McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 23 Risk Management: An Introduction to Financial Engineering

23-1 Key Concepts and Skills  Understand the types of volatility that companies can manage  Understand how to develop risk profiles  Understand the difference between forward contracts and futures contracts and how they are used for hedging  Understand how swaps can be used for hedging  Understand how options can be used for hedging

23-2 Chapter Outline  Hedging and Price Volatility  Managing Financial Risk  Hedging with Forward Contracts  Hedging with Futures Contracts  Hedging with Swap Contracts  Hedging with Option Contracts

23-3 Example: Disney’s Risk Management Policy  Disney provides stated policies and procedures concerning risk management strategies in its annual report  The company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investments  Interest rate swaps are used to manage interest rate exposure  Options and forwards are used to manage foreign exchange risk in both assets and anticipated revenues  The company uses a VaR (Value at Risk) model to identify the maximum 1-day loss in financial instruments  Derivative securities are used only for hedging, not speculation

23-4 Hedging Volatility  Recall that volatility in returns is a classic measure of risk  Volatility in day-to-day business factors often leads to volatility in cash flows and returns  If a firm can reduce that volatility, it can reduce its business risk  Instruments have been developed to hedge the following types of volatility  Interest Rate  Exchange Rate  Commodity Price  Quantity Demanded

23-5 Interest Rate Volatility  Debt is a key component of a firm’s capital structure  Interest rates can fluctuate dramatically in short periods of time  Companies that hedge against changes in interest rates can stabilize borrowing costs  This can reduce the overall risk of the firm  Available tools: forwards, futures, swaps, futures options, and options

23-6 Exchange Rate Volatility  Companies that do business internationally are exposed to exchange rate risk  The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency  If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and do a better analysis of future projects  Available tools: forwards, futures, swaps, futures options

23-7 Commodity Price Volatility  Most firms face volatility in the costs of materials and in the price that will be received when products are sold  Depending on the commodity, the company may be able to hedge price risk using a variety of tools  This allows companies to make better production decisions and reduce the volatility in cash flows  Available tools (depend on type of commodity): forwards, futures, swaps, futures options, options

23-8 The Risk Management Process  Identify the types of price fluctuations that will impact the firm  Some risks are obvious; others are not  Some 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 separately  You must also look at the cost of managing the risk relative to the benefit derived  Risk profiles are a useful tool for determining the relative impact of different types of risk

23-9 Risk Profiles  Basic tool for identifying and measuring exposure to risk  Graph showing the relationship between changes in price versus changes in firm value  Similar to graphing the results from a sensitivity analysis  The steeper the slope of the risk profile, the greater the exposure and the greater the need to manage that risk

23-10 Reducing Risk Exposure  The goal of hedging is to lessen the slope of the risk profile  Hedging will not normally reduce risk completely  For most situations, only price risk can be hedged, not quantity risk  You may not want to reduce risk completely because you miss out on the potential upside as well  Timing  Short-run exposure (transactions exposure) – can be managed in a variety of ways  Long-run exposure (economic exposure) – almost impossible to hedge - requires the firm to be flexible and adapt to permanent changes in the business climate

23-11 Forward Contracts  A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date  Forward contracts are legally binding on both parties  They can be tailored to meet the needs of both parties and can be quite large in size  Positions  Long – agrees to buy the asset at the future date  Short – agrees to sell the asset at the future date  Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

23-12 Figure 23.7

23-13 Hedging with Forwards  Entering into a forward contract can virtually eliminate the price risk a firm faces  It does not completely eliminate risk unless there is no uncertainty concerning the quantity  Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor  The firm also has to spend some time and/or money evaluating the credit risk of the counterparty  Forward contracts are primarily used to hedge exchange rate risk

23-14 Futures Contracts  Futures contracts traded on an organized securities exchange  Require an upfront cash payment called margin  Small relative to the value of the contract  “Marked-to-market” on a daily basis  Clearinghouse guarantees performance on all contracts  The clearinghouse and margin requirements virtually eliminate credit risk

23-15 Futures 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-market  Delivery month  Open price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest  The change in settlement price times the contract size determines the gain or loss for the day  Long – an increase in the settlement price leads to a gain  Short – an increase in the settlement price leads to a loss  Open interest is how many contracts are currently outstanding

23-16 Hedging with Futures  The risk reduction capabilities of futures are similar to those of forwards  The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur  Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires  Credit risk is virtually nonexistent  Futures contracts are available on a wide range of physical assets, debt contracts, currencies, and equities

23-17 Swaps  A long-term agreement between two parties to exchange cash flows based on specified relationships  Can be viewed as a series of forward contracts  Generally limited to large creditworthy institutions or companies  Interest rate swaps – the net cash flow is exchanged based on interest rates  Currency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates

23-18 Example: Interest Rate Swap  Consider the following interest rate swap  Company 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 fixed  By entering into a swap agreement, both A and B are better off than they would be borrowing from the bank with their preferred type of loan and the swap dealer makes.5% PayReceiveNet Company ALIBOR +.5%8.5%-LIBOR Swap Dealer w/A8.5%LIBOR +.5% Company B9%LIBOR +.5%-9% Swap Dealer w/BLIBOR +.5%9% Swap Dealer NetLIBOR + 9%LIBOR + 9.5%+.5%

23-19 Figure 23.10

23-20 Option Contracts  The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date  Call – right to buy the asset  Put – right to sell the asset  Exercise or strike price –specified price  Expiration date – specified date  Buyer has the right to exercise the option; the seller is obligated  Call – option writer is obligated to sell the asset if the option is exercised  Put – option writer is obligated to buy the asset if the option is exercised  Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential  Pay a premium for this benefit

23-21 Payoff Profiles: Calls

23-22 Payoff Profiles: Puts

23-23 Hedging Commodity Price Risk with Options  “Commodity” options are generally futures options  Exercising a call  Owner of the call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures price  Seller of the call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures price  Exercising a put  Owner of the put receives a short position in the futures contract plus cash equal to the difference between the futures price and the exercise price  Seller of the put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price

23-24 Hedging Exchange Rate Risk with Options  May use either futures options on currency or straight currency options  Used primarily by corporations that do business overseas  U.S. 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 currency  Protected if the value of the foreign currency falls relative to the dollar  Still benefit if the value of the foreign currency increases relative to the dollar  Buying puts is less risky

23-25 Hedging Interest Rate Risk with Options  Can use futures options  Large OTC market for interest rate options  Caps, Floors, and Collars  Interest 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 put  The premium received from selling the put will help offset the cost of buying the call  If set up properly, the firm will not have either a cash inflow or outflow associated with this position

23-26 Quick Quiz  What 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?

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. End of Chapter

23-28 Comprehensive Problem  A call option has an exercise price of $50.  What is the value of the call option at expiration if the stock price is $35? $75?  A put option has an exercise price of $30.  What is the value of the put option at expiration if the stock price is $25? $40?