1 / 22

Risk Management

Risk Management. Corporate Finance MSc in Finance/Accounting & Finance. RM.1. Risk Management. Sources of risk Measurement of risk exposure Building blocks of risk management Motives for hedging Hedging with options Hedging with futures / forwards Workshop: Metallgesellschaft. RM.2.

yon
Download Presentation

Risk Management

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Risk Management Corporate Finance MSc in Finance/Accounting & Finance RM.1

  2. Risk Management • Sources of risk • Measurement of risk exposure • Building blocks of risk management • Motives for hedging • Hedging with options • Hedging with futures / forwards • Workshop: Metallgesellschaft RM.2

  3. Sources of Risk • Firms may be exposed to: • interest rate risk • foreign exchange risk • commodity risk • equity market movements RM.3

  4. Measurement of Risk Exposure • Risk exposure can be expressed in terms of a factor beta where is the stock return on firm i are the factors (j=1,…,K) are the factor betas is the firm-specific risk RM.4

  5. Measurement of Risk Exposure • Factor risk: • is undiversifiable and • can be hedged. • Specific risk: • is diversifiable; • cannot be hedged; • but can be insured. RM.5

  6. Building Blocks of Risk Management • Price fixing: • forward contract • obligation for owner to buy the underlying asset at a pre-specified price (forward price or delivery price) at a future date (maturity or settlement date) • if spot price at maturity > delivery price, owner makes a profit < delivery price, owner makes a loss • characteristics • no cash flows occur until maturity • subject to default risk by either counter-party RM.6

  7. Building Blocks of Risk Management • future contract • standardised forward contract • quantity • delivery month (March, June, September, December) • reduced risk of default • initial margin • marking to market RM.7

  8. Building Blocks of Risk Management • swap • agreement between two counter-parties to exchange the cash flows from one security against the cash flows from another security at given times • example: the Vanilla Swap Fixed rate at 5.75% Party A Party B LIBOR+50b.p. RM.8

  9. Building Blocks of Risk Management • Insurance: • options • caps • selling a put + risk-free asset • floors • buying a call + risk-free asset RM.9

  10. Motives for Hedging • In a Modigliani & Miller (1958) world where • investment policy is fixed and • there are no: • taxes • no bankruptcy costs • no agency problems investors will be indifferent between doing the hedging themselves and letting the firm do the hedging RM.10

  11. Motives for Hedging • The objective of managers is to maximise firm value: E(NCFi,t ) is the expected net cash flow r is the discount rate RM.11

  12. Motives for Hedging • Hedging only affects firm value, if it increases future cash flows • by reducing corporate tax • example probability 50% 50% EBT 700 -300 tax rate is 30% on profit, 0% on loss RM.12

  13. Motives for Hedging tax = 30% of 200 = 60

  14. Motives for Hedging • by reducing bankruptcy costs • the probability of bankruptcy increases with the variability of the firm’s value • the expected bankruptcy costs depend on the probability of bankruptcy • by reducing the variance of the firm’s value risk management can reduce the expected bankruptcy costs

  15. Motives for Hedging • by reducing agency costs • managerial remuneration should depend on factors that managers can influence • it should not depend on • interest rat e movements • fluctuations of foreign exchange rates • commodity prices • ... • by reducing the noise in the cash flows it becomes easier to evaluate performance

  16. Motives for Hedging • by improving investment decisions • in an MM world managers maximise firm value by accepting all non-negative NPV projects • equity is a call option on firm value • the higher the variability of the underlying the higher is the value of the option • shareholders have an incentive to gamble with the money of the debtholders • investment in negative NPV projects • debtholders may not invest in the firm a priori

  17. Motives for Hedging • by reducing the variability of firm value the under-investment problem can be mitigated

  18. Hedging with Options • Delta hedging: where c0 and p0 are the option premiums for the call and put respectively units of the underlying in the tracking portfolio • buy 1/ (hedge ratio) options per unit of the underlying • typically 0 

  19. Hedging with Options • dynamic hedging •  needs to be adjusted continuously to reflect changes in price of underlying and as time goes by • Covered option strategy: •  • loss/gain on underlying is exactly offset by gain/loss on option

  20. Hedging with Futures/Forwards • Naive hedging: • one forward/future contract per unit of the underlying • sale of good generating a constant gross revenue of G • raw materials with uncertain price of • net sales G - • payoff from forward - K where K is forward price • at maturity, the payoff is G - K

  21. Hedging with Futures/Forwards • Conventional hedging: • hedging which is not necessarily on a one-to-one basis • random cash flow • sale of  units of a financial instrument with random price of • total return is

  22. Hedging with Futures/Forwards • minimise variance of return • units of financial instrument are sold

More Related