Presentation on theme: "Key Concepts and Skills"— Presentation transcript:
0Risk Management: An Introduction to Financial Engineering ChapterTwenty- ThreeRisk Management: An Introduction to Financial Engineering
1Key Concepts and Skills Understand the types of volatility that companies can manageUnderstand how to develop risk profilesUnderstand the difference between forward contracts and futures contracts and how they are used for hedgingUnderstand how swaps can be used for hedgingUnderstand how options can be used for hedging
2Chapter OutlineHedging and Price VolatilityManaging Financial RiskHedging with Forward ContractsHedging with Futures ContractsHedging with Swap ContractsHedging with Option Contracts
3Example: Disney’s Risk Management Policy Disney provides stated policies and procedures concerning risk management strategies in its annual reportThe company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investmentsInterest rate swaps are used to manage interest rate exposureOptions and forwards are used to manage foreign exchange risk in both assets and anticipated revenuesDerivative securities are used only for hedging, not speculationClick on the web surfer to go to the Disney annual report page.Go to the 2001 annual report, click on financials: Walt Disney Company and subsidiariesInformation on the risk management policy is found on page 11 of the adobe file (page 59 of the annual report).
4Recall that volatility in returns is a classic measure of risk Hedging VolatilityRecall that volatility in returns is a classic measure of riskVolatility in day-to-day business factors often leads to volatility in cash flows and returnsIf a firm can reduce that volatility, it can reduce its business riskInstruments have been developed to hedge the following types of volatilityInterest RateExchange RateCommodity Price
5Interest Rate Volatility Debt is a key component of a firm’s capital structureInterest rates can fluctuate dramatically in short periods of timeCompanies that hedge against changes in interest rates can stabilize borrowing costsThis can reduce the overall risk of the firmAvailable tools: forwards, futures, swaps, futures options and options
6Exchange Rate Volatility Companies that do business internationally are exposed to exchange rate riskThe more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currencyIf a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and do a better analysis of future projectsAvailable tools: forwards, futures, swaps, futures options
7Commodity Price Volatility Most firms face volatility in the costs of materials and in the price that will be received when products are soldDepending on the commodity, the company may be able to hedge price risk using a variety of toolsThis allows companies to make better production decisions and reduce the volatility in cash flowsAvailable tools (depend on type of commodity): forwards, futures, swaps, futures options, options
8The Risk Management Process Identify the types of price fluctuations that will impact the firmSome risks are obvious, others are notSome 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 separatelyYou must also look at the cost of managing the risk relative to the benefit derivedRisk profiles are a useful tool for determining the relative impact of different types of risk
9Risk ProfilesBasic tool for identifying and measuring exposure to riskGraph showing the relationship between changes in price versus changes in firm valueSimilar to graphing the results from a sensitivity analysisThe steeper the slope of the risk profile, the greater the exposure and the more a firm needs to manage that risk
10Reducing Risk Exposure The goal of hedging is to lessen the slope of the risk profileHedging will not normally reduce risk completelyOnly price risk can be hedged, not quantity riskYou may not want to reduce risk completely because you miss out on the potential upside as wellTimingShort-run exposure (transactions exposure) – can be managed in a variety of waysLong-run exposure (economic exposure) – almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate
11Forward ContractsA contract where two parties agree on the price of an asset today to be delivered and paid for at some future dateForward contracts are legally binding on both partiesThey can be tailored to meet the needs of both parties and can be quite large in sizePositionsLong – agrees to buy the asset at the future dateShort – agrees to sell the asset at the future dateBecause they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations
13Hedging with ForwardsEntering into a forward contract can virtually eliminate the price risk a firm facesIt does not completely eliminate risk unless there is no uncertainty concerning the quantityBecause it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favorThe firm also has to spend some time and/or money evaluating the credit risk of the counterpartyForward contracts are primarily used to hedge exchange rate risk
14Forward contracts traded on an organized securities exchange Futures ContractsForward contracts traded on an organized securities exchangeRequire an upfront cash payment called marginSmall relative to the value of the contract“Marked-to-market” on a daily basisClearinghouse guarantees performance on all contractsThe clearinghouse and margin requirements virtually eliminate credit risk
15Futures Quotes See Table 23.1 Commodity, exchange, size, quote units The contract size is important when determining the daily gains and losses for marking-to-marketDelivery monthOpen price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interestThe change in settlement price times the contract size determines the gain or loss for the dayLong – an increase in the settlement price leads to a gainShort – an increase in the settlement price leads to a lossOpen interest is how many contracts are currently outstandingExample: Consider the quote for corn.It trades on the Chicago Board of Trade (CBT)The contract size is for 5000 bushelsThe price is quoted in cents per bushel, so a settlement price of 218 ½ is really $2.185 per bushelExample of marking-to-marketConsider the December corn contract. The change is -1 cent per bushel.A long position would have a loss of .01(5000) = $50; so their margin account would be reduced by $50 per contractA short position would have a gain of $50, so their margin account would be increased by $50 per contract
16Hedging with FuturesThe risk reduction capabilities of futures is similar to that of forwardsThe margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occurFutures contracts are standardized, so the firm may not be able to hedge the exact quantity it desiresCredit risk is virtually nonexistentFutures contracts are available on a wide range of physical assets, debt contracts, currencies and equitiesYou might want to discuss the fact that futures contracts on individual stocks are available beginning in the spring of 2002.
17SwapsA long-term agreement between two parties to exchange cash flows based on specified relationshipsCan be viewed as a series of forward contractsGenerally limited to large creditworthy institutions or companiesInterest rate swaps – the net cash flow is exchanged based on interest ratesCurrency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates
18Example: Interest Rate Swap Consider the following interest rate swapCompany A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed)Company B can borrow from a bank at 9.5% fixed or LIBOR + .5% (borrows floating)Company A prefers floating and Company B prefers fixedBy entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%PayReceiveNetCompany ALIBOR + .5%8.5%-LIBORSwap Dealer w/ACompany B9%-9%Swap Dealer w/BSwap Dealer NetLIBOR + 9%LIBOR + 9.5%+.5%Company A has a comparative advantage borrowing at a fixed rate and company B has a comparative advantage borrowing at a floating rate. However, because of their businesses, A prefers to borrow floating and B prefers to borrow fixed.Net positions:A: pay 8% to bank and LIBOR + .5% to the swap dealer; receive 8.5% from swap dealer for a net position of pay LIBOR (less than LIBOR + 1% that would have to be paid on a floating rate loan from the bank)B: pay LIBOR + .5% to the bank and 9% to the swap dealer; receive LIBOR + .5% from the swap dealer for a net position of pay 9% (less than 9.5% that would have to be paid on a fixed rate loan from the bank)Swap dealer: pay 8.5% to A and LIBOR + .5% to B; receive LIBOR + .5% from A and 9% from B for a net position of .5%Everyone wins (except the banks).See the next slide for another example from the book – this time in picture form
19Figure 23.10This is an illustration of the cash flows from the example in the book.
20Option ContractsThe right, but not the obligation, to buy (sell) an asset for a set price on or before a specified dateCall – right to buy the assetPut – right to sell the assetExercise or strike price –specified priceExpiration date – specified dateBuyer has the right to exercise the option, the seller is obligatedCall – option writer is obligated to sell the asset if the option is exercisedPut – option writer is obligated to buy the asset if the option is exercisedUnlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potentialPay a premium for this benefit
23Hedging Commodity Price Risk with Options “Commodity” options are generally futures optionsExercising a callOwner of call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures priceSeller of call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures priceExercising a putOwner of put receives a short position in the futures contract plus cash equal to the difference between the futures price and the exercise priceSeller of put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price
24Hedging Exchange Rate Risk with Options May use either futures options on currency or straight currency optionsUsed primarily by corporations that do business overseasUS companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars)Buy puts (sell calls) on foreign currencyProtected if the value of the foreign currency falls relative to the dollarStill benefit if the value of the foreign currency increases relative to the dollarBuying puts is less risky
25Hedging Interest Rate Risk with Options Can use futures optionsLarge OTC market for interest rate optionsCaps, Floors, and CollarsInterest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates)Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)Collar – buy a call and sell a putThe premium received from selling the put will help offset the cost of buying a callIf set up properly, the firm will not have either a cash inflow or outflow associated with this position
26Quick QuizWhat 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?