2. CONTENTS:
•Classification of Risk
•Measurement of risk in non financial firms
•Principle of hedging
•Hedging with Forward, Futures, Swap, Options
Contracts, Insurance, Risk management products
•Financial Engineering and Corporate Strategy
•Risk management practices
3. CLASSIFICATION OF
RISK
The wide array of risks that a management firms exposed can be classified into 5
categories:
1.Technological Risk: arise mostly in the R&D and Operations stage of the value
chain.
2.Economic Risks: arise from fluctuations in the revenues(output price and
demand) and production cost ( Raw material cost, energy cost and labor cost)
3.Financial Risks: arise from volatility of Interest rates, currency rates, commodity
prices and stock prices.
4.Performance risks: arise when contracting counterparties do not fulfill their
obligations.
5.Legal and Regulatory risks: change in laws and regulations
4. MEASUREMENT OF RISK IN
NON FINANCIAL FIRMS
To assess the Financial price risk we may:
a)Examine the financial statements to get an idea of the
risk exposure
b)Assess the sensitivity of the firms value or cash flow to
changes in the financial prices and
c)Conduct monte carlo simulation.
5. EXAMINE THE
FINANCIAL STATEMENTS
Examining the Balance sheet and Profit & loss account throw light on a
number of questions like:
•Does the firm have a strong liquidity position as per high Current ratio
and Quick ratio? A strong liquidity position cushions against the volatility
of cash flows caused by changes in Financial prices.
•Does the firm have a low gearing ratio (leverage)? A low gearing ration
provides greater financial flexibility to cope with volatility in financial
prices.
•What is the Foreign exchange transaction exposure? If the balances of
receivables and payables are high, their values would change in response
to shifts in the exchange rates.
•Is the firm exposed to interest rate risk? If the firm relies mainly on free
floating debt it has a high interest rate exposure.
6. ASSESS THE SENSITIVITY
Determine the sensitivity of Firm’s Value or Cash Flow by:
•Analyzing the Historical data on firm value, cash flows and
financial prices
e.g. – The sensitivity of a firm’s value to exchange rate may be estimated as
Firm Value = a + b Exchange rate
7. MONTE CARLO SIMULATION
• Monte carlo methods are used in finance to value and analyze
(complex) instruments, portfolios and investments by simulating the
various sources of uncertainty affecting their value, and then
determining their average value over the range of resultant
outcomes.
• The advantage of monte carlo methods over other techniques
increases as the dimensions (sources of uncertainty) of the problem
increase.
8. PRINCIPLE OF HEDGING
• One way to manage these risks and uncertainties is to enter into transactions
that expose the entity to risk and uncertainty that fully or partially offsets one
or more of the entity’s other risks and uncertainties, transactions known as
‘hedges’.
• The instrument acquired to offset risk or uncertainty is known as ‘hedging
instrument’ and the risk or uncertainty hedged is known as ‘hedged item’.
• There are predominantly two motivations for a company to hedge:
To lock-in a future price which is attractive, relative to an organisation’s costs.
To secure a commodity price fixed against an external contract
9. HEDGING WITH
FORWARD CONTRACTS
• Forward contract is an OTC agreement between two parties, to buy or sell
an asset at a certain time in the future for a certain price.
• The price of the underlying instrument, in whatever form, is paid before
control of the instrument changes.
• This is one of the many forms of buy/sell orders where the time of trade is
not the time where the securities themselves are exchanged.
• The forward price is commonly contrasted with the spot price, which is the
price at which the asset changes hands on the spot date.
• The difference between the spot and the forward price is the forward
premium or forward discount, generally considered in the form of a profit or
loss, by the purchasing party.
10. HEDGING WITH FUTURE
CONTRACTS
What Does Futures Contract Mean?
A contractual agreement, generally made on the trading floor of a
futures exchange, to buy or sell a particular commodity or
financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying
asset; they are standardized to facilitate trading on a futures
exchange.
Some futures contracts may call for physical delivery of the
asset, while others are settled in cash.
11. TYPES OF FUTURE
CONTRACTS
There are many different kinds of futures contracts, reflecting the many different
kinds of "tradable" assets about which the contract may be based such as
commodities, securities (such as single-stock futures), currencies or intangibles
such as interest rates and indexes.
1.Foreign exchange market
2.Money market
3.Bond market
4.Equity market
5.Soft Commodities market
15. HEDGING WITH
SWAPS
What Does Swap Mean?
If firms in separate countries have comparative advantages on interest rates, then
a swap could benefit both firms.
For example, one firm may have a lower fixed interest rate, while another has
access to a lower floating interest rate. These firms could swap to take advantage
of the lower rates.
19. REASON FOR SWAPS
• Spread compression
• Market segmentation
• Market saturation
• Difference in financial norms
20. HEDGING WITH OPTION
CONTRACTS
An option contract is an agreement under which the seller of the option grants
the buyer the right, but not the obligation, to buy or sell(depending on whether it is
a call option or a put option) some asset at a predetermined price during the
specified period. The buyer of the option has to pay a premium to enjoy the right.
Forward vs options:
•In forwards contract both parties agree to act in the future whereas in an option
transaction occurs only if the buyer of the option chooses to exercise it.
•In forward contract no money exchanges hands whereas in options the buyer of
the contract pays option premium.
Hedging with options:diagrams
21. OPTIONS IN DEBT
CONTRACTS
Imagine a firm going for a long term floating rate loan
The risks involved are the interest rates rising sharply
increasing the debt service burden
22. HEDGING WITH
INSURANCE
Main advantages offered by Insurance companies:
•They can price the risks reasonably accurately
•Provides low cost administration service due to specialisation and economies
of scale.
•Provides advice on measures to reduce risks
•Pools risks by holding large diversified pool of assets
Disadvantages of Insurance:
•It incurs administrative costs
•Problem of adverse selection- cant differentiate between good and bad risks
•Exposed to problem of moral hazard
•Loading fee- diff between insurance premium and expected payoff.
23. TYPES OF OPTION
CONTRACTS
• Option contract on debt instruments- options on treasury bill
• Option contract on foreign currencies– options with British
pounds
• Option contract on stock market indices-option on S&P 500
index
• Option contract on stock index futures.
24. HEDGING WITH REAL
TOOLS AND OPTIONS
Real options-
•Diversify product line and services to reduce risks
•Invest in preventive maintenance
•Emphasise quality control to reduce product liability
•Build flexible production systems
•Shorten time to introduce product to market
•Delay investment until uncertainty is resolved
•Carry extra liquidity on the balance sheet to tide over difficult
periods
•Maintain reserve borrowing power to meet contingencies.
25. REAL VS. FINANCIAL
OPTIONS
• Real options cost a great deal.
• In some cases real options may be the only viable
means to handle risks
• Real options are far less liquid
• Firm with real options may profit from assuming
more risk – a firm with flexible production facilities
can benefit more by manufacturing products subject
to high price volatility.
26. EVOLUTION OF RISK
MANAGEMENT TOOLS
The financial and operating environment today is more
riskier than in the past –
•Substantial increase in the average rate as well as volatility
of inflation
•Greater volatility in interest rates , exchange rates, and
commodity prices
•Increased global competition.
27. VOLATILITY AND RISK
MANAGEMENT TOOLS:
• Exchange rate volatility- currency futures, currency
swaps, currency options
• Interest rate volatility- floating rate loans, T-Bill
futures, T-Bond futures, options on T-Bonds, caps
floors and collars.
• Petroleum prices- futures in heating oil, futures in
WTI, hybrids, option in WTI
• Metal price volatility- fwds, futures,
options,hybrids.
29. GUIDELINES FOR RISK
MANAGEMNET
• Align risk management with corporate strategy
• Proactively manage uncertainties
• Employ mix of real and financial methods
• Know the limits of risk management tools
• Don’t put undue pressure on corporate treasury
to generate profits
• Learn when it is worth reducing risk
