Introduction to International Risk

Management
Short perusal of a few risk management texts
produces an extensive taxonomy of risks
Interest rate risk, Credit risk, liquidity risk, foreign
exchange risk, country risk, market risk,
technology and operational risk are all common
forms of risk.
While over the past decades global economies
have become more integrated, international risk
has increased, and international risk
management become more any more
important.
All are important and worthy of attention
Module focuses on:
 Risks that businesses encounter in their financial
dealings
 The motive to manage these risks and the means
available:
We will look at:
 Interest rate risk, hedging short term interest risk using
money market fixed
 Duration & management of risk of debt capital
 Derivative Market instruments and Hedging: Futures,
Options, Forwards, Swaps, and using these derivative
market instruments to hedge currency risk, interest risk
We start with a very basic question
What is risk?
Common response
The possibility of something bad happening to a
person in the future
Too limited from a business perspective
Commonly hear talk of risk-taking innovators
Risk with a positive, upbeat, spin
Risk to be embraced, not avoided
Downside characterisation of risk is one-sided
Modified characterisation of risk
Future outcomes differ from our initial
expectations/forecasts concerning what will
occur
From a business perspective, this definition has
advantages
1. Outcomes that always coincide with initial
outlooks are certainties. Risk-free phenomena
2. Portrays risk has something with upside and
downside aspects
3. Expectations and forecast cannot always be right
The entrepreneurial mindset associates risk with
creative undertakings with uncertain outcomes
On the upside, risk takers reap financial benefits
from successful ventures
On the downside, risk takers experience financial
losses from failed ventures
Key point:
Enterprise is not about avoiding uncertainty
 It’s about taking actions, doing things, knowing
that results are uncertain
 Willingly stepping into the unknown
If this is so: Why talk of risk management?
Suggests a motive to avoid risks, to make outcomes
more certain
Can seem at odds with the spirit of enterprise
Let’s pose the issue slightly differently
Risks that can be managed, reduced, neutralised
ought not to offer rewards
Hence not to manage them would be to accept
risks for which expected rewards are zero
Risk-taking without the prospect of gain is
pointless and foolhardy
Hence risk management is founded on the fact
that the effects of some uncertainties can be
mitigated and controlled
Financial risk management not at odds with
enterprise
Rational to want to minimise risk, maximising the
prospect of achieving enterprise aims
But enterprise can never be devoid of risk: risk is
intrinsic, its DNA
Remainder of the presentation focuses on two
themes:
1. Manageable risks
2. Financial risk management and arbitrage
 1. Manageable risks
Historically, the first systematic risk management
practice to emerge was underwriting/insurance
Basic characteristics of insurance
Downside oriented: offers compensation for
damages incurred due to accidents
No upside: doesn’t reward causing damage
Example of London shipping insurance in 1700s:
 Cargo transport across the seas very risky
 Merchants bought insurance that compensated
them should ships and goods be lost at sea
 Merchants paid premiums to specialist
underwriters
Early days: cases of individuals buying insurance
on goods they did not own
 Perverse incentive, to cause damage
 Receive payment far exceeding premium paid
Hence a core feature of insurance:
A policyholder must demonstrate an
‘insurable interest’
 OK to insure building and contents on a house
you own
 Not OK to insure the building and contents on a
neighbour’s home
• The upside: burn down neighbour’s house
Insurance industry facilitates management of
the financial risks associated with damage to
property and life arising from accidents and
hazards
 Not a mechanism for profiting from risk (except
fraudulently)
Financial risk management is similar to
insurance
 Driving force is to address manageable downside
risks
 Not to seek gains
Example:
A UK business buys raw materials from a supplier in
France. It has agreed to pay €1m in three months
The UK business is inherently risky
 Competition, changing consumer tastes and other
factors mean that it can never be bankruptcy-
proof
 Success in the face of this business risk results in
gains for business owners, failure in losses
It also faces a manageable risk
 The sterling cost of €1m euros in three months
The company can easily fix the sterling cost today:
 Buy euros today with sterling
 Hold euros until the payment date
This fixes the exchange rate on a future transaction
 Creates a fixed forward exchange rate now
 No uncertainty over the sterling cost of €1m euros
Assume:
• GBP/EUR spot rate = €1.13
• Euro area 3-month interest rate = 0.2%
• UK 3-month interest rate = 1.2%
Step 1: Buy present value of €1m (need €1m in 3
months not now)

Step 2: Sterling purchase price

Step 3: Sterling cost (add interest lost on deposit)

€1,000,000 in 3 months costs £887,167
The sterling cost is fixed at the outset
The forward rate of exchange is:

The UK company has fixed the price of euros

Whatever happens to the GBP/EUR rate over the
following 3 months has no impact
It is protected against exchange rate
uncertainty
The management of currency risk is a reasonable
thing for the UK company to do
Without the fix, it adds currency risk to its business
risk
If it did nothing and the GBP/EUR rate after 3 months
is €1.10, the €1m costs £909091 instead of £887,167
It is engaging in, risky, currency speculation on top of
the risks of its business
Unless the business specialises in currency trading
there is no basis for believing it will profit
Hence, it would be taking risk without expectation of
a reward (but it might be lucky)
The exchange rate might move favourably
 What if in 3 months the GBP/EUR rate is €1.15?
 If the company does nothing, it benefits because
€1m costs £869565, less than the fixed price of
£887,167
 If the UK company fixed the sterling cost it does not
benefit from the cheaper euro. It still pays £887,167
Refer back to the earlier point
Financial risk management is similar to insurance
 Driving force is to address manageable
downside risks
 Not to seek gains
 2. Financial risk management and arbitrage
In the example the forward rate is €1.1272
In practice, the company can agree a 3-month
forward rate with a bank
More convenient: company avoids the need to use
withdraw (or borrow) one currency, buy the other
and deposit it.
Simply buy €1m at the fixed rate in 3 months
The rate agreed with the bank ought to be
€1.1272. Why?
Because:
The company’s do-it-yourself approach is a price of
€1m euros in 3 months
The company-bank forward agreement is the price
of €1m euros in 3 months
They are effectively transactions in the same
product - €1m in three months
Hence it is reasonable to expect them to cost the
same
This raises a notion critical in financial risk
management theory
The relation between current and forward
prices should be arbitrage-free
Arbitrage refers to circumstances where products
that are perfect substitutes for one another
simultaneously trade at different prices
Such instances can generate opportunities for
arbitrage-profit
Buy where the price is lower
Sell where the price is higher
Assuming transaction costs are less than the price
difference, an arbitrage profit occurs
Arbitrage profit is rooted in price inefficiency
Recall from the example:
• GBP/EUR spot rate = €1.13
• Euro area 3-month interest rate = 0.2%
• UK 3-month interest rate = 1.2%
Imagine a bank offers a 3-month forward rate of
€1.15, rather than €1.1272
There is an arbitrage opportunity. Example:
 Borrow €1m from the bank
 Buy sterling with the euros
 Save the sterling with the bank for 3 months
 Agree to the bank’s €1.15 3-month forward rate
€1m buys

In three months euro loan repayment

Sterling deposit account in three months

After 3 months £ sterling to buy € under forward agreement

This is €20252 more than the cost of the loan, equivalent to a

return on €1m of
The bank effectively
Charges 0.2% to borrow euros
Pays 8.3% to savers of euros
Bank cannot do this
 Quickly be bankrupt at hands of arbitrageurs
 Forward rate inevitably adjusts to conform to
arbitrage-free level