Risk Management and Derivatives

1. Risk Management and Derivatives

2. Volatility • Volatility in returns is a classic measure of risk • Perfect Market • More systematic risk leads to more return • But Volatility is Costly • External financing • Project funding • Distress • Lower debt or increased prob. of distress • Taxes

3. Risk Management Tools • Hedging • Reduce firm’s exposure to price/rate fluctuations • Financial Hedging • Insurance • Derivatives • Financial assets which are a claim on another asset • Operational Hedging • Using other corporate decisions to manage volatility

4. Sources of Volatility - 1 • Interest Rate Risk • Loans with floating interest rates create IR risk • Exchange Rate Risk • Reduce impact of foreign earnings volatility due to currency rate fluctuations • Commodity Price Risk • Certain input costs and prices of goods sold can be hedged

5. The Risk Management Process • Identify important price fluctuations • Risk profiles are useful for determining the relative impact of different types of risk • Some risks may offset each other • Consider the firm as a portfolio of risks and not just look at each risk separately • Considering risk management • Availability of relevant contracts • Cost of contracts • Cost of management/employee time

6. Risk Profiles • Graph of price changes relative to value changes • Risk profile slope • Steeper ~ Larger exposure • Potentially more need to hedge

7. Derivatives Change Payoff

8. Forward Contract • What’s a forward? • Agreement to exchange an asset for a set price with delivery and payment at a set future date • Long: agree to buy the asset • Short: agree to sell the asset • You want next year’s Ferrari and contract with dealer to buy at a set price in the fall • P Current = P Contract • Over the summer, demand rises • P Current > P Contract • What if car value is below contract price? • P Current < P Contract

9. Future • What’s a future? • Forwards traded on an exchange • Farmer expects to sell 100,000 bushels of soybeans • Wants to sell at a certain price (short position) • Soybean future contracts are for 5,000 bushels • Current price is $4.50/bushel • Farmer shorts 20 soybean futures • Will sell 100,000 bushels • Will receive $4.50/bushel*100,000 bushels = $450,000

10. Commodity Future • No cost today, but margin held in farmer’s account • As soybean price changes, clearinghouse adjusts farmer’s account • September • Farmer delivers soybeans and receives $450,000 • Bumper Crop • Receive $450,000 + Extra Crop * Market Price • Poor Harvest • Receive $450,000 – Amt to Purchase * Market Price

11. Interest Rate Swap • Firm A can borrow at 10% fixed or LIBOR + 1% floating • Firm B can borrow at 9.5% fixed or LIBOR + 2% • A prefers fixed and B prefers floating

12. Options • Call (Put) • Right to buy (sell) a security at a pre-specified price • Underlying • Asset that you have an option to buy or sell • Option Price • Market price of the contract • Exercise (or Strike) Price • Price at which the security can be bought or sold • At-the-money - Exercise price is very close to stock’s current value • In-the-money - Option could be exercised at a profit today • Out-of-the-money – Can’t exercise for profit

13. Reducing Risk Exposure • Hedging changes risk profile • Doesn’t eliminate risk • 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) • Managed in a variety of ways • Long-run exposure (economic exposure) • Difficult to hedge with derivatives

14. Always Hedge? • What if price shock can be passed along to customer? • What if competitors don’t hedge?

15. Not Perfect • Iberia • Large 4th Quarter 2008 Losses • Attributed, in part, to hedging • “Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of 2008.” Wall Street Journal

16. Sources of Volatility - 2 • Contracting with suppliers/customers • Vertical integration • Limiting leverage • Central employees • “Key Man” Insurance • Project specific issues • Diversification • Project choice

17. Corp Fin Applications • Equity as a Call • Employee Stock Options • CEO Stock Options

18. Equity: A Call Option • For leveraged firms, equity is a call option on the company’s assets • Exercise price - the face value of the debt • Expiration date – the date that the debt comes due • Assets > debt • Option is exercised and the stockholders retain ownership • Assets < debt • Option expires unused and assets belong to the bondholders

19. Equity Payoff Value of Equity • Asset substitution Firm Value Debt All goes to Bondholders Shareholders Collect

20. Employee Stock Options • Options given to employees as compensation • Nonqualified • Can be granted at a discount to current value • Qualified or incentive stock options • Primarily for upper mgmt • Special tax treatment • Often used as a bonus or incentive • Huge rise in popularity • Mostly still for upper management

21. Employee Stock Options • Designed to reduce agency problems • Empirical evidence: they don’t well work • Not worth as much to the employee as to an outsider due to the lack of diversification • Reprice underwater options • Other Disadvantages • Management behavior • Costly compensation • Dilutes stock as firm must issue new shares • Sometimes offset with repurchase (usually when stock price is high) • Expensing can hurt profits

22. Value Stock Price CEO Options Use • Executives can protect their stock positions • Given stock or options as an incentive • I-bank creates individual options • “Collars” position with put and call Put Call