Topic 8 Managing Risk

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  • Topic 8 Managing Risk

    1. 1. Risk Management
    2. 2. Outline <ul><li>Hedging and Price Volatility </li></ul><ul><li>Managing Financial Risk </li></ul><ul><li>Hedging with Forward Contracts </li></ul><ul><li>Hedging with Futures Contracts </li></ul><ul><li>Hedging with Swap Contracts </li></ul><ul><li>Hedging with Option Contracts </li></ul>
    3. 3. Hedging Volatility <ul><li>Recall that volatility in returns is a classic measure of risk </li></ul><ul><li>Volatility in day-to-day business factors often leads to volatility in cash flows and returns </li></ul><ul><li>If a firm can reduce that volatility, it can reduce its business risk </li></ul><ul><li>Instruments have been developed to hedge the following types of volatility </li></ul><ul><ul><li>Interest Rate </li></ul></ul><ul><ul><li>Exchange Rate </li></ul></ul><ul><ul><li>Commodity Price </li></ul></ul><ul><ul><li>Quantity Demanded </li></ul></ul>
    4. 4. Interest Rate Volatility <ul><li>Debt is a key component of a firm’s capital structure </li></ul><ul><li>Interest rates can fluctuate dramatically in short periods of time </li></ul><ul><li>Companies that hedge against changes in interest rates can stabilize borrowing costs </li></ul><ul><li>This can reduce the overall risk of the firm </li></ul><ul><li>Available tools: forwards, futures, swaps, futures options and options </li></ul>
    5. 5. Exchange Rate Volatility <ul><li>Companies that do business internationally are exposed to exchange rate risk </li></ul><ul><li>The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency </li></ul><ul><li>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 </li></ul><ul><li>Available tools: forwards, futures, swaps, futures options </li></ul>
    6. 6. Commodity Price Volatility <ul><li>Most firms face volatility in the costs of materials and in the price that will be received when products are sold </li></ul><ul><li>Depending on the commodity, the company may be able to hedge price risk using a variety of tools </li></ul><ul><li>This allows companies to make better production decisions and reduce the volatility in cash flows </li></ul><ul><li>Available tools (depend on type of commodity): forwards, futures, swaps, futures options, options </li></ul>
    7. 7. The Risk Management Process <ul><li>Identify the types of price fluctuations that will impact the firm </li></ul><ul><li>Some risks are obvious; others are not </li></ul><ul><li>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 </li></ul><ul><li>You must also look at the cost of managing the risk relative to the benefit derived </li></ul><ul><li>Risk profiles are a useful tool for determining the relative impact of different types of risk </li></ul>
    8. 8. Risk Profiles <ul><li>Basic tool for identifying and measuring exposure to risk </li></ul><ul><li>Graph showing the relationship between changes in price versus changes in firm value </li></ul><ul><li>Similar to graphing the results from a sensitivity analysis </li></ul><ul><li>The steeper the slope of the risk profile, the greater the exposure and the more a firm needs to manage that risk </li></ul>
    9. 9. Reducing Risk Exposure <ul><li>The goal of hedging is to lessen the slope of the risk profile </li></ul><ul><li>Hedging will not normally reduce risk completely </li></ul><ul><ul><li>For most situations, only price risk can be hedged, not quantity risk </li></ul></ul><ul><ul><li>You may not want to reduce risk completely because you miss out on the potential upside as well </li></ul></ul><ul><li>Timing </li></ul><ul><ul><li>Short-run exposure (transactions exposure) – can be managed in a variety of ways </li></ul></ul><ul><ul><li>Long-run exposure (economic exposure) – almost impossible to hedge - requires the firm to be flexible and adapt to permanent changes in the business climate </li></ul></ul>
    10. 10. Forward Contracts <ul><li>A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date </li></ul><ul><li>Forward contracts are legally binding on both parties </li></ul><ul><li>They can be tailored to meet the needs of both parties and can be quite large in size </li></ul><ul><li>Positions </li></ul><ul><ul><li>Long – agrees to buy the asset at the future date </li></ul></ul><ul><ul><li>Short – agrees to sell the asset at the future date </li></ul></ul><ul><li>Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations </li></ul>
    11. 11. Forward contract payoff
    12. 12. Hedging with Forwards <ul><li>Entering into a forward contract can virtually eliminate the price risk a firm faces </li></ul><ul><ul><li>It does not completely eliminate risk unless there is no uncertainty concerning the quantity </li></ul></ul><ul><li>Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor </li></ul><ul><li>The firm also has to spend some time and/or money evaluating the credit risk of the counterparty </li></ul><ul><li>Forward contracts are primarily used to hedge exchange rate risk </li></ul>
    13. 13. Futures Contracts <ul><li>Futures contracts traded on an organized securities exchange </li></ul><ul><li>Require an upfront cash payment called margin </li></ul><ul><ul><li>Small relative to the value of the contract </li></ul></ul><ul><ul><li>“Marked-to-market” on a daily basis </li></ul></ul><ul><li>Clearinghouse guarantees performance on all contracts </li></ul><ul><li>The clearinghouse and margin requirements virtually eliminate credit risk </li></ul>
    14. 14. Hedging with Futures <ul><li>The risk reduction capabilities of futures are similar to those of forwards </li></ul><ul><li>The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur </li></ul><ul><li>Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires </li></ul><ul><li>Credit risk is virtually nonexistent </li></ul><ul><li>Futures contracts are available on a wide range of physical assets, debt contracts, currencies and equities </li></ul>
    15. 15. Swaps <ul><li>A long-term agreement between two parties to exchange cash flows based on specified relationships </li></ul><ul><li>Can be viewed as a series of forward contracts </li></ul><ul><li>Generally limited to large creditworthy institutions or companies </li></ul><ul><li>Interest rate swaps – the net cash flow is exchanged based on interest rates </li></ul><ul><li>Currency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates </li></ul>
    16. 16. Example: Interest Rate Swap <ul><li>Consider the following interest rate swap </li></ul><ul><ul><li>Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed) </li></ul></ul><ul><ul><li>Company B can borrow from a bank at 9.5% fixed or LIBOR + .5% (borrows floating) </li></ul></ul><ul><ul><li>Company A prefers floating and Company B prefers fixed </li></ul></ul><ul><ul><li>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% </li></ul></ul>+.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. 17. Interest rate Swap
    18. 18. Option Contracts <ul><li>The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date </li></ul><ul><ul><li>Call – right to buy the asset </li></ul></ul><ul><ul><li>Put – right to sell the asset </li></ul></ul><ul><ul><li>Exercise or strike price –specified price </li></ul></ul><ul><ul><li>Expiration date – specified date </li></ul></ul><ul><li>Buyer has the right to exercise the option; the seller is obligated </li></ul><ul><ul><li>Call – option writer is obligated to sell the asset if the option is exercised </li></ul></ul><ul><ul><li>Put – option writer is obligated to buy the asset if the option is exercised </li></ul></ul><ul><li>Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential </li></ul><ul><li>Pay a premium for this benefit </li></ul>
    19. 19. Payoff Profiles: Calls
    20. 20. Payoff Profiles: Puts
    21. 21. Hedging Commodity Price Risk with Options <ul><li>“ Commodity” options are generally futures options </li></ul><ul><li>Exercising a call </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><li>Exercising a put </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>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 </li></ul></ul>
    22. 22. Hedging Exchange Rate Risk with Options <ul><li>May use either futures options on currency or straight currency options </li></ul><ul><li>Used primarily by corporations that do business overseas </li></ul><ul><li>U.S. companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars) </li></ul><ul><li>Buy puts (sell calls) on foreign currency </li></ul><ul><ul><li>Protected if the value of the foreign currency falls relative to the dollar </li></ul></ul><ul><ul><li>Still benefit if the value of the foreign currency increases relative to the dollar </li></ul></ul><ul><ul><li>Buying puts is less risky </li></ul></ul>
    23. 23. Hedging Interest Rate Risk with Options <ul><li>Can use futures options </li></ul><ul><li>Large OTC market for interest rate options </li></ul><ul><li>Caps, Floors, and Collars </li></ul><ul><ul><li>Interest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates) </li></ul></ul><ul><ul><li>Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates) </li></ul></ul><ul><ul><li>Collar – buy a call and sell a put </li></ul></ul><ul><ul><ul><li>The premium received from selling the put will help offset the cost of buying the call </li></ul></ul></ul><ul><ul><ul><li>If set up properly, the firm will not have either a cash inflow or outflow associated with this position </li></ul></ul></ul>
    24. 24. Quick Quiz <ul><li>What are the four major types of derivatives discussed in the chapter? </li></ul><ul><li>How do forwards and futures differ? How are they similar? </li></ul><ul><li>How do swaps and forwards differ? How are they similar? </li></ul><ul><li>How do options and forwards differ? How are they similar? </li></ul>

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