instruments in interest-rate, currency and ... - Volksbank AG

Group Treasury at **Volksbank** **AG** (VB**AG**): Your professional partnerfor manag**in**g **in**terest-**rate**, **currency** **and** commodities risksThe volatile markets **in** recent years show that hedg**in**g treasury risks is a key component of operationalrisk management for SMEs **and** major clients fit for the capital market. Banks must provide high qualityadvisory **and** consult**in**g services to keep pace with constantly chang**in**g conditions on the f**in**ancialmarkets. Professional management of **in**terest-**rate**, **currency** **and** commodity risks can greatly enhance acompany's value.Our specialists, who have extensive product knowledge **and** many years of experience, work with ourclients to develop custom hedg**in**g st**rate**gies. When used properly, products can reduce f**in**anc**in**g costs**and** enhance **in**vestment st**rate**gies. The aim is to elim**in**ate market price risks that cannot be forecast asfar as possible.VB**AG**'s Group Treasury relies on a holistic advisory approach meant to develop personal **and** **in**novativesolutions. In addition to a wide range of services, fundamental **and** methodical expertise, comb**in**ed withmany years of experience on the capital markets, are among our core competencies.We have developed this publication to provide our clients with more **in**formation on these products. Itoffers an overview of our diverse ** instruments** for

4>> Active **in**terest **rate** management secures returns „**and** optimises a company's f**in**ancial assets.“

The decision between hedg**in**g **and** position**in**g, i.e. between a hedged **in**terest situation **and** a deli be **rate**lyassumed **in**terest-**rate** risk, is also an expression of the philosophy of a company’s treasury department:nThe argument **in** favour of employ**in**g a hedg**in**g st**rate**gy is that management can concent**rate** all its attentionon manag**in**g the performance-oriented cash flows, market trends **and** the company st**rate**gy, becausethere is no further need to manage position**in**g decisions.nA pure hedg**in**g st**rate**gy, however, may also result **in** competitive disadvantages, if competitors engage **in**active **in**terest-**rate** management **and** manage to reduce their **in**terest expense by means of their position**in**gdecisions. The position**in**g, i.e. an active stance towards the **in**terest-**rate** risk, therefore forms an importantstep **in** turn**in**g the f**in**ancial area **in**to a profit centre.INTEREST-RATE CURVESThe **in**terest-**rate** structure curve **and** the **in**terest payment curve it implies form a basis for decisions regard**in**g**in**terest-**rate** management.nThe **in**terest-**rate** structure curve is the graphic representation of the correlation of **in**terest **rate**s – **in** thecase of ** instruments** with equal credit risk – dependent on the term to maturity. Interest-

The follow**in**g formula enables us to establish at any time from two positions of the **in**terest structure curve animplied forward **in**terest **rate**, which constitutes one position of the implied forward **in**terest-**rate** curve.This formula calculates for periods longer than one year.ZP t =(1 + ZP N ) N 1/t-1FP t = forward **in**terest-**rate** period tZP n = zero **in**terest **rate** for period nZP N = zero **in**terest **rate** for period NN = long term to maturityn = short term to maturityt = N-n(1 + ZP n ) n 1/1Example2-year market **rate**: 4.75% (30/360), zero **in**terest **rate**: 4.776%3-year market **rate**: 4.80% (30/360), zero **in**terest **rate**: 4.815%(1 + 0.04815) 3Annuity **in** 2 years = -1 = 4.698% (30/360)(1 + 0.04776) 2The **in**terest structure curve **in**dicates a market expectation of 4.698% for the **rate** for anannuity over 2 years.The implied forward **in**terest **rate** is an important decision-mak**in**g criterion because it constitutes the basis forall tools of **in**terest-**rate** management. But: **in**terest-**rate** hedg**in**g only means protection aga**in**st fluctuations **in**the actual **in**terest **rate** compared with **in**terest as a result of the **in**terest-**rate** structure curve. There is noprotection aga**in**st a development of **in**terest **rate**s as shown by the forward **in**terest-**rate** curve.Possible **in**terest structure curvesFlat **in**terest structure curve7

FORWARD RATE **AG**REEMENTSINTEREST-RATE SWAPWhat is an **in**terest-**rate** swap?An **in**terest-**rate** swap (IRS) is an agreement between two parties to swap payments of **in**terest **in** the same**currency** over a determ**in**ed period (e.g. fixed **rate** aga**in**st float**in**g **rate**). The agreement is based on a fixedpr**in**cipal amount (nom**in**al amount) which is not however swapped. In a swap, the float**in**g **in**terest **rate** isusually l**in**ked to a reference **rate**, e.g. to the EURIBOR or LIBOR.The **in**terest-**rate** swap can be used to modify the **in**terest-**rate** characteristics of balance sheet items withoutmodify**in**g the underly**in**g balance sheet items. This is advantageous, especially if restructur**in**g balance sheetitems for **in**terest-**rate** reasons **in** the conventional way would result **in** the extension of the balance sheet **and**the modification of balance sheet ratios or **in** additional costs.Determ**in**ants of an **in**terest-**rate** swapn Currency **and** nom**in**al amountn Time to maturity: between 6 months **and** 30 yearsn Fixed **rate** of **in**terest: market **rate** at the time**in**terest calculated quarterly, half-yearly or annually **in** arrears,on the basis of 30/360 or act/360n Float**in**g **in**terest **rate**: Reference **rate** (EURIBOR, LIBOR, …)roll over dates: 3 or 6 months**in**terest calculated on basis of roll over deadl**in**es quarterlyor half yearly **in** arrears, based on act/360ApplicationsOn the liabilities side:nFor hedg**in**g a float**in**g debt risk when expect**in**g **rate**s to **in**crease.By swapp**in**g from a variable to fixed **in**terest **rate**, the **in**terest expenses are fixed **and** form a fixed basisfor calculations.nFor reduc**in**g borrow**in**g costs by exchang**in**g a long term fixed **in**terest-**rate** agreement **in**to a variableamount, with **rate**s expected to rema**in** stable or to decrease.On the assets side:nMak**in**g use of an expected **in**terest-**rate** **in**crease by swapp**in**g fixed **in**terest **in**vestments **in**to a float**in**g one.10

ExamplesExample 1: Liabilities side – from float**in**g to fixed **rate** (float**in**g aga**in**st fixed)When f**in**anc**in**g us**in**g a float**in**g **in**terest-**rate** loan (roll over loan = R/O loan), liability may **in**crease whenmarket **rate**s **in**crease, without **in**come on the assets side **in**creas**in**g at an equal **rate**. This risk can be avoidedwith a swap chang**in**g the float**in**g **rate** **in**to a fixed **rate**. This creates a firm basis for calculation of **in**terestexpenses over the term of the swap.For this swap the company pays **Volksbank** **AG** (VB**AG**) a fixed **in**terest **rate** **and** **in** return receives a variable**rate**. The company uses this variable **rate** to make the EURIBOR payments on the R/O loan. As both variable**in**terest-payment-flowsbalance on the roll over dates, this transaction results **in** a fixed amount of the **in**terestfor the R/O loan: with a fixed **rate** of **in**terest result**in**g from swap plus marg**in** result**in**g from the R/O loan.Transaction **in** course:A company pays EURIBOR + 100 BP under an R/O loan.Interest-**rate** swap:A company receives EURIBOR ± 0 BP from VB**AG**.The company pays VB**AG** a fixed **rate** of **in**terest.Result:The company pays a fixed **in**terest **rate** + 100 BP.VB**AG**EURIBORFixed **in**terest **rate**CompanyEURIBOR + 100 BP11

Example 2: Liabilities side – from fixed to float**in**g **rate** (float**in**g aga**in**st fixed)A company was able to obta**in** an attractive long term fixed **in**terest-**rate** loan; not expect**in**g the **in**terest **rate**to rise **and** not **in** need of further fixed **in**terest funds, the company can change over to a float**in**g **rate**. A swapis entered **in**to where VB**AG** pays the company a fixed **rate** for servic**in**g the loan. In exchange, thecompany pays a variable EURIBOR **rate** of **in**terest.Exist**in**g transaction: A company pays a fixed **in**terest **rate** (e.g. 6%).Interest-**rate** swap: VB**AG** gives company a fixed **in**terest **rate** (e.g. 5%).Company pays EURIBOR ± 0 BP to VB**AG**Result:Company pays EURIBOR ± difference between fixed **in**terest **rate**s.(here: EURIBOR + 100 BP)VB**AG**EURIBORfixed **in**terest **rate** (5%)Companyfixed **in**terest **rate** (6%)Term**in**ation of an **in**terest-**rate** swapis possible at any time by means of aBack-to-back transaction: a back-to-back swap is entered **in**to at current market conditions, over therema**in****in**g term of the orig**in**al swap. The payee of the fixed **rate** of **in**terest **in** the orig**in**al swap becomes payerof the fixed **rate** **in** the back-to-back transaction. The **in**terest position of the orig**in**al transaction is thereforefully compensated.Cash-out: Premature term**in**ation of the agreement is exercised, balanc**in**g the reciprocal **in**terest amountsreceivable via a counter account based on the current terms **and** conditions of the swap (to cover the lossfrom re-**in**vestment).12

Swap structuresOver the last few years, swap structures have been ref**in**ed **and** developed further **in** order to hedge cash flowsresult**in**g from **in**vestment projects or f**in**ancial **in**vestments to the best possible extent. The follow**in**g structuresdom**in**ate the market:In a swap with f**in**al maturity the nom**in**al amounts rema**in** thesame over the term of the swap.The amortiz**in**g swap is used **in** particular for hedg**in**g amortis**in**gloan facilities.In a forward swap (also known as a delayed start swap, fixeddate swap) a future requirement for f**in**anc**in**g / **in**vestment can behedged already **in** advance aga**in**st the **in**terest-**rate** risk.13

In the step-up swap, the nom**in**al amounts keep **in**creas**in**g overthe term of the agreement. This swap structure is especiallysuited for hedg**in**g the **in**terest **rate** of major **in**vestment projectsto be realised progressively over a period of several years.In the case of an extendable swap, one of the parties has anoption to extend the swap beyond the orig**in**al term at the sameterms **and** conditions.In a callable swap, one party has the option to term**in**ate the swapprematurely.EONIA SWAPWhat is an EONIA swap?A further type of **in**terest-**rate** swap is the EONIA Swap (EONIA = Euro OverNight Index Average). Thisenables liquidity with**in** the call money sector to be controlled. Possible terms to maturity start out at one week**and** enable users to either exclude volatility of the short call money **rate**s when rais**in**g capital or mak**in**g use ofit for **in**vestments. The EONIA **rate** is the average **rate** for call money for **in**terbank transactions calculated bythe European Central Bank s**in**ce 4 January 1999 based on actual transactions us**in**g the act/360 **in**terestcalculation method. Calculation is carried out **in** arrears, tak**in**g **in**to account the compound **in**terest effectthrough the effective **in**terest formula.14

Determ**in**ants of an EONIA swapn Nom**in**al amountn Time to maturity: between 1 week **and** 2 yearsn Fixed **rate** of **in**terest: EURIBOR **rate** as applicable, day count act/360n Reference **in**terest **rate**: EONIA (Euro Overnight Index Average)The EONIA **rate** is calculated us**in**g the follow**in**g formula:R = float**in**g EONIA **rate** to be determ**in**ed tak**in**g compound **in**terest effects **in**to accountt 1 = start**in**g date of the EONIA swapt e = the maturity of the EONIA swapr i = **in**terest **rate** for call money (per cent divided by 100)T i = number of days to which r i applies (normally 1 day, except for weekends **and** EUR-holiday)T = term of the EONIA swap **in** daysApplicationsOn the liabilities side:nThe EONIA swap enables users to vary l**in**ked **in**terest **rate**s **and** thus to m**in**imise the risk of fluctuat**in**gcall money **rate**s.On the assets side:nAn EONIA swap enables users to make use of an **in**verse **in**terest-**rate** structure **and** achieve better resultswhen **in**vest**in**g short to medium term liquidity surplus funds.ExampleAssets side, **in**verse **in**terest-**rate** structure, a one week EONIA swap is entered **in**toA company has short term liquidity available of EUR 10 million, which is currently **in**vested based on theone week EURIBOR **rate** of 10 BP. In order to benefit from the **in**verse **in**terest structure **in** the moneymarket, an EONIA swap is entered **in**to, enabl**in**g the company, **in** spite of hav**in**g **in**vested the funds for aweek to benefit from the market’s higher call money **rate**s.15

Transaction **in** course:A company is paid 10 BP (e.g. 4%) for **in**vestment us**in**g the 1 weekEURIBOR **rate**.EONIA swap:The company pays VB**AG** 4.1% **in**terest over a week (= 1 week fixed **rate**).The company however receives for the same term to maturity **and** thesame pr**in**cipal the **in**terest **rate** of 4.7245% (= average EONIA **rate**).Calculation EONIA **rate**: *)1 st day 4.172 nd day 4.153 rd day 4.124 th day 4.125 th – 7 th day 4.08Basically, the company pays **in**terest amount**in**g EUR 7,972.22, **and** obta**in**s **in**terestof EUR 8,002.36 from the swap. In actual fact, only the difference will be paid out,i.e. the company is paid EUR 30.14 by the swap partner.Result:The company receives the difference between the 1 week fixed **rate****and** the average EONIA **rate**.VB**AG**1 week fixed **rate**average EONIA **rate**Company1 week EURIBOR – 10 BP*) calculation of the average EONIA **rate**:16

CROSS CURRENCY SWAPWhat is a cross **currency** swap?A cross **currency** swap is a special form of **in**terest-**rate** swap. It is an **in**strument of **in**terest-**rate** **and** **currency**management whereby the focus is once aga**in** on the swap of different **in**terest payments.The first difference between the two flows of **in**terest payments runn**in**g **in** opposite directions is theirdenom**in**ation **in** different currencies. Moreover, the pr**in**cipal amounts are usually swapped at the beg**in**n**in**g**and** at the end of the agreement; however, these pr**in**cipal amounts are **in** differ**in**g currencies. Interest paymentobligations of the swap partners result**in**g from possible underly**in**g transactions are not affected. As **in** the caseof **in**terest-**rate** swaps, only the payments between the parties **in**volved are regulated.A cross **currency** swap can be illust**rate**d **in** three steps:nStep 1: Swap of pr**in**cipal amounts upon enter**in**g **in**to the transactionUpon enter**in**g **in**to the transaction, pr**in**cipal amounts **in** the underly**in**g currencies are swapped,usually at the current spot **rate**.Party 1pr**in**cipal **currency** Ix spot **rate** =pr**in**cipal **currency** IIParty 2An actual swap of the pr**in**cipals among the parties is not m**and**atory. What is, however, decisive is to fix the**rate** of exchange because this is the only way to determ**in**e **in**terest payments **and** the re-exchange ratio of the pr**in**cipalamounts. As a rule, the swap takes place **in** the vic**in**ity of the current spot **rate**, with **rate**s rounded up or down –to smooth out the pr**in**cipal amounts.nStep 2: Interest-**rate** swap before maturityInterest on the respective pr**in**cipal amounts received is swapped before maturity.Party 1pr**in**cipal **currency** Ix **in**terest-**rate** **currency** Ipr**in**cipal **currency** IIx **in**terest-**rate** **currency** IIParty 217

nStep 3: Re-exchange of the pr**in**cipal amounts upon maturityUpon maturity, pr**in**cipals are re-exchanged on the basis of the orig**in**al **rate** of exchange (par forward basis).Party 1pr**in**cipal **currency** Ix par forward **rate** =pr**in**cipal **currency** IIParty 2When re-exchang**in**g the pr**in**cipals, it is decisive to ma**in**ta**in** the orig**in**al spot **rate** (par forward **rate**). The parforward **rate** becomes possible because the difference **in** **in**terest exist**in**g between the two currencies is balancedout by the **in**terest payments made **in** the meantime.Note:If the pr**in**cipal amounts are converted **in**stead of be**in**g swapped at the beg**in**n**in**g of the term of the swap therestill is a **currency** risk because of the conversion which is also required upon maturity of the swap.Determ**in**ants of a cross **currency** swapn Currency **and** nom**in**al amountn Exchange **rate**s of the swap currenciesn Term: between 6 months **and** 30 yearsn Fixed **rate** of **in**terest: current market **in**terest **rate****in**terest calculated every three, six or twelve months **in** arrears on thebasis 30/360 or act/360n Float**in**g **rate** of **in**terest: reference **rate** of **in**terest (EURIBOR, LIBOR, …)roll over dates: 3 or 6 months**in**terest calculated accord**in**g to the roll over dates every 3 or 6 months**in** arrears on the basis act/360ApplicationsCross **currency** swaps are used for foreign **currency** management both on the assets as well as on the liabilitiesside. They enable users to lock **in** the achieved foreign exchange ga**in**s or to take advantage of expected trends**in** exchange **rate**s. Items that result **in** **in**terest payments are particularly suitable for this purpose. On the assetsside, for example, this is the case for loans **and** advances owed to the group **and** securities. On the liabilities side,this is the case for the correspond**in**g medium- to long-term, zero **in**terest or float**in**g **in**terest issues **and** loans.Term**in**ation of a cross **currency** swapis possible at any time through a back-to-back transaction or cash-out (just as **in** the case of the **in**terest-**rate** swap).18

Typical cross **currency** swapsnIn the case of the fixed-fixed **currency** swap, fixed **in**terest payments are paid **and** received **in**different currencies.nIn the case of the float**in**g-float**in**g **currency** swap (basis swap) float**in**g **rate** **in**terest is paid **and** received onpr**in**cipal amounts **in** two different currencies.nComb**in**ed cross **currency** swaps are able to swap fixed **and** variable **in**terest payments **in** twodifferent currencies.ExampleLiabilities side – from the float**in**g **rate** EUR loan **in**to a JPY fixed **in**terest loan (EUR float**in**g aga**in**st JPY fixed)A good example for a ”basic loan” is a float**in**g **in**terest-**rate** loan (roll over loan) **in** the local **currency** (EUR),because the best terms **and** conditions are usually available **in** this **in**stance, offers can be directly compared on acredit marg**in** basis us**in**g the EURIBOR **and** restructur**in**g with a swap or a hedge with cap (cf. chapter **in**terest**rate**options) is easy to arrange. With a cross **currency** swap, swapp**in**g the float**in**g EUR **rate** of **in**terest to a fixed**rate** of **in**terest **in** a foreign **currency**, a fixed **in**terest loan is created **in** the chosen low **in**terest-**rate** **currency**. Therisk of the float**in**g **rate** of **in**terest is thus hedged. The foreign exchange risk can be limited better by be**in**g ableto term**in**ate it at any time (by term**in**at**in**g the swap **and** valuation at the market conditions prevail**in**g at thatparticular time).For this cross **currency** swap, the company gets a float**in**g EUR **rate** **and** pays a JPY fixed **in**terest **rate** to VB**AG**.With this variable **rate**, the company services the EURIBOR payments result**in**g from the R/O loan.As both variable **in**terest payment flows balance out on the roll over dates, this transaction results **in** a foreign**currency** loan with a fixed **in**terest **rate** over the full term of the swap.”Basic f**in**anc**in**g“: a company pays EURIBOR + 100 BP on an R/O EUR loan.Cross **currency** swap: The company receives EURIBOR +100 BP from VB**AG**. The company pays VB**AG** a JPY fixed**in**terest **rate** (about 100 BP above current market level).Foreign **currency**: Instead of the **in**itial exchange **and** the f**in**al exchange, Group Treasury executed both conversions(**in**itial **and** f**in**al). The JPY nom**in**al amount is sold **in** the market at the beg**in**n**in**g of the cross **currency** swap, withthis **in**itial **rate** be**in**g crucial for the success of the foreign **currency** f**in**anc**in**g, **and** should occur when the foreign**currency** (JPY) is st**and****in**g as high as possible aga**in**st the local **currency** (EUR). The foreign **currency** amountreceivable by VB**AG** from company is also subject to this **in**itial **rate**. In the event that the JPY/Euro **rate** drops (i.e.EUR/JPY rises), the foreign exchange ga**in** can be realised by term**in**at**in**g the swap or hedge (forward exchangetransaction).Result: The company pays a JPY fixed **in**terest **rate**.19

Initial exchange, to be replaced by conversion at **in**itial **rate**F**in**al exchange, to be replaced by conversion **and** settlement aga**in**st **in**itial **rate** ofexchange – exchange risk!FORWARD RATE **AG**REEMENT (FRA)What is an FRA?A Forward Rate Agreement (FRA) is an agreement between two parties **in** which the **rate** of **in**terest is fixedfor a future period **and** for a nom**in**al amount agreed upon. The FRA does not **in**clude an agreement aboutthe exchange of capital.For the usual terms to maturity, FRAs are usually quoted for both sides, i.e. a buy**in**g side (purchase of a FRA)**and** a sell**in**g side (sale of an FRA) are specified. When quot**in**g an FRA, two figures are given **in** addition to the**in**terest **rate** (e.g. 3 x 9, i.e. 3 aga**in**st 9 months FRA) **in** order to determ**in**e the periods. The first figure refersto the period between the date of the agreement **and** the fix**in**g of the **in**terest **rate** (lead period + **in**terestperiod).A 3 x 9 FRA thus has a three months’ lead period **and** a 9 months’ total term to maturity; the **in**terest periodis 6 months (total term less lead period).Partial periods of the 3 x 9 FRA:total term until maturity 9 monthsLead period3 monthsDeal is f**in**alisedInterest-**rate** period hedged6 monthsInterest-**rate** comparison **and** settlement20

On the assets side:nHedg**in**g the **in**terest **rate** of planned **in**vestments: If a company expects a future excess ofliquidity **and** considers current **in**terest **rate**s to be attractive, it is already possible to fix such **in**terest **rate**sfor a future period now.nHedg**in**g the **in**terest **rate** of exist**in**g **in**vestments: Exist**in**g **in**vestments can be hedged aga**in**stthe risk of decreas**in**g **in**terest **rate**s by sell**in**g FRAs.Term**in**ation of an FRAis possible at any time through a back to back transaction.QUANTO SWAPWhat is a quanto swap?The quanto swap is a way of reduc**in**g **in**terest charges on f**in**anc**in**g – by benefit**in**g from foreign **in**terest **rate**s– without reduc**in**g the foreign exchange risk.The quanto **in**terest payments are based on a foreign **in**terest curve without foreign exchange risk. The onlyrisk is that customer’s **in**terest payments based on a foreign **rate** of **in**terest might be higher than EURIBOR**in**terest payments.ApplicationsA company wants to reduce the future borrow**in**g cost of a conventional loan. This is possible only if (a) theborrower assumes a risk based on his specific expectation on future **in**terest-**rate** differentials **and** (b) hisexpectations are confirmed by the market situation **in** the future.At the outset, the company has a float**in**g **rate** euro loan (e.g. 3M EURIBOR loan).The company assumes that the difference between the 3M EURIBOR **and** the 3M CHF LIBOR will eithercont**in**ue to exist at the same **rate** **in** the future as it is today or that this **in**terest-**rate** differential (3M EUR**in**terest m**in**us 3M CHF **in**terest) will **in**crease. The company therefore enters **in**to a euro quanto swap, **in**addition to the exist**in**g float**in**g euro loan.22

3M EURIBOR Loan3M EURIBORCompany3M EURIBORVB**AG**(3M CHFLIBOR + Spread)**in** EURHow it worksIn a euro quanto swap based on the CHF LIBOR, two euro float**in**g **rate** **in**terest payments are swapped. Thespread on the 3M CHF LIBOR agreed for the euro quanto swap rema**in**s unchanged dur**in**g the term untilmaturity. All **in**terest payments are made **in** EUR, so there is no foreign exchange risk. The bundle consist**in**gof a float**in**g **rate** euro loan plus euro quanto swap results **in** a float**in**g euro loan for the company. Every quarterof a year, the company applies the 3M CHF LIBOR **rate** applicable at the particular time to his EUR pr**in**cipal**in** order to calculate the **in**terest payable **in** EUR.RiskAs far as the market price trend of a euro quanto swap is concerned, the payer of the euro quanto **in**terestpayments (3M CHF LIBOR + spread) is subject to a risk of the difference between the 3M EUR **and** the 3MCHF LIBOR **rate**s narrow**in**g.QuotationBasically, no fee is charged for a euro quanto swap, due to the fact that the spread on the 3M CHF LIBORagreed upon enter**in**g the swap is unchanged.TypesAs alternatives to the type described above, other euro quanto swaps are also possible upon request (euroquanto swap based on USD LIBOR etc.).Term**in**ation of a quanto swapis possible at any time by means of a back-to-back transaction or cash-out (just as **in** the case of the **in**terest**rate**swap).23

CONSTANT MATURITY SWAP (CMS)DescriptionThe constant maturity swap (CMS) is a particular form of **in**terest-**rate** swap where at least one swap partnerpays a variable flow of funds which is periodically adjusted aga**in**st a longer term reference **rate** (e.g. 3 yearswap **rate**).If a company expects the **in**terest curve to flatten **in** a way that is not anticipated by the market, he can enter**in**to a position **in** a “pay CMS – receive EURIBOR **in**terest-**rate** swap”, for this purpose the underly**in**g term tomaturity of the CMS **rate** can be chosen to correspond with precise expectations.This results **in** profit opportunities for the payer of the CMS **in**terest **rate** **in** the event that the swap **rate**s asthey materialise **in** the future (a) range on average below today’s future **rate**s for the respective fix**in**g dates**and**/or (b) **in**crease less than expected by the market at the time the swap is entered **in**to.ApplicationsAt the outset, the company has a float**in**g **rate** euro loan (e.g. a 6M EURIBOR loan). In the present example,VB**AG** pays the 6M EURIBOR each half-year, while the borrower pays 80% of the 3 year EUR swap **rate** eachhalf-year.6M EURIBOR Loan6M EURIBORCompany6M EURIBORCMSpaymentVB**AG**Quotation: Agreement on a premium or discount on the underly**in**g constant maturity swap (CMS) **rate** orfix**in**g of a percentage factor.RiskExamplesDepend**in**g on the form of the CMS – either “pay CMS – receive EURIBOR” or “pay EURIBOR – receiveCMS”, a flatten**in**g or an **in**crease **in** steepness of the **in**terest curve can result **in** opportunities or risks.nnnConstant maturity swap for borrowersConstant maturity swap with zero cost cap for borrowersConstant maturity swap for **in**vestors24

INTEREST OPTIONSCAPWhat is a cap?A cap is an agreement of an upper limitation of the **in**terest **rate** related to an underly**in**g pr**in**cipal amount. If,for this purpose, the reference **rate** (e.g. EURIBOR or LIBOR) exceeds the maximum **in**terest **rate** fixed bythe agreement (strike price), the seller (writer) pays the difference between the cap **and** the reference **rate**of **in**terest to the purchaser of the cap. Settlement is the same as for FRAs.For the buyer, caps thus constitute a hedge aga**in**st ris**in**g **in**terest **rate**s; whilst, however, simultaneouslyoffer**in**g the possibility of benefit**in**g from a lower or decreas**in**g level of market **in**terest **rate**s at the shortend of the **in**terest curve.The important th**in**g is how to design the cap premium, which is normally payable as a non-recurrent fee uponenter**in**g **in**to the agreement. At the company’s request, it is possible to pay the premium at regular **in**tervals,e.g. every six months.Determ**in**ants of a capn Currency **and** nom**in**al amountn Term: between 2 **and** 10 yearsn Strike price: cap leveln Reference **rate** of **in**terest: EURIBOR, LIBOR, ...n Roll over dates: dates when strike price **and** reference **rate** of **in**terest are compared,usually 3,6,9 or 12 monthsn Premium: usually a non-current premium at the beg**in**n**in**g of the contract period,expressed as a percentage of the underly**in**g pr**in**cipal amountIt is easy to derive rules of thumb from the determ**in**ants **in** order to provide buyers with h**in**ts on the capprice trend:nnnnThe longer the term to maturity, the higher the cap premium.The higher the cap, the lower the cap premium.The more the difference between cap **and** implied market **in**terest-**rate** level, the lower the cappremium.The more the **in**terest-**rate** fluctuations expected (volatility), the higher the cap premium.25

Hedg**in**g profile: capApplicationsnBy agree**in**g on a cap, it is possible to limit the upper end of the **in**terest-**rate** risk of float**in**g **in**terestloans. At the same time, the option rema**in**s to realise sav**in**gs of **in**terest expenses result**in**g from lower ordecreas**in**g **rate**s (asymmetrical risk profile).nAs opposed to a swap, caps may result **in** hedg**in**g **in**terest **rate**s also when no forecast is available on thefuture trend of **in**terest **rate**s. This is a result of the asymmetrical nature of caps: hedg**in**g aga**in**st ris**in**g **rate**s– with advantages when **rate**s decrease.nA cap contract is entered **in**to sepa**rate**ly from the underly**in**g transaction (e.g. a loan), mean**in**g that thistool can also be used for loans already **in** existence.ExampleA company raises a EUR 10 m roll over loan with f**in**al maturity, with a 5 year term based on the6 month EURIBOR **rate** + 100 BP **and** decides that it never wants to pay more than 6.00% **in** the future. To ensurethis, it must buy a cap with a strike price of 5.00% (his 6.00% cap m**in**us 1.00% marg**in** from the R/O loan).For a 5 year cap aga**in**st 6MO EUR-R/O at a strike price of 5.00% (6.00% – 1.00%), Group Treasury offers a priceof 125 BP, for example. This non-recurrent premium is payable upon enter**in**g **in**to the contract.On the **in**terest payment date, the strike price is compared with the current EURIBOR **rate**:Company pays VB**AG** resultVB**AG** pays for theEURIBOR Strike price from the R/O loan company company4.50 5.00 5.50 – 5.505.00 5.00 6.00 – 6.005.50 5.00 6.50 0.50 6.0026

Term**in**ation of a capis possible at any time through a back-to-back transaction or cash-out.Special cap structuresChooser capThe chooser cap is – just as a traditional cap – an agreement on a particular cap related to the 3 or6 month EURIBOR **rate**. Unlike a traditional cap, only part of the future **in**terest periods is hedged **in** the formof **in**dividual caplets (= partial periods of a cap). The buyer decides before maturity whether the hedge will beutilised or not **in** the respective **in**terest period. What is the advantage? The expense of the hedge is significantlyless, because not all future **in**terest periods are hedged. The buyer has a “flexible” hedge over the term tomaturity, i.e. he can decide on exercis**in**g the option at each roll over date (useful **in** case the cap is exceededby a narrow marg**in**).ExampleA company raises a EUR 10 m roll over loan with f**in**al maturity, 5 year term based on the 3 months EURIBOR **rate**+ 100 BP **and** decides that it never wants to pay more than 6% **in** the future. With a chooser cap **and** strike price of5.00% (6.00% m**in**us 1.00%) the company acquires the right to be paid the difference between the respectivecurrent 3 month EURIBOR **rate** **and** 5.00% for a certa**in** number of float**in**g **in**terest periods.The chooser cap:Term to maturity: 5 years (= 19 future **in**terest periods)Of which company hedges a) 10 caplets b) 5 caplets of his choiceStrike price: 5.00%Interest **in**dicator: 3M EURIBORThe underly**in**g assumption regard**in**g the **rate** of **in**terest :The company expects, with**in** the 5 year term, the 3 month EURIBOR not to exceed the 6% **in**terest-**rate** capchosena) more often than ten times, b) clearly more often than 5 times.The risk:3 month EURIBOR exceeds 5.00% more often than a) 10 times or b) 5 times.The advantage:The buyer of the chooser cap has the right to benefit from the **in**terest-**rate** cap a) ten times or b) five times. This means it ishis choice when to use the chooser cap over the term of validity. This makes control of the **in**terest-**rate** risk position moreflexible. A marg**in** rema**in**s to allow a reaction **in** the event of an unexpected **in**terest-**rate** development. A conventional cap forthe structure as described would have cost for example 1.6% of the nom**in**al amount, i.e. a premium of EUR 160,000 forEUR 10 million, the chooser cap alternatives as presented would cost, however a) for 10 caplets 1.15%, i.e. EUR 115,000 orb) for 5 caplets 0.85%, i.e. EUR 85,000.27

Participat**in**g capThe participat**in**g cap constitutes a particular cap structure, where the cap buyer hedges the risk of a rise **in****in**terest **rate**s free of charge **and** participates to a certa**in** extent of the contract value **in** the decreas**in**g **in**terest**rate**. Assum**in**g a 50% participation means that 50% of the nom**in**al amount is charged **in**terest with the strikeprice selected **and** 50% with the current float**in**g **rate**, but not exceed**in**g the strike price.ExampleA company raises a EUR 10 m roll over loan with f**in**al maturity, 5 year term based on 3 months EURIBOR +100 BP.For the complete amount of the loan a maximum **in**terest **rate** of 6% is to be hedged, 50% of the capital is tobenefit from fall**in**g **in**terest **rate**s. The company therefore enters **in**to the follow**in**g participat**in**g cap with a strikeprice 5.00% (6.00% m**in**us 1.00%).The participat**in**g cap:Term to maturity: 5 yearsStrike price: 5.00%Rate of participation: 50%Interest **in**dicator: 3M EURIBORThe underly**in**g expected **in**terest **rate**:The company expects that the 3M EURIBOR will sharply decrease over the term to maturity of the loan; however isaware that this expectation is very uncerta**in**.The risk:The 3 month EURIBOR **rate** does not decrease, the company f**in**ances at strike price (5.00%) plus 1.00% over thecomplete term to maturity.The advantage:The hedge is free of charge. A maximum 6.00% **in**terest **rate** is hedged. However, the loan is subject to 50% of adecrease **in** **in**terest **rate**s. The result is to be illust**rate**d **in** the follow**in**g chart:Company pays VB**AG** ResultVB**AG** pays for theEURIBOR Strike Price from the R/O loan company company7.00 5.00 8.00 2.00 6.006.00 5.00 7.00 1.00 6.005.00 5.00 6.00 – 6.00Company pays Company pays ResultVB**AG** VB**AG** from the for theEURIBOR Strike Price from the R/O loan participat**in**g cap company4.00 5.00 5.00 0.50 5.503.00 5.00 4.00 1.00 5.002.00 5.00 3.00 1.50 4.5028

FLOORWhat is a floor?The complement to the cap is a floor, i.e. an agreement on a bottom **in**terest-**rate** limit. If for this purpose thereference **rate** (e.g. EURIBOR or LIBOR) falls short of the m**in**imum **in**terest **rate** fixed by the agreement(strike price), the seller (writer) pays the purchaser of the floor the difference between floor **and** reference**rate** of **in**terest.A check will be performed on each roll over date as to whether the respective current EURIBOR falls short ofthe agreed **in**terest floor. If this is the case, the option writer will pay a compensation sum at the end of the**in**terest period for the amount of the difference between the floor **and** EURIBOR.Details **and** technical h**and**l**in**g of floors are the same as those of caps. The market, however, is not quite asliquid as the cap market.Determ**in**ants of a floorn Currency **and** nom**in**al amountn Term to maturity: between 2 **and** 10 yearsn Strike price: amount of the floorn Reference **rate**: EURIBOR, LIBOR, ...n Roll-over dates: dates when strike price **and** reference **in**terest **rate** are compared;3, 6, 9 or 12 monthsn Premium: non-current premium at the beg**in**n**in**g of time to maturity of the contract,expressed **in** per cent of the underly**in**g nom**in**al amount or annualised overthe aggregate term until maturityHedg**in**g profile: floor29

ApplicationsnA floor can be used for hedg**in**g asset items with a float**in**g **in**terest **rate** aga**in**st possible decreases **in** the**rate** **and** aga**in**st the risk of a decrease of the return on **in**vestment.nA floor secures a m**in**imum return at the level of the floor strike price (less the premium paid).ExampleA company places an amount of EUR 10 m with f**in**al maturity, 5 year term based on the 6 month EURIBOR -25 BP**and** decides that it never wants to receive less than 4.00% **in** the future. To ensure this, it must buy a floor with astrike price of 4.25% (its 4.00% floor plus 0.25% marg**in** from the amount placed).For a 5 year floor aga**in**st 6MO EUR-R/O at a strike price of 4.25% (4.00% + 0.25%), Group Treasury offers a priceof 50 BP, for example. This non-recurrent premium is payable upon enter**in**g **in**to the contract.On the **in**terest payment date, the strike price is compared with the current EURIBOR **rate**:Bank pays VB**AG** Resultto company pays for theEURIBOR Strike price on the amount placed company company4.50 4.25 4.25 – 4.254.25 4.25 4.00 – 4.004.00 4.25 3.75 0.25 4.00Term**in**ation of a flooris possible at any time through a back-to-back transaction or cash-out.30

COLLARWhat is a collar?A collar is the purchase of a cap **and** is fixed simultaneously with the sale of a floor. The **in**terest-**rate** risk ishedged by a cap, at the same time as a floor is fixed. The objective of a collar is to reduce the cost of a cap. Bypurchas**in**g a collar, however, the company can benefit from a possibly decreas**in**g **in**terest **rate** only until thefloor is reached.A special type of collar is the zero cost collar, i.e. a cap where no option premium is payable at the beg**in**n**in**gof the contract because the proceeds from the sale of the floor are equivalent to the cost of purchas**in**g a cap.Determ**in**ants of a collarn Currency **and** nom**in**al amountn Term to maturity: between 2 **and** 10 yearsn Strike price: amount of the cap or floorn Reference **rate**: EURIBOR, LIBOR, ...n Roll-over dates: dates when strike price **and** reference **rate** are compared;3, 6, 9 or 12 monthsn Premium: non-current premium at the beg**in**n**in**g of the term of the contract, def**in**ed **in**percent of the underly**in**g nom**in**al amount or annualised over the totalHedg**in**g profile: collarTerm**in**ation of collaris possible at any time through a back-to-back transaction or cash-out.31

SWAPTIONWhat is a swaption?Aga**in**st the payment of an option premium a swaption gives an option buyer the right to execute, at adeterm**in**ed po**in**t **in** time, a swap specified relat**in**g to its term **and** **in**terest **rate**.Swaptions on the one h**and** enable the party to pay a fixed **in**terest **rate** (purchase of a payer swaption), e.g.for hedg**in**g liabilities aga**in**st ris**in**g **in**terest **rate**s.On the other h**and**, the swaption enables the party to get a fixed **in**terest **rate** (purchase of a receiver swaption),e.g. for hedg**in**g assets aga**in**st fall**in**g **in**terest **rate**s.Determ**in**ants of a swaptionn Currency **and** nom**in**al amountn Term to maturity: between 2 **and** 10 yearsn Term of the option: between 1 day **and** 10 yearsn Strike price: fixed **in**terest **rate** of the underly**in**g **in**terest swapn Option premium: depend**in**g on market situation **and** strike priceApplicationsnTo hedge project f**in**anc**in**g operations, for example **in** connection with bids submitted for a tender**in**vitation. This enables the party to offer the f**in**anc**in**g for an offer of goods **and**/or services simultaneouslywithout **in**curr**in**g an **in**terest-**rate** risk **in** the event of them fail**in**g to be awarded the contract. In addition,the swaption may not have lost value **in** the event of the loss of the contract. Depend**in**g on what happenedon the market, the value of the swaption can even exceed the price orig**in**ally paid. Swaptions are alsofrequently used for hedg**in**g **in**terest expense **in** the case of f**in**ance for planned acquisitions.nTo hedge planned f**in**ance operations. If, for example, a EUR loan is due **in** 12 months, the borrower canhedge the risk of ris**in**g **in**terest **rate**s for the subsequent issuance by means of a swaption.On the exercise date, for example, the purchaser of the payer swaption has two choices:– Market **in**terest **rate**s of a swap are higher than the strike price of the swaption – the option will beexercised. The party takes over the swap **and** thus secures an **in**terest **rate** below current market **rate**s atthe level of the strike price.– Market **in**terest **rate**s fall short of the swap underly**in**g the swaption – the party will not exercise the option**and** will f**in**ance at current market conditions.– The actual cost of the loan comprises of the total of the cost of the f**in**ance plus the premium for theannualised option.32

Term**in**ation of a swaptionis possible at any time through a back-to-back transaction or cash-out.ExampleThe situation at the outset• Invitation to tender: offer submitted today, award possible **in** 6 months• In case of an award, f**in**ance will be required for an amount of EUR 5 m over 10 years• Repayments on borrow**in**g: l**in**ear• Float**in**g **rate** f**in**ance at EURIBOR plus 1.00% possible at any time• At an **in**terest **rate** exceed**in**g 6.00% the project becomes unprofitable• Interest **rate**s are expected to rise, therefore hedge by means of a fixed **in**terest **rate**Group Treasury’s swaption proposalPurchase of a payer swaption with 5.00% strike priceTerm of the option:6 monthTerm of the swap:10 yearsOption premium:non-recurrent 0.85% of the nom**in**al amount or 0.20% calculated as loanpremium per yearThe hedge: In case of award fixed **in**terest f**in**ance at 6.00%.The cost of the swaption hedge must be added.The profit opportunity:In case of ris**in**g **in**terest **rate**s exit possible at a profit.The risk:In case of no award **and** fall**in**g **in**terest **rate**s the risk is limited to the optionpremium paid.The advantage:In the case of a contract be**in**g awarded, the cost of the f**in**anc**in**g is fixed with the swap **rate** (5.00%) plus the loanmarg**in** result**in**g from the float**in**g f**in**ance (plus the cost of the hedge). In the case of the contract not be**in**g awarded,the risk is limited with the option premium paid (0.85% of the nom**in**al amount). In the event that **in**terest **rate**s rise,it is even possible to sell the payer swaption bought for the hedge at a profit. In the case that the swap is taken over,it serves to hedge the **in**terest **rate** **and** can be term**in**ated at any time at the market **in**terest **rate** offered at that time.Active **in**terest-**rate** management is thus possible across the full term of the f**in**anc**in**g.33

34>> Hedg**in**g foreign exchange risks „provides security **in** volatile markets.“

CURRENCY MAN**AG**EMENTA large part of global trade occurs **in** capriciously fluctuat**in**g **currency** markets. In times of globalisation **and**market **in**ternationalisation, it has become absolutely necessary to keep an eye on exchange **rate**s.Particularly **in** turbulent times, it is crucial to hedge aga**in**st foreign **currency** price fluctuations **in** order toprevent price losses from offsett**in**g foreign transaction ga**in**s. Even m**in**or price fluctuations can strongly affectoperat**in**g results.Whether conclud**in**g a bus**in**ess transaction with foreign suppliers, or shift**in**g or rais**in**g capital **in** foreign **currency**,all such transactions are generally subject to **currency** risk.In addition to classic hedg**in**g of foreign **currency** risks, however, **currency** management can also mean aconscious exposure to risks unrelated to ord**in**ary operations **in** order to realise price ga**in**s via **currency** volatility.Although there were really only two possibilities of hedg**in**g the **in**herent transaction price risk until the beg**in**n**in**gof the 90s – foreign exchange spots **and** the forward exchange transactions – today, foreign exchange options**and** numerous related structur**in**g opportunities offer a wide range of hedg**in**g st**rate**gies to choose from.The area of foreign exchange options has passed through a revolutionary phase over the course of the lastfew years. The possibilities for implementation appear limitless. New products are developed almost on a dailybasis that – adorned with promis**in**g names – offer customers new ways of hedg**in**g that are free of risk **and**expense **in** some cases.The names **and** manner of illustrat**in**g the **in**dividual products are manifold **and** often confus**in**g. Names such asButterfly, Condor, Ratio Spread, or Digital Option only partially suggest the structure of the hedg**in**g variant.However, these options **and** option structures all have one th**in**g **in** common: As complicated as they maysound, all of these options are basically comb**in**ations of the three underly**in**g transaction types: spots, forwardexchanges, **and** option contracts.Many of these “st**rate**gies” are short-term **and** only **in**tended for special market **and** portfolio situations. But afew of them have managed to become st**and**ard ** instruments**. They will be described below.35

FOREIGN EXCHANGE SPOTS ANDFORWARD EXCHANGE TRANSACTIONSWhat is a foreign exchange spot?The most simple **and** uncomplicated transaction related to **currency** risk management is the foreign exchange spot.Companies which have receivables or payables denoted **in** foreign currencies as a result of their foreign trad**in**gactivities can convert foreign **currency** debits **and** credits **in**to their book **currency** via foreign exchange spots.Spot transactions are traded on the spot exchange market. This market determ**in**es the exchange **rate**s of the freelyconvertible currencies among one another. Trad**in**g occurs around the clock; the **rate**s change cont**in**uously **and**quickly. The exchange **rate** movements result **in** a cont**in**uous change **in** the amount of foreign **currency** receivables**and** payables.In a st**and**ard spot transaction, one **currency** is exchanged for another. The exchange ratio is determ**in**ed by thecurrent exchange **rate**. The counterparties are obligated to exchange the negotiated sums. The st**and**ard rule fordelivery **and** payment on the spot exchange market is two work**in**g days after the transaction is concluded (spotdate). That is the period required **in** order to be able to conduct payments **and** transactions around the world **in**a timely manner.Price range (spread) **and** calculation of cross-**currency** **rate**sDifferent prices are applied depend**in**g on the type of underly**in**g transaction (purchase or sale of foreign**currency**).The bid price is the price at which the key **currency** can be sold.The ask price is the price at which the key **currency** can be purchased.The **in**terbank spot price is the price at which the banks can trade among one another. Corpo**rate** **and** privatecustomers can also trade at the **in**terbank **rate** plus/m**in**us a certa**in** marg**in**.The key **currency** **in** the **in**terbank market is the euro; however, so-called cross-**rate**s (e.g. CHF/JPY) are alsoneeded. These are calculated us**in**g the cha**in** method:The cha**in** method is illust**rate**d as a rule of three. The question of the unknown is the start**in**g po**in**t. In themiddle, there is a vertical fraction bar. The value sought on the left side is the question; the counter **currency**per unit is on the right side. Each subsequent element on the left beg**in**s with the same designation with whichthe element on the right **in** the previous l**in**e ended. The last element on the right must have the samedesignation as the first element on the left. Every member hav**in**g the same value with the same designation left**and** right is cancelled out of the equation. F**in**ally, the calculation is made: The product of the members of theright side is divided by the product of the left side.36

ExampleSought:CHF/JPY-**rate** determ**in**ed via the EURBase values:EUR/CHF = 1.6450 –> EUR 1 = CHF 1.6450EUR/JPY = 161.00 –> EUR 1 = JPY 161.00CHF/JPY = ? –> CHF 1 = JPY x (how many JPY correspond to 1 CHF)Cha**in** method:JPY x CHF 1 How many JPY equal CHF 1 ifCHF 1.6450 EUR 1 CHF 1.6450 corresponds to EUR 1 **and**EUR 1 JPY 161.00 EUR 1 = JPY 161.00?The euro values cancel each other out **in** this cha**in** method equation. The follow**in**g equation rema**in**s:CHF/JPY = 161.00/1.6450 = 97.8723One problem is the calculation of the bid **and** ask prices, which must also be taken **in**to account **in** the calculation ofthe cross-**rate**.What are limit orders?Limit orders are contracts to buy or sell a specific amount of foreign **currency** when a specific spot price isreached. The temporal validity of these orders can set as desired – either until they are cancelled (withoutspecify**in**g a date) or for a specific period of time. The market observation period takes place around the clock.There are different types:Limit order: This is a contract to buy or sell an amount of foreign **currency** when a specific exchange **rate** targetis reached.Stop loss order: This contract serves to limit losses **in** currently exist**in**g positions. With the help of a stop lossorder, the potential loss of a position **in** the event of strong **rate** movements is limited **in** advance. Long positionsare settled by a sale when the target **rate** is reached **and** vice versa.Loop order: When a specific **rate** is reached, the orig**in**al position is settled **and** a new position is simultaneouslyopened **in** the opposite direction.Take profit order: This contract serves the tak**in**g of profits **in** currently exist**in**g positions. With the help of thetake profit order, **in** the event of **rate** fluctuations profits from a position are realised when a specific target **rate**is reached.37

What is a forward exchange transaction?A forward exchange transaction is an agreement (obligation) to buy or sell a specific amount of foreign**currency** at a later date. When the agreement is made, the forward **rate**, the **currency**, the amount, **and** thesettlement date are established. The transaction is not settled until the negotiated date.Forward **rate**s normally deviate from spot prices. The reason for this is not the assessment of what the futurespot price will be, but rather exclusively **in** the **in**terest-**rate** difference of the currencies.Theoretically, the forward **rate** for a **currency** can be identical with the spot price. However, this would bepure chance. If the forward **rate** exceeds the spot price, one speaks of a forward premium (report, premium,surcharge), or otherwise, of a forward discount (deport, discount). The premiums or discounts for each dateare designated as swap **rate**s.Spot price +/- premium/discount = forward **rate**Determ**in**ants of a forward exchange transactionn Term: from 3 days to 2 yearsn Currencies: all freely convertible currenciesn Exchange **rate**ApplicationsnFor exportersThe exporter can fix the price or **rate** to be applied when the foreign **currency** is expected to be received**in** advance by conclud**in**g a forward exchange transaction. Thus, the exporter is protected from the risk ofthe **rate** fall**in**g, from foreign **currency** devaluation, or appreciation of the euro.nFor importersThe conclusion of a forward exchange transaction offers the importer the possibility of a fixed calculationbasis **and** security from the risk that the price or **rate** will **in**crease, a foreign **currency** will appreciate, or theeuro be devaluated.38

Term**in**ation of a forward exchange transactionis done via counter-transaction converted to the current forward **rate**.There are follow**in**g possibilities when a forward exchange transaction expires:n Utilisation: Through receipt of payments **in** foreign **currency**, debits or credits to a foreign**currency** account, etc.n Prolongation: Forward exchange contracts can be extended to a later date when theyexpire. The forward **rate** is corrected by the amount of the difference betweenthe **in**terest **rate**s of both currencies for the extension period by apply**in**gpremiums or discounts.n Settlement: At the expiry date, the forward exchange transaction is settled **in** exchangefor a spot transaction to be concluded at the same time (official or unofficialmarket transaction). Any positive or negative **rate** differences result **in** acredit or debit to the respective customer account.Calculation formula for forward exchange transactionsExampleLegendExampleD =Days 90FR = Forward **rate** Results of the calculation (98.827)Spot = Spot price 100r kc = Interest **rate** p.a. **in** decimals, key **currency** 5.00%r cc = Interest **rate** p.a. **in** decimals, counter **currency** 0.25%B kc = Calculation base for the key **currency** (360 or 365) 360B cc = Calculation base for the counter **currency** (360 or 365) 36039

FOREIGN EXCHANGE OPTIONWhat is a foreign exchange option?With the purchase of a foreign exchange option, the buyer acquires the right, but not the obligation, to buy(call option) or sell (put option) a specific amount of a foreign **currency** at a **rate** fixed when the transactionis concluded (base price or strike price).The buyer of an option pays the seller (writer of an option) an option premium for this freedom to choose.The amount of this premium depends onnnnnthe chosen strike price,the term,the volatility of the exchange **rate**, **and**the spread **in** **in**terest **rate**s between the two currencies.The premium costs for the purchase of a foreign exchange option are always higher than the hedge costs of acomparable forward exchange transaction. The added costs of the foreign exchange option are the price paid toensure that there is still a chance of earn**in**g a profit despite **rate** hedg**in**g. If one chooses the current forward **rate**as the strike price of the option, then the additional costs correspond exactly to the amount of the premium.Compared to the forward exchange transaction, the foreign exchange option offers the advantage thatnthe buyer of an option can choose the strike price at the conclusion of the transaction, **and**nthe buyer of an option has the choice at the expiry date to exercise his right or – if the spot price isbetter for him – to let it expire.Determ**in**ants of a foreign exchange optionn Term: from 1 day to 5 yearsn Currencies: all freely convertible currenciesn Strike price: the exercise price of the optionn Option premium: **in** BIPS of the exchange **rate** or percent of the domestic **currency** depend**in**gon the market situation **and** the strike pricen Barrier price: additional price specification with respect to an exotic option which makesan option contract valid or **in**valid40

Types of optionsPla**in** vanilla options:Options of the so-called first generation (call **and** put options).Exotic options:Options of the second, third, **and** fourth generation, which, **in** additionto the aforementioned determ**in**ants, are also characterised by additionalparameters such as barriers, triggers, or payouts def**in**ed **in** advance.An option can either be a European option, which can only be exercised on the expiry date, or an Americanoption, which can be exercised anytime dur**in**g the entire term until the expiry date **and** is generally somewhatmore expensive.Risk parameters of optionsThrough changes **in** the fundamentals (spot price, term, swap **rate**s, **and** volatility) the option premium alsochanges. These changes can be calculated with the follow**in**g parameters.Delta: Expresses to what extent the price of the option changes if the spot price of the underly**in**g **currency**pair changes. The largest risk of option price change is that the spot price will change.Gamma: Expresses the change **in** the delta **in** the event that the spot price changes **and** is thus an**in**dication of the price sensitivity of the option.Vega: Is the measure for the change of the option premium **in** the event that the volatility changes.Theta: Shows the change **in** the option premium with respect to decreas**in**g term length if all otherfundamental factors rema**in** constant.Term**in**ation of a foreign exchange optionis possible at any time via counter-transaction.41

ApplicationsThe applications for foreign exchange options **and** structures for the importers **and** exporters are describedbelow.The importerThe exporterpurchases a foreign **currency** call option:Thus he acquires the right to buy a **currency** atthe strike price chosen by him (exercise price).He has the choice of exercis**in**g his right or – if thespot price is lower than the strike price – of lett**in**git expire. For this, he pays an option premium **in**EUR or foreign **currency** at the time the transactionis concluded.purchases a foreign **currency** put option:Thus, the exporter acquires the right to sella **currency** at the strike price chosen by him(exercise price). He has the choice of exercis**in**ghis right or – if the spot price is higher than thestrike price – to let it expire. For this, he pays anoption premium **in** EUR or foreign **currency** atthe time the transaction is concluded.sells a foreign **currency** put option:The importer is obligated to buy a **currency**from the bank at the agreed strike price. Thebank - **and** not the importer – can choosewhether to exercise the option. If the spot pricefalls below the strike price, the bank will sell the**currency** to the importer at the strike price. Ifthe spot price rises, the bank will not exerciseits option; i.e. the importer has an upwardlyopen unsecured price risk. The importersells a foreign **currency** call option:He hereby undertakes to sell a **currency** to thebank at the fixed strike price. The bank - **and**not the exporter – can choose whether toexercise the option. If the spot price rises abovethe strike price, the bank will call the **currency**from the exporter at the strike price. If the spotprice falls, the bank’s option will not be utilised;i.e. the exporter has a downwardly openunsecured price risk. The exporter receives the42

eceives the option premium credited to hisaccount at the time the option is concluded.option premium cred-ited to his account at thetime the option is concluded.OPTION STRUCTURES AND STRATEGIESThe comb**in**ation of a vary**in**g number of options permits a wide variety of possible applications. On the oneh**and**, one can compensate an exist**in**g foreign **currency** risk; on the other h**and**, there is also the possibility ofexpos**in**g oneself to **currency** risk **in** order to profit from certa**in** market situations through the conscious useof options. The risk can also be variously structured with options **and** quite consciously controlled.Zero-cost st**rate**gies for hedg**in**g aga**in**st price fluctuationsZero-cost st**rate**gies are a popular variant for hedg**in**g foreign **currency** risk. The hedg**in**g is accomplishedhere for the importer through the purchase of a foreign **currency** call option **and** the simultaneous sale of aforeign **currency** put option **in** order to cover the costs of the purchase of the call option. The exporter sellsthe call **and** buys the put. Thereby, neither premium expenses, nor premium ga**in**s are **in**curred.The cyl**in**der option (risk reversal)The importer purchases a foreign **currency** call option **and** sells a foreign **currency** put option. This results **in** aprice range. The call hedges above this range. The put is utilised below this range, whereby potential price ga**in**sare limited by the exercise price of the put.Pr**in**cipally: The hedg**in**g side is purchased **and** the f**in**anc**in**g side is sold.43

The structure for the importer:The structure for the exporter:Ratio-spread optionThis is also a zero-cost st**rate**gy that arises from the comb**in**ation of the purchase/sale of call options **and** thesale/purchase of put options. Of course, the value amounts of both options vary here. The fundamental ideahereby is the hedg**in**g of a transaction **and** the specification of a sale price at which a potential future transactionor the total volume of a period can be settled. The concluded underly**in**g prices can serve as the calculationbase for the year as a whole.There are two possibilities.Full hedg**in**g:The purchase of the entire amount on thehedg**in**g side; simultaneously, an even largeramount is sold on the risk side to f**in**ance theoption.Partial hedg**in**g:The purchase of a partial amount on the hedg**in**gside **and** simultaneous sale of a larger amounton the risk side.44

Participat**in**g optionThe participat**in**g option is the reverse of the ratio-spread option. In this scenario, 100% of the hedg**in**gamount **and** a smaller amount on the risk side are traded.Spread optionA spread option consists of 2 of the same options (2 calls or 2 puts) with different strikes, whereby oneoption is sold **and** the other is purchased. Call spreads **and** put spreads are thereby differentiated. Here aswell, a price range is created.Additional option st**rate**giesStraddle **and** strangleStraddle **and** strangle are trad**in**g st**rate**gies that either focus on **in**creas**in**g volatility **in** the market (purchase)or a decrease **in** volatility (sale). Both cases **in**volve the purchase of both a call **and** put option or the sale ofboth a call **and** put option. The difference between straddle **and** strangle is that the strike price of the call **and**put are the same **in** a straddle **and** different **in** a strangle.ExampleStraddle purchase:Purchase of call Strike 100 Premium 2Purchase of put Strike 100 Premium 2Total premium to be paid 4Strangle sale:Sale of call Strike 102 Premium 2Sale of put Strike 98 Premium 2Total premium received 4In this case a profit is made when the pricesmove strongly **in** one direction or the other.Here, the premium is earned as maximumprofit when the prices fluctuate between thestrike prices.45

Exotic optionsHere as well, new **and** ever more complex types of options are be**in**g created almost daily. The mostimportant, however, are:nnnnnnnnBarrier optionsStep payment optionsDigital optionsAverage **rate** options (Asian options)Compound optionKnock **in** forwardForward extra plusOutright switchBarrier optionsAs opposed to the st**and**ard options, these options have one or more price specifications – so-called barriersor triggers. Depend**in**g on the type of option, exotic options become valid or **in**valid when one or more triggerprices are reached. For this reason, these options are generally less expensive than st**and**ard options.All of the previously cited st**rate**gies are naturally not only feasible with pla**in** vanilla options, but also with barrieroptions. With respect to st**rate**gies for hedg**in**g foreign **currency** risks, pr**in**cipally, the barrier should neverbe set on the hedg**in**g side.S**in**gle barriersKnock out/Reverse knock outThese options expire if the barrier price was traded once dur**in**g the entire term. The difference between aknock out **and** a reverse knock out is that the barrier is set “**in** the money” **in** reverse knock outs; that is, theoption has an **in**ternal value if it is “knocked out”.46

ExamplePurchase call option strike 100 Barrier: KO 96.00 Purchase call option strike 100 Barrier: RKO 108The illustration on the right shows the clear **in**crease **in** loss after reach**in**g the barrier **and** the result**in**g**in**validation of the hedg**in**g transaction. In contrast, the knock out price **in** the illustration on the left is alwayswith**in** the profit zone of the underly**in**g transaction **and** thus offers the possibility of react**in**g to the new situation.Knock **in**/Reverse knock-**in** optionsThese options become valid only after the barrier is reached dur**in**g the term. If it is not reached, the optionhas no value.ExamplePurchase call option strike 100 barrier: KI 96.00 Purchase call option strike 100 RKI 10847

European **and** American barriersWith respect to barrier options, there is a difference between European **and** American barriers. The differenceis that the European barriers only apply on the last day, whereas the American barriers apply dur**in**g the entireterm. The purchase of an option with a European barrier is therefore more expensive.St**rate**gy: the “knock **in** forward”The importer purchases a foreign **currency** call option **and** sells a foreign **currency** put option; both optionshave the same exercise price, but the put has a reverse knock **in**. This is also a zero-cost variant of hedg**in**gby which, however, the exercise price is somewhat above the comparable forward **rate**. But it offers additionalpotential for profit as long as the price never reaches the knock **in** price dur**in**g the term, because the traderprofits from cont**in**ually fall**in**g prices until the barrier is reached.ExampleThe forward **rate** on 3 months is 103Hedg**in**g with knock **in** forwardis possible at 104:Purchase of call Strike 104 Premium -2Sale of put Strike 104 RKI 98 Premium 2Total premium: 0Term: 3 monthsAt expiration date:Price > 104Hedged by purchase of call at 104Price < 104 **and** > 98free conversion **in** the marketPrice < 98Conversion at 104 via sale of putDouble barriersDouble knock **in** or double knock outThese options have two barriers **and** become valid or **in**valid when either of the trigger prices is reached.48

Step payment optionsAs with the conventional st**and**ard options, the step payment option offers full hedg**in**g aga**in**st pricefluctuations. They are different from st**and**ard options **in** that no premium is paid when the transaction isconcluded. The premium is only payable **in** partial amounts when certa**in** steps are reached. Where thesesteps lie **and** how many there are is determ**in**ed when the purchase is concluded.A step payment option offers the purchaser the opportunity to receive the hedg**in**g benefit for less money ifnone or not all of the steps are reached.ExampleExpectation of **in**creas**in**g prices with hedg**in**g via purchase of call.Purchase call option strike 105Term 3 monthsPurchase step payment call optionStrike 105 term 3 monthsSt**and**ard call, price 150 basis po**in**ts Step 1 103 70 basis po**in**tsStep 2 102 70 basis po**in**tsStep 3 101 70 basis po**in**tsTotal210 basisIf the expectations of the buyer of the step payment option are confirmed **and** the prices rise immediately then hehas a 100% hedge at 105 without hav**in**g to pay a premium for it. Not until the prices fall below 101 does this hedg**in**gvariant become more expensive than the purchase of the traditional st**and**ard option.Digital optionWith a digital option, two currencies are notexchanged, but rather only payment of a fixedamount at execution – the so-called payout. Therisk here can also be calculated at the time of sale,s**in**ce the loss **in** the event that the option goes “**in**the money” is known **in** advance. On the purchaseside, the profits on the payout are limited.These options are predom**in**antly implementedwhen no further foreign **currency** positions shouldbe entered to f**in**ance hedg**in**g, s**in**ce only the payoutof a fixed sum is **in**volved.49

Average **rate** optionWith this option, an average of prices dur**in**g a specific period is calculated at specific **in**tervals **and** comparedto a specified strike price. If the option is “**in** the money”, the difference on the amount of the option is paidout via cash settlement. This option is generally less expensive than the st**and**ard option.Compound optionThis is an option on an option. It gives the buyer the right to purchase an option at a price **and** time specified**in** advance. If the compound option ends “**in** the money” **and** is executed, a new option is created.Forward extra plusA forward extra plus is **in**itially a full hedg**in**g transaction with an exercise price that is worse than thecomparable forward exchange **rate**. However, a barrier is also negotiated. When the barrier is reached, thehedge ext**in**guishes **and** is replaced by a synthetic forward with a better exercise price. A synthetic forwardrepresents the risk profile **and** the obligation of a forward exchange transaction constructed with options. Thatis, after the trigger is reached, the fulfilment obligation exists at a more favourable level. The advantage of thishedg**in**g st**rate**gy is that, despite an exist**in**g security, positive price fluctuations can be taken advantage of up toa certa**in** degree. With this variant, three barrier options, each with the same trigger level, are traded.Outright switchAn outright switch is shown as a forward deal **and** **in**cludes an obligation even at expiration. When thecontract is made, two forward **rate**s are negotiated: A best case **and** a worst case **rate**. Additionally, a price rangeis negotiated with**in** which the spot price can fluctuate dur**in**g the term. If the outer edges of the price rangeare not touched dur**in**g the term, the transaction is converted at expiration at the better price. In the worsecase – that is, if the outer edges of the price range are touched or crossed at even just one po**in**t – the worstcase price takes effect. The best case price lies above the normal forward exchange **rate**, whereas the worstcase price lies below it. This st**rate**gy can also be calculated on a zero-cost basis.50

Knock **in** / Knock out optionOne of the most frequent forms of exotic option st**rate**gies is the so-called KIKO (knock **in** / knock outoption). This option st**rate**gy is among the most popular, because it is particularly well-suited to gene**rate** apremium (sale via the customers). KIKOs are primarily concluded with a term of 1 to 12 months. They can betraded **in** all freely convertible currencies **and** are usually encountered **in** comb**in**ation, e.g. EUR IRS withCHF-l**in**k (here, the customer is hedged by a fixed **rate** for his f**in**anc**in**g below market level **and** enters **in**toCHF-f**in**anc**in**g only **in** the so-called “worst case”).ExampleOptimisation of EUR-f**in**anc**in**g via KIKOThe customer sells a EUR/CHF put – KIKO with the follow**in**g parameters:Strike: 1.6500, Knock out at 1.6600 **and** Knock **in** at 1.6200 for a 6-month term **and** immediatelyreceives a premium of 1.50%.Possible scenarios at expiry date:EUR/CHF trades for 6 months between 1.6200 **and** 1.6600: the option becomes **in**valid **and** thecustomer has earned a 1.50% premium.EUR/CHF trades dur**in**g the 6 months once at 1.6600: the option immediately becomes **in**valid**and** the customer has earned 1.50% premium.EUR/CHF trades once at 1.6200 **and**– once at 1.660: the option becomes **in**valid.– at the end of the term over 1.6500: the option becomes **in**valid.– at the end of the term below 1.6500: the option is exercised, i.e. the customer switches hisEUR-f**in**anc**in**g to a CHF-f**in**anc**in**g **and** profits from the better CHF-f**in**anc**in**g **in**terest **rate**.In each case, however, the customer earns the 1.50% premium.51

52>> Manag**in**g commodity price risks allows for more reliable „plann**in**g **and** helps companies keep their competitive edge.“

with regard to the fix**in**g of prices of commodities, s**in**ce storage costs, fixed **in**terest **rate** costs **and****in**surance costs as a rule lead to commodities sold for future delivery be**in**g more expensive than thosesold on the spot market. One would therefore expect that the futures markets for commodities wouldalways be **in** a state of contango **and** that the forward price would be higher than the spot price. Thispositive difference would correspond to the **in**terest expenses that would be necessary for the f**in**anc**in**gof the purchase.Unlike other f**in**ancial assets, such as shares or bonds, commodities futures do not, however, comm**and**regular **in**terest earn**in**gs or dividends. A commodities producer knows, however, with a high degree ofcerta**in**ty how much a m**in**e or an oil field can produce **in** a month, six months or two years, **and** thereforesells off part of this production for future delivery. Moreover, banks which grant loans to commoditiescompanies often dem**and** that the production for com**in**g years is sold either partially or fully on futuresmarkets **in** order to ensure that loan repayments are secured.Due to these conditions, forward prices can occur that are lower than the current spot prices. Abackwardation of the commodities markets is a very frequent phenomenon. For example, over the last20 years the copper market has spent approximately 50% of the time **in** a state of backwardation, **and**the oil **and** sugar markets have even been **in** a state of backwardation for 59% of the time s**in**ce 1987.Commodity management ** instruments**VB

Product rangeBase metal futures trades * )Table 1Abbreviation Description QuotationAlu Alum**in**ium EUR **and** USD(LME primary alum**in**ium)Per metric tonCu Copper EUR **and** USD(Goods class A COMEX)Per metric tonNi Nickel EUR **and** USD(LME first class)Per metric tonSn T**in** EUR **and** USD(LME)Per metric tonZn Z**in**c EUR **and** USD(LME special high grade)Per metric tonBase metal options * )Table 2Abbreviation Description QuotationAlu Alum**in**ium EUR **and** USD(LME primary alum**in**ium)Per metric tonCu Copper EUR **and** USD(Goods class A COMEX)Per metric tonNi Nickel EUR **and** USD(LME first class)Per metric tonSn T**in** EUR **and** USD(LME)Per metric tonZn Z**in**c EUR **and** USD(LME special high grade)Per metric ton*) Group Treasury also offers hedg**in**g solutions for smaller volumes.nProduct specifications from the energy sectorFor energy sector products, futures trades **and** pla**in** vanilla options are offered. As with base metals,transactions for these products are also only carried out on the proviso of there be**in**g a cash settlement.For energy sector commodities, other providers of prices apply for determ**in****in**g possible payments fromtransaction hedges. Futures trades are compared with the daily PLATT fix**in**g (the official fix**in**g by themarket maker is published by the PLATT agency) on the due date **and** balanced accord**in**gly. Options areexercised **in** a very similar manner. The PLATT fix**in**g for the strik**in**g date is consulted, **in** order todeterm**in**e whether exploitation has occurred or not. In the event of a strike, the difference between thestrike price **and** the fix**in**g on the strik**in**g date is calculated accord**in**gly **in** favour of the purchaser of theoption. In the case of futures trades there is once aga**in** always an equalisation payment based on thedifference between the orig**in**ally agreed forward price **and** the fixed average price, either **in** favour of orto the detriment of the customer.55

Energy futures trades * )Table 3Abbreviation Description QuotationOil Brent Crude USD or EURper BarrelDiesel 1 ulsd 10 ppm cif fob barges USD or EURrotterdamper metric tonDiesel 2 ulsd 50 ppm cif USD or EURnorth west europeper metric tonHeat**in**g oil heat**in**g oil USD or EURper metric tonKerosene Jet kerosene fob barges USD or EURrotterdamper metric tonNatural gas Multi component product USD or EURper m 3Electricity power eex USD or EURper kilowatt hourEnergy options * )Table 4Abbreviation Description QuotationOil Brent Crude USD or EURper BarrelDiesel 1 ulsd 10 ppm cif fob barges USD or EURrotterdamper metric tonDiesel 2 ulsd 50 ppm cif USD or EURnorth west europeper metric tonHeat**in**g oil heat**in**g oil USD or EURper metric tonKerosene Jet kerosene fob barges USD or EURrotterdamper metric tonNatural gas Multi component product USD or EURper m 3Electricity power eex USD or EURper kilowatt hour*) Group Treasury also offers hedg**in**g solutions for smaller volumes.In order to secure commodities trades **in** the mid-term, various price changes can be effectively bridged by“hedg**in**g“. Relevant hedg**in**g ** instruments** always manage the current price volatility with the aim of produc

58>> Methodical risk management is critical „**in** a rapidly chang**in**g f**in**ancial arena.

RISK MAN**AG**EMENTEvery company is forced to take risks whilst carry**in**g out its bus**in**ess activities. The difference betweensuccess **and** failure often depends on correctly judg**in**g the risk **in**volved **in** a s**in**gle deal, transaction orbalance-sheet item – what risk can be taken, **and** to what extent? – **and** on the targeted risk managementbased upon this.The dynamic nature **in** which the world is develop**in**g is **in**creas**in**g the degree of uncerta**in**ty. Globalisationis creat**in**g new opportunities **and** risks. New technologies are accelerat**in**g bus**in**ess, whilst, however, alsolead**in**g to ever quicker decision mak**in**g **and** often to the radical transformation of organisational structures**and** patterns of behaviour. The price of acquir**in**g modern technology is often considerable, whilst itswork**in**g life, on the other h**and**, is short due to the prevail**in**g rapid speed of development. In addition,**in**creas**in**g concentrations of value **and** the dependency on highly developed **and** sensitive technical systems**in**crease the company’s vulnerability. St**rate**gic decisions **and** the results they lead to are therefore **in**fluencedby all k**in**ds of risk. Such decisions force the management of companies to make decisions that were hithertothe doma**in** of banks **and** **in**surers: those of methodical risk management.It is essential that the risk be identified on the one h**and** **and** then, **in**separably related to this, quantified,**in** order to then be **in** a position to make the right decisions, realise bus**in**ess plans, **and** to evaluate theachieved results **and** secure the f**in**ancial outcome for the company.The risks with which companies are confronted dur**in**g day-to-day bus**in**ess are of a diverse nature.Sometimes it is at least possible to identify the risk, but then considerable problems are revealed dur**in**gthe quantification process. In the f**in**ancial sector a methodology has existed for approximately a decade thathad previously proved successful for specialists, whereby risk can be quantified **in** a relatively simple manner.The development first started **in** 1994, when the controll**in**g department of the **in**ternational **in**vestmentbank, J.P. Morgan, began to summarise the bank’s total risk. It was used to br**in**g **in**terest **rate** risks, foreignexchange risks, stock risks **and** commodity risks down to a common denom**in**ator. The result was thesystem of “value at risk“. This concept lead to a s**in**gle figure, which gave the **in**vestment bank’s controll**in**gdivision **in**formation about how high the maximum loss from all positions per day would be with a certa**in**degree of probability.The concept of value at risk, which forms an estimate for the possible losses under normal marketconditions, has s**in**ce developed **in**to an **in**ternationally-used benchmark. The f**in**ancial **in**formationmentioned **in** the chapters on “Interest Rate Management” **and** “Currency Management” has po**in**ted outa large selection of ** instruments** that are required to control risk. The aim of this chapter is to expla

RISK ANALYSIS AND RISK BEARING ABILITY OF A COMPANYWhat is risk?The term risk is particularly common **in** the f**in**ancial sector. The fact is, however, that there is no precisedef**in**ition of risk. Risk is ma**in**ly associated with uncerta**in**ties **and** opportunities for loss as well as results thatdeviate from preconceived expectations. It rema**in**s open as to whether these risks have been entered **in**toconsciously or not.How much risk can a company enter **in**to?Generally speak**in**g, the risk bear**in**g ability is the ability of the company to be able to susta**in** losses from risksentered **in**to, without becom**in**g **in**solvent. There are no precise figures for this, only basic approaches. One ofthese basic approaches states that the risk bear**in**g ability should be relative to certa**in** key figures for thecompany. In practice profit on ord**in**ary activities, cash flow, EBITDA or level of own funds have served as**in**dicators of this. Relationships between these values must be determ**in**ed on an **in**dividual basis **and** aredependent on the company management’s disposition towards risk. Furthermore, operative risks, bus**in**essrisks **and** rat**in**gs risks must be taken **in**to consideration.THE AIM OF RISK MAN**AG**EMENTEfficient risk analysis **in**creases the company management’s room to manoeuvre **and** the company’s risk bear**in**gability. The aim of risk management is therefore to control exist**in**g risks **and** risks that may turn up **in** the future**in** such a manner that the value of the company is **in**creased because the risks have been decreased without**in**hibit**in**g the yield opportunities, **and** ensur**in**g that the risk position does not exceed the risk bear**in**g ability.PHASES OF RISK MAN**AG**EMENTIdentification of risks, sources of risksGenerally there are two types of risk:a) Internal risks/operative risksb) External risksOperative risks can only **in**cur losses, never profits. Typical **in**ternal risks are events such as fires, explosions,water **in**filtration, staff accidents, damage to mach**in**ery, liability issues etc.External risks are the opposite of **in**ternal risks. Current **and** **in**terest **rate** risks fall under this category. Theyare of a speculative nature **and** conta**in** both elements of the chance to make a profit, as well as the danger ofmak**in**g a loss. External risk, as a rule, is associated with all future-oriented bus**in**ess decisions **and** can thereforebe directly deduced from the company’s aims. In this **in**stance, the risk of losses from external risks is of theutmost **in**terest.60

How easily can this risk be elim**in**ated? Does an exporter, who **in**voices **in** his domestic **currency** for the saleof his goods abroad, elim**in**ate the external risk? The answer is no.The passive or **in**direct foreign **currency** risk still exists. In the event that his own **currency** rises aga**in**st the**currency** used **in** the country he is export**in**g to, then the exporter’s goods become more expensive, **and** heis less able to compete. In actual fact the exporter rel**in**quishes the risk **and** the management of the **currency**fluctuation to his customer. However, the customer does not have to hedge aga**in**st it; **in**stead he can choosefrom offers from different **currency** areas.RISK QUANTIFICATION/VALUE AT RISKThe most well known key figure for risk is the value at risk (VaR). The result is always a s**in**gle figure **in** the formof an absolute magnitude, which states how large the possible f**in**ancial loss from assets can be before countermeasurescan take effect. The value at risk can relate to a s**in**gle f**in**ancial **in**strument, such as a s**in**gle stock ora commodity, or to an entire portfolio of f**in**ancial ** instruments**. A VaR statement like “the possible loss couldbe EUR 2 million” would, however, not be very helpful. A limitation with reference to the time frame

JPY credit portfolio - period of observation 365 days (1 year)Daily change **in** EUR Days Days as percentage of total observation period+50.000 to +25.000 11 3.0%+25.000 to -0 169 46.30%0 to -25.000 175 47.95%-50.000 to -25.000 10 2.74%On 11 days, **in** the above example, the ga**in** was between EUR 25,000 **and** EUR 50,000. For a large proportionof the period of observation, the ga**in** or loss was between - EUR 25,000 **and** + EUR 25,000. Only on 10 days**in** the year or 2.74% of the observation period was the loss greater than EUR 25,000.The assumption is now made that the past development is also representative for the future. Under thisassumption **and** from known data, the statement can therefore be deduced, that with a 97.26% probability theloss with**in** 1 day will not be greater than EUR 25,000. After all, on 355 of 365 days, the loss from a s**in**gle trad**in**gday was less than EUR 25,000.The hold**in**g period of 1 day therefore emerges, as **in** the historical observation, the fluctuations **in** daily valueshave been observed for 365 days. If fluctuations **in** value had been observed on a weekly basis, then the valueat risk statement would apply for a week. This also reveals a problem with the historical simulation. In orderto obta**in** the same statement with the same degree of data **in**tegrity for a week, we would have required thehistorical data for the last 7 years. For a statement about how high the loss **in** a month would be, we wouldrequire data from the past 30 years.A degree of uncerta**in**ty always rema**in**s **in** value at risk statements (e.g. 100% - 97.26% = 2.74%). Thereforethe value at risk statements are frequently qualified with “under normal conditions”. If a value at risk is notgreater than EUR 25,000 for 97.26% of cases, what happens **in** the 2.74% of the cases that rema**in**? Does theloss st**and** at EUR -25,500 or at EUR -1,000,000? Over the period of 1 year with 250 work**in**g days, thestatement also implies that on at least 7 work**in**g days the loss will be higher than the maximum expected lossof EUR 25,000.To answer this question, so-called “stress tests” are recommended, **in** which large historical fluctuations areentered **in**to the equation.The “historical simulation“ works on the pr**in**ciple mentioned above regard**in**g the measurement of value at risk.In the historical simulation, premises must be accepted that changes **in** risk factors (e.g. yields, **in**terest **rate**s **and**exchange **rate**s) observed **in** the past are also relevant for the future. Put simply: What was the case **in** the past,will not change **in** the future. In very short hold**in**g periods e.g. of a s**in**gle day, this assumption is unproblematicas a rule, **and** the volatility of the last 250 days can be viewed as be**in**g representative for another day. In thecase of longer hold**in**g periods or forecasts this statement becomes problematic.62

Monte Carlo simulation/Variance/covariance approachIf this premise is not acceptable, then it is necessary to resort to the Monte Carlo simulation or the variance/covariance approach (with assumed distribution). The Monte Carlo Simulation does not require any historical data**and** works on only a few premises. However, this method is mathematically more dem**and****in**g.The variance/covariance approach on the other h**and** has a considerable advantage over the historical simulation.Instead of long series of data conta**in****in**g historical observations, only two parameters - the mean value **and** thevolatility are required for the value at risk calculation. A requirement for us**in**g this model is a normal distributionof value fluctuations or returns of a stock or portfolio (normal Gaussian distribution or bell curve). The normaldistribution assumption is one of the basic premises for theoretical models for portfolios.The follow**in**g parameters are required for the variance/covariance approach:nnnThe underly**in**g’s current valueIts volatilityA factor which **in**dicates the quality of the gene**rate**d result (= the confidence level)The volatility factorWhat volatility is used for the calculation? For the hold**in**g period of one day, it is not necessarily essential toknow the daily volatility. The volatility can be statistically scaled up or down to fit the desired hold**in**g period.ExampleThe EUR/JPY volatility for a period of 1 year is assumed as be**in**g 15.0%.What is the volatility for a s**in**gle work**in**g day?xd = Number of days for which the volatility should be calculated1Y = the annual volatility= The year is calculated as hav**in**g 250 work**in**g daysVol p.a. Hold**in**g period Vol xd Price Possible loss15% 1 year 15.00% 100 15.0015% 1 day 0.95% 100 0.9515% 5 days 2.12% 100 2.1215% 10 days 3.00% 100 3.0015% 20 days 4.24% 100 4.2415% 30 days 5.20% 100 5.2063

However, we still do not have a statement regard**in**g the quality, **and** thereby the reliability of this figure. Theso-called Z score represents this factor - the confidence level.The Z scoreThe Z score is a statistical measure, the quantile of probability, **and** provides **in**formation about the accuracy ofa statement. It results **in** statements along the l**in**es of: “With X% probability the loss will not be greater thanY%.” The Z score can be calculated for any degree of probability. In Excel the formula is:z=st**and**ard deviation (figure **in** percent)S**in**ce we have ignored the Z score **in** the calculations, we can say z=1. The value 1 corresponds to a probabilityof 84.13% (see table below). The various probabilities are placed **in**to the formula, **and** yield the scorescalculated **in** the table.Quality of the statement **in** % Z score66% 0.4125 a reliability of 66%70% 0.5244 a reliability of 70%75% 0.6745 a reliability of 75%80% 0.8416 a reliability of 80%85% 1.0364 a reliability of 85%84% 1.0000 a reliability of 84%90% 1.2816 a reliability of 90%95% 1.6449 a reliability of 95%99% 2.3263 a reliability of 99%For the example above, this means that the probability is only 84.13% that the loss from the analysed JPYcredit portfolio will not exceed 1.5% **in** a year.In order to reach a certa**in**ty of 90%, the formula must be completed us**in**g the Z score of 90% i.e. 1.2816.64

ExampleJPY creditCurrent price 100.00Annual volatility 15% (z=1)Price * Volatility * z = VaREUR/JPY price Volatility per year Possible lost per year **in** JPY100 15.00% 15.00There is an 84% probability that the loss from this JPY commitment will not be greater than 15% **in** one year.EUR/JPY price Volatility per year Z Possible lost per year100 15.00% 1.2816 19.224There is a 90% probability that the loss from this JPY commitment will not be greater than 19.22% **in** one year.CorrelationsWhat does a mixed portfolio consist**in**g of several values look like?Credit portfolioCurrency Hold**in**g **in** % Volatility 30 days Z Possible lossJPY 33.3% 15% 1 5%CHF 33.3% 3% 1 1%USD 33.3% 11% 1 4%There is a probability of 84% that the total risk does not exceed 10%There is an 84% probability that the **currency** loss from the above credit portfolio will not exceed 10% with **in** thenext 30 days.65

This simple equation neglects the portfolio effect. If there are also stock hold**in**gs or commodities present, then thisfigure would assume an enormous scale. However, all k**in**ds of f**in**ancial ** instruments** or currencies display a certa

CALCULATION OF THE CORRELATED VALUE AT RISKAs already mentioned, **in** the first **in**stance, the volatilities of the risk parameters to the home **currency** for acerta**in** period of time are calculated.Step 1: Determ**in****in**g the market **and** value volatilities:Market volatilities per yearVolatilitiesUSDEUR/USD 11%EUR/CHF 3%EUR/JPY 15%Multiplication by the exist**in**g sum at risk gives the value volatility, the sum of which then gives the uncorrelatedVaR.Volatilities USD CHF JPY TotalAmount of credit **in** EUR 3,000,000.00 3,000,000.00 3,000,000.00 9,000,000.00Amount of credit **in** % 33% 33% 33% 100%Volatilities 11% 3% 15%Value volatility 330,000.00 90,000.00 450,000.00 VaR unkorrZ = 90% = 1.2816 422,911.76 115,339.57 576,697.86 1,114,949.19Value of volatility with 90% probabilityIn the second step, the correlations are determ**in**ed.Step 2: Determ**in**ation of correlations:Correlation to EUR EUR/USD EUR/CHF EUR/JPYEUR/USD 100%EUR/CHF -55% 100%EUR/JPY 60% -13% 100%67

The calculation of the correlated VaR is done us**in**g the follow**in**g variance/covariance method formula.Calculation of the correlated value at risk:VaR p = Value at risk of the portfolioVaR n = Volatility values of the components of the portfolioC n = Correlation coefficients of the components of the portfolioValue vol USD 2 108,900,000,000.00Value vol CHF 2 8,100,000,000.00Var USD 2 202,500,000,000.002* Corr EURUSD/EURCHF* Value vol JPY* Value vol CHF 32,670,000,000.002* Corr EURJPY/EURUSD* Value vol JPY* Value vol USD 178,200,000,000.002* Corr EURCHF/EURJPY* Value vol USD* Value vol CHF 10,530,000,000.00Total 454,500,000,000.00Square root = VaR 674,166.15Z = 90% = 1.28155079437419 863,978.17VaR correlated 863,978.17The **in**dividual value volatilities are squared **and** connected to one another with the respective correlations.The sum of the risk factors is multiplied by the confidence level.The square root of the sum gives the correlated value at risk.The risk position improves enormously even **in** a simple credit portfolio when the correlations are taken **in**toconsideration. F**in**d**in**g the optimal portfolio is therefore only a question of optimis**in**g the portfolio.The volatilities **and** correlations of the major currencies can be found **in** Group Treasury’sMorn**in**g Mail.THE PATH TO AN OPTIMAL PORTFOLIOThe volatilities **and** correlations have been determ**in**ed. We have also found an **in**itial value for the value at riskof our portfolio.Next we want to improve this value by restructur**in**g the portfolio. Based on the above data, a simple exampleshows: With a foreign **currency** portfolio that is equally distributed with each **currency** form**in**g 1/3 of theportfolio, we have a VaR of EUR 879,493.12.68

The worst risk value would be on a 100% JPY f**in**anc**in**g, namely EUR 1,691,647.05.Total Volumes EUR 9.000.000,00 VaRJPY CHF USD33% 33% 33% 879,493.12100% 0% 0% 1,691,647.050% 100% 0% 422,911.760% 0% 100% 1,550,676.465% 75% 20% 467,924.0115% 85% 0% 277,510.4520% 40% 40% 802,705.1540% 40% 20% 782,061.0640% 20% 40% 1,045,230.19The f**in**al result of the VaR analysis would be:Currently the possible loss per day with a probability of 90% does not exceed EUR 858,993.78. This is 8.59% of thetotal credit portfolio. By restructur**in**g the USD **and** JPY loans **and** stock**in**g on CHF loans, the risk could be m**in**imisedso that the statement reads:There is a 90% probability that the loss per day will not exceed more than EUR 277,510.The best distribution can be obta**in**ed, on the basis of the volatilities **and** correlations quoted **in** the example, if15% is f**in**anced **in** JPY **and** 85% **in** CHF.STRENGTHS AND WEAKNESSES OF THE MODELWith 90% probability the loss will not exceed a certa**in** amount. A probability of 90%, however, meansthat a work**in**g year of 250 work**in**g days presupposes that on 25 days the loss will be higher than theamount assumed above of EUR 277,510.00. However, we do not know what the values beyond the 90%threshold are.The stress tests that have already been mentioned should also help to keep these situations under control. Asimple way of carry**in**g out a stress test is to save the market data on eventful days (Asian crisis, stock marketcrash, catastrophes) **and** to use them **in** the actual portfolio, **in** order to see how it then reacts.The largest problem with “crash scenarios”, apart from the soar**in**g rise **in** volatilities, is the divergence **in** theorig**in**ally set correlations.All told, the VaR concept can be deployed without a great deal of effort, **and** offers the opportunity toevaluate the total risk of a portfolio, no matter how large. The system has proven itself **and** is generally used bybanks, **in**vestment banks, **in**surance companies etc. to control risk. Provided that the necessary degree ofattention **and** caution is displayed, a VaR exam**in**ation offers every company the possibility to use risk managementto take advantage of the opportunities present **in** the market.69

GLOSSARYACT/ACT The day count convention of calculat**in**g accrued **in**terest. Annual calculation based on the actual numberof days (normal year 365, leap year 366 days).ACT/360 Actual number of days/360. Day count convention of calculat**in**g accrued **in**terest. The year is assumed tohave 360 days.AMERICAN OPTION The buyer can exercise an option at any time with**in** a pre-determ**in**ed period of time afterthe purchase of the option. Opposite: European option.ANNUALISED PREMIUM The premium is spread out over several years accord**in**g to actuarial pr**in**ciples.ARBITR**AG**E Exploit**in**g regional or **in**ternational price/**rate** differences of the same f**in**ancial ** instruments** (e.g. securities,foreign exchange, banknotes) whereby these

CALL OPTION Is the right to buy that is related to a def**in**ed underly**in**g **in**strument. Opposite: Put option.CAP Contractual agreement about the upper **in**terest-**rate** limit for a specific amount of capital aga**in**st payment of a oneofffee (cap premium). Opposite: floor.CAPLET Portion of a cap referr**in**g to a variable **in**terest-**rate** period.CASH OUT Premature term**in**ation of a forward **rate** agreement or an **in**terest-**rate** options contract whereby theclaims are mutually offset based on current market prices.CASH SETTLEMENT In this case, there is no purchase/sale of the underly**in**g **in**strument when an option is exercised.Instead, the differential amount between the agreed price (strike price) **and** the current market value (market price) ofthe underly**in**g is determ**in**ed **and** paid out.CHOOSER CAP Contractual agreement on a **rate** ceil**in**g for a specific amount of capital **in** return for payment of aone-off fee (cap premium); the choice is limited to a certa**in** number of **in**terest periods.COLLAR The simultaneous purchase of a cap **and** the sale of a floor. The goal of this **in**strument is to secure a certa**in**fluctuation range of the **in**terest **rate**s with**in** a certa**in** set maximum **and** m**in**imum.COMPOUND OPTION An option on an option.CONFIDENCE LEVEL Confidence **in**terval In the value at risk concept, the confidence level denotes the probabilitywith which a potential loss will lie with**in** a certa**in** **in**terval which is shown as the value at risk. See value at risk.CONSTANT MATURITY SWAP CMS. A special form of **in**terest-**rate** swap where at least one swap partner paysa variable swap **rate** with a constant maturity that is periodically reset (e.g. semi-annual adjustment to the 3-year swap**rate**). The second swap partner, on the other h**and**, can pay either a variable **rate** (e.g. 6-month EURIBOR) or a fixed**rate**.CONTANGO Term used **in** commodity futures markets. In this case today’s spot price is lower than the forward price.CONVERSION The exchange of one **currency** **in**to another.CORRELATION Measures the degree to which two or more underly**in**gs move, as a reaction to a predeterm**in**edevent, **in** the same direction. Correlations are **in**dicated on a scale of m**in**us one to plus one. It the prices of two**in**vestments move cont**in**uously **in** the same direction they are perfectly correlated **and** have a grade of plus one on thescale or m**in**us one if the opposite happens.CREDIT FORWARD A bank makes an agreement with a company to provide a loan at a later date at an **in**terest**rate** that is agreed upon **in** advance. Such a structure holds two risks for the bank, the credit risk **and** the **in**terest **rate**risk.CURRENCY SWAP Agreement between two contract**in**g parties to exchange capital **and** **in**terest payments over aspecific period **in** different currencies.CYLINDER OPTION With this option st**rate**gy, for example, an importer buys a foreign **currency** call option **and**sells a foreign **currency** put option. This gives him a certa**in** range, above which he is protected by the call option. If the**rate** drops below this range, the put option will be exercised, limit**in**g possible ga**in**s to the strike price of the put.72

DELTA The delta refers to how much the price of the option changes when the spot **rate** of the underly**in**g **currency**pair changes.DERIVATIVE Derivative **in**strument. A f**in**ancial **in**strument that is not shown on the balance sheet **and** is thereforenot an asset but rather is derived from an asset. Its valuation is ma**in**ly based on the price/.ate, price/**rate** volatility **and**price/**rate** expectations of the underly**in**g **in**strument (such as shares, bonds, foreign currencies, **and** **in**dices). The mostcommon derivatives are swaps, options **and** futures.DIGITAL OPTION In the context of **in**terest-**rate** **and** **currency** management, a digital option (or b**in**ary option) iswhen a fixed amount, the so-called payout, is paid **in**stead of exchang**in**g the two currencies.DOUBLE BARRIERS Options with two additional trigger prices/**rate**s.EONIA Euro Over Night Index Average. S**in**ce 4 January 1999, the European Central Bank has computed this average**rate** based on effective transactions **in** the **in**terbank market. It is calculated accord**in**g to the act/360 day count convention.The calculation is done at the end of the day **and** takes the effect of compound **in**terest **in**to consideration by us**in**g theeffective **in**terest-**rate** formula.EURIBOR European Interbank Offered Rate. Officially published mean **in**terest **rate** at which the banks **in** the EUlend each other money.EUROPEAN OPTION The buyer can only exercise this option on an agreed expiry date. Opposite: Americanoption.EXERCISE PRICE The price at which the underly**in**g **in**strument (e.g. a share, **currency**, **in**dex) can be purchased (**in**the case of a call) or sold (**in** the case of a put).EXOTIC OPTION Options of the second **and** follow**in**g generations that are characterised not only by theirdeterm**in**ants, but also by additional parameters such as barriers **and** payouts.FINANCIAL FUTURE Collective term for a st**and**ardised futures contract that is traded on the stock exchange.FIXED INTEREST RATE Interest **rate** for debt ** instruments** (credit, loans, bonds) that cannot be changed dur

FORWARD/FORWARD See credit forward.FRA Forward Rate Agreement.FUTURE Listed contract st**and**ardised with regard to amount, quality **and** date of delivery **in** which an item traded **in**the money, capital, precious metals or foreign exchange markets is to be delivered or purchased at the price/**rate**determ**in**ed by the stock exchange. Frequently, **in** such contracts (for example, on the basis of share **in**dices), a marg**in**payment is paid **in** order to meet the exist**in**g commitment (**in**stead of a physical delivery or purchase of securities).FUTURES MARKET In the futures market, a deal is concluded for a later po**in**t **in** time, whereby the conditions arelaid down when the deal is contracted (e.g. exchange of foreign **currency** **in** six months at a future exchange **rate** that isfixed today or the purchase of securities with payment **and** delivery at a later date).FX Abbreviation for foreign exchange. Exchange of one (foreign) **currency** **in**to another (usually a country **currency**).GAMMA Change **in** the delta when the spot price/**rate** changes. Used to measure how price-sensitive the option is.GREEK VARIABLES These variables are used to express how sensitively an option price reacts to the change **in** acerta**in** **in**fluenc**in**g factor. They **in**clude delta, gamma **and** theta.HEDGING Procedure by which an exist**in**g risk item is neutralised by a countervail**in**g transaction.HEDGING INSTRUMENTS General term for f**in**ancial ** instruments** that are used to m

INTEREST-RATE FUTURES In f**in**ance, these are futures contracts whose underly**in**g securities are money marketpapers **and** capital market ** instruments**. Interest-

NOMINAL INTEREST RATE The nom**in**al **in**terest **rate** is the percentage of **in**terest charged or paid on the nom**in**alvalue of a debt **in**strument (e.g. loan, bond) at which the debt **in**strument bears **in**terest.NORMAL DISTRIBUTION The normal distribution is a distribution model for “cont**in**uous probability distributions”.It was orig**in**ally developed by Carl Friedrich Gauß (1777-1855) to describe measur**in**g errors: the so-called Gaussianerror curve. The normal distribution assumes a symmetrical distribution form **in** the shape of a bell where the values ofthe probability variables are concent**rate**d **in** the middle of the distribution **and** become less **and** less frequent the fartherthey are away from the middle. The normal distribution is the most important distribution model **in** statistics **and** isused for a wide range of purposes.OFFERED PRICE/RATE Price/**rate** at which a f**in**ancial **in**strument is offered for sale. Opposite: Bid price/**rate**.OPTION PREMIUM The price of an option.OPTION PRICE Premium, option premium. A premium that must be paid to buy an option or a warrant. Thefollow**in**g factors are considered when calculat**in**g the option price: The exercise or strike price, the spot price/**rate** ofthe underly**in**g **in**strument, the term of the option, the risk-free **in**terest **rate**, dividends paid on the underly**in**g **in**strumentdur**in**g the term of the option.OPTION The right to purchase (call option) an underly**in**g item (e.g. securities or foreign **currency**) from a contract**in**gparty (option seller) or to sell (put option) it to such party (option writer) at a previously fixed price/**rate** at a particulartime or **in** the course of a particular period **in** time.OTC DERIVATIVES Over-the-counter f**in**ancial ** instruments** (derivatives) that are not st

QUANTO SWAP A special form of **in**terest-**rate** swap where, by tak**in**g advantage of the different **in**terest-**rate** levelsof two currencies, one succeeds **in** reduc**in**g the price of the **in**terest payable without tak**in**g on a **currency** risk.R/O LOAN Rollover loan, loan with variable **in**terest.RATIO SPREAD OPTION A zero cost st**rate**gy based on a comb**in**ation of buy**in**g/sell**in**g call options **and**sell**in**g/buy**in**g put options. However, **in** this case the amounts of the two options vary.RECEIVER SWAPTION An option on a swap giv**in**g the owner the right to receive fixed **in**terest.REFERENCE INTEREST RATE Term applied to a def**in**ed **in**terest **rate** which lenders **and** borrowers agree onregard**in**g a contractually agreed lend**in**g **rate** which must be periodically reassessed to reflect the current marketconditions. The lend**in**g **rate** is based on a premium (marg**in**), which has been fixed for the entire term of the contract,be**in**g charged over the def**in**ed reference **in**terest **rate** **in** the form of percentage po**in**ts. If the reference **in**terest **rate**falls (rises) the agreed **in**terest **rate** shows a correlated reaction. Typical reference **in**terest **rate**s are, for example,EURIBOR, LIBOR **and** other **in**terbank offered **rate**s.ROLLOVER Regular **in**terest **rate** readjustment for transactions with variable **in**terest **rate**s.ROLLOVER LOAN R/O Loan. Medium- to long-term loan with variable **in**terest **rate** whereby the **in**terest **rate** isusually readjusted every three, six or twelve months. The periodic **in**terest **rate** readjustments are based on, for example,EURIBOR, LIBOR.SINGLE BARRIERS Exotic options with an additional trigger price/**rate** which acts as a knock-**in** or a knock-out.SPOT PRICE/RATE The market price/**rate** that is currently be**in**g charged on money, capital **and** foreign exchangemarkets.SPREAD Interest premium. Marg**in** measured **in** basis po**in**ts.STANDARD NORMAL DISTRIBUTION A normal distribution with a st**and**ard variance of 1 **and** a mean of 0is called a st**and**ard normal distribution.STEP PAYMENT OPTION Option is hedged by pay**in**g the premium **in** partial payments when certa**in** predeterm**in**edlevels are reached.STRIKE PRICE The price that is agreed on when the option contract is made. In the case of a cap, this is equivalentto an upper limit to the **in**terest **rate**, **in** the case of a floor it is a lower limit.SWAP Exchange of payment streams.SWAP INTEREST RATE The **in**terest **rate** for swaps that is published by the reference banks for the term **in**question (**in**terest-**rate** swap). Serves as a reference **in**terest **rate** for fixed **in**terest loans.SWAPTION Gives the purchaser of an option, aga**in**st payment of an option premium, the right to enter **in**to a swapdef**in**ed **in** terms of maturity **and** level of **in**terest at a given time.SYMMETRICAL RISK DISTRIBUTION In a forward **rate** agreement, the opportunity for profit **and** the risk ofloss are the same for both contract**in**g parties (e.g. with **in**terest-**rate** swaps).THETA represents the change **in** the value of an option as the time until maturity decreases where all other conditionsrema**in** the same.77

TRADING Delibe**rate**ly enter**in**g **in**to a risk position.TRIGGER price/**rate** barrier. Additional specification for exotic options.VAR see value at risk.VALUE AT RISK VaR. Statistical measurement of risk frequently used to measure a portfolio’s market risk. The lossmade by a portfolio, measured **in** absolute units of money, that is not exceeded with a specific level of probability with**in**a specific period of time. The probability is expressed as the confidence level **and** the period of time as the hold**in**g time.VALUE AT RISK CONCEPT see value at risk.VARIABLE LOAN WITH INTEREST-RATE CEILING Loan with **in**terest that, at an agreed credit marg**in**, isl**in**ked to a reference **in**terest **rate** (e.g. EURIBOR).VARIANCE/COVARIANCE APPROACH With the variance/covariance approach, cash flows are evaluatedtak**in**g volatilities **and** correlations **in**to consideration.VEGA Is the benchmark for the change **in** the option premium when the volatility changes.VOLATILITY Indicates the change **in** **in**terest **rate**s or prices/**rate**s over time, **in** mathematical terms the annualisedst**and**ard deviation **in** **in**terest **rate**s **and** prices/**rate**s.VOLATILITY RISK Volatility describes the range of fluctuation of the average values of **in**terest **rate**s or prices/**rate**s.The greater the possible evaluation range of an **in**vestment **in**strument, the higher the volatility risk is.Z SCORE The quantile of probability. This is needed to make probability statements about a st**and**ard normaldistribution variable. It is the basis for calculat**in**g the confidence level. See confidence level.ZERO COST COLLAR A special k**in**d of collar (simultaneous purchase of a cap **and** sale of a floor) where no optionpremium must be paid for the cap at the beg**in**n**in**g of the contract because the profit from the sale of the floor is thesame amount as the cost of purchas**in**g the cap.ZERO INTEREST RATE Zero **in**terest **rate**s **and** zero discount factors elim**in**ate the re**in**vestment risk on **in**terestpayments to be made **in** the meantime **and** therefore lead to economically correct results.78

TREASURY PRACTICESInternational **in**terest **rate** practicesInterest **rate** calculation methods on the money market (under one year) **and** the capital market (over one year)Currency Interest **rate** calculation Interest **rate** calculationmethod money marketmethod capital marketAUD - Australian dollar act/360 act/365, quarterlyCAD - Canadian dollar act/360 act/360, semi-annualCHF - Swiss franc act/360 30/360, annualCZK - Czech koruna act/360 act/360, annualDKK - Danish kroner act/360 30/360, annualEUR - euro act/360 30/360, annualGBP - British pound act/365 act/365, annualHKD - Hong kong dollar act/365 act/365, quarterlyHUF - Hungarian for**in**t act/360 act/365, annualIDR - Indonesian rupiah act/360 act/360, quarterlyISK - Icel**and**ic krona act/360 act/360, annualJPY - Japanese yen act/360 act/365, semi-annualMXN - Mexican peso act/360 act/360, monthlyMYR - Malaysian r**in**ggit act/365 act/365, quarterlyNOK - Norwegian krone act/360 30/360, annualNZD - New Zeal**and** dollar act/360 act/365, semi-annualPLN - Polish zloty act/365 act/act, annualRUB - Russian rouble act/360 act/365, annualSEK - Swedish krona act/360 30/360 annualSGD - S**in**gapore dollar act/365 act/365, semi-annualTHB - Thai baht act/365 act/365, semi-annualTRL - Turkish new lira act/360 act/360, annualUSD - US dollar act/360 act/360, annualZAR - South African r**and** act/365 act/365, quarterlyThese **in**terest **rate** calculation methods are market st**and**ards, although differ**in**g rules can be agreed upon, **and**are common, **in** particular where there is a comb**in**ation of ** instruments**.Non st

International FX practices (key **currency**, base **currency**, cross calculations)The follow**in**g rules have been established as **in**ternational FX practices.1. The euro is always quoted as the key **currency**(e.g. EUR 1 = GBP X).2. The British pound is placed ahead of all other currencies (except EUR)(e.g. GBP 1 = AUD X).3. The Australian dollar **and** the New Zeal**and** dollar are always listed first, unless listed aga**in**st EUR or GBP.(e.g. AUD 1 = USD X).4. The USD is the key **currency** aga**in**st all other currencies except **in** the US domestic market(e.g. USD 1 = CAD X).5. ”Cross Rates“, i.e. non-st**and**ard **currency** pairs are placed **in** any order aga**in**st one another.The correspond**in**g reverse **rate** can also be quoted upon request.

IMPRINTPublished by: Österreichische **Volksbank**en-**AG**, 1090 Vienna, Kol**in**gasse 14 - 16, Tel. +43(0)50 4004-0, Fax +43(0)50 4004-3683Authors: Alfred Buder, Alex**and**ra Lauffer-Köppl**in**ger, Harald Klimt, Mart**in** Mayer, Walter Riess, Gernot Rux, Claudia SchleissEditor: Andrea Ra**in**sberger, Österreichische **Volksbank**en-**AG**, Market**in**g & Communications, 1090 Vienna, Kol**in**gasse 14 – 16Graphic design **and** production: Dieter Achter, Österreichische **Volksbank**en-**AG**, Market**in**g & Communications, 1090 Vienna, Kol**in**gasse 14 - 16September 2010May 2011