Introduction to Derivatives and Risk Management Corporate Finance Dr. A. DeMaskey

2 Learning Objectives u Questions to be answered: – Why should a company manage its risk? – What financial techniques can be used to reduce risk? – What are derivatives? – What are the important characteristics of the various types of derivative securities? – How should derivatives be used to manage risk?

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

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

6 Reasons to Manage Risk Risk management allows firms to: borrowing costs u Reduce borrowing costs by using interest rate swaps. tax effects u Minimize negative tax effects due to convexity in tax code.

7 Growth of Derivatives Market u Analytical techniques u Technology u Globalization

8 Derivative Securities u Derivative: Security whose value stems or is derived from the value of other assets. u Types of Derivatives – Forward – Futures – Options – Swaps

9 Forward Contracts u An agreement where one party agrees to buy (or sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into. u Characteristics – Flexibility – Default risk – Liquidity risk u Positions in Forwards – Long position – Short position

10 Futures Contracts u A standardized agreement to buy or sell a specified amount of a specific asset at a fixed price in the future. u Characteristics – Margin Deposits Initial margin Maintenance margin – Marking-To-Market – Floor Trading – Clearinghouse

11 Hedging with Futures u 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. – Perfect hedge : Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

12 Option Contracts u The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time. u Option Terminology – Call option versus put option – Holder versus writer or grantor – Exercise or strike price – Option premium – American versus European option u Market Arrangements

13 Swap Contracts u Financial contracts obligating one party to exchange a set of payments it owns for another set of payments owed by another party. – Currency swaps – Interest rate swaps u Usually used because each party prefers the terms of the other’s debt contract. u Reduces interest rate risk or currency risk for both parties involved.

14 Different Types of Risk u Speculative risks: Those that offer the chance of a gain as well as a loss. u Pure risks: Those that offer only the prospect of a loss. u Demand risks: Those associated with the demand for a firm’s products or services. u Input risks: Those associated with a firm’s input costs. u Financial risks: Those that result from financial transactions. u Property risks: Those associated with loss of a firm’s productive assets. u Personnel risk: Risks that result from human actions. u Environmental risk: Risk associated with polluting the environment. u Liability risks: Connected with product, service, or employee liability. u Insurable risks: Those which typically can be covered by insurance.

15 An Approach to Risk Management u Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm. u Firms often use the following process for managing risks. 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.

16 Techniques to Minimize Risk u Transfer risk to an insurance company by paying periodic premiums. u Transfer functions which produce risk to third parties. u Purchase derivatives contracts to reduce input and financial risks. u Take actions to reduce the probability of occurrence of adverse events. u Take actions to reduce the magnitude of the loss associated with adverse events. u Avoid the activities that give rise to risk.

17 Nature and Purpose of Trading in Financial Derivatives u Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. u Hedging – Protect Value of Securities Held – Protect the Rate of Return on a Security Investment – Reduce Risk of Fluctuations in Borrowed Costs u Speculating

18 Using Derivatives to Reduce Risk u Commodity Price Exposure – 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. u Security Price Exposure – The purchase of a financial futures contract will allow a firm to make a future purchase of the security at today’s price, even if the market price on the asset has risen substantially in the interim.

19 Using Derivatives to Reduce Risk u Foreign Exchange Exposure – The purchase of a currency futures or options contract will allow a firm to make a future purchase of the currency at today’s price, even if the market price on the currency has risen substantially in the interim.

20 Risks to Corporations from Financial Derivatives u Increases financial leverage u Derivative instruments are too complex u Risk of financial distress