Chapter 24 Risk Management: An Introduction to Financial Engineering

1. Chapter 24Risk Management: An Introductionto Financial Engineering • Homework: 1,4,5 & 6

2. Lecture Organization • Hedging and Price Volatility • Hedging with Forward Contracts • Hedging with Futures Contracts • Hedging with Swap Contracts

3. Example: Statement of Risk Management Policy at Walt Disney Company “The company’s foreign currency revenues continue to grow and thus, Disney’s management believes it is prudent to reduce the risk associated with fluctuations in the value of the US dollar in the foreign exchange markets. The Company uses foreign currency forward and option contracts to reduce the impact of changes in the value of its existing foreign currency assets and liabilities, commitments and anticipated foreign currency revenues denominated in Japanese yen, French francs, German marks, British pounds, and other currencies. The primary focus of the company’s foreign exchange risk management program is to reduce earnings volatility. By policy, the company maintains hedge coverages between minimum and maximum percentages of its anticipated foreign exchange exposures for each of the next five years.” (Emphasis added) Excerpt from the Walt Disney Company 1995 Annual Report

4. 1997-1999 Currency crises

5. Nortel Networks stock price (logarithmic scale)

6. The Risk Management Process • Step 1: Identify the source of the risk exposure. Is the nature of the risk financial, currency, commodity, energy? • Step 2: Quantify the risk exposure. What is the extent of the potential loss? • Step 3: Assess the impact of the exposure(s) on the firm’s business and financial strategies. Is hedging always beneficial? To whom, and under what conditions? • Step 4: Assess honestly your firm’s ability to design and implement a risk management program. Does enough expertise exist within the firm to operate the program (or to hire someone to do so)? • Step 5: Select the appropriate risk management products. Adapted from Financial Risk Management by Tim Campbell and William Kracaw, HarperCollins Publishing, 1993

8. 1) Forward Contract Example: Let's say you are a corn farmer. Your crop is planted in April, but will not be harvested until September. You don't know what the price of corn will be in September. To hedge your risk you can enter into a forward contract to sell your corn in September at $4.00/bushel. A forward contract is a contract made today for delivery of an asset in the future at a price agreed upon today. The buyer of a forward contract agrees to take delivery of the underlying asset at a future time T, at a price agreed upon today. No money changes hands until time T. Buying a forward contract is also called taking a position in the forward contract. The seller of a forward contract agrees to deliver the underlying asset at a future time T, at a price agreed upon today. Again, no money changes hands until time T. Selling a forward contract is also called taking a position in the forward.

9. How can the farmer use the forward contract to hedge his risk? The spot price is the price at which you could purchase or sell the asset for today. The delivery price is the price at which you agree to purchase or sell the asset for in the future. The payoff from a long position in a forwards contract is

10. Risk Profile for a Wheat Grower (Figure 24.6)

11. Risk Profile for a Wheat Buyer (Figure 24.7)

12. Payoff Profiles for a Forward Contract (Figure 24.8)

13. 2) Futures Contract In practice, people trade futures contracts, not forwards contracts. A futures contract is exactly like a forwards contract except that intermediate gains or losses are posted each day during the futures contract life. This is what is called . Typically brokers require that you put up cash when you enter a futures contract. The cash you put up is called . Example: Lets say you buy 2 gold futures contracts, each for 100 oz. of gold (so you are long gold futures). The broker requires that you put up $2000 in margin for each contract, or a total of $4000 in margin. The day you enter the futures contract the futures price of gold is $400/oz. The next day the futures price drops to $397.00. What is the balance in your margin account?

14. Note that there is something called a maintenance margin. In this case it is $1500 per contract or a total of $3000. When your margin balance drops below $3000, your broker will give you a . You have to put in enough money so that your balance is back up to the initial margin of $4000. On June 9, your balance dropped to $2,660, which is under the maintenance margin of $3,000. You have to post:

15. Sample National Post Futures Price Quotations (Figure 24.11) FUTURE PRICES Thursday, June 1, 2000 Source: The National Post, June 3, 2000. Used with permission.

16. Convergence of Futures and Spot prices • Difference between spot and futures prices. • The spot price of an asset is what I could buy or sell it for today. For example, the spot price of gold may be $390/oz. • The futures price of gold is what I could buy/sell it for in the future. For example, the February 1995 futures price of gold was $394.50 on October 26, 1994. • As the delivery date is approached, the futures and spot prices must be the same, or else there is an arbitrage opportunity

17. Using futures to speculate • Futures contracts can be used to speculate on the future prices of commodities. You can control a large asset position with relatively little cash. • For example you can speculate on inflation going up. If inflation increases, then the price of gold (an inflation hedge) increases. • Example: Each gold futures contract is for 100 oz. of gold. • What you could do today is go long 10 Feb 95 futures contract for a total of 1000 oz of gold at $394.50/oz. Say you are right and inflation goes up. The price of gold in Feb 95 rises to $400/oz. How much did you make? • If gold drops to $390/oz:

18. Using futures to hedge • Futures are also very useful in hedging. • Example: In May a farmer thinks he is going to have to sell 50,000 bushels of corn sometime in July. He wants to hedge against the price per bushel going down by using a July futures contract. • Each futures contract is for 5,000 bushels. The farmer wants to hedge against a price decrease, so he/she needs to ______ 10 futures contracts. We see that the futures price for July corn futures is $2.41/bushel. • Say that there is a huge surplus of corn in July and the spot price of corn in July is $2.00/bushel. • What is is total gain/loss in futures?

19. To recap: If a firm needs to buy an asset in the future, it can go _____ futures contracts to hedge. If a firm needs to sell an asset in the future (a corn farmer), the firm can go _____ futures contracts to hedge. Long Position Short Position Asset increases in price Make Money Lose Money Asset decreases in price Lose Money Make Money Moral to the story: derivatives can be used to reduce risk (if you ________ ) as well as increase risk (if you ________ )

20. Illustration of an Interest Rate Swap (Figure 24.12)

21. Chapter 24 Quick Quiz 1. Why is risk management more important now than it was in the 1960s? 2. How does a forward contract differ from a futures contract?

22. Solution to Problem 24.1 • Refer to Figure 24.11 in the text to answer this question. Suppose you purchase a September 2000 cocoa futures contract on June 1, 2000. What will your profit or loss be if cocoa prices turn out to be $1,500 per metric ton at expiration? The initial contract value is equal to: (price per ton)(number of tons specified in the contract) Initial contract value = ($871 per ton)(10 tons per contract) = $8,710 Final contract value = ($1,500 per ton)(10 tons per contract) = $15,000 So our gain on the futures contract is$15,000 - $8,710 = $6,290.