liabilities Economic value is very different from the accounting-based definition of value, where reported
shareholders’ funds are given by:
Shareholder funds = Book value of assets ? Book value of liabilities
Under the accounting version a bank’s value remains unchanged whether rates rise or fall. There are three methods that may be used to account for securities holdings. In some
countries all three methods are used depending on the security’s classification:
Carried at cost. Under this method the value of the security on the books is left unchanged at the acquisition price. In a rising interest rate environment this will result in a reported book value that is greater than a bank’s economic value. Marked-to-market – income statement. Under this method the security is revalued at the current market price. Any unrealized gain or loss is taken through the income statement. Marked-to-market – balance sheet treatment. The security is again revalued at current market price. The unrealized gain or loss is not, however, taken through the income statement but is reflected in an additional account within shareholders’ fund. This account is usually called something like “Reserve for unrealized gains or losses on securities”. The loss or gain is only taken through the income statement when realized.
Accountants employed by banks, regulatory bodies or working for standards bodies have an ongoing tussle over whether, and how, to make bank accounting policies provide a realistic picture of the underlying economic value. Banks have by and large resisted moves towards market-based valuations on the grounds that this would make their reported earnings increasingly volatile and that it is difficult to determine a market price for many of their loans.
The result has been, and is likely to continue to be, an uneasy compromise that accepts implicitly that published bank accounts do not provide an accurate measure of economic value. This compromise involves the acceptance of a number of internal inconsistencies.
An example of this inconsistency would be at a bank that has both fixed rate mortgages and fixed rate bonds. There will be a negative impact on the economic value of both the mortgage loans and the bonds if interest rates rise.
In most countries banks are required to recognize the fall in the value of the bonds but will not have to recognize the fall in the value of the fixed rate mortgages.
One of the problems associated with not “marking to market” all investments is that it can provide an incentive for banks to sell investments that have a market value above their book value while retaining other instruments on which the bank has a paper loss. This will result in a book value that is inflated relative to its economic value and artificially inflate reported earnings.
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Jul
06
Passive Currency Management
Passive currency hedging or currency management involves the creation of a currency hedging benchmark and sticking to that benchmark come what may, avoiding any slippage. As a result, it involves the taking of standard currency hedges and then continuing to roll those for the life of the investment. The two obvious ways of establishing a passive hedging strategy are for instance:
Three-month forward (rolled continuously)
Three-month at-the-money forward call (rolled continuously)
The advantage of passive currency management is that it reduces or eliminates the currency risk (depending on whether the benchmark is fully or partially hedged). The disadvantage is that it does not incorporate any flexibility and therefore cannot respond to changes in market dynamics and conditions. Passive currency management can be done either by the portfolio manager themselves or by a currency overlay manager, and focuses on reducing the overall risk profile of the portfolio.
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Jul
05
TO HEDGE OR NOT TO HEDGE — THAT IS THE QUESTION!
Central to the idea of managing currency risk separately and independently from the risk represented by the underlying asset is the issue of whether or not to hedge that currency risk. Just as the idea of separating currency risk continues to attract much debate, so the more specific issue of hedging out that currency risk remains a topic of much controversy and discussion, both within the academic world and within the financial markets themselves. Indeed, while there may be some who take a pragmatic view of compromise, approaching this from the perspective of a case-by-case basis, the majority seem polarized between two opposite and opposing camps. Within the academic world, this is expressed at opposite ends of the spectrum by Perold and Schulman (1988) and by Froot and Thaler (1990, 1993), who advocated on the one hand full hedging of currency risk and on the other leaving currency risk unhedged.
There is a clear division of opinion within the financial markets as well, if perhaps marginally less pronounced and polarized. Within the institutional investor community, international equity funds are generally known for taking a view of either not hedging currency risk or adopting an unhedged currency benchmark. Fixed income funds are clearly more tolerant of the idea of hedging currency risk, frequently adopting a currency hedging benchmark that reflects such a view. We will go through the range of possible currency hedging benchmarks shortly, but for now suffice to say that they vary at the most basic level, being hedged (partially or fully) and unhedged. The “sell side”, which is used to selling foreign exchange-type products, is well versed in the need for hedging availability. Conversely, the fixed income sell side within the financial industry in general appears to focus more on selling the core product rather than on its denomination, or the potential need to separate and hedge out that corresponding currency risk. In response, the majority of rigorous studies have distilled this debate down to an elegant compromise between risk and reward, focusing less on an absolute answer to the question than the need to account for the individual investor’s requirements and the portfolio variance across the spectrum of hedging strategies. The debate between hedging or not hedging thus remains unresolved, and there appears little prospect on the horizon of that changing. There is no one answer to the question of whether or not to hedge currency risk, nor perhaps should there be. Any such answer depends crucially on the specifics of the investor’s portfolio aims and constraints. The assumption might on the face of it be that one’s approach to managing currency risk can be broken down simply into active or passive — or alternatively not to manage currency risk! At a slightly more sophisticated level however, the focus should be on the type of returns targeted; that is absolute vs. relative returns.
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Jul
04
CURRENCY MARKETS ARE DIFFERENT
Throughout this blog, we have looked, albeit from varying perspectives, at the governing dynamics that drive the global currency markets. If we have learned one thing, it is surely this, that the currency markets are by their nature predominantly “speculative”. That is to say, the majority of currency market participants are what we would define as “speculators”, using the definition of this blog for currency speculation as the trading or investing in currencies without any underlying, attached asset. The predominance of speculation within currency markets is neither a good nor a bad thing. On the one hand, it provides needed liquidity for those aspects of the economy deemed productive rather than speculative. On the other hand, it can and frequently does lead to overshooting relative to perceived economic fundamentals.
The speculative nature of the currency markets may be an important reason why most long-term fundamental equilibrium models work poorly in trying to forecast exchange rates. At the least, it serves as an excellent excuse for those who otherwise are unable to forecast exchange rates using the traditional methods. All of this may be true, and all of it makes for a very different world from those of the equity or fixed income, markets. By necessity, these are not speculative by nature since they are themselves underlying assets relating to the economy in some way. This is not at all to suggest that speculation does not occur in equities or fixed income, for any such suggestion would clearly be foolish. The recent bubble in the NASDAQ should serve as an excellent warning for any who think these markets are always fundamentally-driven and incapable of speculative excess. That said, this same example is surely notable by its rarity. Throughout history, there have indeed been examples of speculative excess across all markets. In equity and fixed income markets, relative to “normal” conditions however, these are the exception rather than the rule. This is not the case in currency markets, where traditional economic theory has all but given up trying to explain short-term moves and longer-term exchange rate models have far from perfect results.
The dynamics of the asset and currency markets are “fundamentally” different. Therefore these risks should be dealt with separately and independently from one another. For the international equity fund manager, investing in a country is not the same and should not be the same decision as investing in a country’s currency. Eventually, they may have the same risk profile over a long period of time. However it is questionable whether the investor’s tracking error and Sharpe ratio, not to say the investor themselves, should have to go through that degree of stress!
Equally, currency is not the same as cash. An individual investor may treat currency as cash from a relative performance perspective. Unfortunately, however, such a comparison provides a false picture. Most currency market participants, and therefore the currency market as a whole, do not buy or sell currencies for the income that a “cash” description would of necessity entail. On the contrary, they do so for anticipated directional or capital gain. In other words, they are seeking to profit from precisely the risk that the investor is not hedging! It is a generalization, but nevertheless true that the reluctance to manage currency risk is far more predominant among equity fund managers thanfixed income fund managers. That may have something to do with the intended tenor of the investment, suggesting fixed income fund managers may be more short-term in investment strategy than their equity counterparts. Any such view seems greatly oversimplistic, and would require a study on its own to verify or otherwise. Many cannot manage currency risk simply because the rules of their fund do not allow them so to do. There remains however a substantial community of institutional investors who apparently have yet to be convinced by either the merits or the need to manage currency risk separately. By the end of this series of posts, it is my hope that I will have caused many within this community to at least reconsider their view as regards currency risk. To summarize this part, the way currencies and underlying assets are analysed and the way they trade are both different from each other. Consequently, the way they should be managed should also be different.
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Jul
02
CORE PRINCIPLES FOR MANAGING CURRENCY RISK
So far we have examined currency risk, how to manage and quantify it. Before we go on from theory into practice, it may well be useful to establish a framework, a reference for corporate Treasury of core principles of managing currency risk. There have been several notable efforts along these lines, most notably of course the “Core Principles of Managing Currency Risk” set out by the Group of 31 (US multinational corporations) and Greenwich Treasury Advisors.
Clearly, there is a danger in attempting anything even approaching best practice for corporate Treasury as corporations vary so significantly in terms of their exposures, requirements and focus. Such concerns notwithstanding, the importance of the issue equally requires that the attempt be made to create a reference from which individual corporations can perhaps take what might be appropriate to them. Thus, what follows is my own tentative suggestion of what any such list of core principles of managing currency risk should contain:
1. Determine the types of currency risk to which the corporation is exposed — Break these down into transaction, translation and economic risk, making specific reference to what currencies are related to each type of currency risk.
2. Establish a strategic currency risk management policy — Once currency risk types have been agreed on, corporate Treasury should establish and document a strategic currency risk management policy to deal with these types of risks. This policy should include the corporation’s general approach to currency risk, whether it wants to hedge or trade that risk and its core hedging objectives.
3. Create a mission statement for Treasury — It is crucial to create a set of values and principles which embody the specific approach taken by the Treasury towards managing currency risk, agreed upon by senior management at the time of establishing and documenting the risk management policy.
4. Detail currency hedging approach — Having established the overall currency risk management policy, the corporation should detail how that policy is to be executed in practice, including the types of financial instruments that could be used for hedging, the process by which currency hedging would be executed and monitored and procedures for monitoring and reviewing existing currency hedges.
5. Centralizing Treasury operations as a single centre of excellence — Treasury operations can be more effectively and efficiently managed if they are centralized. This makes it easier to ensure all personnel are clear about the Treasury’s mission statement and hedging approach. Thus, the Treasury can be run as a single centre of excellence within the corporation, ensuring the quality of individual members. Large multinational corporations should consider creating a position of chief dealer to manage the dealing team, as the demands of a Treasurer often exceed the ability to manage all positions and exposures on a real-time basis. The currency dealing team must have the same level of expertise as their counterparty banks.
6. Adopt uniform standards for accounting for currency risk — In line with the centralizing of Treasury operations, uniform accounting procedures with regard to currency risk should be adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the performance of currency hedging.
7. Have in-house modelling and forecasting capacity — Currency forecasting is as important as execution. While Treasury may rely on its core banks for forecasting exchange rates relative to its needs, it should also have its own forecasting ability, linked in with its operational observations which are frequently more real time than any bank is capable of. Treasury should also be able to model all its hedging positions using VaR and other sophisticated modelling systems.
8. Create a risk oversight committee — In addition to the safeguard of a chief dealer position for larger multinational corporations, a risk oversight committee should be established to approve position taking above established thresholds and review the risk management policy on a regular basis.
Clearly, this list of core principles of managing currency risk is aimed at the larger multinational corporations that have the means and the business requirements for such a sophisticated Treasury operation. That said, such a list can also be used as a benchmark for those who, while they cannot or do not need to comply with all elements, can still find some useful. Corporations of whatever size and sophistication must balance the real cost of implementing such an approach to managing currency risk against the possible cost of not doing so. The first cost is tangible, the second intangible — but by the time the second becomes tangible it is too late! That is precisely what we are trying to avoid.
It may be useful for a corporation to split currency risk management into two parts — the first part focusing on the overall approach towards managing of currency risk, the second dealing with the actual execution of currency risk management. Many corporations have this kind of division of labour, whether or not they formalize it. However rigorous a currency risk management policy is, it still runs the risk of being bypassed by events, technology and innovation. Thus, it is very important to have a regular review process to ensure the currency risk management policy remains up-to-date and in line with the corporation’s needs. In this review process, important questions to be raised may include:
Do the currency risk management policy and the Treasury’s mission statement still represent the corporation’s business needs? Should the corporation maintain or change its approach towards managing currency risk?
How has currency hedging performed relative to the established benchmarks? How can the costs of currency hedging be reduced?
Are VaR or credit limits, or the financial instruments relating to currency risk management, still appropriate?
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