BASICS OF FINANCIAL RISK MANAGEMENT

1. BASICS OF FINANCIALRISK MANAGEMENT CAS / ARIA Financial Risk Management Seminar -- Denver, CO April, 1999 Rick Gorvett, FCAS, Ph.D. The College of Insurance

2. BACKGROUNDANDMOTIVATION

3. WHY SHOULD WE STUDY FINANCIAL RISK MANAGEMENT? • To better understand the nature and volatility of financial markets • To understand the development of new financial products -- e.g., derivatives and hybrid securities • To understand how these products can be used to change a firm’s risk profile and protect its financial condition

4. UNPREDICTABILITY • Interest rates • Inflation, cash flows (investing / lending), asset and liability values • Late 1970s -- Volcker / FED policy change • Commodity prices • Costs, substitute products • Price shocks -- OPEC, Kuwait • FX rates • International cash flows, relative competitiveness • Early 1970s -- Breakdown of Bretton Woods

5. FINANCIAL RISKS -- EXAMPLES • Interest rates • Savings & Loans • Inversion of yield curve around 1980 • Commodity prices • Continental Airlines • Price of fuel after Iraq invaded Kuwait • Foreign exchange • Laker Airlines • Strengthening of US$ relative to pound in 1981

6. FINANCIAL RISK MANAGEMENT:A BROAD FRAMEWORK • FRM can take several (familiar and unfamiliar) forms • Asset hedges • Liability hedges • Asset-liability management • Contingent financing • Post-loss financing and recapitalization

7. WHY DO CORPORATIONS USE FINANCIAL DERIVATIVES? • Transaction hedges • FX; debt • Currency and interest rate risk • Strategic (economic) hedges • Protect cash flows or company value from movements in financial prices • Reduce funding costs • FX; synthetic debt • Trading derivatives for profit

8. WHY DON’T CORPORATIONS USE MORE DERIVATIVES? • Credit risk • No suitable instrument • Lack of knowledge • Accounting / legal issues • Transaction costs • Resistance by Board / upper management

9. VOCABULARY • Financial derivative: a financial instrument whose value is a function of another (“underlying”) financial instrument • Financial engineering: the creation and use of financial derivatives to aid in the management of risk • Risk profile: describes the effect of changes in a financial price on the value of a firm

10. FORWARDSANDFUTURES

11. FORWARD CONTRACTS • Obligation / agreement to buy/sell in the future • Contract price is the “exercise price”; no payment until maturity • Physical delivery or cash-settled • Buyer (holder) is “long”; seller (writer) is “short • OTC -- can be tailored • Two-sided risk

12. FUTURES CONTRACTS • Obligation; agree to a future transaction • Traded on organized exchanges • Standardized • Daily settlement (marking to market) • Reduces default risk: essentially, a series of one-day contracts • Margins (performance bonds) • Initial margin • Maintenance margin • Margin call • Exchange clearinghouse

13. Exchanges Advantages Clearinghouse Liquidity Standardization Disadvantages Lack of flexibility Regulation Trading costs Public OTC Markets Disadvantages Credit risk Low liquidity Non-standardization Advantages Flexible Less regulation Lower regulatory costs Private EXCHANGES VS. OTC

14. TYPES OF CONTRACTS • Agricultural commodities • Wheat, corn, soybeans • Farmer (supplier) can lock in sales price before harvest (short futures) • Consumer (user) can lock in purchase price (long futures) • Other commodities • Metals, petroleum • Financial assets • FX, stock market indices, interest rates

15. EXAMPLE • Ann agrees to buy from Bill one barrel of oil, five months from now, for $20 • Ann is in the “long” position • Bill is in the “short” position • If the price of oil is $25 five months from now, who pays to whom, and how much? • If the price of oil is $12 five months from now, who pays to whom, and how much?

16. OPTIONS

17. OPTIONS • Option to buy or sell the underlying asset • Right, not obligation • Call option: right to buy the U/L asset • Put option: right to sell the U/L asset • Buyer = holder = long position (option to exercise) • Seller = writer = short position

18. PARAMETERS OF OPTIONS • Exercise price = strike price = price at which the holder of the option can exercise the option (and thus buy or sell the underlying asset) • Expiration date • Premium = amount paid for the option • American option: can exercise any time up to and including expiration date • European option: can exercise only on expiration date

19. EXAMPLES OF OPTIONS --THEY’RE EVERYWHERE • Traded options • On stocks, indices, FX, interest rates, futures, swaps, options,... • Convertible bonds • Call provisions on bonds • On projects • To expand, abandon, postpone • Insurance

20. EXAMPLE • Amy sells Bob a January European call option on one share of Compaq stock • Suppose Compaq stock is trading at 32.5 • Exercise price = 35 • Premium = 3 • In January, suppose: ST=30ST=40 Total payoff [profit/loss] Amy: 0 [3] -5 [-2] Bob: 0 [-3] 5 [2]

21. OPTION VALUES (cont.) • Prior to expiration: CallPut • In-the-money St > X St < X • At-the-money St = X St = X • Out-of-the-money St < X St > X • Intrinsic value - profit that could be made if the option was immediately exercised • Call: stock price - exercise price • Put: exercise price - stock price • Time value - the difference between the option price and the intrinsic value

22. OPTION VALUES:PAYOFF CHART Payoff • Call -- long position • Call -- short position • Put -- long position • Put -- short position ST X

23. PUT-CALL PARITY • Arbitrage implies a certain relationship between put, call, and underlying asset prices • Two portfolios have, at payoff, identical values: • One European call option + cash of PV(X) • One European put option + one share of stock • C + PV(X) = P + S

24. BLACK-SCHOLES FORMULA VC = S N(d1) - X e-rt N(d2) d1 = [ln(S/X)+(r+0.5s2)t] / st0.5 d2 = d1 - st0.5

25. PURPOSES OF DERIVATIVES • Speculative • Highly risky • Highly leveraged • Very volatile • Hedging • Combine with other securities • Hedge (minimize) risk from other securities

26. HEDGING • “Hedge”: Take a position that offsets a risk • Risk: Uncertainty regarding the value of the underlying asset • By hedging, one changes the risk inherent in owning the underlying asset • The return distribution of the underlying asset is not changed

27. USING OPTIONS TO HEDGE • Combine the underlying asset with an option or options • Can reduce or eliminate downside risk while retaining upside potential • Can protect against falls in held asset values, or against increases in input prices

28. OPTION STRATEGIES • Protective put • Own stock (long position) • Own put (long position) • Covered call • Own stock (long position) • Sell call (short position) • Straddle • Spread

29. PROTECTIVE PUT • Investor owns asset • Investor also buys (holds) a put on the asset • Guarantees investment portfolio proceeds at least equal to the exercise price of the put + =

30. PROTECTIVE PUT EXAMPLE • Suppose you own a share of stock, and you purchase a put option with an exercise price of 22.5 on that stock, for a premium of $ 0.75 ST : 30 25 20 15 Premium: -0.75 -0.75 -0.75 -0.75 Put Payoff: 0 0 2.50 7.50 === === === === Overall: 29.25 24.25 21.75 21.75

31. COVERED CALL • Investor purchases stock • Investor also sells (writes) a call option on the stock • Option position is “covered” by owning the underlying stock itself • (vs. “naked option”) • Provides additional (premium) income = +

32. COVERED CALL EXAMPLE • Suppose you own a share of stock, and you write a call option with an exercise price of 35 on that stock, for a premium of $ 2.00 ST : 30 35 40 45 Premium: 2 2 2 2 Call Payoff: 0 0 -5 -10 === === === === Overall: 32 37 37 37

33. STRADDLE • (Long) Straddle: buy both a call and a put on a stock • Each option has the same exercise price and expiration date • Believe stock will be relatively volatile • Worst-case: no movement in stock price

34. SPREAD • Combination of options • Two or more calls, or • Two or more puts • Vertical spread: simultaneous sale and purchase of options with different exercise prices • Horizontal spread: sale and purchase of options with different expiration dates

35. INTEREST RATE OPTIONS • Cap: a call option on an interest rate • Floor: a put option on an interest rate • Collar: simultaneously buying a cap and selling a floor • These options can be used to hedge rate-sensitive debt and assets

36. INTEREST RATE OPTIONS:TERMINOLOGY • Underlying index: interest rate being hedged or speculated upon; e.g., LIBOR, prime rate • Strike rate: determines cash flows (similar to exercise price) • Settlement frequency: how often the strike rate and underlying index are compared • Notional amount: principal to which the interest rate is applied • Up-front premium: paid by purchaser to seller for the option

37. INTEREST RATE CAPS • At each settlement date, check whether index rate is greater than strike rate • If not, cap purchaser does not receive cash flows • If so, purchaser receives from seller: [ (index rate - strike rate) x (days in settlement period / 360) x notional amount ]

38. INTEREST RATE CAPS:EXAMPLE • $20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8% • Cost: 150 basis points • Up-front premium = 0.015 x $20M = $300,000 • If 3-month LIBOR = 9%, seller pays (.09-.08) x 90/360 x $20M = $50,000 (for that quarter)

39. INTEREST RATE FLOORS • At each settlement date, check whether index rate is greater than strike rate • If so, floor purchaser does not receive cash flows • If not, purchaser receives from seller: [ (strike rate - index rate) x (days in settlement period / 360) x notional amount ]

40. INTEREST RATE COLLARS • Purchase a cap to hedge floating-rate liabilities • Sell a floor at a lower strike rate • Sale of floor helps finance purchase of cap • Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates • Can achieve zero-premium collar

41. SWAPS

42. SWAPS • Agreement between two parties • “Counterparties” • Exchange sets of future cash flows • Two major types • Interest rate swaps • Currency swaps • Relatively new FRM tool

43. SWAPS VS. FUTURES • Futures • Standardized • Exchange-traded • Short horizons • Swaps • Custom tailored between counterparties • Little regulation; potential for privacy • Term flexibility

44. INTEREST RATE SWAPS • One party pays a fixed interest rate and receives a floating rate • The other party pays a floating rate and receives a fixed rate • Floating rates involve greater exposure to interest rate risk • “Notional principal” is amount on which the interest payments are determined

45. INTEREST RATE SWAPS (cont.) • Principal is not actually exchanged -- only interest payments • Generally, only net interest payments are transacted • Avoids unnecessary transactions • Helps credit risk • At each “settlement date,” a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

46. CURRENCY SWAPS • One party holds one currency, and desires a different currency • Three sets of cash flows: • Exchange principal at inception of swap • Periodic interest payments • Exchange principal at termination of swap • Interest rates fixed ==> only change in value is from FX change • Generally, only make net payments

47. LIMITATIONS OF SWAPS • Counterparties must find each other • Meet specific needs • Cost, time; facilitators • Lack of “liquidity”; difficult to unwrap / trade / change without consent of other party • Credit risk of counterparty

48. DEVELOPMENT OF SWAP MARKET • Originally: • Unique contracts • Had to search for counterparty • Investment banks were dominant intermediaries • More recently: • More standardized and liquid • Intermediaries accept contract, then lay off risk • More highly capitalized firms -- e.g., commercial banks