Join Your Exam WhatsApp group to get regular news, updates & study materials HOW TO JOIN

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University : Here we provide direct download links for International Pricing Process And Policies For International Marketing MCOM Sem 3 Delhi University notes in pdf format. Download these International Pricing Process And Policies For International Marketing MCOM Sem 3 Delhi University Complete notes in pdf format and read well.

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University : Interest rate risk should be managed where fluctuations in interest rate impact on the organisation’s profitability. In an organisation where the core operations are something other than financial services, such financial risk should be appropriately managed, so that the focus of the organisation is on providing the core goods or services without exposing the business to financial risks.

Download here Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes in pdf format 

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University : Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset’s value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk. This article introduces you to ways that both businesses and consumers manage interest rate risk using various interest rate derivative instruments.

Why Interest Rate Risk Should Not Be Ignored

As with any risk-management assessment, there is always the option to do nothing, and that is what many people do. However, in circumstances of unpredictability, sometimes not hedging is disastrous. Yes, there is a cost to hedging, but what is the cost of a major move in the wrong direction?

One need only look to Orange County, Calif., in 1994 to see evidence of the pitfalls of ignoring the threat of interest rate risk. In a nutshell, Orange County Treasurer Robert Citron borrowed money at lower short-term rates and lent money at higher long-term rates. The strategy was great – short-term rates fell and the normal yield curve was maintained. But when the curve began to turn and approach inverted yield curve status, things got ugly. Losses to OrangeCounty, and the almost 200 public entities for which Citron managed money, were estimated at $1.6 billion and resulted in the municipality’s bankruptcy – a hefty price to pay for ignoring interest rate risk.

Luckily, those who do want to hedge their investments against interest rate risk have many products to choose from.

Investment Products

Forwards

A forward contract is the most basic interest rate management product. The idea is simple, and many other products discussed in this article are based on this idea of an agreement today for an exchange of something at a specific future date.

  • Forward Rate Agreements (FRAs)An FRA is based on the idea of a forward contract, where the determinant of gain or loss is an interest rate. Under this agreement, one party pays a fixed interest rate and receives a floating interest rate equal to a reference rate. The actual payments are calculated based on a notional principal amount and paid at intervals determined by the parties. Only a net payment is made – the loser pays the winner, so to speak. FRAs are always settled in cash.FRA users are typically borrowers or lenders with a single future date on which they are exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in a swap all payments are at the same rate. Each FRA in a series is priced at a different rate, unless the term structure is flat.

Futures

A futures contract is similar to a forward, but it provides the counterparties with less risk than a forward contract, namely a lessening of default and liquidity risk due to the inclusion of an intermediary.

Swaps

Just like it sounds, a swap is an exchange. More specifically, an interest rate swap looks a lot like a combination of FRAs and involves an agreement between counterparties to exchange sets of future cash flows. The most common type of interest rate swap is a plain vanilla swap, which involves one party paying a fixed interest rate and receiving a floating rate, and the other party paying a floating rate and receiving a fixed rate.

Options

Interest rate management options are option contracts for which underlying security is a debt obligation. These instruments are useful in protecting the parties involved in a floating-rate loan, such as adjustable-rate mortgages (ARMs). A grouping of interest rate calls is referred to as an interest rate cap; a combination of interest rate puts is referred to as an interest rate floor. In general, a cap is like a call and a floor is like a put.

  • SwaptionsA swaption, or swap option, is simply an option to enter into a swap.
  • Embedded optionsMany investors encounter interest management derivative instruments via embedded options. If you have ever bought a bond with a call provision, you too are in the club. The issuer of your callable bond is insuring that if interest rates decline, they can call in your bond and issue new bonds with a lower coupon.
  • CapsA cap, also called a ceiling, is a call option on an interest rate. An example of its application would be a borrower going long, or paying a premium to buy a cap and receiving cash payments from the cap seller (the short) when the reference interest rate exceeds the cap’s strike rate. The payments are designed to offset interest rate increases on a floating-rate loan.If the actual interest rate exceeds the strike rate, the seller pays the difference between the strike and the interest rate multiplied by the notional principal. This option will “cap,” or place an upper limit, on the holder’s interest expense.The interest rate cap is actually a series of component options, or “caplets,” for each period the cap agreement exists. A caplet is designed to provide a hedge against a rise in the benchmark interest rate, such as the London Interbank Offered Rate (LIBOR), for a stated period.
  • FloorsJust as a put option is considered the mirror image of a call option, the floor is the mirror image of the cap. The interest rate floor, like the cap, is actually a series of component options, except that they are put options and the series components are referred to as “floorlets.” Whoever is long the floor is paid upon maturity of the floorlets if the reference rate is below the floor’s strike price. A lender uses this to protect against falling rates on an outstanding floating-rate loan.
  • CollarsA protective collar can also help manage interest rate risk. Collaring is accomplished by simultaneously buying a cap and selling a floor (or vice versa), just like a collar protects an investor who is long a stock. A zero-cost collar can also be established to lower the cost of hedging, but this lessens the potential profit that would be enjoyed by an interest rate movement in your favor, as you have placed a ceiling on your potential profit.

Conclusion

These products all provide ways to hedge interest rate risk, with different products being appropriate for different scenarios. There is, however, no free lunch. With any of these alternatives, one gives up something – either money (premiums paid for options) or opportunity cost (the profit one would have made without hedging

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University : Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Currency risk can be reduced by hedging, which offsets currency fluctuations.

BREAKING DOWN ‘Currency Risk’

If a U.S. investor holds stocks in Canada, the realized return is affected by both the change in stock prices and the change in value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs. Managing currency risk began to capture attention in the 1990s. This was in response to the 1994 Latin American crisis and the 1997 Asian currency crisis.

Reducing Currency Risk

U.S. investors should consider investing in countries that have strong rising currencies and interest rates, as well as to reduce currency risk. Investors need to review a country’s inflation as high debt typically precedes it. This may result in a loss of economic confidence causing a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio. As of 2016, the Swiss franc is an example of a currency that is likely to remain well supported due to the country’s stable political system and low debt-to-GDP ratio of 34.40. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry that may contribute to the possibility of interest rate rises. Foreign stocks are also likely to outperform during periods of U.S. dollar weakness. This typically occurs when interest rates in the United States are less than other countries.

Investing in bonds may expose investors to currency risk as they have smaller profits to offset losses caused by currency fluctuations. Currency fluctuations in the foreign bond index are often double a bond’s return. Investing in U.S. dollar-denominated bonds produces more consistent returns as currency risk is avoided.

Currency Hedged Funds

Many exchange-traded funds (ETFs) and mutual funds are currency hedged, typically using options and futures, which reduces currency risk. The rise in the U.S. dollar has seen a plethora of currency-hedged funds introduced for both developed and emerging markets such as Germany, Japan and China. The downside of currency-hedged funds is they can reduce gains and are more expensive than currency-hedged funds. Investors reduced their exposure to currency-hedged ETFs in response to a weakening U.S. dollar in early 2016.

Diversify Globally

Investing globally is a prudent strategy for mitigating currency risk. Having a portfolio that is diversified by geographic regions effectively provides a hedge for fluctuating currencies. Investors may consider investing in countries that have their currency pegged to the U.S. dollar such as China. This is not without risk, however, as central banks may adjust the pegging relationship, which would be likely to affect investment returns.

Unit IV Managing Currency Risk And Interest Rate Risk For International Financial Management MCOM Sem 4 Delhi University Notes

Cakart.in provides India’s top MCOM Sem 4 Delhi University faculty video classes – online & in Pen Drive/ DVD – at very cost effective rates. Get MCOM Sem 1 Delhi University  Video classes from www.cakart.in  to do a great preparation for primary Student.

Watch  MCOM Sem 4 Delhi University  sample video lectures
Watch  MCOM Sem 4 Delhi University sample lecture books  
Watch MCOM Sem 4 Delhi University free downloads  

Leave a comment

Your email address will not be published. Required fields are marked *