22 types and causes of risk.pdf

7/28/2019 22 Types and causes of risk.pdf

1/25


2/25

BUSINESSCH22ACCAPAPERF9V1JA.doc2

1 Foreign currency risk

In a floating exchange rate system:

the authorities allow the forces of supply and demand to continuously change the

exchange rates without intervention

the future value of a currency vis-a-vis other currency is uncertain

the value of foreign trades will be affected unlike when trading domestically.

1.1 Depreciation and appreciation of a foreign currency

If a foreign currency depreciates it is now worth less in our home currency.

Receipt adverse movement will receive less in your home currency.

Payment favourable movement will end up paying less in your home currency.

If a foreign currency appreciates it is simply worth more in our home currency

Receipt favourable movement will receive more in your home currency.

Payment adverse movement will end up paying more in your home currency.

The Comfort Table:

Sell fewer $s to get a pound Sell more $s to get a pound

App (0.10) $10m 0.10 Depr

Rates $/ $1.5 $1.6 $1.7

Cash flow 6.67m 6.25m 5.88m

Receipts

Payments

Test your understanding 1

Qualification ACCA

Paper F9

Chapter 22 Types and causes of riskContent Objective 295 297

Content, illustration andTYU included?

yes

Source ACCA Paper 3.7 Study notes session20, ACCA Paper 3.7 Study Text Chp 14,


3/25


What would a strong pound mean for the UK economy?

UK exporters:

UK importers

What would a weak euro mean for Euroland?

European exporters:

European importers:

Test your understanding 1 - solution

A strong pound for the UK economy

i.e. the pound has appreciated therefore other foreign currencies have depreciated relative to

the pound

UK exporters: Bad news; receipts in currencies that are depreciating; receive less pounds.

UK importers: Good news; payments in currencies that are depreciating; pay less pounds.

A weak euro for Eurolandi.e. the euro has depreciated therefore other foreign currencies have appreciated relative to the

euro.

European exporters: Good news; receipts in currencies that are appreciating; receive

more euros.

European importers: Bad news payments in currencies that are appreciating pay more

euros.

The Currency BluesIf a currency appreciates, companies complain that they cannot sell their goods abroad and

workers agitate about losing their jobs.

If a currency depreciates, consumers are unhappy because inflation is imported and their money

travels less far when they go abroad.

1.2 Exchange rate systems

The worlds leading currencies e.g.:

US Dollar Japenese Yen

British Pound European Euro

float against each other. However only a minority of currencies use this system.

Other systems include:

Fixed exchange rates

Local currency Fixed XCSingle other

currency e.g. US $


4/25


Freely floating exchange rates

Managed floating exchange rates

Although the worlds leading trading currencies, like the US Dollar, Japanese Yen, British Poundand European Euro are floating against the other currencies. A minority of countries uses floating

exchange rates. The main exchange rate systems include:

a) Fixed exchange rates

This involves publishing the target parity against a single currency (or a basket of currencies),and a commitment to use monetary policy (interest rates) and official reserves of foreignexchange to hold the actual spot rate within some trading band around this target.

Local

currency

othercurrencies

othercurrencies

othercurrencies

Pre-set (often confidential)limits

Local currency


5/25


Fixed against a single currency

This is where a country fixes its exchange rate against the currency of another country scurrency. More than 50 countries fix their rates in this way, mostly against the US dollar. Fixedrates are not permanently fixed and periodic revaluations and devaluations occur when theeconomic fundamentals of the country concerned strongly diverge (e.g. inflation rates).

Fixed against a basket of currencies

Using a basket of currencies is aimed at fixing the exchange rate against a more stable currencybase than would occur with a single currency fix. The basket is often devised to reflect the majortrading links of the country concerned.

Historical Perspective: British pound previously used a fixed rate system.

The pound was fixed against the US dollar from 1945 to 1972, and more recently was part of theEuropean Exchange Rate Mechanism (ERM) between 1990 and 1992. The rules of the ERMwere complicated, UK membership of the ERM involved a target rate of 2.95 DM against the DMwith a +/- 6% trading band: in other words, a minimum spot rate of around 2.77 DM. To holdsterling above this rate in 1992, the government used a significant amount of the UK s foreign

currency reserves and a high interest rate policy. Following its failure to defend the pound withinthe system, the UK left the ERM in September 1992.

b) Freely floating exchange rates (sometimes called a clean float)

A genuine free float would involve leaving exchange rates entirely to the vagaries of supply anddemand on the foreign exchange markets, and neither intervening on the market using officialreserves of foreign exchange nor taking exchange rates into account when making interest ratedecisions. The Monetary Policy Committee of the Bank of England clearly takes account of theexternal value of sterling in its decision-making process, so that although the pound is no longerin a fixed exchange rate system, it would not be correct to argue it is on a genuinely free float.

c) Managed floating exchange rates (sometimes called a dirty float)

The central bank of countries using a managed float will attempt to keep currency relationshipswithin a predetermined range of values (not usually publicly announced), and will often intervenein the foreign exchange markets by buying or selling their currency to remain within the range.

2 Types of foreign currency risk

Since firms regularly trade with firms operating in countries with different currencies, and may

operate internationally themselves, it is essential to understand the impact that foreign exchange

changes can have on the business.

2.1 Transaction risk

Transaction risk is the risk of an exchange rate changing between the transaction date and thesubsequent settlement date i.e. it is the gain or loss arising on conversion.

It arises primarily on imports and exports.


6/25


Illustration 1

On 1st

January a UK firm enters into a contract to buy a piece of equipment from the US for

$300,000. The invoice is to be settled on 31st

March.

The exchange rate on 1st

January is $1.6/ (i.e. $1.6 = 1)

However by 31st

March, the pound may have

1 strengthened to $1.75/ or

2 depreciated to $1.45/

Explain the risk faced by the UK firm

Solution

The UK firm faces uncertainty over the amount of sterling they will need to use to settle the USdollar invoice.

The cost of the equipment on 1st

January is$300,000

1.6= 187,500

However on settlement, the cost may be

1$300,000

1.75= $171,429

2$300,000

1.45

= $206,897

This uncertainty is the transaction risk.

A firm may decide to hedgetake action to minimise the risk if it is:

a material amount

over a material time period

thought likely exchange rates will change significantly.

See Chapter 23 for details of hedging strategies.


7/25


This type of risk is primarily associated with imports and exports. If a company exports goods on

credit then it has a figure for receivables in its accounts. The amount it will finally receive depends

on the foreign exchange movement from the transaction date to the settlement date.

As transaction risk has a potential impact on the cash flows of a company, most companies

choose to hedge against such exposure. Measuring and monitoring transaction risk is normally

an important component of treasury management.The degree of exposure involved, which is dependent on: The size of the transaction, is it material? The hedge period, the time period before the expected cash flows occurs. The anticipated volatility of the exchange rates during the hedge period.

The corporate risk management policy should state what degree of exposure is acceptable. This

will probably be dependent on whether the Treasury Department is been established as a cost or

profit centre.

2.2 Economic risk

Economic risk is the variations in the value of the business (i.e. the present value of future cashflows) due to unexpected changes in exchange rates. It is the long-term version of transactionrisk.

For an export company it could occur because:

the home currency strengthens against the currency in which it trades

a competitors home currency weakens against the currency in which it trades.

Illustration 2

An UK exporter sells one product in Europe on a cost plus basis.

The selling price is based on a UK price of 16 to cover costs and provide a profit margin.

The current exchange rate is 1.56/

What would be the effect on the exporter s business if sterling strengthened to 1.71/?

Solution

The product was previously selling at 16 x 1.56 = 24.96

After the movement in exchange rates the exporter has an unhappy choice:

Either they must


8/25


raise the price of the product to maintain their profits: 16 x 1.71= 27.36 but risk losingsales as the product is more expensive and less competitive, or

maintain the price to keep sales volume but risk eroding profit margins.

The exporter is facing economic risk.

A favoured but long term solution is to diversify all aspects of the business internationally.

Economic risk

Transaction exposure focuses on relatively short-term cash flows effects; economic exposureencompasses these plus the longer-term effects of changes in exchange rates on the market

value of a company. Basically this means a change in the present value of the future after taxcash flows due to changes in exchange rates.

There are two ways in which a company is exposed to economic risk

Directly: If your firms home currency strengthens then foreign competitors are able to gain salesat your expense because your products have become more expensive (or you have reduced yourmargins) in the eyes of customers both abroad and at home.

Indirectly: Even if your home currency does not move vis--vis your customers currency youmay lose competitive position. For example suppose a South African firm is selling into HongKong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens againstthe Hong Kong dollar the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favoured strategy is to diversity internationally, in termsof sales, location of production facilities, raw materials and financing. Such diversification is likelyto significantly reduce the impact of economic exposure relative to a purely domestic company,and provide much greater flexibility to react to real exchange rate changes.

2.3 Translation risk

Where the reported performance of an overseas subsidiary in home-based currency terms isdistorted in consolidated financial statements because of a change in exchange rates.

N.B. This is an accounting risk rather that a cash based one.


9/25


The financial statements of overseas subsidiaries are usually translated into the home currency inorder that they can be consolidated into the group s financial statements. Note that this is purely apaper-based exercise it is the translation not the conversion of real money from one currency toanother.

The reported performance of an overseas subsidiary in home-based currency terms can beseverely distorted if there has been a significant foreign exchange movement.

If initially the exchange rate is given by $/ 1.00 and an American subsidiary is worth $500,000,then the UK parent company will anticipate a balance sheet value of 500,000 for the subsidiary.A depreciation of the US dollar to $/ 2.00 would result in only 250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing atranslation exposure loss in the company's accounts, translation exposure will not normally behedged. The company's share price, in an efficient market, should only react to exposure that islikely to have an impact on cash flows.

3 Why exchange rates fluctuate

Changes in exchange rates result from changes in the demand for and supply of the currency.These changes may occur for a variety of reasons:

3.1 Balance of payments

Since currencies are required to finance international trade, changes in trade may lead tochanges in exchange rates. In principle:

demand for imports in the UK represents a demand for foreign currency or a supply ofsterling

overseas demand for UK exports represents a demand for sterling or a supply of thecurrency.

Thus a country with a current account deficit where imports exceed exports may expect to see its

exchange rate depreciate since the supply of the currency (imports) will exceed the demand forthe currency (exports).

Any factors which are likely to alter the state of the current account of the balance of paymentsmay ultimately affect the exchange rate.

3.2 Capital movements between economies

Qualification ACCA

Paper F9

Chapter 22 Types and causes of risk

Content Objective 300 305


yes

Source ACCA Paper 3.7 Study notes session21, ACCA Paper 3.7 Study Text Chp 20


10/25


There are also capital movements between economies. These transactions are effectivelyswitching bank deposits from one currency to another. These flows are now more important thanthe volume of trade in goods and services.

Thus supply/demand for a currency may reflect events on the capital account. Several factorsmay lead to inflows or outflows of capital:

changes in interest rates: rising (falling) interest rates will attract a capital inflow (outflow)and a demand (supply) for the currency

inflation: asset holders will not wish to hold financial assets in a currency whose value isfalling because of inflation.

These forces which affect the demand and supply of currencies and hence exchange rates havebeen incorporated into a number of formal models.

3.3 Purchasing Power Parity Theory (PPPT)

PPPT claims that the rate of exchange between two currencies depends on the relative inflationrates within the respective countries.

PPPT is based on:

The Law of One Price:

In equilibrium, identical goods must cost the same regardless of the currency in whichthey are sold.

Illustration 3

An item costs $3,000 in the US

Assuming the sterling and the US dollar are at PPPT equilibrium at the current spot rate of $/

1.50 i.e. the sterling price x current spot rate of $1.50 = dollar price.

The US market The UK market

Cost of item now $3,000 $1.50 2,000

Estimated inflation 5% 3%

Cost in one year $3,150 2,060

The Law of One Price states that the item must always cost the same. Therefore in one year:


11/25


1 infl

Current spot rate x Future expected spot rate in one year's time1 infl

st1

nd2

$3,150 must equal 2,060

and so the expected future spot rate can be calculated:

1.5291$))2,060

$3,150(

Rule: The country with the higher inflation will be subject to a depreciation of its currency.If you need to estimate the expected future spot rates, simply apply the following formula:

Where:

1 inflst1

= Inflation rate in country for which the spot is quoted

12

inflnd

= Inflation rate in the other country

Illustration 4

So where inflation in the US is expected to be 5% and in the UK 3%, the future expected spot is

1.5291$))1.031.05(x1.50


The dollar and sterling are currently trading at $1.72/

Inflation in the US is expected to grow at 3%pa, but at 4%pa in the UK.

Required: Predict the future spot rate in a year s time.

Test your understanding 2 solution

1.03

1.72 x ( )) $ 1.70351.04


12/25


Purchasing power theory can be used as our best predictor of future spot rates, however it suffersfrom the following major limitations:

the future inflation rates are only estimates.

the market is dominated by speculative transactions (98%) as opposed to tradetransactions; therefore purchasing power theory breaks down.

government intervention: governments may manage exchange rates, thus defying theforces pressing towards PPPT.

The main function of an exchange rate is to provide a means of translating prices expressed inone currency into another currency. The implication is that the exchange will be determined insome way by the relationship between these prices. This arises from the law of one price.

The law of one price states that in a free market with no barriers to trade no transport ortransactions costs, the competitive process will ensure that there will only be one price for anygiven good. If price differences occurred they would be removed by arbitrage; entrepreneurswould buy in the low market and resell in the high market. This would eradicate the pricedifference.

If this law is applied to international transactions, it suggests that exchange rates will alwaysadjust to ensure that only one price exists between countries where there is relatively free trade.

Thus if a typical set of goods cost $1,000 in the USA and the same set cost 500 in the UK, freetrade would produce an exchange rate of 1 to $2.

How does this result come about?

Let us suppose that the rate of exchange was $1.5 to 1: the sequence of events would be:

US purchasers could buy UK goods more cheaply (500 at $1.5 to 1 is $750). There would be flow of UK exports to the US: this would represent demand for sterling. The sterling exchange rate would rise. When the exchange rate reached $2 to 1, there would be no extra US demand for UK

exports since prices would have been equalised: purchasing power parity would have beenestablished.

The clear prediction of the purchasing power parity model of exchange rate determination is thatif a country experiences a faster rate of inflation than its trading partners, it will experience adepreciation in its exchange rate. It follows that if inflation rates can be predicted, so canmovements in exchange rates.

The purchasing power parity model can be stated as

1

i

1+ i

F

S

f

n

where if = expected foreign inflation rate

in = expected home inflation rate

F = expected future spot rate


13/25


S = current spot rate.

In practice the purchasing power parity model has shown some weaknesses and is a poorpredictor of short term changes in exchange rates:

It ignores the effects of capital movements on the exchange rate.

Trade and therefore exchange rates will only reflect the prices of goods which enter intointernational trade and not the general price level since this includes non-tradeables (e.g.inland transport).

Governments may manage exchange rates, e.g. by interest rate policy.

It is likely that the purchasing power parity model may be more useful for predicting longrun changes in exchange rates since these are more likely to be determined by theunderlying competitiveness of economies as measured by the model.

3.4 Interest rate parity theory (IRPT)

The Interest Rate Parity theory claims that the difference between the spot and the forwardexchange rates is equal to the differential between interest rates available in the two currencies.

Illustration 5

UK investor invests in a one-year US bond with a 9.2% interest rate as this compares well withsimilar risk UK bonds offering 7.12%. The current spot rate is $1.5/

When the investment matures and the dollars are converted into sterling IRPT states that theinvestor will have achieved the same return as if the money had been invested in UK governmentbonds.

The UK market The US market

Spot $/ 1.5

Start 1m $1.5m

x 1.0712 x 1.092

End 1.0712m $1.638m

What you gain in extra interest you lose on an adverse movement in exchange rates.


14/25


timesyear'oneinrateForward

nd2i1

st1i1

xratespotCurrent

Any attempt to fix the future exchange rate by locking into an agreed rate now (for example bybuying a forward (see Chapter 13 for details)), will also fail:

The forward rates moves to bring about interest rate parity amongst different currencies.

1.5291$))1.07121.092(x1.50

If you need to calculate the forward rate in one year s time:

Where:

i = interest rate

Illustration 6

Using the formula in the above example:

1.5291$))1.0712

1.092(x1.50

The IRPT generally holds true in practice. There are no bargain interest rates to be had onloans/deposits in one currency rather than another.

However it suffers from the following limitations:

government controls on capital markets

controls on currency trading

intervention in foreign exchange markets.


An treasurer can borrow in Swiss Francs at a rate of 3% pa or in the UK at a rate of 7% pa. The

current rate of exchange is 10SF/


15/25


What is the likely rate of exchange in a year s time?


1.03

10 x ( )) $ 9.62621.07

The interest rate parity model shows that it may be possible to predict exchange rate movementsby referring to differences in nominal exchange rates. If the forward exchange rate for sterlingagainst the dollar were no higher than the spot rate but US nominal interest rates were higher, thefollowing would happen:

UK investors would shift funds to the US in order to secure the higher interest rates sincethey would suffer no exchange losses when they converted $ back into

the flow of capital from the UK to the US would raise UK interest rates and force up thespot rate for the US $.

3.5 Expectations theory

The expectations theory claims that the current forward rate is an unbiased predictor of the spotrate at that point in the future.

If a trader takes the view that the forward rate is lower than the expected future spot price there isan incentive to buy forward. The buying pressure on the forward raises the price until the forwardprice equals the market consensus view on the expected future spot price.

It is a poor unbiased predictor sometimes it is wide of the mark in one direction and sometimeswide of the mark in the other.

3.6 The International Fisher Effect

The International Fisher Effect claims that the interest rate differentials between two countriesprovide an unbiased predictor of future changes in the spot rate of exchange. International FisherEffect assumes that all countries will have the same real interest rate, although nominal or moneyrates may differ due to expected inflation rates.

It is a poor unbiased predictor of future exchange rates.

Factors other than interest differentials influence exchange rates such as government interventionin foreign exchange markets.

3.7 Four-way equivalence


16/25


The four theories can be pulled together to show the overall relationship between spot rates,interest rates, inflation rates and the forward and expected future spot rates. As shown above,these relationships can be used to forecast exchange rates.

Difference in interest rates

1st

2nd

1 + infl

1 + infl

EQUAL

International Fisher Effect

Expected difference ininflation rates

1st

2nd

1 + i

1 + i

EQUAL

Interest RateParity Theory

EQUAL

Purchasing PowerParity Theory

Difference between forwardand spot rates

spot

forward

EQUAL

Expectations theory

Expected change in spot rates

spot

expected future spot

4 Interest rate risk

Financial managers face risk arising from changes in interest rates as well as exchange rates, i.e.a lack of certainty about the amounts or timings of cash payments and receipts. Managers arenormally risk-averse, so they will look for techniques to manage and reduce these risks.

4.1 Gap / interest rate exposure

Interest rate risk refers to the risk of an adverse movement in interest rates and thus a reductionin the companys net cash flow.

Adverse Interest Rate Movements

Qualification ACCA

Paper F9


Content Objective 298

299


yes



17/25


Loan Interest Rate Deposit Interest Rate

Compared to currency exchange rates, interest rates do not change continually:

currency rates change throughout the day

interest rates can be stable for much longer periods

but changes in interest rates occur frequently, and the size of the changes can be substantial.

It is the duty of the corporate treasurer (to hedge) to reduce the company s exposure to theinterest rate risk.

4.2 Basis risk

There are a number of ways in which a corporate treasurer can hedge exposure to interest raterisk. One method (discussed further in Chapter 23) is to lock the company into an agreed interestrate by buying futures.

However, normally these futures do not completely eliminate interest rate exposure, and theremaining exposure is known as basis risk.

Even non-bank companies can have substantial exposures to interest rate risk. Many companiesborrow at a floating rate of interest (or variable rate of interest).

For example, a company might borrow at a variable rate of interest, with interest payable every

six months and the amount of the interest charged each time varying according to whether short-term interest rates have risen or fallen since the previous payment.

Some companies also budget to receive large amounts of cash, and so budget large temporarycash surpluses that can be invested short-term. Income from those temporary investments willdepend on what the interest rate happens to be when the money is available for depositing.


18/25


Some investments earn interest at a variable rate of interest (for example money in bank depositaccounts) and some short-term investments go up or down in value with changes in interest rates(for example, Treasury bills and other bills).

Some companies hold investments in marketable bonds, either government bonds or corporatebonds. These change in value with movements in long-term interest rates.

Some companies borrow by issuing bonds. If a company foresees a future requirement to borrowby issuing bonds, it will have an exposure to interest rate risk until the bonds are eventuallyissued.

Many companies borrow, and if they do they have to choose between borrowing at a fixed rate ofinterest (usually by issuing bonds) or borrow at a floating rate (possibly through bank loans).There is some risk in deciding the balance or mix between floating rate and fixed rate debt. Toomuch fixed rate debt creates an exposure to falling long-term interest rates and too much floatingrate debt creates an exposure to a rise in short-term interest rates.

Interest rate risk can be significant. For example, suppose that a company wants to borrow $10million for one year, but does not need the money for another three weeks. It would be expensiveto borrow money before it is needed, because there will be an interest cost. On the other hand, a

rise in interest rates in the time before the money is actually borrowed could also add to interestcosts. For example, a rise of just 0.25% (25 basis points) in the interest rate on a one-year loan of$10 million would cost an extra $25,000 in interest.

5 Why interest rates fluctuate

5.1 The Yield Curve

The term structure of interest rates refers to the way in which the yield of a debt security orbond varies according to the term of the security, i.e. to the length of time before the borrowingwill be repaid.

The yield curve is an analysis of the relationship between the yields on debt with different periods

to maturity

Gross

redemption

Qualification ACCA

Paper F9


Content Objective 306 310


yes



19/25


yield

Term to maturity

0 4 8 12 16 20 24 28 30 (years)

The shape of the yield curve at any point in time is the result of the three following theories actingtogether:

expectations theory

liquidity preference theory

market segmentation theory.

5.2 Expectations theory

The normal upward sloping yield curve reflects the expectation that inflation levels, and thereforeinterest rates will increase in the future.

Note: Downward sloping yield curve:

In the early 1990s interest rates were high to counter act high inflation, everybody expectedinterest rates to fall in the future, which they did. Expectations that interest rates would fall meantit was cheaper to borrow long term than short term.

5.3 Liquidity preference theory

Investors have a natural preference for more liquid (shorter maturity) investments. They will needto be compensated if they are deprived of cash for a longer period.

Therefore the longer the maturity period, the higher the yield required leading to an upwardsloping curve, assuming that the interest rates were not expected to fall in the future.

5.4 Market segmentation theory

Alwayspushes up


20/25


The market segmentation theory suggests that there are different players in the short-term end ofthe market and the long-term end of the market:

investors are assumed to be risk averse and to invest in segments of the market thatmatch their liability commitments. E.g.:

o banks tend to be active in the short term end of the market

o pension funds would tend to invest in long term maturities to match the long termnature of their liabilities.

the supply and demand forces in various segments of the market in part influence theshape of the yield curve:

If there is an increased supply in the long-term end of the market because the governmentneeds to borrow more, this may cause the price to fall and the yield to rise and may resultin an upward sloping yield curve

5.5 The significance of the yield curve

Financial managers should inspect the current shape of the yield curve when deciding on theterm of borrowings or deposits, since the curve encapsulates the market's expectations of futuremovements in interest rates.

For example, a yield curve sloping steeply upwards suggests that interest rates will rise in thefuture. The manager may therefore:

wish to avoid borrowing long-term on variable rates, since the interest charge mayincrease considerably over the term of the loan

short-term variable rate borrowing or long-term fixed rate borrowing may instead be moreappropriate.

The term structure of interest rates refers to the way in which the yield of a debt security orbond varies according to the term of the security, i.e. to the length of time before the borrowingwill be repaid.

It is usually presented in the form of a table or a graph called a yield curve.

As a graph, it shows the current gross yield earned by investing in a number of similar financialinstruments with differing remaining terms to maturity. The return for each instrument is plotted ona graph where the y axis represents the annual return and the x axis represents the instrument sremaining term to maturity. The points plotted on the graph are then joined up to produce a yieldcurve.

Analysis of term structure is normally carried out by examining risk-free securities such as UKgovernment stocks (gilts). Newspapers such as the Financial Timesshow the gross redemptionyield (i.e. interest yield plus capital gain/loss to maturity) and time to maturity of each gilt on adaily basis.


21/25


This term structure of interest rates might be shown as a yield curve, as follows.

0 5 10 15 20 25

5

6

7

8

Grossredemptionyield (%)

Years to maturity

The redemption yield on shorts is less than the redemption yield of mediums and longs, and thereis a 'wiggle' on the curve between 5 and 10 years.A yield curve can have any shape, and can fluctuate up and down for different maturities.

Generally however, yield curves fall into one of three typical patterns.

Normal. A normal yield curve is upward-sloping, so that the yield is higher on instruments with alonger remaining term to maturity. The higher yield compensates the investor for tying up capitalfor a longer period. Although the yield curve slopes upwards, the gradient of the curve is notsteep. A normal yield curve might be expected when interest rates are not expected to change.

Inverse. An inverse yield curve is downward-sloping, so that the yield is lower on instrumentswith a longer remaining term to maturity. An inverse yield curve might be expected when interestrates are currently high but are expected to fall.

Steep upward-sloping curve. When interest rates are expected to rise, the yield curve is likelyto have a steep upward slope, with yields on longer-term investments much higher than the yieldon shorter-dated investments.

Yield curves are usually drawn for benchmark investments that are either risk-free (governmentsecurities) or low risk (such as yields on interest rate swaps). However, they are representative ofthe slope of the yield curve generally for all other financial instruments, such as inter-bank lendingrates and corporate bond yields.

The shape of the yield curve at any particular point in time is generally believed to be a

combination of three theories acting together:

expectations theory



Expectations theory


22/25


This theory states that the shape of the yield curve varies according to investors' expectations offuture interest rates. A curve that rises steeply from left to right indicates that rates of interest areexpected to rise in future. There is more demand for short-term securities than long-term securitiessince investors' expectation is that they will be able to secure higher interest rates in the future sothere is no point in buying long-term assets now. The price of short-term assets will be bid up, theprice of long-term assets will fall, so the yields on short-term and long-term assets will consequently

fall and rise.

A falling yield curve (also called an inverted curve, since it represents the opposite of the usualsituation) implies that interest rates are expected to fall. For much of the period of sterling'smembership of the ERM, for instance, high short-term rates were maintained to support sterlingand the yield curve was often inverted since the market believed that the long-term trend ininterest rates should be lower than the high short-term rates.

A flat yield curve indicates expectations that interest rates are not expected to change materiallyin the future.

Liquidity preference theory

Investors have a natural preference for holding cash rather than other investments, even low risk

ones such as government securities. They therefore need to be compensated with a higher yieldfor being deprived of their cash for a longer period of time. The normal shape of the curve asbeing upwards sloping can be explained by liquidity preference theory.

Market segmentation theory

This theory states that there are different categories of investor who are interested in differentsegments of the curve. Typically, banks and building societies invest at the short end of themarket while pension funds and insurance companies buy and sell long-term gilts. The two endsof the curve therefore have 'lives of their own', since they might react differently to the same set ofnew economic statistics.

Market segmentation theory explains the 'wiggle' seen in the middle of the curve where the shortend of the curve meets the long end it is a natural disturbance where two different curves arejoining and the influence of both the short-term factors and the long-term factors are weakest.

Significance of yield curves to financial managers

Financial managers should inspect the current shape of the yield curve when deciding on theterm of borrowings or deposits, since the curve encapsulates the market's expectations of futuremovements in interest rates.

For example, a yield curve sloping steeply upwards suggests that interest rates will rise in thefuture. The manager may therefore wish to avoid borrowing long-term on variable rates, sincethe interest charge may increase considerably over the term of the loan. Short-term variable rateborrowing or long-term fixed rate borrowing may instead be more appropriate.

A corporate treasurer might analyse a yield curve to decide for how long to borrow. For example,suppose a company wants to borrow $20 million for five years and would prefer to issue bonds ata fixed rate of interest. One option would be to issue bonds with a five-year maturity. Anotheroption might be to borrow short term for one year, say, in the expectation that interest rates willfall, and then issue a four-year bond. When borrowing large amounts of capital, a small differencein the interest rate can have a significant effect on profit. For example, if a company borrowed$20 million, a difference of just 25 basis points (0.25% or one quarter of one per cent) wouldmean a difference of $50,000 each year in interest costs.


23/25


Expectations of future interest rate movements are monitored closely by the financial markets,and are important for any organisation that intends to borrow heavily or invest heavily in interest-bearing instruments. A company might use a forward yield curve to predict what interest ratesmight be in the future. For example, if we know the current interest rate on a two-month and a six-month investment, it is possible to work out what the market expects the four-month interest rateto be in two months time.


Answer the following question:

1 What is gap exposure?

2 What are the three determinants of the yield curve?


1 Gap exposure refers to the risk of an adverse movement in interest rates and thus areduction in the companys net cash flow.

2 The shape of the yield curve at any point in time is the result of the three followingtheories acting together:

expectations theory



Chapter summary

Qualification ACCA

Paper F9


Template ID CS1

Source ACCA Paper 3.7 Study notes session18 21, ACCA Paper 3.7 Study Text

chapter 6, 14

15.


24/25


Types of risk

Foreign currency riskMovement of one currency against another

Affects value of foreign trades

Interest rate risk

Exchange ratesystems

Fixed against one otherFixed against a basket

Free floatingManaged floating

Types ofcurrency risk

Reasons forcurrency risk

See summary below

The Yield Curve

TransactionXC rate change

between transactionand settlement

EconomicLong term movements

Changes in business value

TranslationAccounting risk on

consolidationof a foreign subsidiary

Gap

Adverse movementsin interest rates BasisCannot create

a perfect hedge

Expectationstheory

Inflation & interestrates expected to rise

Liquiditypreference

Natural preference forshort term investments

Marketsegmentation

Different preferences applysupply & demand forces

Reasons for currency risk

Balance of paymentsDemand for imports=demand for foreign currencyDemand for exports=demand for home currency

Capital movementsbetween economies

Expectationstheory

Forward predictorof spot

International FisherEffect

Inflation causes interestrate differencesexpectedinflation can predict spot

Purchasing Power Parity Theory1st

2nd

1+ inflCurrent spot x =Expected future spot

1+ infl

Interest Rate Parity Theory1st

2nd

1 + iCurrent spot x =Expected forward

1+ i


25/25

Checklist submit with each chapter

NGLM CHECKLIST Tick1 Table completed per content objective

2 Icons 3 Followed blueprint 4 Read and followed the house style document 5 Content, illustrations, TYUs included 6 Legacy material used and referenced, although text must

be up to date with current standards.

7 Activities etc. taken from legacy material (please list):

8 No bullet after heading begin with some explanatory

text

9 Bullets used, max. 9 bullets per heading, 70 words perbullet

10 Any exceptions to rule 9 as per the syllabus 11 Expandable text, 500 words max per paragraph 12 Main content Arial 10, headings bold 14, subheadings

bold 12, correctly numbered with 1, 1.1, 1.2, etc.

13 Diagrams/tables used

14 Tables are 15 cm across and rules on text followed (moreinfo on balance sheets etc., layout in the house styleguide)

15 Varied style for illustrations 16 Reviewed pilot 17 Chapter overview, summary and checklist completed 18 Saved correctly

22 types and causes of risk.pdf

Documents