International Finance - Meeting 7

INTERNATIONAL
FINANCE
MEETING 7
Basic Methods of Foreign Risk 2
Management
• Dealing with transaction imports and exports where payments and
receipts depend on exchange rates is vulnerable to risk.
• It requires a firm to take measures to eliminate or reduce the risk is called
hedging the risk or hedging the exposure.
• Many techniques to reduce the risk: Internal Hedging Techniques such as:
• Currency Invoice
• Leading and Lagging
• Netting and Matching
• Forward Exchange Contract
• Money Market Hedging
• Do Nothing
Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Management (cont.)
• Currency Invoice @ Invoicing in the Domestic Currency

✓ One method of eliminating transaction risk is for an exporter to
invoice the customer in the domestic currency.
✓ Insist all customers pay in your own home currency and pay for
all imports in home currency.
✓ This eliminates transaction risk for the exporter but exposes the
exchange rate risk to the customer @ importer. It is only a one-
sided technique.
✓ Achievable if you are in a monopoly position, however in a
competitive environment this is an unrealistic approach

Management (cont.)
• Leading and Lagging
✓ Leading means making a payment early, before the end of
the credit period allowed. It is to pay early in a foreign
currency that is expected to increase in value against the
payer’s home currency during the credit period.
✓ Lagging means making a payment as late as possible by
taking longer credit than allowed. It is to delay payment as
long as possible in a currency that is expected to fall in value.
✓ Leading or lagging might be used when the exchange rate
between two currencies will change significantly up or down
during a credit period. Leading and lagging are a form of
speculation.

Management (cont.)
Example 14
Mercedes Pte, a US company imported electrical goods at a price of £300,000
from Everton Pte, a UK company. The payment to Everton Pte is due in one
month’s time. The current exchange rate is as follows: £0.5450 = $1. Determine the
strategy and amount of savings in terms of leading or lagging that Mercedes Pte
would benefit from based on the following situation:
a) If the US dollar is expected to appreciate against the pound sterling by 3% in
the next month and by a further 1.5% in the second month.
b) If the US dollar was to depreciate against the pound sterling by 2% in the next
month and by a further 1% in the second month.
Answer: Refer to text
Note:
• Companies should be aware of the potential finance costs associated with
paying early.
• By delaying payments there may be a loss of goodwill from the supplier which
may result in tighter credit terms in the future.
Management (cont.)
Netting and Matching
• Netting and matching can be applied to cash flows in a foreign
currency by offsetting a payment against a receipt to get a net payment
or a net receipt to reduce a currency exposure to the net amount.
Alternatively, netting means offsetting a liability against an asset in the
same currency.
• In the case of bilateral netting, only two companies in the same group
are involved. The lower balance is netted off against the higher balance
and the difference is the amount remaining to be paid.
Illustration 14: Bilateral Netting
A UK holding company has subsidiaries located in South Africa and US. Xerox Ltd and
Yarn Ltd are respectively South African and US-based subsidiaries. If Xerox owed Yarn
£350,000 and Yarn owed Xerox £250,000 the two intercompany balances can be
netted off, leaving a net debt owed by Xerox to Yarn of £100,000. It is primarily a way
to reduce transaction costs.
Management (cont.)
• Multilateral netting is a more complex procedure in which the

debts of more than two group companies are netted off
against each other.
• Involves minimizing the number of transactions taking place
through each country’s banks. This limits the bank fees and
therefore some governments do not allow multilateral netting
in order to maximize the fees received by their local banks.
• On the contrary, some governments allow multilateral netting
to encourage companies more willing to operate from those
countries, and any banking fees lost will be compensated by
the extra business brought by these companies and their
subsidiaries.
Management (cont.)
 The operation of multilateral netting using the tabular method.

 Tabular method (transaction matrix)
Step 1 Set up a table with the name of each company down the
side and across the top.
Step 2 Input all the amounts owing from one company to another
into the table and convert them into a home currency
(base) at a spot rate.
Step 3 By adding across and down the table, identify the total
amount payable and the total amount receivable by each
company.
Step 4 Compute the net payable or receivable and convert back
into the original currency.
Management (cont.)
Example 16: Multilateral Netting
Pussy Ltd, UK is the parent company of a group that contains 3 subsidiaries as follows: Que Ltd -
based in Europe, Ray Ltd – in USA, Sun Ltd – in Canada. The subsidiaries produce raw materials
for the use of other subsidiaries and have recorded the inter-company transactions.
Owed by (Paid by-Payment) Owed to (Paid to-Receipt) Amount
The mid-rate spot
exchange rates in three Pussy Ltd Sun Ltd CAD$ 3.5 million
months’ time are expected Pussy Ltd Ray Ltd USD$ 5 million
to be: Que Ltd Ray Ltd USD$ 4 million
Que Ltd Sun Ltd CAD$ 6.3 million
£1 = USD$1.60
Ray Ltd Sun Ltd CAD$ 2.2 million
£1 = EUR€ 2.50
£1 = CAD$ 1.25 Ray Ltd Pussy Ltd USD$ 6 million
Sun Ltd Que Ltd EUR€ 12.8 million
Sun Ltd Pussy Ltd USD$ 5 million
Ray Ltd Que Ltd EUR€ 8.4 million
Required: Calculate, using a tabular format (transaction matrix), the impact of undertaking
multilateral netting by Pussy Ltd and its three subsidiary companies for the cash flows due in three
months.
Answer: Refer to text
Management (cont.)
• Matching is similar, except the receipt/asset and payment/liability are the
same amounts. Matching reduces exposure to currency risk to 0.
• When a company has receipt/asset and payment/liability in the same foreign
currency due at the same time, it can simply match them against each other.
The unmatched portion can be hedged by other means of hedging.
• The terms netting and matching are often used interchangeably but strictly
speaking they are different.
Management (cont.)
Forward Contract
A forward contract is a private contract between two parties (buyer
and seller) to fix a pre-determined foreign exchange rate at the time the
contract is made for the settlement of a transaction at a specific future
date. It is used to hedge against the price risk to mitigate the problem of
currency movement.
Example 17
Paper Best Ltd, a UK company is selling product paper-based to Forest
Pte, a customer from the US for $50 million. Payment will be received in
three months period. Paper Best Ltd will protect itself against exchange
rate risk by taking out a forward contract to deliver $50 million in three
months. The three-month forward rate $/£ is 1.5200 ± 0.0005. What is the
amount of receipt in pound sterling (£) from the transaction?
Answer: Refer to text (including note)
Management (cont.)
Money Market Hedging – The principles of Money Market Hedge
• Money market hedge involves borrowing in one currency, converting the
money borrowed into another currency, and putting the money on deposit
until the time the transaction is completed, hoping to take advantage of
favorable interest rate movements.
✓ The result is very similar to forward contracts, but the process is quite
complex.
✓ Risk is eliminated by changing the currency now rather than when it is
received or paid.
✓ We need to look at two cases: receiving a foreign currency amount and
paying a foreign currency amount
• Choosing the hedging method
The choice between forward and money markets is:
Payment - which method is cheaper
Receipt – which method is higher
Management (cont.)
Illustration 16: Money Market Hedge - Foreign Currency Payment
Koala Co, an Australian company needs to pay a German creditor in euro
(€) currency in three months’ time. Koala wishes to hedge using a money
market hedge for a foreign currency payment instead of using a forward
contract. Koala believes that it is cheaper to hedge using a money market
hedge and Koala does not have sufficient funds to pay the German
creditor now but will have enough cash in three months’ time.
Below are the steps in money market hedge for a foreign currency
payment:
Step 1 Borrow the appropriate amount in AUD now (home currency)
Step 2 Convert the AUD to euro (€) immediately
Step 3 Put the euro (€) on deposit in a euro bank account (foreign currency).
Step 4 When the due date for payment to German creditor:
(a) pay the German creditor out of the euro bank account
(b) repay the AUD loan account

Management (cont.)
Example 19
Koala Co, an Australian company owes a German creditor euro €5,000,000 in three months’ time.
The spot exchange rate is €/AUD$ 1.5509 – 1.5548. The company can borrow in AUD for 3 months
at 8% per annum and can deposit euro (€) for 3 months at 10% per annum.
a) What is the cost in AUD with a money market hedge?
b) What effective forward rate would this represent?
Answer:
a)
1. Deposit in €
= €5,000,000 / (1+ (0.025) = €4,878,049 Now: Borrow (2%) Now: Deposit (2.5%)
€4,878,049 / €1.5509 €5,000,000 / (1+
2. Borrow in AUD today = AUD3,145,302 × (1 + (0.025) =
= €4,878,049 / €1.5509 = AUD3,145,302 0.02) = AUD3,208,208 €4,878,049
= AUD3,145,302 × (1 + 0.02) = AUD3,208,208
3. Payment in 3 months
= AUD$3,208,208 (AUD loan account) and
€5,000,000 (euro bank account). In 3 months: Use cash In 3 months: Use
b) to pay AUD Loan deposit to pay German
$3,208,208 Creditor €5,000,000
The effective forward rate is
= €5,000,000/ AUD3,208,209 = €1.5585.
Management (cont.)
Illustration 17: Money Market Hedge - Foreign Currency Receipt

Similarly, a money market hedge also can be used to cover a foreign
currency receipt from a debtor. Suppose a British company will receive
from a Swiss company in Swiss Franc (CHF) currency in three months’
time.
Instead of negotiating a forward contract, the company could hedge
using a money market hedge for a foreign currency receipt, follow the
steps below:
Step 1 Borrow the appropriate amount in foreign currency today (CHF)
Step 2 Convert it immediately to home currency (£)
Step 3 Place it on deposit in the home currency (£)
Step 4 When the debtor’s cash is received:
(a) Repay the foreign currency loan (CHF)
(b) Take the cash from the home currency deposit account (£)
Management (cont.)
Example 20
Oxford will receive money CHF3,000,000 in three months’ time from Carrefour, a Swiss company.
The spot exchange rate is CHF/£ 1.2498 – 1.2510. The company can deposit in pound sterling (£)
for 3 months at 8.00% per annum and can borrow Swiss France (CHF) for 3 months at 7.00% per
annum.
a) What is the receipt in pounds (£) with a money market hedge?
b) What effective forward rate would this represent?
Answer:
a)
1. Borrow in CHF today
= CHF3,000,000 / (1 +0.0175) = CHF2,948,403 Now: Borrow (1.75%) Now: Deposit (2%)
CHF3,000,000/1.0175 = CHF2,948,403/CHF1.2510
2. Convert CHF to £ CHF2,948,403 = £2,356,837 × (1 + 0.02) =
= CHF2,948,403/CHF1.2510 = £2,356,837 £2,403,974
3. Deposit in £
= £2,356,837 × (1 + 0.02) = £2,403,974
4. Receipt in 3 months = pay CHF3,000,000 (CHF In 3 months: Receipt In 3 months: Take

loan account) and Take £2,403,974 (Deposit £ account) from Swiss Debtor pay deposit from Pound
loan CHF3,000,000 account £2,403,974
b) The effective forward rate is
= CHF3,000,000/£2,403,974 = CHF/£ 1.2479.
Management (cont.)
Do Nothing
• A company may choose not to manage risk management by

not doing hedging its foreign exchange rate risks.
• By doing nothing, in the long run, the company would “win
some, lose some”. This method works for small occasional
transactions.
• It may save in transaction costs, but it could be dangerous as
a possible huge potential loss occurs.

18
Risk Management for Interest Rate
• Types of interest rate risk

• Causes of interest rate fluctuations
• Basic Hedging Methods
❑ Internal Hedging
✓ Matching & Smoothing
✓ Asset and Liability Management
❑ External Hedging
✓ Forward Rate Agreements
✓ Interest Rate Derivatives (not in the syllabus)

19
Types of Interest Rate Risk
• Interest rate risk is the risk of incurring losses due to adverse movements in interest
rates.
• Company may borrow at a fixed or floating (variable) rate of interest.
• There is some risk in deciding the balance or mix between floating rate and
fixed rate debt.
• Too much fixed-rate debt creates exposure to falling long-term interest rates
even though the interest rate is predictable.
• Too much floating-rate debt creates exposure to a rise in short-term interest
rates. The Interest rate is unpredictable due to changes in the base rate(KLIBOR).
• Some effects will cancel if there are both debt assets and liabilities. Even if debt
assets match debt liabilities, there is basis risk because the interest rates might
not move together as they are determined using different bases.
• Interest rate risk faced by companies can arise from gap exposure and basis risk.

Types of Interest Rate Risk (Gap 20
Exposure and Basis Risk)
• An exposure to the interest rate arises due to the market values of

the anticipated income/asset or payment/liability in the future
depending on the movements in the market interest rate.
• The risks from interest rate movements due to:
(a) Many companies borrow at a floating rate of interest.
(b) Some companies expect to receive large cash surpluses and
invest in short-term investments. Income from investments will
depend on the rate of interest when the cash surplus is
deposited.
(c) Some companies hold investments in marketable bonds, either
government bonds or corporate bonds. The bond value is
changed with movements in long-term interest rates.
(d) Some companies borrow by issuing bonds. The perceived credit
risk ratings of the bond issuer and interest rates on government
bonds might affect the yields on corporate bonds.

Exposure and Basis Risk)(cont.)
• The degree to which a firm is exposed to interest rate risk can be

identified by using the method of gap analysis.
• Gap analysis is based on the principle of grouping together assets and
liabilities which are sensitive to interest rate changes according to their
maturity dates. Two different types of gaps may occur.
a) A negative gap – The amount of interest-sensitive liabilities exceeds
the amount of interest-sensitive assets maturing at the same time.
b) A positive gap – The amount of interest-sensitive assets exceeds the
amount of interest-sensitive liabilities maturing at the same time.
• The difference between the two amounts indicates the net exposure.
• With a negative gap, the company faces exposure if interest rate rise by
the time of maturity. With a positive gap, the company will lose out if
interest rates fall by maturity.

Exposure and Basis Risk)(cont.)
• Basis risk is where an organization has assets and liabilities with

floating interest rates, but the interest rates are set on different bases
(KLIBOR).
• For example, one loan may be linked to a three-month KLIBOR rate
and the other loan to a six-month KLIBOR rate.
• Another example, a company might borrow at a floating rate of
interest, with interest payable every six months, and the amount of
the interest charged each time payment was made varying
according to whether short-term interest rates have risen or fallen.
• The basis is the difference between the futures price and the spot
price.
Basis = Futures prices – Spot price

23
Causes of Interest Rate Fluctuations
• Structure of interest rates

• Yield curves
• Changing economic factors

Causes of Interest Rate Fluctuations 24
(cont.)
Yield Curve; It is an analysis of the The Structure of Interest Rates;

relationship between the yields on Why interest rates differ in
debt with different period of maturity. different market and market
Three main types of yield curve; segment?
1. Normal yield curve - longer maturity 1. Risk
bonds have a higher yield compared with 2. Need to make a profit on re-
shorter-term bonds due to the risks lending
associated with time. 3. Size of the loan
2. Inverted yield curve - the short-term 4. Different types of financial asset
yields are higher than the longer-term yields, 5. Government policy
which can be a sign of upcoming recession.
6. Duration of the lending
3. Flat yield curve - the shorter- and longer-
term yields are very close to each other,
The shape of the yield curve is the
which is also a predictor of an economic
transition.
result of the 3 theories acting
#The greater the slope, the greater the gap together
between short- and long-term rates. 1. Liquidity preference theory
2. Expectations theory
3. Market segmentation theory
(cont.)
Rate of
Interest Rate of
(%) Interest
Higher Yield-Long Term
(%)
Higher Yield-Short Term
An Upward Sloping for

Normal Yield Curve Market Forecast Interest Rate Fall
Lower Yield-Long Term
Lower Yield-Short Term

Period of
Period of
Maturity
Maturity
(Years)
(Years)
Liquidity preference theory - Normal Expectations theory - Inverse

(cont.)
Liquidity preference Expectations theory: Market segmentation

theory: ❖ The shape of the yield curve theory:
❖ Investors prefer to have varies according to investors' ❖ The slope of the yield curve is
cash sooner than expectations of future interest reflected by conditions in
having cash later. rates. different segments of the
❖ They will need to be ❖ If upward sloping, the future market.
compensated if they short-term interest rates are ❖ Lenders and borrowers
are deprived of cash for expected to rise more than the specialize in different terms
a longer period current short-term interest rates. and interest rates are a
❖ Therefore, the longer the ❖ There is more demand for function of supply and
maturity period, the short-term securities than demand in each segment.
higher the yield required long-term securities. since ❖ There are different players
leading to an upward investors expect to secure in the short-term and the
sloping curve, assuming higher interest rates in the long-term market.
that the interest rates future so no point to buy long- ❖ It caused the curve may
were not expected to term assets now. have different shapes
fall in the future. ❖ If downward sloping indicates (kinked or discontinuous) as
that rates of interest are they are influenced
expected to drop in the future. independently by different
factors.
(cont.)
Importance of Yield Curve

to Financial Managers:
❖ Usually, interest rates are
higher for long-term debt
because of the additional risk
involved with money that is
tied up for a longer time.
(yield premium).
❖ Financial managers should
inspect the current shape of
the yield curve when
deciding terms of borrowing
or deposit, since the curve
encapsulates the market's
expectations of future
movements in interest rates.
❖ The yield curve influences the
Market segmentation theory ability of the businesses to
obtain bank loans financing
Basic Hedging Methods of Interest 28
Rate Risk Management
• Internal Hedging
✓ Matching & Smoothing
✓ Asset and Liability Management
• External Hedging
✓ Forward Rate Agreements

29
Matching & Smoothing
• Matching and smoothing are ‘internal’ methods of hedging interest

risk. Matching is where liabilities and assets with a common interest
rate are matched.
• Matching involves setting off interest income against interest payment
so that the interest rate exposure is to the net amount of interest
payments (or net interest income).
• This method is difficult to achieve as interest payments on loans are
likely to be much higher than interest payments on deposits or
investments. Matching is likely to be more practicable for financial
institutions such as banks.
Illustration 18
Rose Co, a subsidiary of Rozzell Ltd investing in the money markets instruments at
KLIBOR and Jazz Co, another subsidiary is borrowing under money market
instruments of the same market at KLIBOR. If the rate of KLIBOR increases, Rose Co
enjoys the increase in return on short-term investment whilst Jazz Co is suffering due
to an increase in the borrowing cost. Rozzell Ltd may therefore match the interest
rates on the assets and liabilities of both subsidiaries.
30
Matching & Smoothing (cont.)
• Smoothing is where a company keeps a balance between its

fixed rate and floating rate of borrowing.
• If interest rates rise the disadvantage of higher variable
interest rates will be offset by the comparatively low fixed
rates. If interest rates fall the disadvantage of the fixed rate will
be offset by a lower variable rate.
• A rise in interest rates will make the floating-rate loan more
expensive but this will be compensated for by the less
expensive fixed-rate loan.
Illustration 19
Aston Ltd might choose to have 50% of its debt capital in the form of
fixed-interest liabilities and the other 50% in floating-rate liabilities.
31
Asset & Liability Management
• Asset and liability management means managing risk in financial

assets (loans to customers) and liabilities (borrowings by banks).
• It is a process of managing the assets or cash flow to reduce the risk
of loss from not paying the liability when the debt is due (credit risk).
• It focuses on the timing of cash flow where the assets are used to
generate earnings as cash inflow and use the cash outflow for
payment of the available debt on time.
• In banks, asset and liability management involves monitoring risks,
such as interest rate risk and credit risk.
• Where possible, assets are matched with liabilities in order to control
risk arising from gap exposures and basis risk.

32
Forward Rate Agreements (FRA)
• Forward rate agreements (FRAs) are used extensively by some

companies to hedge exposures to short-term interest rate risk.
• A forward rate agreement (FRA) is a forward contract for an interest
rate. FRAs are negotiated ‘over-the-counter’ with a bank. In some
respects, an FRA is similar to a forward exchange rate contract.
• It is a contract arranged ‘now’ that fixes the rate of interest for a loan
or deposit period starting at some time in the future.
• For example, an FRA can be used to fix the interest rate on a six-
month loan starting in three months’ time.
• Two types of FRA:
✓ FRA for borrowing
✓ FRA for deposit
33
Forward Rate Agreements (FRA)(cont.)
FRA for Borrowing FRA for Deposit

(a) FRA is to hedge the interest rate rise. (a) FRA is to hedge interest rate drop.
(b) Buy a matching FRA from a bank to (b) Sell a matching FRA from a bank to
receive compensation if the rates rise. receive compensation if the rates drop.
(c) FRA fixes the interest rate for borrowing (c) FRA fixes the interest rate for deposits
with the bank at a certain time in the future. with the bank at a certain time in the future.
(i) If the actual interest rate is higher than (i) If the actual interest rate is higher than
the rate agreed in FRA, the bank pays the rate agreed in FRA, the company
the company the difference. pays the bank the difference.
(ii) If the actual interest rate is lower than (ii) If the actual interest rate is lower than
the rate agreed in FRA, the company the rate agreed, the bank pays the
pays the bank the difference. company the difference.

34
Example 21 (Similar in timing of FRA term versus period interest rate may rise)
The budgeted cash flow statements of Rocky Co reveal an expected cash deficit in three months'
time amounting to $10 million which will last for approximately three months. It is now 1 March 2022.
The finance manager is concerned that interest rates may rise before 1 June 2022. Rocky Co must
hedge against the interest rates rise for three months period; March-May (a period of the risk of
adverse movement may occur where the interest rate will increase). The company wishes to take
Forward Rate Agreement (FRA) with local banks.
Rocky Co needs to borrow and may locked-in an interest rate today, for a future loan. The
company takes out a loan as normal and pays interest at the market rate at the date the loan is
taken out. It will then receive or pay compensation under the separate FRA to return to the locked-
in rate.
A 3-6 FRA at 5.25% – 4.75% is agreed; This means that:
• A “3-6” FRA is an agreement that fixes the interest rates for a period starting in 3 months’ time
and lasting for 3 months to the end of months 6.
• The FRA is quoted as simple annual interest rates for borrowing and lending; 5.25% – 4.75%.
• The borrowing rate is always the highest rate (5.25%) whilst lending/deposit rate at the lowest
rate (4.75%)
• A basis point is 0.01%.
Calculate the interest payable if in three months’ time the market rate is:
(a) 6%
(b) 4%
35
Solution:
The FRA: 6% 4%
Features of FRA
Locked in the effective interest rate of (131,250) (131,250) oThe FRA is a separate
5.25% (10m × 5.25% × 3/12) contractual agreement
from the loan itself and
Interest payable : (150,000) could be arranged with a
10m × 6% × 3/12 different bank.
oThey can be tailor-made
10m × 4% × 3/12 (100,000) to the company’s needs.
oFRA is a hedging method
Compensation receivable 18,750 that is independent of any
Compensation Payable (31,250) loan agreement
oEnables you to hedge for
a period of one month up
❖In this case, the company is protected from a rise in interest to two years.
rates but is not able to benefit from a fall in interest rates – it oUsually on amounts > £1
is locked into a rate of 5.25% – FRA hedges the company million. The daily turnover
against both an adverse and favorable movement. in FRAs now exceeds £4
billion.
36
Additional Example (Difference in timing of FRA term versus

period interest rate may rise)
A company’s financial projections show an expected cash
deficit in two months' time of $8 million, which will last for
approximately three months. It is now 1 November 2019.
The treasurer is concerned that interest rates may rise
before 1 January 2020. Protection is required for two
months. The treasurer can lock into an interest rate today,
for a future loan. The company takes out a loan and pays
the interest market rate when the loan is taken out. It will
then receive or pay compensation under the separate FRA
to return to the locked-in rate.
A 2-5 FRA at 5.00% – 4.70% is agreed upon:
• The agreement starts in 2 months time and ends in 5
months' time.
• The FRA is quoted as simple annual interest rates for
borrowing and lending; 5.00% – 4.70%.
• The borrowing rate is always the highest.
Required:
Calculate the interest payable if in two months’ time the
market rate is:
a) 7%
b) 4%.

International Finance - Meeting 7

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

International Finance - Meeting 7

Uploaded by

Copyright:

Available Formats

INTERNATIONAL

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

• Currency Invoice @ Invoicing in the Domestic Currency

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

• Multilateral netting is a more complex procedure in which the

 The operation of multilateral netting using the tabular method.

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Illustration 17: Money Market Hedge - Foreign Currency Receipt

4. Receipt in 3 months = pay CHF3,000,000 (CHF In 3 months: Receipt In 3 months: Take

• A company may choose not to manage risk management by

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Risk Management for Interest Rate

• Types of interest rate risk

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Types of Interest Rate Risk

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Exposure and Basis Risk)

• An exposure to the interest rate arises due to the market values of

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Exposure and Basis Risk)(cont.)

• The degree to which a firm is exposed to interest rate risk can be

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Exposure and Basis Risk)(cont.)

• Basis risk is where an organization has assets and liabilities with

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Causes of Interest Rate Fluctuations

• Structure of interest rates

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Yield Curve; It is an analysis of the The Structure of Interest Rates;

An Upward Sloping for

Lower Yield-Long Term

Lower Yield-Short Term

Liquidity preference theory - Normal Expectations theory - Inverse

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Liquidity preference Expectations theory: Market segmentation

Importance of Yield Curve

Rate Risk Management

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Matching & Smoothing

• Matching and smoothing are ‘internal’ methods of hedging interest

Matching & Smoothing (cont.)

• Smoothing is where a company keeps a balance between its

Asset & Liability Management

• Asset and liability management means managing risk in financial

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Forward Rate Agreements (FRA)

• Forward rate agreements (FRAs) are used extensively by some

Forward Rate Agreements (FRA)(cont.)

FRA for Borrowing FRA for Deposit

Copyright @ 2023 by McGraw Hill Malaysia. All rights reserved.

Forward Rate Agreements (FRA)(cont.)

Forward Rate Agreements (FRA)(cont.)

Forward Rate Agreements (FRA)(cont.)

Additional Example (Difference in timing of FRA term versus

You might also like