Financial consultant

Futures versus Forward Contracts

admin — Thu, 25 Nov 2010 19:44:45 +0000

A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time. Futures contracts are standardized agreements as to the delivery date (or month) and quality of the deliverable, and are traded on organized exchanges. A forward contract differs in that it is usually nonstandardized (that is, the terms of each contract are negotiated individually between buyer and seller), there is no clearinghouse, and secondary markets are often nonexistent or extremely thin. Unlike a futures contract, which is an exchange-traded product, a forward contract is an over-the-counter instrument.
Futures contracts are marked to market at the end of each trading day. Consequently, futures contracts are subject to interim cash flows as additional margin may be required in the case of adverse price movements, or as cash is withdrawn in the case of favorable price movements. A forward contract may or may not be marked to market, depending on the wishes of the two parties. For a forward contract that is not marked to market, there are no interim cash flow effects because no additional margin is required.
Finally, the parties in a forward contract are exposed to credit risk because either party may default on the obligation. Credit risk is minimal in the case of futures contracts because the clearinghouse associated with the exchange guarantees the other side of the transaction.
Other than these differences, most of what we say about futures contracts applies equally to forward contracts.

Par Value

admin — Mon, 25 Oct 2010 19:43:14 +0000

The par value of a bond is the amount that the issuer agrees to repay the bondholder by the maturity date. This amount is also referred to as the principal, face value, redemption value, or maturity value. Bonds can have any par value.
Because bonds can have a different par value and currency (e.g., U.S. dollar, euro, pound sterling), the practice is to quote the price of a bond as a percentage of its par value. A value of 100 means 100% of par value. So, for example, if a bond has a par value of $1,000 and the issue is selling for $900, this bond would be said to be selling at 90. If a bond with a par value of Eur 5,000 is selling for Eur 5,500, the bond is said to be selling for 110.

Using Real Instead of Nominal Cash Flows and Discount Rates

admin — Sat, 25 Sep 2010 19:42:32 +0000

Companies can be valued by projecting cash flow in real terms (for example, in constant 1999 dollars) and discounting this cash flow at a real discount rate (for example, the nominal rate less expected inflation). Most managers think in terms of nominal rather than real measures, so nominal measures are often easier to communicate. Interest rates are generally quoted nominally rather than in real terms (excluding expected inflation). Moreover, since historical financial statements are stated in nominal terms, projecting future statements in real terms is difficult and confusing.
An important difficulty occurs when calculating rates of return on invested capital. The historical statements are nominal, so historical returns on invested capital are nominal. But if the projections for the company are real rather than nominal, returns on new capital are also real. Projected returns on total capital (new and old) are a combination of nominal and real, which are impossible to interpret. The only way around this is to restate historical performance on a real basis, a complex and time-consuming task.

What Drives Cash Flow and Value

admin — Wed, 25 Aug 2010 19:41:45 +0000

You could stop right here and say that once you have projected free cash flow and discounted it at the WACC, the valuation is complete. This would not be satisfying, however, because you have not evaluated the free cash flow projection upon which the valuation was based. How does the projection compare to past performance? How does the projection compare with other companies? What are the economics of the business? Are they expressed in a way that managers and others can understand? What are the important factors that could increase or decrease the value of the company? You need to step back and understand the underlying economic value drivers of the business.
Since value is based on discounted free cash flow, the underlying value drivers of the business must also be the drivers of free cash flow. There are two key drivers of free cash flow and ultimately value: the rate at which the company is growing its revenues, profits, and capital base, and the return on invested capital (relative to the cost of capital). These value drivers make common sense. A company that earns higher profit for every dollar invested in the business will be worth more than a similar company that earns less profit for every dollar of invested capital. Similarly, a faster growing company will be worth more than a slower growing company if they are both earning the same return on invested capital (and this return is high enough to satisfy the investors).
A simple model will demonstrate how growth and return on invested capital actually drive free cash flow. First, some definitions are needed. Return on invested capital (ROIC) equals the operating profits of the company divided by the amount of capital invested in the company.

Value of Equity

admin — Sun, 25 Jul 2010 19:40:57 +0000

The value of the company’s equity is the value of its operations plus nonoperating assets, such as investments in unrelated, unconsolidated businesses, less the value of its debt and any nonoperating liabilities. The valuation of Hershey’s equity is $9.4 billion, including $450 million representing the value of its pasta business, which was sold in early 1999.

Interest Rate Swaps

admin — Mon, 16 Nov 2009 08:42:53 +0000

Interest rate swaps are simply a form of multiple period FRAs. The term of the agreements may be a matter of many months or even years. As is the case with FRAs there is no exchange of principal.
The netting effect disguises the true nature of this transaction. The duration of an asset or liability that is repriced against market rates on a frequent basis is close to zero. That is not the case for a fixed rate asset or liability. In fact the fixed rate payer has effectively shortened duration while the floating rate receiver has lengthened it.
An international swaps dealers association is largely responsible for having established standardized international swap agreements. One of the early legal challenges was to come up with a structure where in the event of one party breaching a swap agreement on which it is due to make payments the other party is under no obligation to continue to make payments on other swap contracts. This reduces the potential exposures of both participants in the event of either party becoming bankrupt. In entering into swap agreements banks are potentially exposed to credit risk. For swap contracts where the bank is a net payer there is clearly no credit risk. Credit risk only arises on contracts where the bank is a net receiver.

FINANCIAL FUTURES

admin — Mon, 19 Oct 2009 08:44:10 +0000

Futures represent a contractual agreement to buy or sell a financial instrument or commodity at a fixed price on a fixed future date. Futures differ from forward contracts in that they are traded on an exchange while forwards are contracts between two parties. A crucial difference between an option and a future contract is that returns for the participants of futures contracts are symmetric.
These are contracts to buy or sell interest-earning assets, at a predefined level of interest rate at a future date. In most cases these assets take the form of government securities. There are two types of US$ futures contract, Treasury-bill (T-bill) futures and Eurodollar futures. T-bill futures provide a contract to buy short-term US government paper while Eurodollar futures are based on short-term time interbank deposit rates. When interest rates fall the value of interest rate futures contracts rises.
I shall use an example based on our 15-year government bond, currently trading at $7453 and a 90-day futures contract priced at $7500. If we buy the contract then in three months’ time we are committed to buying the bond at that price.
If the bond’s price is $7500 (including accrued coupon payment) then neither the seller nor the buyer of the contract will make any profit or loss. If, however, the price of the bond is above that of the futures price the buyer of the contract will make a profit and the seller a matching loss. If, on the other hand, the price of the bond falls then the situation is reversed. The seller will make a profit and the buyer a loss.
The gains (losses) on the bond are exactly compensated by the losses (gains) on the futures contract.
The symmetry of returns means that no premium is involved. Both parties are, however, potentially exposed to counterparty risk. At the end of each day each members’ contracts are marked to market. Where a member’s net position is at a loss they are required to make a matching deposit with the exchange to cover those potential losses. Exchange members are also required to contribute to an exchange fidelity, or insurance fund, to further reduce risk.
It is worth noting that no cash payments are involved even if interest rates rise and we have a loss on our futures contract. This is because the bond can be used to meet the margin requirement. Futures contracts do not exist for all issues or for all maturities. If this is the case a close equivalent has to be used. This will result in a partial hedge.
When interest rates fall the value of interest rate futures contracts rises. The buyers of interest rate futures contracts effectively lengthen net duration while the sellers shorten duration.

INVESTORS AND CURRENCY RISK

admin — Mon, 06 Jul 2009 21:09:35 +0000

The relationship between institutional investors and the idea of currency risk has been an uneasy one. For a start, there remain an overly large number of investors who are either unwilling or unable, due to the specific regulations of their fund, to consider currency risk as separate and independent from the underlying risk of their investment. Such a view is particularly prevalent among equity, although it is also present to a smaller extent with fixed income fund managers. The aim of this blog is to err on the practical, to take the ideological out of the equation and seek to demonstrate empirically and theoretically that managing currency risk can consistently boost a portfolio’s return.
On the face of it, this blog may seem targeted at only those who manage currency risk on an active basis. This is not the case. Rather, it is aimed at any institutional investor who faces in the course of their “underlying business” exposure to a foreign currency, whether or not they are in fact allowed to carry out some of the ideas and strategies presented herein. Let us start then with two core principles on the issue of currency risk:
1. Investing in a country is not the same as investing in that country’s currency.
2. Currency is not the same as cash; the incentive for currency investment is primarily capital gain rather than income.
Almost before we have started, some may view the above as controversial. In my career, I have come up against not infrequent opposition to these principles, albeit for varying reasons. The answer I have given back has always been the same:
The dynamics that drive a currency are not the same as those that drive asset markets

THE CORPORATION AND PREDICTING EXCHANGE RATES

admin — Sun, 05 Jul 2009 21:08:38 +0000

A key aspect of corporate pricing strategy is forecasting future exchange rates. Aside from using banks to help them do this, the internal models corporations use are typically one or more of the following kinds:
Political event analysis
Fundamental
Technical
For the reasons we have mentioned earlier in this blog, it is not a good idea for corporations to use the forward rate as a predictor of the future spot rate because of “forward rate bias” — the idea that the unbiased forward rate theory does not in fact work. Academics argue that markets are efficient and therefore there is no point in corporations trying to “beat the market” by forecasting future exchange rates. This supposition is premised on a falsehood — markets may be efficient over the long term, but they are inherently inefficient over short time periods. The latter can be substantial enough to make a material impact on the corporation’s income statement were it to assume a perfectly efficient market and use unbiased forward rate theory accordingly.
The importance of market-based forecasts for the corporation is derived from comparing these to anticipated net cash flows. For the corporation, the crucial question is how will these cash flows respond if the future spot exchange rate is not equal to the forecast? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets.

BUDGET RATES

admin — Fri, 03 Jul 2009 21:07:55 +0000

The setting of budget rates is crucially important for a corporation as it can drive not only the corporation’s hedging but also its pricing strategy as well. Budget exchange rates can be set in several ways. The benchmark or budget rate for an investment in a foreign subsidiary should normally be the exchange rate at the close of the previous fiscal period, often referred to as the accounting rate. On the other hand, when dealing with forecasted cash flows, the issue becomes more complex. Theoretically, the budget exchange rate should be derived from the domestic sales price, which is the operating cost plus the desired profit margin, as an expression of the foreign subsidiary sales price. Thus, if the parent sales price for a good is USD10 and the Euro area sales price is EUR15, the budget rate should be 0.67. The actual exchange rate for Euro–dollar may be some way away from that. Thus, the corporation needs to evaluate the degree of demand for its product relative to changes in the product’s Euro price to see whether or not it has leeway to cut its Euro price without also reducing margin substantially in order to set a budget rate that is closer to the spot exchange rate. If there is a major difference between the spot and budget exchange rates, either the hedging or the pricing strategy may have to be reconsidered.
Corporations can also set the budget rate so as to link in with their sales calendar and thus their hedging strategy. If a corporation has a quarterly sales calendar it may want to hedge in such a way that its foreign currency sales in one quarter is no less than that of the same quarter one year before, implying that it should make four hedges per year, each of one-year tenor. Alternatively, instead of hedging at the end of a period, thus using the end-of-period exchange rate as its budget rate, the corporation may choose to set a daily average rate as its budget rate. In this case, if the corporation chooses as its budget rate the daily average rate for the previous fiscal year, it only needs to execute one hedge. It stands to reason that the best way of achieving this in the market place is to use an average-based instrument such as an option or a synthetic forward, entered into on the last day of the previous fiscal year, with its starting day being the first day of the new fiscal year. Of late, an option structure known as a double average rate optio (DARO) has become increasingly popular among multinational corporations. This allows a corporation to protect the average value of a foreign currency cash flow over a specified time period relative to another period. This is a simple way of passive currency hedging, taking out discretionary uncertainties and instead putting the hedging programme on auto pilot where it can be more easily monitored.
Whether a corporation hedges currency risk passively or actively, once the budget rate is set the Treasury is responsible for securing an appropriate hedge rate and ensuring there is minimal slippage relative to that hedge rate. Timing and the instruments used are key to being able to achieve that. The last point to make on budget rates is that they flow naturally from relative price differentials. This however is also the heart of the concept of PPP, which states that exchange rates should adjust for relative price differentials of the same good between two countries. While PPP models are of relatively little use in forecasting short-term exchange rate moves, they have a substantially better record in forecasting exchange rates over the long term. Thus, a corporation could do worse than setting the budget rate with a PPP model in mind, albeit with the realization that tactical hedging may be necessary either side of that budget rate over the short term in order to capture exchange rate deviation from where PPP suggests it should be. Finally, it is important to underline that budget rates can provide companies with one thing only: a level of reference. Set up randomly, they are of very little use. And at some point, prolonged currency moves against the functional currency must be passed on, or strategic positioning and hedging must be addressed; in any case two topics well beyond our budget rates discussion. In the end, while the process of setting budget rates cannot resolve all of a corporation’s issues, it can be dramatically improved by clearly defining the company’s sensitivities and benchmarking priorities. The hedging frequency as well as the choice of the hedge instrument will naturally flow from this process.