Risk management: An introduction to financial engineering

1. Chapter 24 Risk management: An introduction to financial engineering

2. Chapter Outline • Hedging and Price Volatility • Managing Financial Risk • Forward Contracts • Futures Contracts • Option Contracts

3. Hedging Volatility • Volatility in returns is a 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 Hedging (immunization) – reducing a firm’s exposure to price or rate fluctuations

4. Managing Financial Risk • Instruments have been developed to hedge the following types of volatility • Interest Rate • Exchange Rate • Commodity Price • Derivative – A financial asset that represents a claim to another asset. It derives its value from that other asset

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

6. 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 do a better analysis of future projects • Available tools: forwards, futures, swaps, futures options, and options

7. 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 (depends on type of commodity): forwards, futures, swaps, futures options, and options

8. The Risk Management Process • Identify the types of price fluctuations that will impact the firm • 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 • 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

9. Risk Profiles • Basic tool for identifying and measuring exposure to risk • Graph showing the relationship between changes in price versus changes in firm value

10. Risk Profile for a Wheat Grower

11. Risk Profile for a Wheat Buyer

12. Reducing Risk Exposure • Hedging will not normally reduce risk completely • 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

13. Timing • Short-run exposure (transactions exposure) – can be hedged • Long-run exposure (economic exposure) – almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate

14. 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 customized to meet the needs of both parties and can be quite large in size • Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

15. Positions • Long – agrees to buy the asset at the future date (buyer) • Short – agrees to sell the asset at the future date (seller)

16. Payoff profiles for a forward contract

17. Hedging with Forwards • Entering into a forward contract can virtually eliminate the price risk a firm faces • It does not completely eliminate risk because both parties still face credit risk • Since 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

18. Hedging with forward contracts

19. Futures Contracts • Futures vs. Forwards • Futures contracts trade publicly on organized securities exchange • Require an upfront cash payment called margin • 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

20. Swaps • A long-term agreement between two parties to exchange (or swap) cash flows at specified times based on specified relationships • Can be viewed as a series of forward contracts • Generally limited to large creditworthy institutions or companies

21. Types of Swaps • 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 • Commodity swaps – fixed quantities of a specified commodity are exchanged at fixed times in the future

22. Option Contracts • The right, but not the obligation, to buy (or 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 • Specified exercise or strike price • Specified expiration date

23. Seller’s Obligation • Buyer has the right to exercise the option, but the seller is obligated • Call – option writer is obligated to sell the asset if the option is exercised • Put – option writer is obligated to buy the asset if the option is exercised • Option seller can also be called the writer

24. Hedging with Options • Unlike forwards and futures, options allow the buyer to hedge their downside risk, but still participate in upside potential • The buyer pays a premium for this benefit

25. Payoff Profiles: Calls

26. Payoff Profiles: Puts

27. Hedging with Options

28. 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 • Canadian 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