Risk Management

Outline

Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Futures Contracts Hedging with Swap Contracts Hedging with Option Contracts

Hedging Volatility

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

2

Interest Rate Volatility

Debt is a key component of a firms 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
3

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 firms 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

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
5

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
6

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
7

Forward contract payoff

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 companys 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
9

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
10

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

11

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

12

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
13

Payoff Profiles: Calls

Buy a call with E = $40
70 60 50
Payoff

Sell a Call E = $40

0 -10 0 -20 20 40 60 80 100

40 30 20 10 0 0 20 40 60 80 100 Stock Price

Payoff

-30 -40 -50 -60 -70 Stock Price

14

Payoff Profiles: Puts

Buy a put with E = $40
45 40 35 30 25 20 15 10 5 0 0 20 40 60 80 100 Stock Price
15

Sell a Put E = $40

0 -5 0 -10 -15 20 40 60 80 100

Payoff

Payoff

-20 -25 -30 -35 -40 -45 Stock Price

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?
16