Topics covered in Final Exams

a. Credit risk
b. Risk measurement/Challenges in Financial Risk Management
c. Interest rate risk – KLIBOR futures /Duration analysis
d. Commodity price risk – Crude Palm Oil (CPO) futures
e. Foreign Exchange risk – Interest Rates Swaps (IRS) and Currency Swap (CS)

Derivatives Instruments
a. Futures
b. Options
c. Swaps – eg. IRS and CS

Three types of market players/traders

a. Hedger
b. Speculator
c. Arbitraguer

PRICING

Foreign Exchange Risk Management

a. Definition – The risk that the exchange rate fluctuations/movements may

negatively/adversely impact the profitability of market players. For example, import
from US i.e. buy FC. If USD increases in comparison to RM, we have to pay more, this
negatively affect our profit.
How do we manage this risk?
Conventions: HC vs FC

b. To manage this risk we use derivatives instruments:

a. How does this instruments work? The mechanics of these instruments?
1. IRS – notional principal is never exchanged
2. CS – notional principal is always exchanged
c. Interest Rate Parity - Pricing

Example:
You are a US investor considering purchase of one of the following securities. Assume that the currency
risk of the Canadian government bond will be hedged, and the 6-month discount on Canadian dollar forward
Contracts is -0.75% versus the U.S dollar.
Bond Maturity Coupon Price
US 6 months 6.5% 100
Canada 6 months 7.5% 100

Calculate the expected price change required in the Canadian government bond that would result in the 2
Bonds having equal total returns in US dollars over a 6-month horizon. Assume that the yield on the US
Bond is expected to remain unchanged.
Solution:

Return on Canadian bond = Coupon income + gain/losses from premium/discount in the forward rate
relative to the spot exchange rate + capital gain/losses on the bond

=7.5%/2 + (-0.75%)+Price change in %

= 3% + % capital gain

The expected semiannual return on the US bond is 3.25%. Since the US bond is selling at par and its yield
Is expected to remain unchanged, there is no expected capital gain or loss on the US bond. Therefore, in
order to provide the same return, the Canadian bond must provide a capital gain of 0.25% (i.e. ¼ point
relative to par value of 100) over and above any expected capital gain on the US bond.