1. BASICS OF FINANCIAL RISK MANAGEMENT
CAS / ARIA Financial Risk Management Seminar -- Denver, CO
April, 1999
Rick Gorvett, FCAS, Ph.D.
The College of Insurance

2. BACKGROUND AND MOTIVATION

3. WHY SHOULD WE STUDY FINANCIAL RISK MANAGEMENT?
To better understand the nature and volatility of financial markets
To understand the development of new financial products -- e.g., derivatives and hybrid securities
To understand how these products can be used to change a firm’s risk profile and protect its financial condition

4. UNPREDICTABILITY Interest rates Commodity prices FX rates
Inflation, cash flows (investing / lending), asset and liability values
Late 1970s -- Volcker / FED policy change
Commodity prices
Costs, substitute products
Price shocks -- OPEC, Kuwait
FX rates
International cash flows, relative competitiveness
Early 1970s -- Breakdown of Bretton Woods

5. FINANCIAL RISKS -- EXAMPLES
Interest rates
Savings & Loans
Inversion of yield curve around 1980
Commodity prices
Continental Airlines
Price of fuel after Iraq invaded Kuwait
Foreign exchange
Laker Airlines
Strengthening of US$ relative to pound in 1981

6. FINANCIAL RISK MANAGEMENT: A BROAD FRAMEWORK
FRM can take several (familiar and unfamiliar) forms
Asset hedges
Liability hedges
Asset-liability management
Contingent financing
Post-loss financing and recapitalization

7. WHY DO CORPORATIONS USE FINANCIAL DERIVATIVES?
Transaction hedges
FX; debt
Currency and interest rate risk
Strategic (economic) hedges
Protect cash flows or company value from movements in financial prices
Reduce funding costs
FX; synthetic debt
Trading derivatives for profit

8. WHY DON’T CORPORATIONS USE MORE DERIVATIVES?
Credit risk
No suitable instrument
Lack of knowledge
Accounting / legal issues
Transaction costs
Resistance by Board / upper management

9. VOCABULARY
Financial derivative: a financial instrument whose value is a function of another (“underlying”) financial instrument
Financial engineering: the creation and use of financial derivatives to aid in the management of risk
Risk profile: describes the effect of changes in a financial price on the value of a firm

10. FORWARDS AND FUTURES

11. FORWARD CONTRACTS Obligation / agreement to buy/sell in the future
Contract price is the “exercise price”; no payment until maturity
Physical delivery or cash-settled
Buyer (holder) is “long”; seller (writer) is “short
OTC -- can be tailored
Two-sided risk

12. FUTURES CONTRACTS Obligation; agree to a future transaction
Traded on organized exchanges
Standardized
Daily settlement (marking to market)
Reduces default risk: essentially, a series of one-day contracts
Margins (performance bonds)
Initial margin
Maintenance margin
Margin call
Exchange clearinghouse

13. EXCHANGES VS. OTC Exchanges Advantages Disadvantages OTC Markets
Clearinghouse
Liquidity
Standardization
Disadvantages
Lack of flexibility
Regulation
Trading costs
Public
OTC Markets
Disadvantages
Credit risk
Low liquidity
Non-standardization
Advantages
Flexible
Less regulation
Lower regulatory costs
Private

14. TYPES OF CONTRACTS Agricultural commodities Other commodities
Wheat, corn, soybeans
Farmer (supplier) can lock in sales price before harvest (short futures)
Consumer (user) can lock in purchase price (long futures)
Other commodities
Metals, petroleum
Financial assets
FX, stock market indices, interest rates

15. EXAMPLE
Ann agrees to buy from Bill one barrel of oil, five months from now, for $20
Ann is in the “long” position
Bill is in the “short” position
If the price of oil is $25 five months from now, who pays to whom, and how much?
If the price of oil is $12 five months from now, who pays to whom, and how much?

16. OPTIONS

17. OPTIONS Option to buy or sell the underlying asset
Right, not obligation
Call option: right to buy the U/L asset
Put option: right to sell the U/L asset
Buyer = holder = long position (option to exercise)
Seller = writer = short position

18. PARAMETERS OF OPTIONS
Exercise price = strike price = price at which the holder of the option can exercise the option (and thus buy or sell the underlying asset)
Expiration date
Premium = amount paid for the option
American option: can exercise any time up to and including expiration date
European option: can exercise only on expiration date

19. EXAMPLES OF OPTIONS -- THEY’RE EVERYWHERE
Traded options
On stocks, indices, FX, interest rates, futures, swaps, options,...
Convertible bonds
Call provisions on bonds
On projects
To expand, abandon, postpone
Insurance

20. EXAMPLE
Amy sells Bob a January European call option on one share of Compaq stock
Suppose Compaq stock is trading at 32.5
Exercise price = 35
Premium = 3
In January, suppose: ST=30 ST=40
Total payoff [profit/loss]
Amy: 0 [3] -5 [-2]
Bob: 0 [-3] 5 [2]

21. OPTION VALUES (cont.) Prior to expiration: Call Put
In-the-money St > X St < X
At-the-money St = X St = X
Out-of-the-money St < X St > X
Intrinsic value - profit that could be made if the option was immediately exercised
Call: stock price - exercise price
Put: exercise price - stock price
Time value - the difference between the option price and the intrinsic value

22. OPTION VALUES: PAYOFF CHART
Call -- long position
Call -- short position
Put -- long position
Put -- short position
Payoff ST X

23. PUT-CALL PARITY
Arbitrage implies a certain relationship between put, call, and underlying asset prices
Two portfolios have, at payoff, identical values:
One European call option + cash of PV(X)
One European put option + one share of stock
C + PV(X) = P + S

24. BLACK-SCHOLES FORMULA
VC = S N(d1) - X e-rt N(d2)
d1 = [ln(S/X)+(r+0.5s2)t] / st0.5
d2 = d1 - st0.5

25. PURPOSES OF DERIVATIVES
Speculative
Highly risky
Highly leveraged
Very volatile
Hedging
Combine with other securities
Hedge (minimize) risk from other securities

26. HEDGING “Hedge”: Take a position that offsets a risk
Risk: Uncertainty regarding the value of
the underlying asset
By hedging, one changes the risk inherent in owning the underlying asset
The return distribution of the underlying asset is not changed

27. USING OPTIONS TO HEDGE
Combine the underlying asset with an option or options
Can reduce or eliminate downside risk while retaining upside potential
Can protect against falls in held asset values, or against increases in input prices

28. OPTION STRATEGIES Protective put Covered call Straddle Spread
Own stock (long position)
Own put (long position)
Covered call
Sell call (short position)
Straddle
Spread

29. PROTECTIVE PUT Investor owns asset
Investor also buys (holds) a put on the asset
Guarantees investment portfolio proceeds at least equal to the exercise price of the put + =

30. PROTECTIVE PUT EXAMPLE
Suppose you own a share of stock, and you purchase a put option with an exercise price of 22.5 on that stock, for a premium of $ 0.75
ST :
Premium:
Put Payoff:
=== === === ===
Overall:

31. COVERED CALL Investor purchases stock
Investor also sells (writes) a call option on the stock
Option position is “covered” by owning the underlying stock itself
(vs. “naked option”)
Provides additional (premium) income = +

32. COVERED CALL EXAMPLE
Suppose you own a share of stock, and you write a call option with an exercise price of 35 on that stock, for a premium of $ 2.00
ST :
Premium:
Call Payoff:
=== === === ===
Overall:

33. STRADDLE (Long) Straddle: buy both a call and a put on a stock
Each option has the same exercise price and expiration date
Believe stock will be relatively volatile
Worst-case: no movement in stock price

34. SPREAD Combination of options
Two or more calls, or
Two or more puts
Vertical spread: simultaneous sale and purchase of options with different exercise prices
Horizontal spread: sale and purchase of options with different expiration dates

35. INTEREST RATE OPTIONS Cap: a call option on an interest rate
Floor: a put option on an interest rate
Collar: simultaneously buying a cap and selling a floor
These options can be used to hedge rate-sensitive debt and assets

36. INTEREST RATE OPTIONS: TERMINOLOGY
Underlying index: interest rate being hedged or speculated upon; e.g., LIBOR, prime rate
Strike rate: determines cash flows (similar to exercise price)
Settlement frequency: how often the strike rate and underlying index are compared
Notional amount: principal to which the interest rate is applied
Up-front premium: paid by purchaser to seller for the option

37. INTEREST RATE CAPS
At each settlement date, check whether index rate is greater than strike rate
If not, cap purchaser does not receive cash flows
If so, purchaser receives from seller:
[ (index rate - strike rate) x
(days in settlement period / 360) x
notional amount ]

38. INTEREST RATE CAPS: EXAMPLE
$20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8%
Cost: 150 basis points
Up-front premium = x $20M = $300,000
If 3-month LIBOR = 9%, seller pays
( ) x 90/360 x $20M
= $50,000 (for that quarter)

39. INTEREST RATE FLOORS
At each settlement date, check whether index rate is greater than strike rate
If so, floor purchaser does not receive cash flows
If not, purchaser receives from seller:
[ (strike rate - index rate) x
(days in settlement period / 360) x
notional amount ]

40. INTEREST RATE COLLARS
Purchase a cap to hedge floating-rate liabilities
Sell a floor at a lower strike rate
Sale of floor helps finance purchase of cap
Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates
Can achieve zero-premium collar

41. SWAPS

42. SWAPS Agreement between two parties Two major types
“Counterparties”
Exchange sets of future cash flows
Two major types
Interest rate swaps
Currency swaps
Relatively new FRM tool

43. SWAPS VS. FUTURES Futures Swaps Standardized Exchange-traded
Short horizons
Swaps
Custom tailored between counterparties
Little regulation; potential for privacy
Term flexibility

44. INTEREST RATE SWAPS
One party pays a fixed interest rate and receives a floating rate
The other party pays a floating rate and receives a fixed rate
Floating rates involve greater exposure to interest rate risk
“Notional principal” is amount on which the interest payments are determined

45. INTEREST RATE SWAPS (cont.)
Principal is not actually exchanged -- only interest payments
Generally, only net interest payments are transacted
Avoids unnecessary transactions
Helps credit risk
At each “settlement date,” a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

46. CURRENCY SWAPS
One party holds one currency, and desires a different currency
Three sets of cash flows:
Exchange principal at inception of swap
Periodic interest payments
Exchange principal at termination of swap
Interest rates fixed ==> only change in value is from FX change
Generally, only make net payments

47. LIMITATIONS OF SWAPS Counterparties must find each other
Meet specific needs
Cost, time; facilitators
Lack of “liquidity”; difficult to unwrap / trade / change without consent of other party
Credit risk of counterparty

48. DEVELOPMENT OF SWAP MARKET
Originally:
Unique contracts
Had to search for counterparty
Investment banks were dominant intermediaries
More recently:
More standardized and liquid
Intermediaries accept contract, then lay off risk
More highly capitalized firms -- e.g., commercial banks