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Dan McGarvey, CPCU, ARM Managing Director, Marsh The Other Face or Risk Management – The Art and Science of Hedging April 17, 2007 RIMS 2007 Webinar Series.

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Presentation on theme: "Dan McGarvey, CPCU, ARM Managing Director, Marsh The Other Face or Risk Management – The Art and Science of Hedging April 17, 2007 RIMS 2007 Webinar Series."— Presentation transcript:

1 Dan McGarvey, CPCU, ARM Managing Director, Marsh The Other Face or Risk Management – The Art and Science of Hedging April 17, 2007 RIMS 2007 Webinar Series “Speak Finance Like a Native” Module 3

2 2 Your Webcast Host Dan McGarvey, CPCU, ARM Dan McGarvey, CPCU, ARM Greenville, SC Office Head Greenville, SC Office Head Retired (old) Naval Officer Retired (old) Naval Officer 17 Yr Marsh Veteran 17 Yr Marsh Veteran MBA Univ. of Rhode IslandMBA Univ. of Rhode Island

3 3 My Other Job…

4 4 Greetings from :

5 5 Thanks for your terrific feedback from Session 2… “It was a little less boring than the first module” Unnamed Risk Manager

6 6 Your questions are most welcome… …and will be answered in short order Your questions are most welcome… …and will be answered in short order

7 7 In Our Last Episodes...  Who are your owners?  What is their appetite for risk?  Digging to find the answers  Building a business case  Converting your good ideas to “finance-speak” “finance-speak” Don’t miss the exciting conclusion at: www.RIMS.org

8 8 The value of a dollar, depends on whose it is…

9 9 A dollar received today is worth more than one promised in the future…

10 10 The Risk-Reward Continuum Level of Risk Expected Reward Where is Where is your firm? your firm? 3.7% (historical T-bill average) EquityRiskPremium

11 11 The Beta Factor and the Volatility Continuum Volatility (Beta) Expected Reward Where is Where is your firm? your firm?

12 12 Sometimes I will pay a dollar today to avoid maybe taking a beating tomorrow… Today’s Theme: / / /

13 13 This may be in the form of insurance premium, but other times the insurance market may not offer an optimal solution Today’s Theme:

14 14 Fundamentally, the exposure to unfavorable variances in any expected outcome What is Risk?

15 15 Some Types of Risk Hazard/Casualty Hazard/Casualty Systematic Systematic Unsystematic Unsystematic Basis Risk Basis Risk Counterparty Risk Counterparty Risk

16 16 What is a “Hedge” What is a “Hedge” The concept is really quite simple… The Suit Example

17 17 A Typical Business Cycle... It’s Feast or Famine!

18 18 A Typical Business Cycle... Impact of a Typical Hedge “Volatility is not our friend”

19 19

20 20 Overview of Pop’s Sells in Southwestern US and approximately 20% in Mexico Sells in Southwestern US and approximately 20% in Mexico Four flavors of popsicles Four flavors of popsicles Differentiators: Differentiators: Low cost Low cost Family owned Family owned Strong brand Strong brand

21 21 Pop’s Risk Analysis Pop’s Risk Analysis Start with “pro-forma” annual business plan and evaluate: business plan and evaluate:  Potential sources of raw material cost increases material cost increases  Potential sources of demand reduction reduction  Other potential sources of profitability disruption profitability disruption

22 22 Raw Materials Sugar Sugar Orange Juice Orange Juice Wood Wood Paper Paper Citric Acid Citric Acid

23 23 Raw Materials- Projected Impact Sugar Sugar Oranges Oranges Wood Wood Paper Paper Acid Acid Highly volatile, a significant ingredient – major impact Mitigation strategy established Volatility exists, but per unit price not sufficient to generate concern Material impact, but historically not a volatile commodity Limited impact but some volatility

24 24 The Spring Water Issue Part of our marketing since ’62 Part of our marketing since ’62 A neighbor-owned spring has always provided us water at very reasonable prices A neighbor-owned spring has always provided us water at very reasonable prices Change is in the air… Change is in the air…

25 25 Demand Factors Economic outlook Economic outlook Temperature variances Temperature variances Foreign exchange rates (Peso) Foreign exchange rates (Peso) Pricing and elasticity of demand Pricing and elasticity of demand

26 26 Demand Factors Economic outlook Economic outlook Temperature variances Temperature variances Foreign exchange rates (Peso) Foreign exchange rates (Peso) Who doesn’t face this variable? (This is clearly a systematic risk) Very material - but what can we do about the weather besides talk about it? This is an issue – exceeds 20% of sales Changing demand elasticity ??? Changing demand elasticity ???

27 27 Orange Juice Modeling of regional “degree days” and OJ prices yields a strong correlation Modeling of regional “degree days” and OJ prices yields a strong correlation This is known as a “natural hedge” This is known as a “natural hedge” Further mitigation is likely needed Further mitigation is. likely needed Why? Why?

28 28 “Basis Risk” This is what correlation looks like… This is what correlation looks like… 051015 20 25 0 10 20 30 40 50 Degree days in excess of expected OJ Price

29 29 “Basis Risk” A hedge is only as effective as the reliability of the correlation upon which it is based … A hedge is only as effective as the reliability of the correlation upon which it is based … 05101520 25 0 10 20 30 40 50

30 30 Operational Mitigation Pops produces four flavors – only the orange variety contains real juice Pops produces four flavors – only the orange variety contains real juice Adjusting the mix contained in a box can help mitigate an OJ price spike impact Adjusting the mix contained in a box can help mitigate an OJ price spike impact Orange is historically the favorite flavor Orange is historically. the favorite flavor Impact on demand? Impact on demand?

31 31 Decision Tree Analysis +2 cents No mitigation Subtract two Subtract one Subtract one No change 20% reduction 10% reduction 10% reduction OJ Price Increase Our Respon se Impact on Demand

32 32 Monte Carlo Analysis Allows for “stochastic” (non- deterministic) analysis using multiple variables and randomly generated “real world” trials Allows for “stochastic” (non- deterministic) analysis using multiple variables and randomly generated “real world” trials Useful when one has modeled a series of decisions and outcomes that rely upon one another Useful when one has modeled a series of decisions and outcomes that rely upon one another

33 33 Monte Carlo Analysis

34 34 Sticks Though the price is volatile, large numbers of popsicle sticks may be safely stored in inventory Though the price is volatile, large numbers of popsicle sticks may be safely stored in inventory A perfect candidate for the use of forward purchasing A perfect candidate for the use of forward purchasing Stockpiling is an option too Stockpiling is an option too

35 35 “Forward” Purchase Any agreement with another party to purchase some item at a future date for a pre-agreed price Any agreement with another party to purchase some item at a future date for a pre-agreed price In its most simple form, a forward need not be traded on any exchange. This can reduce frictional cost. In its most simple form, a forward need not be traded on any exchange. This can reduce frictional cost. A forward normally implies an obligation to purchase on the agreed date A forward normally implies an obligation to purchase on the agreed date

36 36 Stockpiling $ Month Buy Another option to reduce volatility Razors – A real-life example

37 37 Sugar Highly volatile with no natural hedge Highly volatile with no natural hedge Spoilable and difficult to stockpile Spoilable and difficult to stockpile Actively traded on an established exchange Actively traded on an established exchange Our demand is variable Our demand is variable

38 38 Options/Futures Markets

39 39 Using “Options” For a premium payment, I receive the right (but not the obligation) to purchase a given quantity at a pre-agreed price For a premium payment, I receive the right (but not the obligation) to purchase a given quantity at a pre-agreed price This “call” will help me meet future commodity needs at predictable prices This “call” will help me meet future commodity needs at predictable prices Effective for meeting surge needs Effective for meeting surge needs

40 40 Option vs. Insurance Premium Premium Commission Commission ISDA form ISDA form Strike price Strike price Option limit Option limit Expiration Expiration Counterparty Counterparty credit rating credit rating

41 41 In the Money Out of the Money Terminology… Strike Price

42 42 “Puts” and “Calls” These terms represent the identical options transaction as viewed from the two sides of the transaction mirror… These terms represent the identical options transaction as viewed from the two sides of the transaction mirror…

43 43 Option – 2000 pork bellies at $100 per – expiring June 30th “Put” “Call” Sell a Buy a

44 44 What is a Collar? I kn ow th is one ! Buy a “call” Sell a “put”

45 45 Option Variations American Option – Can be American Option – Can be exercised at any time prior to exercised at any time prior to expiration expiration European Option – Exercisable European Option – Exercisable only on a specified date only on a specified date Bermudian Option – Exercisable Bermudian Option – Exercisable only on certain specified dates only on certain specified dates Asian Option – Exercisable at Asian Option – Exercisable at the average price over a the average price over a specified period specified period

46 46 Paper and Cartons Too much volume to make storage of large quantities practical Too much volume to make storage of large quantities practical Many qualified suppliers exist Many qualified suppliers exist “Safety stock out” quantity is always kept on hand “Safety stock out” quantity is always kept on hand Demand is predictable Demand is predictable Active exchange exists Active exchange exists

47 47 Using “Futures” Obligate you to accept delivery on a given date at a pre-agreed price Obligate you to accept delivery on a given date at a pre-agreed price Lower frictional cost than Options due to this lesser amount of flexibility Lower frictional cost than Options due to this lesser amount of flexibility Effective for meeting Effective for meeting baseline needs baseline needs

48 48 Peso Conversion As the dollar gets stronger against the Peso, our foreign revenue stream shrinks As the dollar gets stronger against the Peso, our foreign revenue stream shrinks What is the most efficient way to hedge this while minimizing frictional cost? What is the most efficient way to hedge this while minimizing frictional cost? Could a “Swap” work? Could a “Swap” work?

49 49 Similar is size to us, but based in Mexico Similar is size to us, but based in Mexico - with 20% of sales in Texas. - with 20% of sales in Texas.

50 50 “Counterparty Risk” The effectiveness of a hedge is only as solid as the willingness and capability of your counterparty to the transaction to hold up its end of the bargain The effectiveness of a hedge is only as solid as the willingness and capability of your counterparty to the transaction to hold up its end of the bargain This is very similar to requiring an A- VII or better AM Best rating of your insurers This is very similar to requiring an A- VII or better AM Best rating of your insurers

51 51 Citric Acid No active options/futures exchange No active options/futures exchange Can’t find anyone who profits when the cost of citric acid increases (except for the manufacturer) Can’t find anyone who profits when the cost of citric acid increases (except for the manufacturer) Need a willing partner Need a willing partner Can my bank help? Can my bank help?

52 52 A “Derivative” A financial instrument whose value is derived from an underlying index A financial instrument whose value is derived from an underlying index The issuer may have no intrinsic interest in this commodity or index The issuer may have no intrinsic interest in this commodity or index “I don’t care about the price of citric acid, but for a premium I will pretend that I do” “I don’t care about the price of citric acid, but for a premium I will pretend that I do” A very viable risk management tool A very viable risk management tool

53 53 Pure Spring Water Why not acquire the spring? Why not acquire the spring? Also known as Vertical Integration Also known as Vertical Integration Guarantees availability Guarantees availability What do you think? What do you think?

54 54 Sensitivity Analysis Sensitivity analysis uses economic modeling to evaluate the potential bottom line impact of volatility involving key business variables Sensitivity analysis uses economic modeling to evaluate the potential bottom line impact of volatility involving key business variables

55 55 Sensitivity Analysis In this case, as simple spreadsheet that includes all the elements of the Income Statement (revenues and expenses) for Pop’s could be used as a starting point… In this case, as simple spreadsheet that includes all the elements of the Income Statement (revenues and expenses) for Pop’s could be used as a starting point…

56 56 Evaluating Overall Impacts… BadGood Standard Deviations Raw material potential price variation

57 57 Parametric Hedge A financial instrument whose payout is not tied to any loss amount actually sustained, but fixed in advance and based on a specified event that is logically projected to create a loss A financial instrument whose payout is not tied to any loss amount actually sustained, but fixed in advance and based on a specified event that is logically projected to create a loss Treating a breakdown in the natural orange juice hedge involving heat with extended drought Treating a breakdown in the natural orange juice hedge involving heat with extended drought

58 58 You may strike an agreement to You may strike an agreement to purchase a commodity that you find purchase a commodity that you find out you do not need out you do not need If your hedge is “in the money”, it is If your hedge is “in the money”, it is likely worth something to someone else likely worth something to someone else You may even buy options and futures You may even buy options and futures for pure speculation for pure speculation Caution – do not try this at home Caution – do not try this at home Hedge Valuation

59 59 The Value of an Option Price of underlying commodity 30 Day 90 Day “One minute option” 1 min. Value Strike Price

60 60 The Value of an Option Price of underlying commodity Value Beta = 1.0 Beta = 1.2 30 day option Strike Price

61 61 Current price relative to exercise price Current price relative to exercise price Standard Deviation of underlying price Standard Deviation of underlying price Time remaining until expiration Time remaining until expiration Black and Scholes Valuation An increase in any of the above increases the PV of an option increases the PV of an option How far in the money am I today? How volatile is the underlying index? How much time left for this to go South?

62 62 The “Greeks” Delta Delta Gamma Gamma Vega Vega Theta Theta Change in option price with change in underlying commodity price Change in Delta with change in Change in Delta with change in underlying commodity price underlying commodity price Change in option price with change in volatility of underlying commodity Change in option price with change in time to expiration

63 63 Slope = Delta Today’s Price 80 90 100 80 90 100 OptionValue “Delta” Today’s Spot Price is $90 Today’s Spot Price is $90 Our Option (30 day) Strike Price is $90 Our Option (30 day) Strike Price is $90 Does our option have any value?

64 64 Delta Rules The difference between the underlying commodity price right now and the strike price of the option is the largest determinant of option market price

65 65 56” !!! So How Do You Lose Lots? Example: Pop’s manages its exposure to volatile sugar prices with an open ended volatile sugar prices with an open ended sugar swap with a Hawaiian cruise line. sugar swap with a Hawaiian cruise line. ($1 million per inch off expected) ($1 million per inch off expected) 40” 45” 50” 40” 45” 50” Out of the Money In the In theMoney 95% confidence Interval

66 66 “Lightening can’t strike twice” “Lightening can’t strike twice” Bank half the loss for next year Bank half the loss for next year We’ll pay double if out of the money We’ll pay double if out of the money Dan the “Rogue Trader” Did I mention this gets worse? 56” or rain is so heavy, it washes away much of the sugar cane crop!!! How do you manage this risk?

67 67 Value at Risk (VAR) Confidence interval must be stipulated Confidence interval must be stipulated Akin to MPL in property analysis Akin to MPL in property analysis VAR limitations are a board level issue VAR limitations are a board level issue A single figure estimate of possible loss A single figure estimate of possible loss potential in a portfolio potential in a portfolio Monte Carlo analysis used to identify Monte Carlo analysis used to identify “perfect storm” loss conditions within “perfect storm” loss conditions within anticipated trading ranges anticipated trading ranges

68 68 Value at Risk (VAR) Traders view VAR guidelines the way you may view your “insurance budget” budget” Board members may view it differently

69 69 Bonus Term “Wearing” the Risk – A colloquial term traders use to describe what we might call risk allocation. They view risk as a hot potato to be passed among parties to a deal until some poor sap (by design or by default) ends up “wearing” it.

70 70 The Secrets to Becoming Conversant in Finance and Accounting Finance and Accounting have a language all their ownFinance and Accounting have a language all their own Risk management also has its own set of terms - which can generate frustrationRisk management also has its own set of terms - which can generate frustration Actively listen and ask questions to increase your vocabularyActively listen and ask questions to increase your vocabulary Its not all about numbers and math!Its not all about numbers and math!

71 71 Thanks to Marsh and RIMS for their sponsorship of this series All three modules will be archived at www.RIMS.org and available for your access I hope to see you in New Orleans! Shameless Plug:

72 72 You are most welcome to join my Wednesday sessions at RIMS national..

73 73 Thank You for Your Kind Attention


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