Chapter 23 risk management an introduction to financial engineering

Chapter 23
Risk Management:
An introduction to
Financial
Engineering
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills
•
Understand the risk exposure companies
face and how to hedge these risks
•
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
23-2

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
23-3

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
–
The company uses a VaR (Value at Risk) model to identify
the maximum 1-day loss in financial instruments
–
Derivative securities are used only for hedging, not

speculation
23-4

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
–
Quantity Demanded
23-5

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
23-6

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 conduct a better analysis of future projects
•
Available tools: forwards, futures, swaps, futures
options
23-7

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
23-8

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
23-9

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 greater the need to
manage that risk
23-10

Reducing Risk Exposure
•
The goal of hedging is to lessen the slope of the risk
profile
•
Hedging will not normally reduce risk completely
–
For most situations, 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
23-11

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
23-12

Figure 23.7
23-13

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
23-14

Futures Contracts
•
Futures 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
23-15

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
23-16

Hedging with Futures
•
The risk reduction capabilities of futures are
similar to those 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
23-17

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
23-18

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 a swap agreement, both A and B are better off than
they would be borrowing from the bank with their preferred type of
loan, and the swap dealer makes .5%
Pay Receive Net
Company A LIBOR + .5% 8.5% -LIBOR
Swap Dealer w/A 8.5% LIBOR + .5%
Company B 9% LIBOR + .5% -9%
Swap Dealer w/B LIBOR + .5% 9%
Swap Dealer Net LIBOR + 9% LIBOR + 9.5% +.5%
23-19

Figure 23.10
23-20

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
23-21

Payoff Profiles: Calls
23-22

Payoff Profiles: Puts
23-23

Hedging Commodity Price
Risk with Options
•
“Commodity” options are generally futures options
•
Exercising a call

–
Owner of the 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 the 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 the 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 the put receives a long position in the futures
contract and pays cash equal to the difference between the
futures price and the exercise price
23-24

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
•
U.S. 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
23-25