FM11 Ch 23 Derivatives and Risk Management

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
Risk management and stock value
maximization.

Derivative securities.

Fundamentals of risk management.

Using derivatives to reduce
interest rate risk.
CHAPTER 23
Derivatives and Risk Management
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
If volatility in cash flows is not caused by
systematic risk, then stockholders can
eliminate the risk of volatile cash flows
by diversifying their portfolios.

Stockholders might be able to reduce
impact of volatile cash flows by using
risk management techniques in their own
portfolios.
Do stockholders care about volatile
cash flows?
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How can risk management increase the
value of a corporation?
Risk management allows firms to:


Have greater debt capacity, which
has a larger tax shield of interest
payments.

Implement the optimal capital budget
without having to raise external
equity in years that would have had
low cash flow due to volatility.
(More )
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Risk management allows firms to:

Avoid costs of financial distress.

Weakened relationships with
suppliers.

Loss of potential customers.

Distractions to managers.

Utilize comparative advantage in
hedging relative to hedging ability of
investors.
(More )
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Risk management allows firms to:

Reduce borrowing costs by using
interest rate swaps.

Example: Two firms with different
credit ratings, Hi and Lo:
Hi can borrow fixed at 11% and
floating at LIBOR + 1%.
Lo can borrow fixed at 11.4% and
floating at LIBOR + 1.5%.
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Hi wants fixed rate, but it will issue
floating and “swap” with Lo. Lo wants
floating rate, but it will issue fixed and
swap with Hi. Lo also makes “side
payment” of 0.45% to Hi.
CF to lender -(LIBOR+1%) -11.40%
CF Hi to Lo -11.40% +11.40%
CF Lo to Hi +(LIBOR+1%) -(LIBOR+1%)
CF Lo to Hi +0.45% -0.45%
Net CF -10.95% -(LIBOR+1.45%)
(More )
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Risk management allows firms to:

Minimize negative tax effects due to
convexity in tax code.
Example: EBT of $50K in Years 1 and 2,
total EBT of $100K,
Tax = $7.5K each year, total tax of $15.
EBT of $0K in Year 1 and $100K in Year 2,
Tax = $0K in Year 1 and $22.5K in Year 2.
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Corporate risk management is the
management of unpredictable
events that would have adverse
consequences for the firm.
What is corporate risk management?
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
Speculative risks: Those that offer the
chance of a gain as well as a loss.

Pure risks: Those that offer only the
prospect of a loss.

Demand risks: Those associated with the
demand for a firm’s products or services.

Input risks: Those associated with a
firm’s input costs.
Definitions of Different Types of Risk
(More )
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Financial risks: Those that result from
financial transactions.

Property risks: Those associated with loss
of a firm’s productive assets.

Personnel risk: Risks that result from
human actions.


Environmental risk: Risk associated with
polluting the environment.

Liability risks: Connected with product,
service, or employee liability.

Insurable risks: Those which typically can
be covered by insurance.
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Step 1. Identify the risks faced by the
firm.
Step 2. Measure the potential impact of
the identified risks.
Step 3. Decide how each relevant risk
should be dealt with.
What are the three steps of
corporate risk management?
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
Transfer risk to an insurance company
by paying periodic premiums.

Transfer functions which produce risk
to third parties.

Purchase derivatives contracts to
reduce input and financial risks.
What are some actions that
companies can take to minimize

or reduce risk exposures?
(More )
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
Take actions to reduce the
probability of occurrence of
adverse events.

Take actions to reduce the
magnitude of the loss associated
with adverse events.

Avoid the activities that give rise
to risk.
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
Financial risk exposure refers to the
risk inherent in the financial markets
due to price fluctuations.

Example: A firm holds a portfolio of
bonds, interest rates rise, and the
value of the bonds falls.
What is a financial risk exposure?
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
Derivative: Security whose value stems or
is derived from the value of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.


Futures: Contracts which call for the
purchase or sale of a financial (or real) asset
at some future date, but at a price determined
today. Futures (and other derivatives) can be
used either as highly leveraged speculations
or to hedge and thus reduce risk.
Financial Risk Management Concepts
(More )
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Hedging: Generally conducted where
a price change could negatively affect a
firm’s profits.

Long hedge: Involves the purchase
of a futures contract to guard against
a price increase.

Short hedge: Involves the sale of a
futures contract to protect against a
price decline in commodities or
financial securities.
(More )
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
Swaps: Involve the exchange of cash
payment obligations between two
parties, usually because each party
prefers the terms of the other’s debt

contract. Swaps can reduce each
party’s financial risk.
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The purchase of a commodity
futures contract will allow a firm to
make a future purchase of the input
at today’s price, even if the market
price on the item has risen
substantially in the interim.
How can commodity futures markets
be used to reduce input price risk?
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
Risk identification and
measurement

Property loss, liability loss, and
financial loss exposures

Bond portfolio risk management
Chapter 23 Extension:
Insurance and Bond Portfolio
Risk Management
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
Large corporations have risk manage-
ment personnel which have the
responsibility to identify and measure
risks facing the firm.


Checklists are used to identify risks.

Small firms can obtain risk manage-ment
services from insurance companies or
risk management consulting firms.
How are risk exposures identified
and measured?
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
Property loss exposures: Result from
various perils which threaten a firm’s real
and personal properties.

Physical perils: Natural events

Social perils: Related to human
actions

Economic perils: Stem from external
economic events
Describe (1) “property” loss and
(2) “liability” loss exposures.
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
Liability loss exposures: Result from
penalties imposed when responsi-
bilities are not met.

Bailee exposure: Risks associated
with having temporary possession of

another’s property while some service
is being performed. (Cleaners ruin
your new suit.)

Ownership exposure: Risks inherent
in the ownership of property.
(Customer is injured from fall in store.)
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
Business operation exposure:
Risks arising from business
practices or operations. (Airline
sued following crash.)

Professional liability exposure:
Stems from the risks inherent in
professions requiring advanced
training and licensing. (Doctor
sued when patient dies, or
accounting firm sued for not
detecting overstated profits.)
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
Both property and liability exposures
can be accommodated by either self-
insurance or passing the risk on to an
insurance company.

The more risk passed on to an insurer,
the higher the cost of the policy.

Insurers like high deductibles, both to
lower their losses and to reduce moral
hazard.
What actions can companies take
to reduce property and
liability exposures?
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
By appropriately spreading business
risk over several activities or
operations, the firm can significantly
reduce the impact of a single random
event on corporate performance.

Examples: Geographic and product
diversification.
How can diversification reduce
business risk?