Chapter 23 risk management an introduction to financial engineering

Key Concepts and Skills• Understand the risk exposure companies face and how to hedge these risks • Understand the difference between forward contracts and futures contracts and how th

Chapter 23

Risk Management:

An introduction to Financial

Engineering

Key Concepts and Skills

• Understand the risk exposure companies face and how to hedge these risks

• Understand the difference between

forward contracts and futures contracts

and how they are used for hedging

• Understand how swaps can be used for

hedging

• Understand how options can be used for

hedging

Chapter Outline

• Hedging and Price Volatility

• Managing Financial Risk

• Hedging with Forward Contracts

• Hedging with Futures Contracts

• Hedging with Swap Contracts

• Hedging with Option Contracts

Example: Disney’s Risk

Management Policy

• Disney provides stated policies and procedures

concerning risk management strategies in its

– Options and forwards are used to manage foreign

exchange risk in both assets and anticipated revenues

– The company uses a VaR (Value at Risk) model to identify the maximum 1-day loss in financial instruments

– Derivative securities are used only for hedging, not

speculation

Hedging Volatility

• Recall that volatility in returns is a classic

measure of risk

• Volatility in day-to-day business factors often

leads to volatility in cash flows and returns

• If a firm can reduce that volatility, it can reduce its business risk

• Instruments have been developed to hedge the

following types of volatility

– Interest Rate

– Exchange Rate

– Commodity Price

– Quantity Demanded

Interest Rate Volatility

• Debt is a key component of a firm’s capital

structure

• Interest rates can fluctuate dramatically in short

periods of time

• Companies that hedge against changes in

interest rates can stabilize borrowing costs

• This can reduce the overall risk of the firm

• Available tools: forwards, futures, swaps, futures options, and options

Exchange Rate Volatility

• Companies that do business internationally are

exposed to exchange rate risk

• The more volatile the exchange rates, the more

difficult it is to predict the firm’s cash flows in its

domestic currency

• If a firm can manage its exchange rate risk, it

can reduce the volatility of its foreign earnings

and conduct a better analysis of future projects

• Available tools: forwards, futures, swaps, futures options

Commodity Price Volatility

• Most firms face volatility in the costs of materials and in the price that will be received when products are sold

• Depending on the commodity, the company may be able

to hedge price risk using a variety of tools

• This allows companies to make better production

decisions and reduce the volatility in cash flows

• Available tools (depend on type of commodity): forwards,

futures, swaps, futures options, options

The Risk Management

Process

• Identify the types of price fluctuations that will impact the firm

• Some risks are obvious; others are not

• Some risks may offset each other, so it is important

to look at the firm as a portfolio of risks and not just

look at each risk separately

• You must also look at the cost of managing the risk

relative to the benefit derived

• Risk profiles are a useful tool for determining the

relative impact of different types of risk

Risk Profiles

• Basic tool for identifying and measuring

exposure to risk

• Graph showing the relationship between

changes in price versus changes in firm value

• Similar to graphing the results from a sensitivity

analysis

• The steeper the slope of the risk profile, the

greater the exposure and the greater the need to manage that risk

Reducing Risk Exposure

• The goal of hedging is to lessen the slope of the risk

profile

• Hedging will not normally reduce risk completely

– For most situations, only price risk can be hedged,

not quantity risk

– You may not want to reduce risk completely because you miss out on the potential upside as well

• Timing

– Short-run exposure (transactions exposure) – can be managed in a variety of ways

– Long-run exposure (economic exposure) – almost

impossible to hedge - requires the firm to be flexible

and adapt to permanent changes in the business

climate

Forward Contracts

• A contract where two parties agree on the price of

an asset today to be delivered and paid for at some future date

• Forward contracts are legally binding on both

parties

• They can be tailored to meet the needs of both

parties and can be quite large in size

• Positions

– Long – agrees to buy the asset at the future date – Short – agrees to sell the asset at the future

date

• Because they are negotiated contracts and there is

no exchange of cash initially, they are usually

limited to large, creditworthy corporations

Figure 23.7

Hedging with Forwards

• Entering into a forward contract can virtually

eliminate the price risk a firm faces

– It does not completely eliminate risk unless there is no uncertainty concerning the quantity

• Because it eliminates the price risk, it prevents

the firm from benefiting if prices move in the

company’s favor

• The firm also has to spend some time and/or

money evaluating the credit risk of the

counterparty

• Forward contracts are primarily used to hedge

exchange rate risk

– Small relative to the value of the contract

– “Marked-to-market” on a daily basis

• Clearinghouse guarantees performance on all contracts

• The clearinghouse and margin

requirements virtually eliminate credit risk

Futures Quotes

• See Table 23.1

• Commodity, exchange, size, quote units

– The contract size is important when determining the daily gains and losses for marking-to-market

• Delivery month

– Open price, daily high, daily low, settlement price,

change from previous settlement price, contract lifetime high and low prices, open interest

– The change in settlement price times the contract size

determines the gain or loss for the day

• Long – an increase in the settlement price leads to a gain

• Short – an increase in the settlement price leads to a loss

– Open interest is how many contracts are currently

outstanding

Hedging with Futures

• The risk reduction capabilities of futures are

similar to those of forwards

• The margin requirements and marking-to-market require an upfront cash outflow and liquidity to

meet any margin calls that may occur

• Futures contracts are standardized, so the firm

may not be able to hedge the exact quantity it

desires

• Credit risk is virtually nonexistent

• Futures contracts are available on a wide range of physical assets, debt contracts, currencies, and

• A long-term agreement between two parties to

exchange cash flows based on specified

relationships

• Can be viewed as a series of forward contracts

• Generally limited to large creditworthy institutions

or companies

• Interest rate swaps – the net cash flow is

exchanged based on interest rates

• Currency swaps – two currencies are swapped

based on specified exchange rates or foreign vs domestic interest rates

Example: Interest Rate Swap

• Consider the following interest rate swap

– Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed)

– Company B can borrow from a bank at 9.5% fixed or LIBOR + 5% (borrows floating)

– Company A prefers floating and Company B prefers fixed

– By entering into a swap agreement, both A and B are better off than they would be borrowing from the bank with their preferred type of loan, and the swap dealer makes 5%

Pay Receive Net

Swap Dealer w/A 8.5% LIBOR + 5%

Swap Dealer w/B LIBOR + 5% 9%

Figure 23.10

Option Contracts

• The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date

– Call – right to buy the asset

– Put – right to sell the asset

– Exercise or strike price –specified price

– Expiration date – specified date

• Buyer has the right to exercise the option; the seller is

• Unlike forwards and futures, options allow a firm to hedge

downside risk, but still participate in upside potential

Payoff Profiles: Calls

Buy a call with E = $40

Payoff Profiles: Puts

Buy a put with E = $40

Hedging Commodity Price

Risk with Options

• “Commodity” options are generally futures options

• Exercising a call

– Owner of the call receives a long position in the futures

contract plus cash equal to the difference between the

exercise price and the futures price

– Seller of the call receives a short position in the futures

contract and pays cash equal to the difference between the

exercise price and the futures price

• Exercising a put

– Owner of the put receives a short position in the futures

contract plus cash equal to the difference between the futures price and the exercise price

– Seller of the put receives a long position in the futures

contract and pays cash equal to the difference between the

futures price and the exercise price

Hedging Exchange Rate

Risk with Options

• May use either futures options on currency or

straight currency options

• Used primarily by corporations that do business

overseas

• U.S companies want to hedge against a

strengthening dollar (receive fewer dollars when

you convert foreign currency back to dollars)

• Buy puts (sell calls) on foreign currency

– Protected if the value of the foreign currency falls

relative to the dollar

– Still benefit if the value of the foreign currency increases relative to the dollar

– Buying puts is less risky

Hedging Interest Rate

Risk with Options

• Can use futures options

• Large OTC market for interest rate options

• Caps, Floors, and Collars

– Interest rate cap prevents a floating rate from going

above a certain level (buy a call on interest rates)

– Interest rate floor prevents a floating rate from going

below a certain level (sell a put on interest rates)

– Collar – buy a call and sell a put

• The premium received from selling the put will help offset the cost of buying the call

• If set up properly, the firm will not have either a cash inflow

or outflow associated with this position

Quick Quiz

• What are the four major types of

derivatives discussed in the chapter?

• How do forwards and futures differ? How

are they similar?

• How do swaps and forwards differ? How

are they similar?

• How do options and forwards differ? How

are they similar?

Comprehensive Problem

• A call option has an exercise price of $50.

– What is the value of the call option at

expiration if the stock price is $35? $75?

• A put option has an exercise price of $30.

– What is the value of the put option at

expiration if the stock price is $25? $40?

End of Chapter