Module III: Techniques for Risk Management

1. Module III: Techniques for Risk Management Week 6 – February 16, 2006

2. Asset-Liability Risk Cash Outflows Cash Inflows

3. Cash-Flow Risks Variation in Cash Flows Due to Relation Between Inflows and Outflows

4. Risk Management Product Prices Substitute Prices Exchange Rates Commodity Input Prices Fixed Asset Values Labor Costs Short-Term Borrowing Long-Term Borrowing

5. Asset-Liability Management • Focus on variability of cash flows • Main concern is to be able to make all contractual payment to avoid defaults • Secondary concern is to minimize risk (variability) • Third concern is to increase net cash flows by taking advantage of predictability in variations • Objective is to measure and manage variability in cash flows

6. Exposure to Risk • A general term to describe a firm’s exposure to a particular risk (e.g. a commodity price) is to classify the exposure as long or short • Long exposure means that the firm will benefit from increases in prices or values • Short exposure means that the firm will benefit from decreases in prices or values

7. Long Exposure • A firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples • The firm owns assets, as in inventories of raw materials or finished goods • The firm produces a commodity or product, as in an agribusiness raising wheat or livestock • The firm will take possession in the future or a commodity or an asset • The firm has bought a commodity or asset

8. Short Exposure • A firm (or individual) is short if at the time of the risk assessment if it needs or will need an asset or commodity. As examples • The firm is planning or has promised to deliver raw materials or finished goods • The firm uses a commodity or product in production as inputs, like steel or lumber • The firm will have possession in the future or a commodity or an asset it does not need or needs to sell • The firm has sold a commodity or asset and must deliver

9. Price Exposure in a Diagram Profit Profit Long 0 0 P0 P0 Loss Loss Short

10. Exposure to Risks

11. Examples of Exposure • Farmer with wheat is long wheat • Honey Baked Ham is short pork before Easter selling season • Treasurer with excess cash in three months is short investments • Company needing cash in nine months is long financial assets (its liabilities are others’ assets) to sell

12. Types of Derivative Contracts • Three basic types of contracts • Futures or forwards • Options • Swaps (we discuss next week) • Many basic underlying assets • Commodities • Currencies • Fixed incomes or residual claims

13. Futures Contracts • Wall Street Journal tables • Standardized contracts • Quantity and quality • Delivery date • Last trading date • Deliverables • Clearing house is counterparty • Margin requirements, mark to market

14. Forward vs. Futures Contracts • Bilateral contract (usually with a financial firm as counterparty) • Terms are tailor made to needs of corporate, not standardized • No exchange of cash until maturity of contract • Over-the-counter market not as liquid as organized exchange

15. Managing Risk with Futures • Offset price or interest rate risk with contract which moves in opposite direction • “Cross diagonally in the box” • Identify contract with price or interest rate which moves as close as possible with the price or interest rate exposure • Imperfect correlation is basis risk • Not using futures or forwards can be speculation

16. Bank Planning to Borrow Hedging Insurance Company Hedge Borrowing Hedge Insurance Company with Premiums

17. Forward Contracts • Example 1: GE is awarded a contract to supply turbine blades to British Air. On August 1, GE will receive ₤10 million. • How should GE hedge its risk?

18. Forward Market Hedge • Current spot price for ₤ 1 = $ 1.74 • Six month forward rate is ₤ DM 1 = $1.75 • Hedge future income by selling ₤ 10 million for delivery in one year (short in futures or forward market) • This transaction assures future revenue of $17.5 million without any cash flows today.

19. Possibilities • Say the spot price on December 1 is $1.70 per ₤ . • GE sells its ₤ 10 million for $1.75 per ₤ , yielding $17.5 million • If it had not hedged, its ₤ 10 million, at a rate of $1.70 would yield $17 million. • The forward is worth $0.5 million.

20. Possible Outcomes

21. Key Points • Revenues are guaranteed irrespective of exchange rate movements • The cost of hedging varies depending on exchange rate movements • Futures hedging is effective when the magnitude and timing of future currency cash flows is known • Pricing in dollars simply shifts risk

22. Options (Definition) • An option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date • call is right to buy, put is right to sell • strike or exercise price is a fixed price which determines conversion value • expiration date • Options on stocks, commodities, real estate, and future contracts

23. Call Options Profits at Maturity Profit Payoff to Buyer 0 Asset Value Strike Price

24. Call Writer’s (Seller’s) Profits Profit Strike Price Asset Value 0 Possible Cost to Writer Loss

25. Option Value Sensitivityto Price Changes in Assets Buy Call Buy Put S S Write Call Write Put

26. Managing Risk with Options • Similar to hedging risk with futures or forwards except that you only hedge again bad or adverse outcomes • Partially offset price or interest rate risk with contract which moves in opposite direction • Identify options with price or interest rate which moves as close as possible with the price or interest rate exposure but again imperfect correlation results in basis risk • Options only hedge against adverse outcome so they are similar to insurance and cost money

27. Foreign Currency Options • Useful if the timing of foreign currency cash flows is uncertain • Example 2: GE submits a bid to supply turbine blades to Lufthansa for ₤ 10 million • The funds will be received on August 1 only ifGE wins • How does GE hedge this risk?

28. Using Options • Selling ₤ forward is not the answer: GE may lose the bid and the ₤ may rise • Options solve the problem; GE buys put options to sell ₤ 10m on August 1 at a rate of, say, 1 ₤ = $1.70 • GE pays a bank $100,000 for the puts

29. Suppose GE Loses the Bid • If the rate is below $1.70, GE can buy ₤ DM in the market at a lower price and sell them for a profit by exercising the put. • If the rate is above $1.70, GE lets the option expire • Hedging costs in either event are $100,000 • If the puts are fairly priced GE will not suffer an expected loss even net of hedging costs

30. Suppose GE Wins the Bid • If the rate is below $1.70, GE exercises the put for $17m, using the ₤ 10 million paid by Lufthansa. • If the rate is above $1.70, GE lets the option expire, and converts the ₤ 10 million at the market rate • GE makes at least$17 million if it wins the bid, less the $100,000 cost of the option

31. Other Uses of Options • Use call options to hedge the risk of foreign tender offers • Hedge risk when quantity of cash flows is uncertain • Currency options can be used to protect profit margins and prevent frequent revisions of product prices abroad

32. Interest-Rate Derivatives • Interest rates and asset values move in opposite directions • Long cash means short assets • Short cash means long (someone else’s) asset • Basis risk comes from spreads between exposure and hedge instrument, e.g. default risk premiums • Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown

33. Caps, floors, and collars • If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note • If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call • A collar is a cap and a floor

34. Collars: Cap 6%, floor 4% Profit 0 9400 9500 9600 Loss

35. Other option developments • Credit risk options • Casualty risk options • Requirements for developing an option • Interest • Calculable payoffs • Enforceable

36. Replication Futures with Options Profit Profit Buy Call Long 0 0 P0 P0 Loss Loss Write Put

37. Next Week – February 23, 2006 • Review this week’s discussion to identify areas needing clarification • Read and prepare case Union Carbide Corporation Interest Rate Risk Management and identify issues in the case you have questions about • Review weekly Objectives and prepare for midterm examination due March 9, 2006