Topic 8 Managing Risk

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  • 1. Risk Management
  • 2. Outline
    • Hedging and Price Volatility
    • Managing Financial Risk
    • Hedging with Forward Contracts
    • Hedging with Futures Contracts
    • Hedging with Swap Contracts
    • Hedging with Option Contracts
  • 3. 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
  • 4. 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
  • 5. 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 do a better analysis of future projects
    • Available tools: forwards, futures, swaps, futures options
  • 6. 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
  • 7. 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
  • 8. 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 more a firm needs to manage that risk
  • 9. 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
  • 10. 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
  • 11. Forward contract payoff
  • 12. 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
  • 13. 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
  • 14. 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
  • 15. 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
  • 16. 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%
    +.5% LIBOR + 9.5% LIBOR + 9% Swap Dealer Net -9% -LIBOR Net LIBOR + .5% 8.5% Swap Dealer w/A LIBOR + .5% 9% Company B 9% LIBOR + .5% Swap Dealer w/B 8.5% LIBOR + .5% Company A Receive Pay
  • 17. Interest rate Swap
  • 18. 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
  • 19. Payoff Profiles: Calls
  • 20. Payoff Profiles: Puts
  • 21. 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
  • 22. 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. Hedging Interest Rate Risk with Options
    • Can use futures options
    • Large OTC market for interest rate options
    • Caps, Floors, and Collars
      • Interest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates)
      • Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)
      • Collar – buy a call and sell a put
        • The premium received from selling the put will help offset the cost of buying the call
        • If set up properly, the firm will not have either a cash inflow or outflow associated with this position
  • 24. Quick Quiz
    • What are the four major types of derivatives discussed in the chapter?
    • How do forwards and futures differ? How are they similar?
    • How do swaps and forwards differ? How are they similar?
    • How do options and forwards differ? How are they similar?