1. Off-Balance Sheet Managing Risk

2. Off-Balance Sheet Liabilities on the balance sheet represent liabilities that are both firm and quantifiable. Liabilities on the balance sheet represent liabilities that are both firm and quantifiable. Some liabilities are not on the balance sheet because they are either not firm (such as risks), or not quantifiable (meaning the actual dollar liability is unknown). Some liabilities are not on the balance sheet because they are either not firm (such as risks), or not quantifiable (meaning the actual dollar liability is unknown).

3. OBS Financing The most common off-balance sheet financing is an operating lease. The most common off-balance sheet financing is an operating lease. Capital leases show up on the balance sheet, but operating leases do not. Capital leases show up on the balance sheet, but operating leases do not. Analysts can estimate a value to put them on the balance sheet. Analysts can estimate a value to put them on the balance sheet.

4. OBS Pension A long-term liability receiving more attention today is pension agreements. A long-term liability receiving more attention today is pension agreements. There are two main types of pensions: There are two main types of pensions: Defined contribution Defined contribution Defined benefit Defined benefit

5. OBS Defined Contribution With a defined contribution pension, the company is only liable for the contribution. With a defined contribution pension, the company is only liable for the contribution. As long as they have made the contribution to a pension fund as they agreed, their liability is over. As long as they have made the contribution to a pension fund as they agreed, their liability is over.

6. OBS Defined Benefit With the defined benefit plan, the company agreed to pay the employee a certain living (and sometime health insurance) until they die. With the defined benefit plan, the company agreed to pay the employee a certain living (and sometime health insurance) until they die. The amount of liability is unknown, and therefore not stated on the balance sheet. The amount of liability is unknown, and therefore not stated on the balance sheet. They have assets to offset some of these costs – but they tend to be insufficient. They have assets to offset some of these costs – but they tend to be insufficient.

7. Managing Risk In a firms attempt to manage its risk, it can incur off-balance sheet liabilities. In a firms attempt to manage its risk, it can incur off-balance sheet liabilities. These activities can (in some instances must) be disclosed in the notes to the financial statements. These activities can (in some instances must) be disclosed in the notes to the financial statements.

8. Managing Risks Risk reduction does not add value Risk reduction does not add value Hedging is a zero sum game Hedging is a zero sum game Investors always have a do-it- yourself alternative Investors always have a do-it- yourself alternative How? How? Insurance (may not be disclosed) Insurance (may not be disclosed) Hedging (must be disclosed) Hedging (must be disclosed)

9. Insurance Most businesses face the possibility of a hazard that can bankrupt the company in an instant. Most businesses face the possibility of a hazard that can bankrupt the company in an instant. These risks are neither financial or business and can not be diversified. These risks are neither financial or business and can not be diversified. The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk. The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.

10. Hedging Spot Contract - A contract for immediate sale & delivery of an asset. Spot Contract - A contract for immediate sale & delivery of an asset. Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.

11. Futures Contracts Margins – required to put up a portion of the purchase price now to demonstrate financial ability. Margins – required to put up a portion of the purchase price now to demonstrate financial ability. Marked to Market – The change in market prices are adjusted daily; you may pay more, or receive partial refunds depending on the spot market for that good. Marked to Market – The change in market prices are adjusted daily; you may pay more, or receive partial refunds depending on the spot market for that good.

12. Futures Contract The basic relationship between futures prices and spot prices for equity securities.

13. Futures Contracts The basic relationship between futures prices and spot prices for commodities.

14. Options In addition to futures, firms can be commodity, financial and currency options. In addition to futures, firms can be commodity, financial and currency options. An option allows the holder to buy (call) or sell (put) a product, commodity or currency at an agreed upon rate. An option allows the holder to buy (call) or sell (put) a product, commodity or currency at an agreed upon rate. But they do not need to exercise that option. But they do not need to exercise that option.

15. Swaps Definition - An agreement between two firms, in which each firm agrees to exchange the interest rate characteristics of two different financial instruments of identical principal. Definition - An agreement between two firms, in which each firm agrees to exchange the interest rate characteristics of two different financial instruments of identical principal.

16. Swaps Key points regarding interest rate swaps: Key points regarding interest rate swaps: Know whether your company is the fixed rate payer (usually) or the floating rate payer. Know whether your company is the fixed rate payer (usually) or the floating rate payer. Note that usually, the maturity of the note is affected by the market rate. Note that usually, the maturity of the note is affected by the market rate. Who are the counterparties? Who are the counterparties? Swap gain = Fixed spread – Variable spread Swap gain = Fixed spread – Variable spread

17. Swaps Currency swaps: Swapping currency streams. Currency swaps: Swapping currency streams. For example - borrowing in dollars, and repaying in yen (via a swap arrangement). For example - borrowing in dollars, and repaying in yen (via a swap arrangement). In some instances, a counterparty may be found who wants to do the other end of the agreement In some instances, a counterparty may be found who wants to do the other end of the agreement Sometimes it is just a speculator. Sometimes it is just a speculator.

18. Hedging A true hedge is one where risk is reduced to zero. A true hedge is one where risk is reduced to zero. You sell a futures contract for 10,000 bushels of corn, and you have the 10,000 bushels of corn. You sell a futures contract for 10,000 bushels of corn, and you have the 10,000 bushels of corn. Many firms believe they are hedging, and reducing risks when they can in fact be increasing their risks. Many firms believe they are hedging, and reducing risks when they can in fact be increasing their risks.