FEI Week 8 – Risk Analysis & Building Financial Models BPP BUSINESS SCHOOL BPP BUSINESS SCHOOL
What is risk analysis • Process of defining and analysing the dangers to the business posed by potential natural and human‐caused adverse events • Quantitative • Qualitative • For example, risk analysis techniques in IT 2 BPP BUSINESS SCHOOL
Risks in financial world • Credit risk: loss arising from a borrower who does not make payments as promised • Operation risk: arising from execution of a company's business functions • Market risk: value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors 3 BPP BUSINESS SCHOOL
Risks in business world • Profit=revenue – cost =Average Price *Quantity ‐ (fixed cost + variable cost) • Revenue risks: actual benefits of a venture being lower than the projected, or estimated, benefits of that venture • Cost risks: unexpected cost incurred in excess of a budgeted amount due to an under‐estimation of the actual cost during budgeting 4 BPP BUSINESS SCHOOL
Other risks in business world • Financing risk • Equity contribution not received • Bank loans guarantee forfeited • Bank reduces overdraft facility • Reputation risk • E.coli & Spanish vegetables • Melamine & Chinese milk • Burgers & horse meat • Currency risk • Export & import • Political risk/country risk 5 BPP BUSINESS SCHOOL
Measuring risks • Variance: how far a set of numbers are spread out from each other 2 n i Value Mean ( ) 2 i 1 n 6 BPP BUSINESS SCHOOL
Measuring risks • Standard deviation: how much variation or "dispersion" there is from the average n 2 ( Value Mean ) i i 1 n 7 BPP BUSINESS SCHOOL
Currency risk • Transaction risk: cash flow • Translation risk: assets and liabilities • Cause: • Buy and sell in foreign countries • Financing arrangements – equity , debt • Multinational corportions • Speculation v hedge 8 BPP BUSINESS SCHOOL
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Currency risk ‐ examples • Japanese companies experiencing difficulties in export when yen went up • Eastern European countries borrowing from western banks in Euro • UK investor investing in US stocks • Chinese companies floating on US exchanges 11 BPP BUSINESS SCHOOL
Country Risk Country Local Currency Rating Rating-based Default Spread Total Equity Risk Premium Country Risk Premium CDS Default Spread Total Equity Risk Premium Country Risk Premium Abu Dhabi Aa2 0.50% 5.75% 0.75% 1.00% 5.81% 0.81% Albania B1 4.50% 11.75% 6.75% NA NA NA Andorra A3 1.20% 6.80% 1.80% NA NA NA Angola Ba3 3.60% 10.40% 5.40% NA NA NA Argentina B3 6.50% 14.75% 9.75% 14.73% 26.41% 21.41% Armenia Ba2 3.00% 9.50% 4.50% NA NA NA Aruba Baa1 1.60% 7.40% 2.40% NA NA NA Australia Aaa 0.00% 5.00% 0.00% 0.70% 5.36% 0.36% Austria Aaa 0.00% 5.00% 0.00% 0.74% 5.42% 0.42% Azerbaijan Baa3 2.20% 8.30% 3.30% NA NA NA Bahamas Baa1 1.60% 7.40% 2.40% NA NA NA Bahrain Baa2 1.90% 7.85% 2.85% 2.97% 8.77% 3.77% Bangladesh Ba3 3.60% 10.40% 5.40% NA NA NA Barbados Ba1 2.50% 8.75% 3.75% NA NA NA Belarus B3 6.50% 14.75% 9.75% NA NA NA Belgium Aa3 0.60% 5.90% 0.90% 0.97% 5.77% 0.77% Belize Caa2 9.00% 18.50% 13.50% NA NA NA Benin B2 5.50% 13.25% 8.25% NA NA NA Bermuda Aa3 0.60% 5.90% 0.90% NA NA NA Bolivia Ba3 3.60% 10.40% 5.40% NA NA NA Bosnia and Herzegovina B3 6.50% 14.75% 9.75% NA NA NA Botswana A2 0.85% 6.28% 1.28% NA NA NA — Source Ashwath Damodaran, Stern School of Business, New York University — http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html 12 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
Foreign exchange derivatives • Forward contract: transaction agreed to executed in a fixed future time • Flexible in amount, execution date • Obligation to execute • Suitable to hedge certain cash flows • Rapid growth after Bretton Woods system • Extremely large market – banks & corporations to manage FX risks 13 BPP BUSINESS SCHOOL
Foreign exchange derivatives • E.g. Your start‐up firm selling to US and receiving US$1.65 million in 3 months • Solution – long the forward contract, i.e. Long the Sterling and short the dollar • Current rate 1.60 v forward rate 1.65 v in 3 month 1.70 • Can settle in cash or actual delivery of the currency 14 BPP BUSINESS SCHOOL
Foreign exchange derivatives • Futures – standardised forward contracts • Designated size and quotation unit • e.g. A Euro contract covers € 125,000 and is quoted in dollars per euro. Futures price such as $0.8555 stated in dollar. Contract price=125,000*$0.8555=$106,937.50 • Leveraged • Margin calls • Obliged to execute 15 BPP BUSINESS SCHOOL
Foreign exchange derivatives • Not as widely used as forward but market still very active • Mostly traded on exchanges e.g. Chicago Mercantile Exchange, New York Board of Trade 16 BPP BUSINESS SCHOOL
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Foreign exchange derivatives • Options – allows the holder, who pays an amount of money, to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, on (European option) or up to (American option) the exercise date. • Right, not obligation, to execute • Suitable to hedge uncertain cash flows • Call options v put options 18 BPP BUSINESS SCHOOL
Foreign exchange derivatives • Large market, similar to forward • Mostly OTC • E.g. Your export to US will bring you $3.2m in 3 months. • Solution ‐ buy a call option on sterling specified in terms of dollar • Current rate 1.60 vs exercise rate 1.65 . R ate in 3 months 1.70/1.50 • Other applications – equity shareholders 19 BPP BUSINESS SCHOOL
Black Scholes model for valuing Derivatives • Call option • Put option where 20 BPP BUSINESS SCHOOL
Foreign exchange derivatives • Swap – each party makes interest payments to the other in different currencies • Example: American firm Target Corporation (TGT) needs € 9m but can‘t issue bond in European market at reasonable rate. What to do? 21 BPP BUSINESS SCHOOL
Foreign exchange derivatives • (TGT) issue $10m bond for lower rate available to it in US at 6% • Deutsche Bank (DB) agrees to swap • At outset, DB pays TGT € 9m and TGT pays DB $10m • DB pays TGT 6% in $ twice a year (0.06*0.5*$10m=$300,000) • TGT pays DB 4.9% in € twice a year (0.049*0.5* € 9m=220,500) • At the end, DB pays TGT $10m and TGT pays DB € 9m 22 BPP BUSINESS SCHOOL
Foreign exchange derivatives • Currency swap – equivalent of bond swap here • TGT issues bond in € to DB • DB issues bond in $ to TGT • End result – TGT issues bond in € at lower rate 23 BPP BUSINESS SCHOOL
Problems in Valuing Start-Ups Source: How to value a start-up? The use of options to assess the value of equity in start-ups - Guillaume Desaché 24 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
Survival of Start-Ups source: How to value a start-up? The use of options to assess the value of equity in start-ups - Guillaume Desaché 25 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
http://www.ft.com/cms/s/0/40146b80-91bf-11e5-94e6-c5413829caa5.html#ixzz3sOtZjDin 26 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
Increasing Defaults The jump in defaults has been reflected in the average yield on US corporate junk bonds, rising from 5.6% at the start of 2014 to 8% at present, according to Barclays. The sell-off has been concentrated in the energy and materials industries and the average yield for junk bonds in the two sectors shot above 12% last week; no other sector has a yield above the overall average. Emerging market borrowers have accounted for 19 of the defaults — the second largest source of failures, Europe has counted 13 and the remainder are in other developed countries, such as Japan and Canada. The number of weaker companies rated by the credit agencies has also risen from 167 in the previous quarter to 178. S&P defines these “weakest links” as borrowers with junk bonds rated B-minus or lower and at risk of further downgrade. Diane Vazza, head of global fixed income research at S&P, said: “By most measures, the rising number of defaults in the near future likely will be muted by historical standards, but the current crop of US speculative-grade issuers appears fragile and particularly susceptible to any sudden or unanticipated shocks.” 27 BPP BUSINESS SCHOOL TITLE HERE 00 MONTH 0000
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