Forward contract: This is a type of a derivative contract that involves an agreement between parties on the rate of interest that will be applicable to specified national loans or deposits within a specified time period. The aim of this is to offer the borrower protection against the uncertainty that may result from unexpected rise in the interest rates. For instance, farmers face a significant price risk resulting from the fact that they do not know the price their products will sell at come the harvest time (Melnikov, 1999). The uncertainty resulting experienced in the farming sector may be as a result of the unpredictability of the weather conditions. This consequently affects the aggregate supply of the agricultural produce. To insure themselves against this risks, the farmers can sell a crop forward on the crop the farmer produces to account for losses that are likely to occur in the future if incase the products do not sell at a favorable price. This contract grants the farmer (grower) the obligation to deliver a given quantity of the agreed product at a particular date in the future for an agreed price. Delivery and payment are made on the forward date and initially, no money changes hands.
Future contract: This derivative contract involves exchange agreements that occur over the counter, which may involve assets or services. This contract provides a range of specific periods of delivery, thereby terming this derivative contract as a standardized contract. Futures are settled on daily basis depending on the interests of the parties bound to the contract, which are the buyer and the seller. The seller makes the delivery of assets or services at a given time in future, while the buyer makes payment of a specific price and takes the asset delivery. The seller holds the short position in the contact and the buyer holds the long position in the same contract, based on the obligations of each contract party (Melnikov, 1999). The cash flows generated in the practice of this contract are shown in the figure below:
Options: In this contract, the party bound to the contract has the right to buy or sell particular futures contracts at a specified price at any significant time up to a date that is predetermined and agreed upon. However, that party is obliged to undertake the buying or selling outlined in the contract. Options occur in two different types, namely call and put options (Melnikov, 1999). Call option is an option contract that gives the buyer the right to buy a given future contract at a specific price and at any time, provided the contract has not expired. A put option on the other hand is one that grants the buyer the rights of sale of specific future contacts at a given price and at any time that the contract remains operational. The figures below show an example of a quotation for gold options:
A quotation of gold options is shown above
Interest rate swaps: This refers to the process by which streams of interest rates are transferred, without necessarily transferring the debts that are underlying. Interest rate swaps are used as a management tool in operations involving interest rates for clients with financial plans and /or arrangements that are likely to be affected by change in the rates of interest. A fundamental aspect to consider in interest rate swaps is that these swaps are not facilities of lending but interest rate management tools that observe series of changes that occur on interest rates and consequently guide the individuals on making the right decisions and conclusions on the matter at hand (Melnikov, 1999). Considering the activities of a lending entity, CIT, and a financial plan that is subject to changing interest rates, the operations and activities between the two parties can be summarized by the graph below:
Credit default swaps: This is a contract based agreement that brings on board two parties, thereby called the counterparties. These parties enter into a contractual agreement and bound to make regular payment at specific time periods to each other, with the amount, currency and the applicable interest being predetermined. Securities that directly price the credit event in the financial markets constitute the credit default swaps. Deutsche Bank was the first to issue this kind of security in the year 2000.
Mortgage backed securities: These are defined as forms of fixed income investments in the financial markets. Mortgage backed securities are unique from other fixed income investments by the feature of risks that accrue from prepayment. Prepayment risks results from the prepayment factor and options in the advancement of mortgage loans. The allowance to prepay mortgage loans at any time the borrower wants without conditions or penalty constitutes the prepayment risk that is characteristic of the mortgage backed securities (Melnikov, 1999). The figure below shows an example of yields from mortgage backed securities for five years:
The above instruments can be used in the management of risk by reducing the chances that an unfortunate event will occur. The future is untold and the instruments outlined above can be in a position to handle cases of uncertainty by protecting either party that is bound to any kind of contract against losses that accrues from such events that cannot be forecasted. This special feature that allows these instruments mitigate risks consequently grants them thre3 ability to be used as debt instruments. This is solely based on their ability to serve as debt instruments (Melnikov, 1999).
What is value-at-risk?
In its most general form, the value- at- risk is a parameter that is used to measure the prospective loss in value of a risky asset over a given period of time and for a given confidence interval. For instance, if the Value –at –risk (VaR) on an asset is valued at $ 1000 million at a given period of time, let say, a week, then 95% of this is termed as the confidence level. This will also mean that only the value of the asset will only go down by a 5% value below the valuation of $ 1000. In other words, the term may also be narrowed down to mean, a probable loss in value form the determined of standard market risk. In determining the probable lost value, we ought to draw the distinctions that exist between the normal and the abnormal risks as much as we look at the distinction between the market and the non-market risks firm (Wilson, Nganje & Cullin 2007(581-595).
As much as the value-at-risk is employed by an entity in determining its potential risk exposures, it is also used by the commercial enterprises and investment banks in determining the probable loss in the value of their traded assortments from unfavorable markets over a particular period of time. The loss incurred is compared to the capital on hand and the cash reserves. This is an assurance that the available investments and the reserves are enough to counterbalance the losses incurred and alleviate the business from any risks.
In essence, the value –at risk may be used in diverse business terms as long as its computation is computed in the best way possible putting into consideration all the market factors. In our case, Value –at –risk that is computed for the bread baking firm aids the management team in reporting the risks involved in the process, evaluate the best ways possible in reducing the identified risks and lastly be able to set the limits of the encountered risks. The outcome after the risks have been valued indicated that, the Value-at- risk is a better gadget in managing the risks captured in this agriculture processing firm (Wilson, Nganje & Cullin 2007(581-595).
What instrument was most effective (futures, option, or a combination of both) in managing the value-at-risk of the firm in the article?
In our case study, the most effective instrument that was employed was the concept of the future contract. This is an aspect that discourages very many people but at the same time, it is the best parameter in managing the price risks. As discussed above, an entity may want to purchase or sell a commodity at some time in the future at a price that is agreed upon at the present moment. In mitigating the price risks, future contracts were created for the commercial interests but not for individual purposes. In determining the consumer price for the commodities produced by the bread baking company, there is a need to have a computation of both the inputs and the outputs used. Diverse firms are therefore engaged in providing the company with the required inputs and outputs.
Since the company has decided to manage the price risks that it has been experiencing for a quite long period, effective contractual agreements ought to be effected. For instance in the future contract that the company agreed upon with various firms comprised of prices for the patent flour Midwest beet sugar, Decatur soybean oil from the Milling & Baking News. The prices in this case were cumulated into monthly prices. Energy services were also an input from the Midwest on road no.2 (Wilson, Nganje & Cullin 2007(581-583).
The future contract that was agreed upon was for MGE hard red spring, which was to supply the company with the wheat extracts. The corn future was selected to hedge the price risks of the Company considering that they had a strong relationship with Midwest beet sugar. In order to minimize the price risks, related firms were put in a single enclosure as this would reduce the risks. In essence this was to ensure that there was a pool of risks between the related firms and in this case, there would be a better management in the price risks. After the computation of all this price associated risks, White pan bread prices were to be provided by the U.S department of labor under the Bureau of Labor Statistics' Consumer Price Index. In essence, the future contract used by the Company reduced the prices related risks and only option pricing model was used by the Treasury bill rates obtained from the Federal Reserve department (Wilson, Nganje & Cullin 2007(583-584).
Swiss bank in United States of America is a good example of a financial institution that offers banking and financial services to persons of different kind ranging from individual people to cooperate bodies. This bank has a wide network of branches all over the country hence therefore managing to have a big number of customers. Swiss bank in USA has been able to perform very well due to the fact that it offers quality services to its customers or addition to this it has an effective customer service. However, this financial institution has its own share of challenges which are very common to any kind of a business of this kind (Frost, 2004).
Firms of this kind are exposed to so many risks which if not taken care of they might hamper smooth running of the business or even make the company to go down completely. It is therefore very necessary or a must to put in place measures which can control such risks from happening or else if they happen there should be ways to compensate for the losses that have been suffered. The following part of the paper will review Swiss bank in US and answer the questions below (Frost, 2004).
What risks are faced by their institution and how are they affected by the recent financial crisis?
Poor performance in the capital market- this is a major risk that many banks faces whereby they buy shares without assessing properly the market forces that might prevail in future. Swiss bank has made losses in this manner whereby it purchases stocks which later on due various factors such as financial crisis the value of the stocks falls making the bank a loss.
Theft-this one of the most common risks that most financial institutions face all over the world whereby people arrange skillfully on how to rob a bank and successively does it. Most banks have lost huge chunks of money due to theft. Such cases are either done b y people with no affiliation to the bank at all while some bank robberies are done out of conspired plan between outsiders and the people who work within the banks. Bank robberies have been a major to Swiss bank in the USA though it has been able to set up tough measures to curb such scenarios from happening (Frost, 2004).
Fraud-this is another major setback that affects many financial institutions across the globe and there so many cases of fraud that have been reported in America. Swiss bank is one of the victims of fraud which basically happens in different ways but the bottom line of this kind of a crime concerns using fake means to get money from the institution. For instance a person can disguise to be working for a firm such as Deloitte and go with a fake name almost like the actual Deloitte hence therefore request to offer particular services to the bank such auditing.
If the bank is not cautious enough it will give in to the hoax been played to them b y the unauthentic firm which will pretend to offer similar services as the actual authorized company hence therefore pay for the services which actually will not be recognized by the regulatory bodies. This makes the bank to suffer since it will have to pay again to the genuine company that offers recognized services. Such an instance is a good example of how Swiss bank in America suffers from fraud (Frost, 2004).
Credit risks-credit risks are challenges that banks suffer due to the loans they advance to their customers without first evaluating on the credit worthiness of a person. Many banks such as Swiss bank have had problems in recovering their money from customers who are unable to pay back the loans given to them.
Ways in which Swiss bank is affected b y the recent financial crisis:
There are a number of challenges that emanated from the recent financial crisis in USA that affected the Swiss bank. One of the ways that that Swiss bank is suffering from the crisis is that the rates of taxation sky-rocketed hence therefore dictating that the bank has to pay more tax than it usually does in the past. Rise in taxation in the country also led to an increase in the cost of production since prices of almost all the crucial recourses hiked hence therefore making the bank to be forced to incur more cost than before (Frost, 2004).
How does Swiss bank in USA measure risks and what tools are used to manage risks? Discuss specific measures used to mitigate the risks from the recent financial crisis.
There are various ways in which Swiss bank applies to measure risks and from their findings they are able to come up with particular tools that they use to manage the risks. For instance there is one common way that Swiss bank applies to measure risks which is referred to as the Value at risk which involves aggregation of risk from all corners of the bank. This method basically involves evaluating the risk of experiencing a particular loss on a certain group of assets in the financial institutions which is done over a period of time frame (Frost, 2004).
This method helps the bank to identify where a particular risk is likely to happen hence therefore giving the institution an appropriate idea of how to mitigate the risks. A risk such as the fall in the value of shares that a bank owns in the capital market which basically has been caused b y the recent financial crisis that hit America can be edged by using the Value at risk measurement. This will enable the bank to evaluate the best stocks to buys and the safest time to do so as to avoid the risk of suffering losses related to falling in price of the shares (Frost, 2004).
Contrast the difference between how Swiss bank measure and manage risks to the discussion in parts I and II.
The discussion above is a clear indication that there is a big difference between how Swiss bank measures and manages risks. This is evident because, the risks that it still faces should not have been occurring if the methods of measurements and those of managing risks were corresponding. For instance, this bank could not suffer the losses concerning poor performance of the stocks if it had carried a good Value at risk analysis of the portfolio of shares it was buying before the recent financial crisis.
Frost, S. (2004). The bank analyst's handbook: money, risk, and conjuring tricks, Chicago: John
Wiley and Sons.
Melnikov, A. V. (1999). Financial markets: stochastic analysis and the pricing of derivative
securities. California: AMS Bookstore.
Wilson, W, Nganje, W and Cullin H. (2007). “Value at Risk for Grain Processing Firms,”
Review of Agricultural Economics. Vol.29, No.3 (fall):581-595.