Risk Management: An Introduction to Financial Engineering

1. Chapter Twenty- Three Risk Management: An Introduction to Financial Engineering

2. Key Concepts and Skills • Understand the types of volatility that companies can manage • Understand how to develop risk profiles • 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

3. 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

4. Example: Disney’s Risk Management Policy • Disney provides stated policies and procedures concerning risk management strategies in its annual report • The company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investments • Interest rate swaps are used to manage interest rate exposure • Options and forwards are used to manage foreign exchange risk in both assets and anticipated revenues • Derivative securities are used only for hedging, not speculation

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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 more a firm needs to manage that risk

11. Reducing Risk Exposure • The goal of hedging is to lessen the slope of the risk profile • 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 • 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

12. 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

13. Figure 23.7

14. 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

15. Futures Contracts • Forward contracts traded on an 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

16. 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

17. Hedging with Futures • The risk reduction capabilities of futures is similar to that 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 equities

18. Swaps • 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

19. 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 the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%

20. Figure 23.10

21. 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 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 • Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential • Pay a premium for this benefit

22. Payoff Profiles: Calls

23. Payoff Profiles: Puts

24. Hedging Commodity Price Risk with Options • “Commodity” options are generally futures options • Exercising a call • Owner of 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 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 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 put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price

25. 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 • US 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

26. 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 a call • If set up properly, the firm will not have either a cash inflow or outflow associated with this position

27. 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?