Financial risk management
Financial risk management in light of our turbulent times Vijay Panday
7 October 2008
Contents
Financial markets turmoil -
Interactive discussions of the actual financial markets Credit default swap Know your risks Lessons to learn
KLM Group Treasury activities - brief overview of: Cash management Currency Management Interest rate management And: Counterparty risk management
2
Bull wrestling bear markets: driven by testosterone?
3
Dan Mitchell's article “Trading on Testosterone” in the New York Times
Movements in financial markets are correlated to the levels of hormones in the bodies of male traders.
John Coates, a research fellow in neuroscience and finance, and Joe Herbert, a professor of neuroscience, sampled the saliva of 17 traders on a stock trading floor in London two times a day for eight days. They matched the men’s levels of testosterone and cortisol with the amounts of money the men lost or won on the markets. Men with elevated levels of testosterone, a hormone associated with aggression, made more money. When the markets were more volatile, the men showed higher levels of cortisol, considered a “stress hormone”.
“Conclusion” if more women and older men were trading, the markets would be more stable.”
4
Consumers Pile on $ 25 Billion More Debt in July 2008!
Americans are piling on the debt at an alarming pace while one of the most valuable assets (the homes) is plummeting in value. A recent article from Bloomberg points out that consumer debt levels increased by a whopping $25.3 billion in July 2008, which was substantially more than economists had projected.
According to the article: "Consumers are turning to credit cards after banks tightened standards for home-equity loans and other borrowing. The March figures brought U.S. consumer borrowing in the first quarter to $34 billion, the most since the first three months of 2001, when the economy entered its last official recession." As banks turn away more people, they are likely to pursue alternative financing on sites like Prosper, LendingClub, etc.. America's debt problem has only gotten worse over the years and the current credit crisis may end up being a healthy event in that it will constrict American's ability to keep borrowing (at least for a short time). But, with the weak economy and fewer sources of capital, lenders beware...
5
World has been witnessing the aftermath of the sub-prime crisis and it doesn’t just seem to stop.
6
Financial markets turmoil
Investment bankers have earned almost USD 300 billion in the last 10 years Repackaging and selling the high risky assets to naïve investors is a criminal activity
Rating agencies are also responsible for the collapse of the financial markets Not to forget Hedge funds who have had a major part.
The FED has had not control on the activities of banks and other investment houses.
The Bush administration has announced a bailout of USD 700 bln which shall be paid by the American citizen 7
US borrowers fail to benefit from rate cuts Banks
are not only tightening up on the conditions on loans, but their cost has been rising too Banks are facing higher funding costs themselves, and are trying to rebuild their profitability and capital bases. In fact, despite the Fed easing, long term borrowing costs have risen… …take a look at 15 year mortgage yields…which have risen compared with Jan 2007.. ..the same is true of corporate bond yields. A weighted average of the two rates suggests that financial conditions are if anything tighter, not looser
bp difference since Jan 2007 200
Impact of Fed easing Yields higher than Jan 07
150
bp difference since Jan 2007 200 150
100
100
50
50
0
0
-50 -100 -150 -200 -250
-50 -100
BBB corp yields
-150
Weighted average 15Y Fixed mortgage yields Fed funds easing
-200 Yields lower than Jan 07
-250
-300
-300
-350 Jan- Mar- May07 07 07
-350 Jul07
Sep- Nov- Jan- Mar- May07 07 08 08 08
Jul08
8
ACTION STATIONS: US President George W. Bush, flanked by Federal Reserve Chairman Ben Bernanke (L), Treasury Secretary Henry Paulson (2nd R), and SEC Chairman Christopher Cox, talks of the US Government's plan to attack the current credit crisis by tapping hundreds of billions of dollars in taxpayer funds to buy up toxic mortgage-related debt.
Paulson and Federal Reserve Chairman Ben Bernanke have already put close to US$1 trillion of taxpayer money on the line to try to keep credit flowing, and the new effort could double that amount. The White House said it was too soon to say how the plan would impact the nation's debt, and said it was possible many of the funds could be recovered as markets stabilize and currently bad assets are sold off. 9
What a difference a year makes… 12 month performance (% return)
Oil
Corn
Euro
US house prices
S&P 500 Banks
"A" rated MBS
-100
-80
-60
-40
-20
0
20
40
60
80
10
Financial market turmoil…continuing
After the onset of the credit crisis, many thought it would be over by the end of 2007
Oil prices were expected to stabilise
A year later, the end of the credit crunch is not in sight
Commodity and asset prices are volatile…
…reflecting huge uncertainty about the outlook:
Credit crunch • interaction with construction, currencies and the evolution of the developed
markets ¾ Commodity crunch • interaction with supply shocks, demand responses and the evolution of the
emerging markets Policy responses • Monetary, fiscal and regulatory: mistakes could be costly!
11
Oil: winners and losers Crude oil reliance - net imports / exports as % of GDP
(% of GDP) 200
$100/bbl $66/bbl (2006 ave.)
150 100
Net Importer
Net exporter
50 0
Kuwait
UAE Saudi Arabia
Venezuela
Iran
Norway
Mexico Russia
Malaysia
Argentina
Canada
UK Indonesia
Brazil
Australia
Switzerland
Romania Sweden
USA
E'zone
Iceland Japan
Hungary
China
Hong Kong
Poland Czech Rep
Slovakia
N Zealand
Turkey
S Africa India
S Korea
Philippines
Ukraine
Taiwan Thailand
Singapore
-50
The
burden of higher oil prices falls primarily on Asia The IMF has encouraged Asian nations to drop oil subsidies and allow a greater pass through of costs • … which has encouraged more appreciation in local currencies • … oil exporters are well documented … • … although OPEC now accounts for around only 37% of global oil production Pressure will remain on currencies of oil exporters, with the Russian Ruble the most likely.
12
Brent Crude oil Sept 2003 – Sept 2008 in EURO and in USD
13
‘Credit Crunch’ - Bank losses mount Assets written down: $494bn 2. Capital being raised: $354bn 1.
(USD bn) 500
Global Bank Losses and Capital Raised So Far...
450
Asia
400
Europe Americas
350 300 250 200 150 100 50 0 Total credit losses
Total capital raised
Source: Bloom berg
14
Credit Crunch….more bad news to come… (%) 70
Tighter lending standards suggests more defaults Senior Loan Officers' Survey % of institutions tightening standards on commercial & industrial loans 1Y lead (lhs)
60 50
Speculative grade default rates (rhs)
40
(%) 12
Residential delinquencies - further to rise...
19 18
% o f to ta l
3.8 3.6
10
17 8
3.4
Sub-prime delinquencies, lhs
16
3.2
Prime delinquencies, rhs
30 20
15
3.0
14
2.8
13
2.6
12
2.4
11
2.2
10
2.0
6
10 4 0 -10 2 -20 Moody's baseline forecasts 0
-30 98
99
00
01
02
03
04
05
06
07
08
09
99
00
01
02
03
04
05
06
07
08
Banks are risk averse, hoarding liquidity and rebuilding capital bases, and funding costs remain high Credit losses are far from over… 15
Credit Default Swap Air France-KLM
16
Credit Default Swap Air France KLM for a 5 year tenor
17
Credit Default Swap Lufthansa for a 5 year tenor
18
Credit Default Swap – AirlinesCDS Spread for 5 years as per September 23, 2008 Spread
1000 900 800 700 600 500 400 300 200 100
British Airways
SAS
Qantas
Air France KLM
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
0
Lufthansa
South West
19
Europe is in a “triple-C” slowdown • Currency appreciation is weighing on net exports
Tighter Credit conditions are affecting investment & consumption
Construction boom in some Eurozone countries is unwinding
20
Responsibility of Corporate Treasury
Cash Management -
-
Logistic bank account management Centralized Treasury operations Repatriation of cash - responsibilities - Top 10 cash balance overview - Problem countries Transfer costs
Financial Risk management Foreign exchange risk - Transactional risk - Translation risk - Economic risk Interest rate risk Counterparty risk Credit risk Liquidity risk
Corporate finance - Long term funding
Bank relations
In house bank
21
Cash management…….
Logistic Cash management: -
Deutsche bank is our Asia Cash management bank
-
ABN AMRO for The Netherlands Citibank for the rest of the world
-
Centralized contract management of these Cash management banks
Centralized Treasury -
Central cash investments
-
Central Interest rate risk management Management of 35 (Head office) currencies covering 85% of total turnover Active (hedging) management of 12 currencies Hedging the currency risk of new ordered aircrafts Acts as an In house bank for Subsidiaries derivatives are being used as hedging instruments Acting in accordance with Financial Plan, RMC and risk committee guidelines Close relationship with Air France Treasury (Joint proposals to RMC)
22
Advantages of a Centralized Treasury Qualitative -
•
Professionalized staff in Head office Equipment available to support decision making Better knowledge of financial markets Achievement of credit lines from banks Research of banks and other institutions available Assessment on Counterparty risk Avoidance of sub-optimalisation Controller attention back to sales
Quantitative -
Better conversion rate of exchange (Economies of scale) Reduction of Currency risk to a minimum Reduction of transfer costs to a minimum Higher return because of higher cash position Avoidance of short term borrowing from banks 23
Currency risk management In establishing a currency risk management program, companies need to identify the risks that they face and articulate their hedging philosophy Currency management overview 1. Objective: -
Reduce volatility in earnings EUR terms Reduce volatility in cash flows in EUR terms
2.
Impact on firm value: - Academic, empirical and anecdotal evidence overwhelmingly support that hedging increases firm value - The hedging “premium” is on average 5% - Hedging premium is both statistically and economically significant
3.
Rationale: - Investors in a stock seek exposure to foreign markets, not currencies - Lower volatility provides investors greater visibility into performance - Predictable cash flows reduce debt cost and increase access to debt markets and financial flexibility - Lower volatility increases ability to make value enhancing investments
24
Hedging can have a positive impact on firm value
Firm value is created by making value enhancing investments that increase operating cash flow
1.
Key to supporting good investments is the internal generation of cash to fund those investment Internally generated cash flow can be disrupted by changes in interest rates, foreign exchange rates, and commodity prices. Hedging ensures the firm has sufficient cash flow available to make value enhancing investments (by reducing or eliminating these disruptions)
2. 3.
Firm value is created by reducing the asymmetries of information between internal management and external observers, including shareholders, equity analysts, credit agencies, etc.
1.
Reducing fluctuations caused by exogenous factors (interest rates, foreign exchange rates, and commodities prices) provides more reliable information on the firm’s outlook and increases stability of credit ratings and borrowing costs
2.
It also helps provide more reliable information to evaluate management’s performance
Isolating the impact of different hedging philosophies and strategies on firm value is difficult
1.
Specific currency exposures and hedging strategies executed across firms vary and cannot be easily identified, isolated and measured across a sample of firms to evaluate their impact on firm value
2.
Because of intercompany flows, multiple currencies, functional currency decisions, accounting and tax issues, currency risk is more complicated to manage than any other market risk
3.
We believe that the premium awarded to companies that hedge currency risk is comparable to the premium awarded to companies that hedge their consumer commodity exposures
4.
The 5% premium is an average of companies that “right way” hedge and “wrong way” hedge
25
Types of foreign exchange exposures: transactional risks Definitions: 1. Transactions recorded in a foreign currency are revalued into local currency on each balance sheet date, through earnings 2. Most common example are trade receivables/payables, but also includes revaluation of long term currency denominated debt and other balance sheet items 3. Most often hedged currency risk among firms (Most firms hedge 100% of currency A/R and A/P using forwards “balance sheet hedging”)
Example: Firm sells its products in foreign countries priced in foreign currency terms
26
Types of foreign currency exposures: translational risks
Definition
1.
Translation of foreign currency denominated assets and liabilities, and revenues and expenses into home (parent company) currency The translation of revenues and expenses of foreign subsidiaries impacts reported earnings to shareholders but is itself obscure In their MD&As, firms often delineate changes in operating income items (sales, cost of goods sold) due to changes in exchange rates
2. 3.
Example: Firm has a subsidiary in Switzerland, and is required to translate the Swiss sub’s CHF denominated financial statements into EUR on each reporting date (usually quarterly) 27
Historical chart EUR-USD 1989 - 2008
28
Interest Rate risk management
Defining interest rate risk
Interest rate risk can be defined as the sensitivity of a portfolio to changes in interest rates All debt is essentially floating, with only the repricing frequency and the term varying The interest rate sensitivity of a liability portfolio is a function of: • • •
The frequency of rate repricing The average life of the portfolio's fixed rate debt (i.e. duration) The annual growth rate of the portfolio
KLM has runs an interest rate risk on both the Debt – and cash portfolio. Additionally KLM has a counterparty risk on the cash portfolio Debt portfolio risk management Long term cash product hedges on financed aircrafts Interest Rate Swaps Forward starting swap (Pre-hedging) Cash investment portfolio Liquidity funds Deposits Commercial Paper Derivatives
29
Interest rate Swaps (Swap) A Swap is the most common derivatives strategy used to manage risk by Corporates A Swap is an agreement between two parties (counterparties) to exchange different interest payments in the same currency
- A counterparty is a principal in a derivative transaction - Amount of interest paid is based on “notional” principal. No principal is exchanged by either party - Typically, one counterparty's payments are fixed rate, the other counterparty’s payments are floating rate - Payments are often netted - Initially, a swap has zero NPV to both parties, but may take on positive or negative value during its life - USD market convention quotes the swap rate as a spread over Treasuries. - Swap spreads reflect the difference between Treasuries and LIBOR curves
Treasury + Swap spread = Swap rate Tenor
Treasury yield
Swap spread (bps)
Swap rate
2yr
2.30%
103.25
3.33%
3yr
2.55%
112.75
3.68%
4yr
2.81%
111.00
3.92%
5yr
3.06%
102.75
4.09%
6yr
3.21%
101.00
4.22%
7yr
3.37%
97.25
4.34%
8yr
3.52%
91.25
4.43%
9yr
3.68%
83.50
4.52%
10yr
3.83%
74.75
4.58%
30
Interest rate swaps have a zero net present value at inception •
Swap pricing
•
swap is priced in order to equate the fixed rate payments to the expected floating rate payments - PV floating = PV fixed
Floating rate cash flows are calculated using the LIBOR forward curve • In a swap where KLM pays floating, the floating payments are less than the fixed payments in the beginning of the transaction (assuming upward sloping yield curve) •
- Forward curve predicts higher floating payments in the back end of the transaction - The swap rate equates the present value of the fixed cash flows - it intersects the forward curve such that the areas between the curves are equal - If the forward curve over predicts rates, paying floating rates will reduce interest expense.
31
Various factors impact swap spreads •
Swap spreads are similar to credit spreads and can be compared to “AA” rated financial institution credit spreads
•
Swap spread levels are determined by the market and based on several fundamental, economic, and technical factors - Corporate debt issuers that want to pay floating –
Corporations swapping fixed liabilities into floating typically compress spreads
- Investors and arbitrageurs executing asset swaps of fixed rate assets –
Investors swapping fixed assets into floating typically widen spreads
- Business cycle –
Credit health of banking industry and industrial corporations
- Level of interest rates; shape of yield curve – –
Flatter curve: Wider spreads Steep curve: Tighter spread
32
Swap market participants: Dealers, End Users, Speculators/Arbitrageurs • •
•
•
•
•
•
Dealers Dealers, banks and other financial institutions offer themselves as counterparties to satisfy Issuers' Company for managing financial risk (or trade for their own account and risk) Once a position is made, a dealer matches it by entering into an opposing transaction Derivatives portfolios are managed on a net basis, or residual risk of their overall position, allowing risk management to be focused on portfolio exposures which improve dealers' ability to accommodate a broad spectrum of Issuers' transactions Able to provide customized rather than “one size fits all” solutions unlike standardized futures market Dealer is responsible for ongoing administration (processing, bookkeeping, billing, and payment calculations Revenue is generated by the Bid/Offer
•
End users
•
As end users, issuers use derivatives for hedging as part of their asset/liability management while banks use derivatives to take positions as part of their proprietary trading
•
Pre-issuance hedging using Treasury Locks and Forward Starting Swaps Swapping fixed/float issuance to float/fixed Arbitraging difference in option value between OTC derivatives market and the cash market Call monetization strategy
• •
•
•
Speculators/Arbitrageurs
•
By using derivative products, organizations may also become speculators by taking an unhedged market view or arbitrageurs by recognizing and acting on a zero-net investment strategy that generates savings or profits Exploitation of curvature mis-pricings on the swap curve by trading multipoint barbells Expressing curve and barbell views conditionally through the use of swaptions/options on futures Trading options across different instrument and sovereign markets to profit from volatility mis-pricings
•
•
•
33
The spread over LIBOR is approximately the difference between the bond coupon and the swap rate Bond Terms - Company new 10 year A
Bond coupon
5.00%
semi-annual, 30/360 daycount
4.23%
semi-annual, 30/360 daycount
A - B Difference between bond coupon and swap rate
0.7700%
semi-annual, 30/360 daycount
Conversion to money-market convention
0.76%
Quarterly, actual/360 daycount
Credit charge*
2.0 bps
Bid/Offer*
1.0 bps
Swap Rates B
10 yr swap rate Spread over LIBOR
Company's spread over LIBOR
0.79%
Note: Calculations are approximations only to hand check model pricing Assuming 3m LIBOR of 2.81% *For discussion purposes only
34
The value of a swap increases or decreases with changes in market rates Mark-to-market Mark-to-market of of a a swap swap where where KLM KLM pays pays floating floating and and receives receives fixed fixed Rates are higher - swap becomes out-of-the6.50% money to client
5.50%
4.50%
5yr s wap rat e
3.50%
Rates are lower swap becomes inthe-money to client
2.50%
1.50% Aug- 08
Fe b- 09
Aug- 09
LIBOR f wd c ur ve
Fe b- 10
Aug- 10
5Yswa p r a t e
Fe b- 11
Aug- 11
100 bps wide r
Fe b- 12
Aug- 12
Fe b- 13
Aug- 13
100 bps t ight e r
35
Counterparty Risk Management
1. BACKGROUND
Market value on counterparties increasing rapidly (hedge transactions for Crude oil, USD and other currencies, cash investments etc.)
Various tools are proposed to deal with counterparty credit risk issue
2. MAXIMUM EXPOSURE PER COUNTERPARTY • •
A table showing the exposure per counterparty connected to their rating Regular reporting will show any deviations ; it is suggested to entitle management to take necessary action to limit risk if CFO or VP are agreeing doing so
36
Counterparty risk
INVESTMENTS : SEARCH FOR QUALITY AND DIVERSIFICATION Confirmation
of minimum rating
Less than 1 year
A1/P1
More than 1 year
AA-/Aa3
Reminder • •
:
CP’s (commercial paper) , deposits and Money market funds represent all-in-all about 90% risk on the Bank market a spread of 55bp with Treasury Bonds justifies this approach
Check regularly the status of the banks credit lines enabling to trade Update Credit default swap numbers of counterparties
37
Credit Default Swap – BanksCDS Spread versus Benchm ark 23 Septem ber 2008 Spread
250 Fortis
Natixis
200 Citi Bank RBS
150 JP Morgan ING
100
Calyon ABN AMRO
Rabobank
Deutsche Bank Societe Generale
Mizuho
BNP
50
0 AAA
AA+
AA
AA-
A+
38
39
7 October 2008
Contents
Financial markets turmoil -
Interactive discussions of the actual financial markets Credit default swap Know your risks Lessons to learn
KLM Group Treasury activities - brief overview of: Cash management Currency Management Interest rate management And: Counterparty risk management
2
Bull wrestling bear markets: driven by testosterone?
3
Dan Mitchell's article “Trading on Testosterone” in the New York Times
Movements in financial markets are correlated to the levels of hormones in the bodies of male traders.
John Coates, a research fellow in neuroscience and finance, and Joe Herbert, a professor of neuroscience, sampled the saliva of 17 traders on a stock trading floor in London two times a day for eight days. They matched the men’s levels of testosterone and cortisol with the amounts of money the men lost or won on the markets. Men with elevated levels of testosterone, a hormone associated with aggression, made more money. When the markets were more volatile, the men showed higher levels of cortisol, considered a “stress hormone”.
“Conclusion” if more women and older men were trading, the markets would be more stable.”
4
Consumers Pile on $ 25 Billion More Debt in July 2008!
Americans are piling on the debt at an alarming pace while one of the most valuable assets (the homes) is plummeting in value. A recent article from Bloomberg points out that consumer debt levels increased by a whopping $25.3 billion in July 2008, which was substantially more than economists had projected.
According to the article: "Consumers are turning to credit cards after banks tightened standards for home-equity loans and other borrowing. The March figures brought U.S. consumer borrowing in the first quarter to $34 billion, the most since the first three months of 2001, when the economy entered its last official recession." As banks turn away more people, they are likely to pursue alternative financing on sites like Prosper, LendingClub, etc.. America's debt problem has only gotten worse over the years and the current credit crisis may end up being a healthy event in that it will constrict American's ability to keep borrowing (at least for a short time). But, with the weak economy and fewer sources of capital, lenders beware...
5
World has been witnessing the aftermath of the sub-prime crisis and it doesn’t just seem to stop.
6
Financial markets turmoil
Investment bankers have earned almost USD 300 billion in the last 10 years Repackaging and selling the high risky assets to naïve investors is a criminal activity
Rating agencies are also responsible for the collapse of the financial markets Not to forget Hedge funds who have had a major part.
The FED has had not control on the activities of banks and other investment houses.
The Bush administration has announced a bailout of USD 700 bln which shall be paid by the American citizen 7
US borrowers fail to benefit from rate cuts Banks
are not only tightening up on the conditions on loans, but their cost has been rising too Banks are facing higher funding costs themselves, and are trying to rebuild their profitability and capital bases. In fact, despite the Fed easing, long term borrowing costs have risen… …take a look at 15 year mortgage yields…which have risen compared with Jan 2007.. ..the same is true of corporate bond yields. A weighted average of the two rates suggests that financial conditions are if anything tighter, not looser
bp difference since Jan 2007 200
Impact of Fed easing Yields higher than Jan 07
150
bp difference since Jan 2007 200 150
100
100
50
50
0
0
-50 -100 -150 -200 -250
-50 -100
BBB corp yields
-150
Weighted average 15Y Fixed mortgage yields Fed funds easing
-200 Yields lower than Jan 07
-250
-300
-300
-350 Jan- Mar- May07 07 07
-350 Jul07
Sep- Nov- Jan- Mar- May07 07 08 08 08
Jul08
8
ACTION STATIONS: US President George W. Bush, flanked by Federal Reserve Chairman Ben Bernanke (L), Treasury Secretary Henry Paulson (2nd R), and SEC Chairman Christopher Cox, talks of the US Government's plan to attack the current credit crisis by tapping hundreds of billions of dollars in taxpayer funds to buy up toxic mortgage-related debt.
Paulson and Federal Reserve Chairman Ben Bernanke have already put close to US$1 trillion of taxpayer money on the line to try to keep credit flowing, and the new effort could double that amount. The White House said it was too soon to say how the plan would impact the nation's debt, and said it was possible many of the funds could be recovered as markets stabilize and currently bad assets are sold off. 9
What a difference a year makes… 12 month performance (% return)
Oil
Corn
Euro
US house prices
S&P 500 Banks
"A" rated MBS
-100
-80
-60
-40
-20
0
20
40
60
80
10
Financial market turmoil…continuing
After the onset of the credit crisis, many thought it would be over by the end of 2007
Oil prices were expected to stabilise
A year later, the end of the credit crunch is not in sight
Commodity and asset prices are volatile…
…reflecting huge uncertainty about the outlook:
Credit crunch • interaction with construction, currencies and the evolution of the developed
markets ¾ Commodity crunch • interaction with supply shocks, demand responses and the evolution of the
emerging markets Policy responses • Monetary, fiscal and regulatory: mistakes could be costly!
11
Oil: winners and losers Crude oil reliance - net imports / exports as % of GDP
(% of GDP) 200
$100/bbl $66/bbl (2006 ave.)
150 100
Net Importer
Net exporter
50 0
Kuwait
UAE Saudi Arabia
Venezuela
Iran
Norway
Mexico Russia
Malaysia
Argentina
Canada
UK Indonesia
Brazil
Australia
Switzerland
Romania Sweden
USA
E'zone
Iceland Japan
Hungary
China
Hong Kong
Poland Czech Rep
Slovakia
N Zealand
Turkey
S Africa India
S Korea
Philippines
Ukraine
Taiwan Thailand
Singapore
-50
The
burden of higher oil prices falls primarily on Asia The IMF has encouraged Asian nations to drop oil subsidies and allow a greater pass through of costs • … which has encouraged more appreciation in local currencies • … oil exporters are well documented … • … although OPEC now accounts for around only 37% of global oil production Pressure will remain on currencies of oil exporters, with the Russian Ruble the most likely.
12
Brent Crude oil Sept 2003 – Sept 2008 in EURO and in USD
13
‘Credit Crunch’ - Bank losses mount Assets written down: $494bn 2. Capital being raised: $354bn 1.
(USD bn) 500
Global Bank Losses and Capital Raised So Far...
450
Asia
400
Europe Americas
350 300 250 200 150 100 50 0 Total credit losses
Total capital raised
Source: Bloom berg
14
Credit Crunch….more bad news to come… (%) 70
Tighter lending standards suggests more defaults Senior Loan Officers' Survey % of institutions tightening standards on commercial & industrial loans 1Y lead (lhs)
60 50
Speculative grade default rates (rhs)
40
(%) 12
Residential delinquencies - further to rise...
19 18
% o f to ta l
3.8 3.6
10
17 8
3.4
Sub-prime delinquencies, lhs
16
3.2
Prime delinquencies, rhs
30 20
15
3.0
14
2.8
13
2.6
12
2.4
11
2.2
10
2.0
6
10 4 0 -10 2 -20 Moody's baseline forecasts 0
-30 98
99
00
01
02
03
04
05
06
07
08
09
99
00
01
02
03
04
05
06
07
08
Banks are risk averse, hoarding liquidity and rebuilding capital bases, and funding costs remain high Credit losses are far from over… 15
Credit Default Swap Air France-KLM
16
Credit Default Swap Air France KLM for a 5 year tenor
17
Credit Default Swap Lufthansa for a 5 year tenor
18
Credit Default Swap – AirlinesCDS Spread for 5 years as per September 23, 2008 Spread
1000 900 800 700 600 500 400 300 200 100
British Airways
SAS
Qantas
Air France KLM
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
0
Lufthansa
South West
19
Europe is in a “triple-C” slowdown • Currency appreciation is weighing on net exports
Tighter Credit conditions are affecting investment & consumption
Construction boom in some Eurozone countries is unwinding
20
Responsibility of Corporate Treasury
Cash Management -
-
Logistic bank account management Centralized Treasury operations Repatriation of cash - responsibilities - Top 10 cash balance overview - Problem countries Transfer costs
Financial Risk management Foreign exchange risk - Transactional risk - Translation risk - Economic risk Interest rate risk Counterparty risk Credit risk Liquidity risk
Corporate finance - Long term funding
Bank relations
In house bank
21
Cash management…….
Logistic Cash management: -
Deutsche bank is our Asia Cash management bank
-
ABN AMRO for The Netherlands Citibank for the rest of the world
-
Centralized contract management of these Cash management banks
Centralized Treasury -
Central cash investments
-
Central Interest rate risk management Management of 35 (Head office) currencies covering 85% of total turnover Active (hedging) management of 12 currencies Hedging the currency risk of new ordered aircrafts Acts as an In house bank for Subsidiaries derivatives are being used as hedging instruments Acting in accordance with Financial Plan, RMC and risk committee guidelines Close relationship with Air France Treasury (Joint proposals to RMC)
22
Advantages of a Centralized Treasury Qualitative -
•
Professionalized staff in Head office Equipment available to support decision making Better knowledge of financial markets Achievement of credit lines from banks Research of banks and other institutions available Assessment on Counterparty risk Avoidance of sub-optimalisation Controller attention back to sales
Quantitative -
Better conversion rate of exchange (Economies of scale) Reduction of Currency risk to a minimum Reduction of transfer costs to a minimum Higher return because of higher cash position Avoidance of short term borrowing from banks 23
Currency risk management In establishing a currency risk management program, companies need to identify the risks that they face and articulate their hedging philosophy Currency management overview 1. Objective: -
Reduce volatility in earnings EUR terms Reduce volatility in cash flows in EUR terms
2.
Impact on firm value: - Academic, empirical and anecdotal evidence overwhelmingly support that hedging increases firm value - The hedging “premium” is on average 5% - Hedging premium is both statistically and economically significant
3.
Rationale: - Investors in a stock seek exposure to foreign markets, not currencies - Lower volatility provides investors greater visibility into performance - Predictable cash flows reduce debt cost and increase access to debt markets and financial flexibility - Lower volatility increases ability to make value enhancing investments
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Hedging can have a positive impact on firm value
Firm value is created by making value enhancing investments that increase operating cash flow
1.
Key to supporting good investments is the internal generation of cash to fund those investment Internally generated cash flow can be disrupted by changes in interest rates, foreign exchange rates, and commodity prices. Hedging ensures the firm has sufficient cash flow available to make value enhancing investments (by reducing or eliminating these disruptions)
2. 3.
Firm value is created by reducing the asymmetries of information between internal management and external observers, including shareholders, equity analysts, credit agencies, etc.
1.
Reducing fluctuations caused by exogenous factors (interest rates, foreign exchange rates, and commodities prices) provides more reliable information on the firm’s outlook and increases stability of credit ratings and borrowing costs
2.
It also helps provide more reliable information to evaluate management’s performance
Isolating the impact of different hedging philosophies and strategies on firm value is difficult
1.
Specific currency exposures and hedging strategies executed across firms vary and cannot be easily identified, isolated and measured across a sample of firms to evaluate their impact on firm value
2.
Because of intercompany flows, multiple currencies, functional currency decisions, accounting and tax issues, currency risk is more complicated to manage than any other market risk
3.
We believe that the premium awarded to companies that hedge currency risk is comparable to the premium awarded to companies that hedge their consumer commodity exposures
4.
The 5% premium is an average of companies that “right way” hedge and “wrong way” hedge
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Types of foreign exchange exposures: transactional risks Definitions: 1. Transactions recorded in a foreign currency are revalued into local currency on each balance sheet date, through earnings 2. Most common example are trade receivables/payables, but also includes revaluation of long term currency denominated debt and other balance sheet items 3. Most often hedged currency risk among firms (Most firms hedge 100% of currency A/R and A/P using forwards “balance sheet hedging”)
Example: Firm sells its products in foreign countries priced in foreign currency terms
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Types of foreign currency exposures: translational risks
Definition
1.
Translation of foreign currency denominated assets and liabilities, and revenues and expenses into home (parent company) currency The translation of revenues and expenses of foreign subsidiaries impacts reported earnings to shareholders but is itself obscure In their MD&As, firms often delineate changes in operating income items (sales, cost of goods sold) due to changes in exchange rates
2. 3.
Example: Firm has a subsidiary in Switzerland, and is required to translate the Swiss sub’s CHF denominated financial statements into EUR on each reporting date (usually quarterly) 27
Historical chart EUR-USD 1989 - 2008
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Interest Rate risk management
Defining interest rate risk
Interest rate risk can be defined as the sensitivity of a portfolio to changes in interest rates All debt is essentially floating, with only the repricing frequency and the term varying The interest rate sensitivity of a liability portfolio is a function of: • • •
The frequency of rate repricing The average life of the portfolio's fixed rate debt (i.e. duration) The annual growth rate of the portfolio
KLM has runs an interest rate risk on both the Debt – and cash portfolio. Additionally KLM has a counterparty risk on the cash portfolio Debt portfolio risk management Long term cash product hedges on financed aircrafts Interest Rate Swaps Forward starting swap (Pre-hedging) Cash investment portfolio Liquidity funds Deposits Commercial Paper Derivatives
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Interest rate Swaps (Swap) A Swap is the most common derivatives strategy used to manage risk by Corporates A Swap is an agreement between two parties (counterparties) to exchange different interest payments in the same currency
- A counterparty is a principal in a derivative transaction - Amount of interest paid is based on “notional” principal. No principal is exchanged by either party - Typically, one counterparty's payments are fixed rate, the other counterparty’s payments are floating rate - Payments are often netted - Initially, a swap has zero NPV to both parties, but may take on positive or negative value during its life - USD market convention quotes the swap rate as a spread over Treasuries. - Swap spreads reflect the difference between Treasuries and LIBOR curves
Treasury + Swap spread = Swap rate Tenor
Treasury yield
Swap spread (bps)
Swap rate
2yr
2.30%
103.25
3.33%
3yr
2.55%
112.75
3.68%
4yr
2.81%
111.00
3.92%
5yr
3.06%
102.75
4.09%
6yr
3.21%
101.00
4.22%
7yr
3.37%
97.25
4.34%
8yr
3.52%
91.25
4.43%
9yr
3.68%
83.50
4.52%
10yr
3.83%
74.75
4.58%
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Interest rate swaps have a zero net present value at inception •
Swap pricing
•
swap is priced in order to equate the fixed rate payments to the expected floating rate payments - PV floating = PV fixed
Floating rate cash flows are calculated using the LIBOR forward curve • In a swap where KLM pays floating, the floating payments are less than the fixed payments in the beginning of the transaction (assuming upward sloping yield curve) •
- Forward curve predicts higher floating payments in the back end of the transaction - The swap rate equates the present value of the fixed cash flows - it intersects the forward curve such that the areas between the curves are equal - If the forward curve over predicts rates, paying floating rates will reduce interest expense.
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Various factors impact swap spreads •
Swap spreads are similar to credit spreads and can be compared to “AA” rated financial institution credit spreads
•
Swap spread levels are determined by the market and based on several fundamental, economic, and technical factors - Corporate debt issuers that want to pay floating –
Corporations swapping fixed liabilities into floating typically compress spreads
- Investors and arbitrageurs executing asset swaps of fixed rate assets –
Investors swapping fixed assets into floating typically widen spreads
- Business cycle –
Credit health of banking industry and industrial corporations
- Level of interest rates; shape of yield curve – –
Flatter curve: Wider spreads Steep curve: Tighter spread
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Swap market participants: Dealers, End Users, Speculators/Arbitrageurs • •
•
•
•
•
•
Dealers Dealers, banks and other financial institutions offer themselves as counterparties to satisfy Issuers' Company for managing financial risk (or trade for their own account and risk) Once a position is made, a dealer matches it by entering into an opposing transaction Derivatives portfolios are managed on a net basis, or residual risk of their overall position, allowing risk management to be focused on portfolio exposures which improve dealers' ability to accommodate a broad spectrum of Issuers' transactions Able to provide customized rather than “one size fits all” solutions unlike standardized futures market Dealer is responsible for ongoing administration (processing, bookkeeping, billing, and payment calculations Revenue is generated by the Bid/Offer
•
End users
•
As end users, issuers use derivatives for hedging as part of their asset/liability management while banks use derivatives to take positions as part of their proprietary trading
•
Pre-issuance hedging using Treasury Locks and Forward Starting Swaps Swapping fixed/float issuance to float/fixed Arbitraging difference in option value between OTC derivatives market and the cash market Call monetization strategy
• •
•
•
Speculators/Arbitrageurs
•
By using derivative products, organizations may also become speculators by taking an unhedged market view or arbitrageurs by recognizing and acting on a zero-net investment strategy that generates savings or profits Exploitation of curvature mis-pricings on the swap curve by trading multipoint barbells Expressing curve and barbell views conditionally through the use of swaptions/options on futures Trading options across different instrument and sovereign markets to profit from volatility mis-pricings
•
•
•
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The spread over LIBOR is approximately the difference between the bond coupon and the swap rate Bond Terms - Company new 10 year A
Bond coupon
5.00%
semi-annual, 30/360 daycount
4.23%
semi-annual, 30/360 daycount
A - B Difference between bond coupon and swap rate
0.7700%
semi-annual, 30/360 daycount
Conversion to money-market convention
0.76%
Quarterly, actual/360 daycount
Credit charge*
2.0 bps
Bid/Offer*
1.0 bps
Swap Rates B
10 yr swap rate Spread over LIBOR
Company's spread over LIBOR
0.79%
Note: Calculations are approximations only to hand check model pricing Assuming 3m LIBOR of 2.81% *For discussion purposes only
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The value of a swap increases or decreases with changes in market rates Mark-to-market Mark-to-market of of a a swap swap where where KLM KLM pays pays floating floating and and receives receives fixed fixed Rates are higher - swap becomes out-of-the6.50% money to client
5.50%
4.50%
5yr s wap rat e
3.50%
Rates are lower swap becomes inthe-money to client
2.50%
1.50% Aug- 08
Fe b- 09
Aug- 09
LIBOR f wd c ur ve
Fe b- 10
Aug- 10
5Yswa p r a t e
Fe b- 11
Aug- 11
100 bps wide r
Fe b- 12
Aug- 12
Fe b- 13
Aug- 13
100 bps t ight e r
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Counterparty Risk Management
1. BACKGROUND
Market value on counterparties increasing rapidly (hedge transactions for Crude oil, USD and other currencies, cash investments etc.)
Various tools are proposed to deal with counterparty credit risk issue
2. MAXIMUM EXPOSURE PER COUNTERPARTY • •
A table showing the exposure per counterparty connected to their rating Regular reporting will show any deviations ; it is suggested to entitle management to take necessary action to limit risk if CFO or VP are agreeing doing so
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Counterparty risk
INVESTMENTS : SEARCH FOR QUALITY AND DIVERSIFICATION Confirmation
of minimum rating
Less than 1 year
A1/P1
More than 1 year
AA-/Aa3
Reminder • •
:
CP’s (commercial paper) , deposits and Money market funds represent all-in-all about 90% risk on the Bank market a spread of 55bp with Treasury Bonds justifies this approach
Check regularly the status of the banks credit lines enabling to trade Update Credit default swap numbers of counterparties
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Credit Default Swap – BanksCDS Spread versus Benchm ark 23 Septem ber 2008 Spread
250 Fortis
Natixis
200 Citi Bank RBS
150 JP Morgan ING
100
Calyon ABN AMRO
Rabobank
Deutsche Bank Societe Generale
Mizuho
BNP
50
0 AAA
AA+
AA
AA-
A+
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