1 Chapter 24 Derivatives and Risk Management

2 Topics in Chapter Risk management and stock value maximization. Derivative securities. Fundamentals of risk management. Using derivatives to reduce interest rate risk.

3 Do stockholders care about volatile cash flows? If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios.

4 How can risk management increase the value of a corporation? Risk management allows firms to: Have greater debt capacity, which has a larger tax shield of interest payments. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. (More... )

5 Risk management allows firms to: Avoid costs of financial distress. Weakened relationships with suppliers. Loss of potential customers. Distractions to managers. Utilize comparative advantage in hedging relative to hedging ability of investors. (More... )

6 Risk management allows firms to (Continued): Reduce borrowing costs by using interest rate swaps. Example: Two firms with different credit ratings, Hi and Lo: Hi can borrow fixed at 11% and floating at LIBOR + 1%. Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%. (More... )

7 Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of 0.45% to Hi. Hi Lo CF to lender-(LIBOR+1%)-11.40% CF Hi to Lo-11.40%+11.40% CF Lo to Hi+(LIBOR+1%)-(LIBOR+1%) CF Lo to Hi+0.45%-0.45% Net CF-10.95%-(LIBOR+1.45%) (More…)

8 Risk management allows firms to: Minimize negative tax effects due to convexity in tax code. Example: EBT of $50K in Years 1 and 2, total EBT of $100K, Tax = $7.5K each year, total tax of $15. EBT of $0K in Year 1 and $100K in Year 2, Tax = $0K in Year 1 and $22.5K in Year 2.

9 What is corporate risk management? Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm.

10 Different Types of Risk Speculative risks: Those that offer the chance of a gain as well as a loss. Pure risks: Those that offer only the prospect of a loss. Demand risks: Those associated with the demand for a firm’s products or services. Input risks: Those associated with a firm’s input costs. (More... )

11 Financial risks: Those that result from financial transactions. Property risks: Those associated with loss of a firm’s productive assets. Personnel risk: Risks that result from human actions. Environmental risk: Risk associated with polluting the environment. Liability risks: Connected with product, service, or employee liability. Insurable risks: Those which typically can be covered by insurance.

12 What are the three steps of corporate risk management? Step 1.Identify the risks faced by the firm. Step 2.Measure the potential impact of the identified risks. Step 3.Decide how each relevant risk should be dealt with.

13 What are some actions that companies can take to minimize or reduce risk exposures? Transfer risk to an insurance company by paying periodic premiums. Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial risks. (More... )

14 Take actions to reduce the probability of occurrence of adverse events. Take actions to reduce the magnitude of the loss associated with adverse events. Avoid the activities that give rise to risk.

15 What is financial risk exposure? Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

16 Financial Risk Management Concepts Derivative: Security whose value stems or is derived from the value of other assets. Swaps, options, and futures are used to manage financial risk exposures. (More... )

17 Futures: Contracts which call for the purchase or sale of a financial (or real) asset at some future date, but at a price determined today. Futures (and other derivatives) can be used either as highly leveraged speculations or to hedge and thus reduce risk.

18 Hedging: Generally conducted where a price change could negatively affect a firm’s profits. Long hedge: Involves the purchase of a futures contract to guard against a price increase. Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities. (More... )

19 Swaps: Involve the exchange of cash payment obligations between two parties, usually because each party prefers the terms of the other’s debt contract. Swaps can reduce each party’s financial risk.

20 How can commodity futures markets be used to reduce input price risk? The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at today’s price, even if the market price on the item has risen substantially in the interim.

21 Chapter 24 Extension: Insurance and Bond Portfolio Risk Management Risk identification and measurement Property loss, liability loss, and financial loss exposures Bond portfolio risk management

22 How are risk exposures identified and measured? Large corporations have risk manage- ment personnel which have the responsibility to identify and measure risks facing the firm. Checklists are used to identify risks. Small firms can obtain risk manage- ment services from insurance companies or risk management consulting firms.

23 Describe (1) “property” loss and (2) “liability” loss exposures. Property loss exposures: Result from various perils which threaten a firm’s real and personal properties. Physical perils: Natural events Social perils: Related to human actions Economic perils: Stem from external economic events

24 Liability loss exposures: Result from penalties imposed when responsi-bilities are not met. Bailee exposure: Risks associated with having temporary possession of another’s property while some service is being performed. (Cleaners ruin your new suit.) Ownership exposure: Risks inherent in the ownership of property. (Customer is injured from fall in store.)

25 Business operation exposure: Risks arising from business practices or operations. (Airline sued following crash.) Professional liability exposure: Stems from the risks inherent in professions requiring advanced training and licensing. (Doctor sued when patient dies, or accounting firm sued for not detecting overstated profits.) (More…)

26 What actions can companies take to reduce property and liability exposures? Both property and liability exposures can be accommodated by either self- insurance or passing the risk on to an insurance company. The more risk passed on to an insurer, the higher the cost of the policy. Insurers like high deductibles, both to lower their losses and to reduce moral hazard.

27 How can diversification reduce business risk? By appropriately spreading business risk over several activities or operations, the firm can significantly reduce the impact of a single random event on corporate performance. Examples: Geographic and product diversification.

28 What is financial risk exposure? Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

29 Financial risk management concepts Duration: Average time to bondholders' receipt of cash flows, including interest and principal repayment. Duration is used to help assess interest rate and reinvestment rate risks. Immunization: Process of selecting durations for bonds in a portfolio such that gains or losses from reinvestment exactly match gains or losses from price changes.

30 Hedging a bond issue with T- Bond Futures It is January, Tennessee Sunshine will issue $5 million in bonds in June. TS is worried interest rates will rise between now and then. Current interest rates are 7% for the 20-year issue. But TS fears rates might rise by 1% by June. June T-bond futures are

31 What are risks of not hedging? Interest rates might increase before the bonds are issued. At a yield of 8%, how much will the $5 million worth of 20-year 7% semi-annual coupon bonds be worth?

32 Pmt = $5 million x 7%/2 = $175, NI/YR PV PMTFV -4,505,181 INPUTS OUTPUT

33 The bonds will be worth only $4,505,181 so TS will lose $5,000,000 - $4,505,181 = $494,819 if interest rates decline. Actually, TS might just issue $5,000,000 of 8% bonds if it waits and interest rates increase, but the cost of this higher interest rate is the $494,819 we calculated.

34 How can Tennessee Sunshine hedge this risk? T-Bond futures represent a contract on a hypothetical 20-year 6% bond with semiannual payments. A futures price of 111’25 means 111% plus 25/32 percent of par, or for a $1,000 par bond, a price of $1,

35 T-bond futures contract One T-bond futures contract is for $100,000 par value of underlying bonds, which is 100 of the $1,000 par- value bonds. Since each bond is worth $1,117.81, one contract is for $111,781 worth of bonds. TS will sell $5,000,000/$111,781 = 44.7 = 45 contracts.

36 Implied yield on futures contract A price of $1, gives a semi- annual yield of % or an annual yield of about 5.057%: NI/YR PV PMTFV INPUTS OUTPUT

37 Futures price changes T-bond futures prices change every day as interest rates change. If interest rates increase, bond prices decrease and so does the T-bond futures price. If interest rates decrease, then bond prices increase, and so does the T-bond futures price.

38 What happens if interest rates increase 1%? The yield on the bond underlying the futures contract will increase to 5.057% + 1% = 6.057%. This gives a new price of $ (N=40, I/YR=6.057/2, PMT = -30, FV = ; solving gives PV = per underlying bond, or a contract price of $99,344. This is a decrease of $111,781 - $99,344 = $12,437 for each contract.

39 Profit or loss from contract Since TS sold futures contracts, then it makes money when the futures price declines. In this case, TS will make $12,437 on each of its 45 contracts. Since TS sold the futures contracts and the price went down, it earns a positive profit of $12,437 x 45 contracts = $559,665.

40 What is the effectiveness of the hedge? TS will lose $494,819 on its own bonds when it issues them at the higher coupon rate, but it earns $559,665 on its futures contracts. Net result = 559,665 – 494,819 = $64,846 profit from the hedge.

41 Suppose interest rates fall instead of rise? If interest rates fall, then: TS gains on its bond issue TS loses on its futures contracts