Managing your company s exchange and interest rate risks

Transcription

1 Managing your company s exchange and interest rate risks 1

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3 Exchange risk Managing your company s exchange and interest rate risks Forward foreign exchange contracts Currency swaps Currency options Zero cost collars Participating forwards Interest rate risk Forward rate agreements Interest rate swaps Interest rate options Collars Swaptions

4 You re not working on an island, but in an open world economy in which everything is linked up with everything else. Events that take place in the international financial and monetary markets will have a major impact on your business. The substantial fluctuations of foreign currencies against the euro have rekindled awareness of the exchange risks among many business leaders. The exchange rates exert a direct influence on the price of raw materials, the value of foreign investments and sales and even on your company s competitiveness in markets at home and abroad. But it s not just exchange rates; interest rates too have an impact on the value and profits of your business. If you want to make sure your balance sheet stays balanced, you will have to reduce your company s sensitivity to fluctuations in exchange and interest rates. KBC is the ideal partner to help you achieve this objective. We will make a thorough analysis of all risks you might be exposed to and develop appropriate 4

5 financial instruments to ensure those risks are properly managed. This will give you the freedom you need to do business in an international economy. This brochure gives you more insight into the various exchange and interest rate risks, and into risk management techniques. You can manage and hedge your exchange and/or interest rate risks with the aid of a number of financial instruments, the characteristics and risks of which are described below. If you have any questions, don t hesitate to contact the KBC specialists. Our staff will be delighted to give you the benefit of their expertise. You can also call, or fax: Treasury & Capital Markets Corporate Sales, Tel , Fax kbc.corp.sales.vlaanderen@kbc.be kbc.corp.sales.antwerpen@kbc.be kbc.corp.sales.bra.lim@kbc.be 5

6 The financial products used to mitigate the risks attached to economic positions are called hedges. For each financial product you will find a description and an overview of the risks associated with that product. A summary and description of the risks may be found in the table below. This will provide you with the necessary understanding to decide how certain risks should be hedged. Credit risk Counterparty risk Liquidity risk Exchange risk Interest rate risk Risk definitions The risk that the financial counterparty in a professional transaction is unable to discharge his/her obligations for lack of funds or is unwilling to do so. The risk that an instrument will have limited or no tradability in the market due to an imbalance between supply and demand, thereby adversely affecting the market price of the product. The risk that the value of a product is adversely affected by exchange rate changes. The risk that the value of a product is adversely affected by interest rate changes. We draw a distinction between: the risk that a client wants to hedge, i.e. the risks facing the client as a result of his/her own economic position (also referred to as exposure). Typical examples are exchange risk, interest rate risk and credit risk. the risk of the financial product used as a hedging instrument. A summary and description of the risks may be found in the table Hedging exchange rate risks on page 7. KBC classifies these financial products by level of complexity, ranging from 1 (straightforward products) up to and including 3 (more complex products). A higher level of complexity does not necessarily mean that the financial product is also riskier. The complexity level is a measure for the comprehensibility of the product. More complex products are composed of various financial instruments (also known as building blocks), and therefore have a complicated structure. KBC tests and assesses the knowledge and experience needed by the client in order to understand possible combinations of product classes and complexity. The relevant products are subdivided into three different complexity levels graded according to the required level of knowledge and experience. This brochure is designed to provide support when making hedging decisions for a particular exposure. It should be noted that hedging is not the same as speculation. As noted above, hedging means the conclusion of an agreement to hedge an existing or future exposure. The hedge may be taken out for the entire exposure, i.e. for the same amount as the exposure, or for part of the exposure. The financial instruments rule out (wholly or partially) any potential negative effects on the results. The intention is for the client s results to be less susceptible to market fluctuations (as regards exchange rates and interest rates, etc.) through the combination of the client s own economic position and the hedging with a financial product. The partial hedging of an underlying risk position may also be labelled as active risk management. If the underlying risk position disappears, open risks may arise if the client retains the financial product that was originally taken out in order to hedge the risk position. Speculation is the conclusion of an agreement without an underlying exposure, with a view to making profits on market movements anticipated by the client. Since there is no compensating effect for the exposure, the speculator can suffer substantial losses if the market evolves unfavourably from his/her point of view. Speculation, it may be noted, is not permitted within KBC. If the 6

7 underlying exposure disappears, the position will be regarded as speculative and we would recommend dissolving it. General OTC (over the counter) Financial instruments that are traded over the counter are instruments that are traded outside an organised market. They are traded bilaterally and privately between two parties. Leverage The extent to which the price of a financial instrument changes due to a change in the value of the underlying risk is known as leverage. Volatility The price volatility of the underlying security. Deliverability The contract is settled by the delivery of the underlying currency/currencies (physical delivery). Cash settled In contrast to the physical delivery of the underlying currency/currencies, the contract is settled in cash in a basic currency (generally euros). Description of the financial instruments Apart from the existing financial instruments and building blocks, KBC offers a wide range of complex structures. Since this range is regularly changing, this brochure contains no more than a selection of the available structures. More information and a more detailed risk description may be found in the product sheets for the available products. You can of course also always contact your account manager. Main risks per product These are the most important factors that determine the market value of the product (also known as the mark to market), i.e. without the underlying exposure. Hedging exchange rate risks Forward foreign exchange contracts Currency swaps Currency options Zero cost collars Participating forwards Credit risk x x x x x Liquidity risk x x x x x Exchange risk x x x x x Interest rate risk x x x x x Hedging interest rate risks Forward rate agreements Interest rate swaps Interest rate options Collars Credit risk x x x x Liquidity risk x x x x Exchange risk Interest rate risk x x x x 7

8 Exchange risk What is exchange risk? Exchange risk is the risk of a change in the countervalue of a foreign currency in terms of a domestic or basic currency (generally the euro) as a result of exchange rate fluctuations. In other words, the value in euros, expressed in a foreign currency, of an amount shown on the books can fluctuate. As long as the amount remains unconverted into euros, you cannot be sure how much you will ultimately receive. This is illustrated in the EUR/USD Trend and EUR/GBP Trend graphs on page 10. The key element is the exchange rate of the euro against another currency. At the moment when the amount to be paid is agreed, the exchange rate can be a good deal lower than at the moment when payment actually takes place. When actual payment is made, the countervalue in euros could therefore be higher. 8

9 What impact do exchange rates have on my business? As a manager, monitoring or even just checking all the factors that affect your company is not necessarily straightforward. Apart from that, you re not working on an island: globalisation involves an ever-growing number of contacts with other countries. Central and Eastern Europe, Asia and North and South America are steadily becoming familiar territory for the Belgian entrepreneur. But apart from the complexity of foreign payment transactions, this activity often involves a new element, namely fluctuations in the exchange rate, i.e. the exchange risk. The introduction of the euro in 1999 eliminated a large part of those risks, but for companies exporting or importing outside the euro area the exchange risk remains an acute problem. The impact of exchange rates Some examples: Suppose you are a timber wholesaler and you buy your raw materials in Poland. The amount you have to pay is specified in Polish zlotys and is payable within three months. Exchange rate fluctuations can affect the countervalue of that amount in euros, so that you end up paying a totally different amount. A risk that is more difficult to manage is a quote. Not just a one-off quote but also a catalogue price in a foreign currency exposes a company to an exchange-rate risk. The minute the client commits him/herself, he/she is bound by the price stated. The exchange rate can be a major factor for a company headquartered in the euro area, but with branches elsewhere, when it consolidates its results at the end of the financial year. Translating the results into the accounting currency of the parent company necessarily involves an exchange rate and hence also a risk. These examples are summarised below: I need to pay an amount in foreign currency I am to receive an amount in foreign currency I have submitted a quote in a foreign currency (one-off or included in a catalogue) A rise in the euro against other currencies means in my case: A fall in the euro against other currencies means in my case: Profit Loss as I need to pay less in euros for the as I need to pay more in euros for the same amount in foreign currency. same amount in foreign currency. Profit Profit as I need to pay less in euros for the as I will receive more in euros for the same amount in foreign currency. same amount in foreign currency. A possibility of a loss A possibility of a profit for if my customer accepts the quote, for if my customer accepts the quote, I will be paid less in euros then I I will be paid more in euros then I thought when I drew up the price. thought when I drew up the price. 9

10 Managing your company s exchange and interest rate risks Which risk do we mean? The first step has been taken: we know where the risks could be located. But how big are they? And what is the likelihood that they will arise? The volatility of the currency The graph below shows the trend in the US dollar and Sterling, expressed in euros, from 2002 to From the peaks and troughs in the graph, you can see that the exchange rates of these currencies have undergone marked changes. The dollar has for example evolved from 0.82 US dollars per euro to 1.60 US dollars per euro. There is therefore a very real risk that the exchange rate can spoil your plans. And the longer the interval between the determination of the amount and the actual payment, the more likely it is that the exchange rate will alter in the meantime. Foreign currency share of your sales A second element that needs to be taken into account is the proportion of your activities that is not invoiced in euros. The bigger the share of your sales that is traded in a foreign currency, the bigger the potential impact on your result. EUR/USD Trend EUR/GBP Trend USD per EUR exchange rate Koers USD per Eur ,8 GBP per EUR exchange rate Koers GBP per Eur , , , , , ,0 EUR/USD , ,7 EUR/GBP , ,

11 Attitude towards exchange risks Finally you need to take account of your company s strategy and vision concerning exchange rates. There are two variants: You do not hedge the exchange rate risk and feel the effects of any exchange rate fluctuations. You do not take any risk whatever and ensure that every risk is properly hedged. How can you hedge exchange risks? There are a number of natural ways to deal with exchange risks. Unfortunately, they are not all equally feasible. When you determine the price, you can also determine the amounts in your own currency. In this way, the exchange risk is shifted to the counterparty, which will feel the impact of a fluctuating exchange rate. Much will however depend on your powers of persuasion in the negotiations. For example: To purchase a consignment of timber from Poland, the buyer pays zlotys. At the time of purchase that corresponds with approximately euros. Payment will only be made six months later, however, upon delivery of the timber. When the parties sign the contract, there are therefore two possibilities: The contract states The exchange risk lies with euros the vendor zlotys the buyer One can also try as far as possible to state the incoming and outgoing flows in the same currency. If you receive and pay in the same currency, the positive and negative elements of the fluctuation will cancel one another out. Unfortunately such solutions are often not readily available, which is why KBC offers a whole range of products so that you can always find a solution: no risk versus limited risk, premium or no premium, and various intermediate solutions. These solutions are tailored to each client (i.e. are over the counter or OTC) and are therefore not traded on any exchange. The amounts and expiry dates can therefore be tailored precisely to the client s circumstances. 11

12 Forward foreign exchange contracts Definition A forward foreign exchange contract is a forward purchase or sale of an amount in a foreign currency at a pre-agreed exchange rate. Explanatory notes A forward foreign exchange contract regulates the conversion of two amounts in different currencies at a specified future time at an exchange rate agreed upon when entering into the contract. The following elements are agreed upon when entering into the contract: the point at which the amounts are converted, i.e. the expiry date; the exchange rate; the amounts; the currencies; purchase or sale. If you take out a forward foreign exchange contract, this gives you certainty as to the value in euros of an amount in foreign currency. You do not therefore have to wait until actual conversion is made. Suppose the client has concluded a euro/us dollar forward foreign exchange contract at an exchange rate of On the expiry date i.e. the date on which the amounts are converted the client will always receive the exchange rate of irrespective of the market rate. If the client has not entered into a forward exchange contract, he/she will then be required to exchange the amounts in question at the prevailing (spot) exchange rate. The graph below indicates the exchange rate the client will receive on the expiry date, based on the market rate. Forward foreign exchange contract on expiry date Cliëntenkoers Client rate 1, , , , , , , , , , ,30 1, , , No Geen hedge indekking Forward Valutatermijncontract foreign exchange contract Market Marktkoers rate 12

13 The forward rate If you ask the bank for a forward rate, you will be quoted a rate that differs from the current spot rate. This has to do with exchange rate gap between the two currencies. Suppose you want to purchase US dollars in three months time (90 days) and to pay for this in euros. The bank wants to hedge that risk itself and immediately invests in US dollars, so that the amount plus interest over those three months will amount to US dollars. In order to make that investment, the bank first takes out a loan in euros. That amount is then converted at a spot rate to an investment in US dollars. On the expiry date, US dollars is placed against the amount borrowed and the interest payable in order to determine the forward rate. This is illustrated by the calculation below. So that it can specify US dollars in 90 days time, the bank must at an interest rate of 1.5% now invest US dollars. At a spot rate of 1.30 it has to borrow euros for this purpose. On account of the euro interest rate of 1% the bank ultimately has to repay euros. The forward rate is therefore US dollars / euros = Evaluation Advantages You can be certain of the future exchange rate No premium Simple product with a predictable result Disadvantages You are unable to benefit from a favourable evolution of the exchange rate You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 13

14 Currency swaps Definition A currency swap is a combination of a spot transaction (i.e. a currency swap at the spot rate) and a forward foreign exchange contract. The parties therefore exchange an amount in one currency for an amount in another currency and agree to reverse that exchange after a certain period. Explanatory notes A currency swap is a treasury operation. The following are some examples of situations in which a swap is useful: The payment of an invoice (for which a purchase of foreign currency had been anticipated) is postponed. The sale of the foreign currency on the original contract date and the purchase on the new date resolve the problem. A company has cash balances in euros, but has a temporary requirement for US dollars. Instead of borrowing the dollars, the company will buy them for cash by selling its euros and immediately sell them again at a forward date so as not to be exposed to changes in the exchange rate of the dollar. Evaluation Advantages Solid alternative to a loan depo operation Off-balance sheet Does not draw on credit lines Disadvantages Calls for professional lines You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 14

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16 Currency option - client buys EUR call USD put Cliëntenkoers Client rate 1, Currency options 1, , , , , , , , , , , ,50 1, Market Marktkoers rate Client Cliënt buys koopt EUR EUR call call Geen No hedge indekking Definition A currency option provides the buyer with the right to buy (call) or sell (put) an agreed amount in a particular currency at an agreed exchange rate either on (European style) or until (American style) a specified date. If the buyer of the currency option exercises his/her right, the seller (or writer) of the currency option must deliver (call) or sell (put) the amount in the agreed currency and at the previously determined exchange rate. In order to obtain that right, the buyer of the currency option pays the seller a premium. Explanatory notes In the case of clients wanting the certainty of a guaranteed exchange rate (either a minimum or a maximum) while at the same time being able to benefit from a favourable evolution of the exchange rate, there is the currency option. This gives the buyer of the currency option the right to a particular, pre-agreed exchange rate. The buyer is not however obliged to accept that exchange rate. If the market rate is more favourable at the point at which the currency option can be exercised, the buyer is able to disregard the option and trade at the market rate. A currency option therefore offers a major advantage in relation to a forward contract, in that the client is able to follow a favourable development of the exchange rate and avoid a negative one. The client does, however, have to pay the seller a premium for this extra advantage. That premium depends in particular on the term of the option, the protection level (i.e. the rate at which the option can be exercised) and of course the amount of the exposure. Variations A currency option comes in a number of variants: Call or put A call provides the right to buy a particular amount in foreign currency at a pre-agreed exchange rate. A put provides the right to sell a particular amount in foreign currency at a pre-agreed exchange rate. If the exchange rate evolves favourably, the buyer is able to benefit as a result. If the exchange rate evolves unfavourably, he/she can fall back on his/her option. Since the exchange rate always indicates the relationship between two currencies, a call in one of those currencies is necessarily a put in the other. The right to buy euros against dollars at an agreed rate is also the right to sell dollars against euros at the same price. Buying an option Importer Buy call on foreign currency Exporter Buy put on foreign currency The client pays a premium, but consequently limits the possible loss The client pays a premium, but consequently limits the possible loss 16

17 Currency option - client buys EUR put USD call Currency option - client buys EUR put USD call Cliëntenkoers Client rate Cliëntenkoers Client rate 1, , ,38 1, ,36 1, , ,32 1, , ,28 1, ,26 1, , ,22 1, , , ,10 1, , ,40 1, , , , ,24 1, , , ,32 1, , , ,40 Market Marktkoers rate Market Marktkoers rate Client Cliënt buys koopt EUR EUR put put No Geen hedge indekking Cliënt Client buys koopt EUR EUR put put USD USD call call No Geen hedge indekking Forward Termijnkoers rate European or American A European-style option can only be exercised on the expiry date, while an American-style option can be exercised on any working day up to and including the expiry date. When an option is exercised, the currencies will be exchanged on the value date, i.e. two business days later. Example On 1 March, a Belgian company places an order in the US for equipment worth 1.1 million US dollars. The invoice has to be paid in three months time, i.e. on 1 June. At the present time, the three-month forward rate for the euro/us dollar is If the value of the dollar rises, the company will have to pay more for the equipment. The company wants to hedge against a rise in the dollar but also wants to benefit from any fall in the currency. Solution: The company buys a call option in US dollars (put option in euros) with the following features: size of the contract: 1.1 million US dollars Euro/US dollar exercise price: 1.30 option premium: 0.02 US dollars per euro expiry date: 1 June European-style option If the call option in US dollars reaches the expiry date, the client has the following possibilities: the client exercises his/her call option and can buy US dollars at the agreed rate; the client does not exercise his/her option and can trade at the market rate. The buyer of the option can always select the best possible rate: either the rate offered by the option, or the market rate. Advantages Offers protection against an unfavourable change in the exchange rate Offers the possibility of still taking advantage of a positive change in the exchange rate Disadvantages Premium You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 17

18 Zero cost collars (also known as range forward, tunnel or risk reversal) Definition A zero cost collar is a combination of a bought and a written option, whereby the paid and received premiums are the same. The client consequently has certainty that the exchange rate will be between a certain minimum and maximum, but that it can fluctuate within that range. Explanatory notes The added value of the zero cost collar derives from the combination of the cost-free aspect and the (limited) possibility of a profit. At the same time there is also a (limited) risk of a loss, compared to a forward foreign exchange contract. The range within which the rate can fluctuate is agreed at the point at which the contract is concluded. Since the zero cost collar is a combination of a bought and a put currency option, these determine the range. The zero cost collar offers just a little more flexibility than a forward foreign exchange contract since the exchange of currencies at some future point does not take place at a specific rate but within a certain range. As the buyer or seller of a zero cost collar, you still have a limited profit potential, without being actually exposed to any major risk. In relation to an ordinary currency option, the zero cost collar has the advantage that you do not have to pay a premium. Zero cost collar Client Cliëntenkoers rate 1, , , , , , , , ,30 1, ,34 1, No Geen hedge indekking Forward Termijnkoers rate Participating Range forward forward Market Marktkoers rate 18

19 Example A company is required to pay Canadian dollars for a large consignment of timber from Canada. Payment is required in six months time, upon delivery. The present exchange rate is and the forward rate is The exchange rate could however evolve favourably, so that the bank is proposing a zero cost collar with a range of between and On the expiry date, the client is able to exercise a cash transaction within the limits of the range. This, therefore, means that the price may still go up or down slightly. However, both increases and decreases in the price are capped, which also means that any potential losses or gains are limited compared to a forward foreign exchange contract. Evaluation Advantages You retain a certain profit potential The product is fairly straightforward No premium Disadvantages You are unable to benefit in full from a favourable evolution of the exchange rate You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 19

20 Participating forwards Definition A participating forward is a forward foreign exchange contract that guarantees a basic rate while at the same time enabling partial participation in any favourable movement of the exchange rate. Explanatory notes A participating forward is a variant of a forward exchange contract that is composed on the basis of a bought and a sold currency option. By paying a relatively small premium, the buyer can (i) fall back on a guaranteed exchange rate and (ii) simultaneously also participate in a favourable movement in the exchange rate. The graph below demonstrates a participating forward in the case of an importer. In addition to the situation without hedging, for which a cash transaction is used on the expiry date, and the situation of a forward foreign exchange contract, where the exchange rate is fixed, the participating forward offers an intermediate solution. Participating forward Client Cliëntenkoers rate 0, , , , , , , ,8000 0, , , , , , No Geen hedge indekking Forward Termijnkoers rate Participating Forward forward Market Marktkoers rate When setting up a participating forward various intermediate forms are also possible. By varying the exchange rate an appropriate solution can be found, with or without premium, and with a different degree of participation. Much also depends on that point on the market conditions for the currencies in question. 20

21 Example In return for the sale of commodities in the UK, the company is to receive a large amount in Sterling in three months time. Although the company expects Sterling to strengthen slightly, it does not want to run any risk. The bank is therefore offering a participating forward. The present exchange rate is 0.83 and the forward rate The company takes out a participating forward for an exporter guaranteeing him a maximum rate of (he will therefore receive at least euro per Pound Sterling), and 60% of the potential profit. The precise composition and location of the curves depend on the market conditions at the time of concluding the agreement and can make it more interesting or less interesting to procure that product. Evaluation Advantages Guaranteed minimum or maximum exchange rate The buyer remains able to benefit from a favourable movement in the exchange rate Disadvantages The guaranteed rate is less favourable than the rate offered by a straightforward forward exchange contract You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 21

22 Interest rate risks What is interest rate risk? You run an interest rate risk if you face a cash deficit or surplus in your treasury management system. In those cases you will receive or need to pay interest, which means you leave yourself open to the uncertainties of interest rate movements. That financial result forms part of a company s overall results and as such needs to be managed. Some examples make that clear: A company that exports on a large scale to Germany is thinking of buying a storage depot there in order to support its activities. The decision is taken, but the actual investment does not take place until six months later. When the company approaches the bank for a loan, interest rates have gone up. This increases the investment costs and could potentially endanger the profitability of the project. A second company sells a plant and uses the proceeds to acquire a stake in another company. However, the company does not receive its money for the sale until two months after paying for the participating interest. During those two months, the company therefore has a large cash shortfall, which it wants to cover on the best possible terms. A large company issues bonds, offering a fixed rate of interest in order to attract investors. The company would, however, prefer to work with a floating rate of interest. Therefore, the bank provides an interest rate swap, i.e. a structured exchange of interest cash flows. 22

23 It may not be something that keeps you awake at night, but interest rates can regularly upset your plans. Needless to say the impact will not be equally as great or frequent for each company. It is therefore important to be able to identify the risk and its potential consequences. Is hedging still necessary? Although interest rates have fallen in recent years, the graph below shows that things were different in the past, with alternating periods of rising and falling rates, sometimes with highly divergent rates of interest for the periods in question. The graph therefore shows that it is certainly advisable to deal cautiously with the rate of interest and to provide for the necessary protection. 1-month & 1-year EURIBOR 6, , , , , , , EURIBOR Euribor 11-month maand EURIBOR Euribor 11-year jaar What s the best way to go about it? The best way to manage your interest rate risk is to follow the steps below. The table provides an overview. 1 Determining the interest rate risk Survey of existing positions Impact of new projects 2 Analysis of the risk Interest-rate scenarios 3 Strategy definition Internal factors - risk appetite - financial instruments 4 Execution For more information about the possibilities, please contact the KBC specialists. 23

24 The first and probably most important step is the identification of the risk. This can be done on the basis of the incoming and outgoing cash flows that you know and expect. You should however also take account of any plans of the company that could have an effect on your liquidity management: large investments for which a loan will need to be taken out, or large cash surpluses, for example from the sale of assets. For the purposes of this exercise, it is important to have the broadest view possible of the company and to have a view to the future. If you leave some of the flows out of the analysis this will diminish the effectiveness of the exercise. Each manager will have his/her own way of identifying those cash flows. In order to help outline the position, a graphic representation of a treasury position is shown below. Example The figure shows the company s predicted cash flow, spread over a number of periods. The dark blue bars above the line denote surpluses and the light blue bars below the line, shortfalls. By way of illustration an investment in period 11 has been assumed. A certain build-up of cash in the preceding periods has also been assumed. As soon as a company has a clear picture of where it stands and will stand, the second step is to examine the impact of interest rate fluctuations in the case of a rise, fall or no change in the status quo. How dependent is the company s result on the rate of interest? The above figure (or other diagram serving an equivalent purpose) is used for the analysis. General rule: the bigger the surpluses or shortfalls, the bigger the risks, as this increases the amount and the period for which it is necessary to borrow or invest. As a third step the company s attitude towards risk needs to be examined. Some companies simply allow shortfalls/surpluses to arise and then decide on a daily basis how to deal with these. Others do take steps to prepare and try to hedge future situations as best they can. The most appropriate solution probably lies somewhere in between. Most companies follow a strategy as proposed below. They concentrate on the outliers, related to specific projects or otherwise. In the case of the current shortfalls and surpluses a solution is worked out, while for the outliers a customised approach is sought. 24

25 Example In the graph above that would mean that the company concentrates on the dark blue or light blue areas. If a company concentrates on the outliers (i.e. timing and size of the amounts) the appropriate course of action will generally be to work out a customised solution together with the bank. Timing, size of the amount and the currency can play a role in determining the optimal solution, and the bank can offer various instruments. Some potentially suitable products are shown below. Derivatives The appropriate products for the management and protection of interest rate risks are derivatives. This means that there is no exchange of principals and that the interest is consistently offset (only the difference between the agreed rate of interest and the market rate is exchanged). Although derivative products are traded independently, both upon conclusion of the agreement and afterwards, the results thereof (in the case of hedging) must be regarded as a supplement to an underlying transaction. Credit margins may accordingly also be applied to the underlying transaction in question. 25

26 Forward rate agreements Definition A forward rate agreement (FRA) is an agreement between two parties on a future rate of interest, for an agreed underlying amount and period. Explanatory notes An FRA offers fairly straightforward protection against an unfavourable movement in interest rates. An FRA may always be bought as well as sold, whereby the buyer seeks protection against a rise in the interest rate and the seller seeks protection against a fall. On the contract date they agree the rate of interest, period and amount to which the FRA relates. Two working days before the start of the underlying period of the FRA the agreed rate of interest is compared with the market rate (e.g. EURIBOR). If the market rate is higher than the FRA rate, the seller pays the buyer the difference; If the market rate is lower than the FRA rate, the buyer pays the seller the difference. The difference is the interest rate differential on the agreed amount over the underlying period. This is made clear in the graph below: Cliëntenkoers in % FRA Client rate , , ,00 1, , ,50 3, , ,00 4, ,00 If Als the de client cliënt doesn t niets do doet anything FRA at tegen 1,15% 1,15% Market Marktkoers rate in in % Irrespective of the market rate when the FRA reaches its underlying period, the client always receives the interest from the FRA. No principals or gross interest are however exchanged. Only the interest rate difference is exchanged. That needs to be viewed in combination with, for example, an investment or a fixed advance at the market rate, while also allowing for a possible margin: Investment at the market rate Effect of FRA Balance for the client - Market rate (where appropriate with a margin) + Market rate - FRA rate - FRA rate (where appropriate with a margin) 26

27 Example Company X predicts that it will be facing a cash shortfall in four months time since its clients have more generous payment terms than its suppliers. In order to protect itself, the company therefore wants to fix the interest rate in advance. It contacts the bank and concludes an FRA with the following features: Underlying period: 3 6 months, amounting to commencement in three months and termination after six months = 92 days. Notional amount of principal: euros. Fixed interest rate: 1.15%. Three months later various scenarios are possible: If the market rate is above the fixed rate, the seller pays the buyer the difference. Suppose the market rate is 2.15%: The buyer will then receive euros, for if the market rate is lower than the fixed rate, the buyer pays the seller. In the case of a market rate of 0.75% at the fixing date, the buyer pays euros to the seller. If the market rate and the fixed rate are the same on the fixing date, nothing is exchanged. At that point the company takes out a fixed advance at market rate + credit margin. One other point: As the difference in interest rates is paid at the beginning of the underlying period in the case of FRAs, this amount is discounted at the underlying market rate (in this case 2.15%). Formula = (Market rate - FRA rate) * (number of days/360) / (1 + (92/360) * 2.15%). In practice this comes down to the fact that the bank can withhold interest on the amount paid, calculated at the market rate. Evaluation Advantages Protection against a negative movement in interest rates Simple product No premium Disadvantages Advantage of a positive movement in interest rates disappears You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 27

28 Interest rate swaps Definition An interest rate swap (IRS) is a transaction between two parties who agree to exchange interest flows in the same currency for a given period and on certain conditions. Explanatory notes An IRS is a structured exchange of various interest flows between the parties. Broadly speaking it therefore becomes possible to convert an interest rate flow from a loan or investment into another type of interest rate flow. This may be from fixed to variable or the other way round, or with an adjusted frequency. All sorts of combinations are possible. The most straightforward possibilities are examined below. There follows an example of a simple IRS, under which two types of interest are exchanged. A floating rate of interest is received every three months, whereas a fixed rate is paid once a year. Although each IRS relates to a particular principal, that sum is never exchanged. Only the interest flows are exchanged between the two parties. There are various possibilities, but an IRS may be modelled quite strongly. IRSs are offered in many forms. The basic principle is that the interest flows must be equivalent in both directions. On the basis of that principle numerous swap variants can then be worked out, often tailored to the specific needs of the company in question. Interest rate swap Intresten in % (buiten kredietmarge) Interest (excl. credit margin) Effectieve Interest rente rate , , , , ,00 Without in % Zonder IRS Met With IRS 1,50% at 1.50% Market Marktrente rate 28

29 Example A company has taken out a long-term loan at a floating rate of interest, i.e. an interest rate that is brought into line each period with the market rate. Hence, the company is susceptible to interest rate fluctuations. It can opt to convert the variable rate into a fixed rate with an IRS. To do so the company will approach a bank, which will determine an equivalent fixed rate. Once the swap has been concluded we find ourselves in the following situation: the company pays a fixed rate of interest to the bank, which pays a pre-agreed variable rate in exchange. The company then pays that rate on in order to pay off its loan. On balance the company therefore pays a fixed rate of interest. Where appropriate the payment frequency (monthly, quarterly, six-monthly or annual) may be adjusted in line with the company s liquidity management. The company wants to take out a hedge for a period of three years and a sum of 5 million euros, under a roll-over credit at a quarterly floating interest rate. The following swap is agreed with the bank: the company pays fixed interest of 1.50% on a quarterly basis and receives the 3-month EURIBOR at the same periodicity for a sum of 5 million euros. For the first quarter the 3-month EURIBOR has been set at 1.25%. The company pays 1.25% + credit margin (under the loan), receives 1.25% (3-month EURIBOR) and pays 1.5% under the IRS. On balance the 1.5% + credit margin is paid out. For the second quarter the 3-month EURIBOR has been set at 1.75%. The company pays 1.75% + credit margin (under the loan), receives 1.75% (3-month EURIBOR) and pays 1.5% under the IRS. On balance the 1.5% + credit margin is paid out. Evaluation Advantages A swap enables a company to adjust its interest flows so that they fit optimally into its liquidity management An IRS does not in principle involve any costs; at the point at which the IRS is concluded, the market value of both legs is the same Disadvantages As soon as a swap has been entered into, everything is fixed You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 29

30 Interest rate options Definition An interest rate option gives the buyer the right to borrow (cap) or to invest (floor) at a pre-agreed interest rate by paying the seller a premium. In the case of a cap, the seller of the interest rate option must guarantee a pre-agreed interest rate. The seller of a floor must accept an investment at the pre-agreed interest rate. At this stage no account is taken of any credit margin. Explanatory notes An interest rate option gives the buyer the right to a pre-agreed interest rate. In exchange for this right the seller is paid a premium. From the buyer s point of view the premium may be regarded as an insurance premium. With regard to interest rate options, we draw a distinction between two different types: The cap guarantees the future borrower a maximum rate of interest. If the market rate at the time of borrowing is higher than the interest on the option, the difference is paid by the seller of the cap. If the market rate is lower, nothing happens. In that case the buyer of the cap borrows at the market rate (+ credit margin). The floor guarantees the future investor a minimum rate of interest. If the market rate at the point of investment is lower than the interest rate of the floor, the buyer of the floor is paid the difference. If not, nothing happens. Purchase of floor Interesten in % Effectieve rente Interest ,50 1 1, ,50 3 3, in % Without Zonder indekking hedge IRS at 1,50% 1.50% Floor at 0,5% 0.5% Market Marktrente rate 30

31 Example On 15 March, a company is expecting a cash surplus of euros for the period from 15 June through 15 June of the following year. The company wants to cover itself against any fall in interest rates, but does not want to miss out on the benefits of any rise. Solution: The company buys a floor with the following features: underlying amount: 5 million euros exercise price: 1.1% option premium: 0.20% of the nominal amount = euros index = 3-month EURIBOR expiry date: 13 June interest period: 15 June through 15 June of the next year The company therefore never receives less than the exercise price less the option premium and stands to benefit from an interest rate rise. Evaluation Advantages Protection against an unfavourable movement in interest rates Profit potential in the event of a favourable movement remains intact Disadvantages Premium You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 31

32 Collars Definition A collar is a combination of a cap and a floor, but with a different exercise price. One of the contracts is bought and the other is sold, so that the interest rate fluctuations remain confined in return for a limited premium. Explanatory notes Often an important obstacle in the case of a standard interest rate option (or plain vanilla) is the premium. A company wants to be able to benefit from a favourable evolution of interest rates while still being protected. But the premium for an ordinary cap or floor often constitutes a problem. The collar therefore provides an alternative. By selling and buying an option at the same time, part of the premium received can be used in order to pay the other premium. The graph immediately shows that the rate of interest lies within a strict collar, even though there is (limited) room for manoeuvre. Depending on whether you need to borrow or invest, you can select a different combination: Borrowing: purchase of a cap and sale of a floor. Investing: purchase of a floor and sale of a cap. The premium received is consistently used to pay for all or part of the premium due. The precise structure of the collar can be worked out in terms of the prevailing market conditions and the client s preferences. If the client has specific questions about the collar itself, the premium is determined on that basis. Collar Interesten Interest in % , , , , ,25 1, , ,00 2, , , ,00 3, ,50 3, , month Euribor 3 EURIBOR Maanden in % Without Zonder hedge indekking IRS at 2,0% 2.00% Collar 32

33 Example A company is taking out a long-term floating-rate loan. It wants to cover itself for a period of three years and an amount of euros. The company is not, however, convinced that interest rates will rise quickly and wants therefore to benefit for as long as possible from the low floating rate. At the time, the interest rate swap is quoted at 2% and the 3-month EURIBOR at 1.25%. The company decides to buy a 3% cap and to sell a 1.20% floor at zero cost (i.e. the premium paid for the purchase of the cap is compensated in full by the premium received for the sale of the floor). Scenarios: For the first quarter, the 3-month EURIBOR has been set at 1%. The company pays 1% + credit margin (under the loan) plus 0.20% (1.20% - 1%) (under the floor option). On balance, the company pays 1.20% + credit margin (i.e. the floor less the minimum base rate of interest). For the second quarter, the 3-month EURIBOR has been set at 1.75%. The company pays 1.75% + credit margin (under the loan); the collar is worthless in that quarter. On balance the company pays 1.75% + credit margin. For the tenth quarter, the 3-month EURIBOR has been set at 3.25%. The company pays 3.25% + credit margin (under the loan) and receives 0.25% (i.e. 3.25% - 3%) (under the cap option). On balance the company pays 3% + credit margin (i.e. the cap less the maximum base rate of interest). Evaluation Advantages Protects against extreme interest rate fluctuations Limited cost price Still allows a certain profit potential Disadvantages Profit potential is limited You should also take account of the risks inherent in the product (see tables Main risks per product on page 7). Possibilities For more information about the possibilities, please contact the KBC specialists. 33

34 Swaptions Definition A swaption is an option on an interest rate swap (IRS). In exchange for the payment of a premium the buyer of the swaption has the right to an IRS on pre-agreed terms. Explanatory notes As an option on an IRS, a swaption confers the right to an IRS on pre-agreed terms. There are two ways in which a swaption can be approached: A payer swaption provides the buyer of the swaption with the right to an interest rate swap, where he/she pays a fixed rate of interest and receives a floating rate of interest; A receiver swaption provides the buyer of the swaption with the right to an interest rate swap, where he/she receives a fixed rate of interest pays a floating rate of interest. A swaption provides a company with more flexibility than an ordinary swap, as the buyer of the swaption has the right to take up the option or not to do so. The seller must enter into the swap if the buyer so decides. He/She will of course once again be paid a premium in order to accept this obligation. If the buyer of the swaption exercises his/her right on the expiry date, an amount representing the value of the swap will generally be exchanged (the cash settlement). Where appropriate, an interest rate swap may also be used on the terms laid down in the swaption, in combination with a fixed advance or a long-term investment. 34