Risk Management and Options. What is Risk? Risk describes a situation where a range of possible outcomes or returns exist. The fundamental aspect of risk.

Risk Management and Options

What is Risk?

• Risk describes a situation where a range of possible outcomes or returns exist .

• The fundamental aspect of risk is the uncertainty or doubt attributable to the outcome of a particular action

What is Risk?

• Volatility and unpredictability in the business environment give rise to different types of risk.

• These include economic, regulatory, tax, political, country and financial price risks

Financial Risks

• A number of risks arise from financial transactions.

• Financial Price Risk - Occurs whenever the value of future cash flows may change because of foreign exchange rate movements, interest rate movements or commodity price movements.

• Other risks related to financial transactions are credit, liquidity and operational risks

What is Risk Management ?

• Risk management involves identifying and measuring firm-specific and market wide risk exposures and managing those exposures by means of insurance products or other actions.

• To manage risk, a firm needs – minimise the likelihood of those events that

represent a threat to cash flow or– minimise their impact on the firm’s cash flows

Risk Management

A firm could manage its risk by :

1.Building flexibility into operations (real options)

2.Buying an insurance policy against hazards 3.Diversification4.Hedging with derivatives

Risk Analysis Questions

• What are the major risks that the company faces and what are the possible consequences?

• Is the company being paid for taking these risks?• Can the company take any measures to reduce the

probability of a bad outcome or to limit its impact? • Can the company purchase fairly priced insurance to

offset any losses?• Can the company use derivatives, such as options or

futures, to hedge the risk?

Hedging

Hedging is the process of managing risks by taking a position which offsets existing or anticipated exposure to a change in market prices or rates.

• One can choose to hedge nothing, hedge everything or hedge selectively.

• Financial risks are hedged using instruments known as derivatives.

Why Hedge?

• Hedging involves a cost and a debate exist as to whether hedging is likely to add value to a firm.

• There is a view that transactions undertaken only for the purpose of reducing risk are unlikely to add value to a firm. This would be the case in a perfect capital market setting.

Arguments against hedging • Hedging is a zero sum game – Hedging

transactions only transfer risk. One party’s gain is the counterparty’s loss. Hedging does not eliminate risk

• Investors Do it yourself alternative- Diversification by shareholders may be superior to hedging, thus saving the costs associated with hedging at a corporate level

Some benefits of hedging • Reduce costs of financial distress• Expand a company's debt capacity especially

where interest rate exposure is hedged. • Helps distinguish between the impact of not

hedging and of poor management. • Reduce underinvestment • Maintain the competitive position of the firm• Positive impact on the firm’s external rating

Derivatives • A derivative instrument is a security whose

payoff is determined by (derived from) the value of other assets or financial variables, known as the underlying assets or variables.

• Derivative transactions cover a broad range of

underlyings. For example – interest rates, exchange rates, commodities, equities, stock indices.

Derivatives

• Since they depend on the value of another asset or variable, derivative instruments are also known as contingent claims.

• The basis of hedging with derivatives involve offsetting a cash transaction or position with buying or selling a derivative instrument linked to the cash transaction.

Derivatives

• Can be exchange traded – Contract terms standardised, price only variable to be determined. Contractual obligation is to the clearing house of the exchange

• Can be over the counter – custom tailored with terms and conditions designed to fit the particular business and risk management needs of the counterparties. Contract obligation is between the counterparties

Forwards and Futures • Both are agreements to buy or sell an asset in

the future at an agreed price.• The forward is an over the counter custom-

tailored contract while a future is a standardised exchange traded contract

• Forwards can be written for any maturity date and for delivery of any quantity of the underlying . Contract usually between two financial institutions or between a financial institution and one of its clients

Futures • Standardised exchange traded contracts with

gains and losses realised daily • Typical standardised terms include: Quantity

and quality of the asset (underlying) to be delivered, Delivery date and location, last date on which contract can be traded.

Profit to seller = initial futures price - ultimate market price

Profit to buyer = ultimate market price - initial futures price

Hedging with futuresTo hedge the price of a commodity or asset you

take opposite positions in the futures and spot (cash) markets.

In BMM example 24.1, a farmer has wheat that he would wishes to sell. The farmer is ‘long’ in the asset.

To hedge the risk of a price fall, the farmer would have to take a ‘short’ position in the futures market. He has to obtain futures contracts to sell wheat in the future.

Stock index futures

• Can be used to hedge investment portfolios. • If an investor expects the value of his shares

to fall, he can sell stock index futures forward, locking in a higher price for his shares.

• If the stock market falls, the money which he receives from selling the futures forward can then be used to buy back stocks on the spot market at a lower price. This will compensate for losses made on the underlying stocks.

Hedging with futures

ExampleSharesPrice = 3,700

• If I sell forward today, I can lock in the value of my portfolio

6 month index futuresPrice today = 3,700

In six months’ time . . . .

Assume index has fallen from 3,700 to 3,500 . . .

• I sell shares:

Shares at cost = 3,700Proceeds = 3,500Loss = 200

• I deliver on futures contract:

Purchase price = 3,700Cash outlay = 3,500Profit = 200

If shares have risen in value . . . .

• I sell shares:

Shares at cost = 3,700Proceeds = 4,200Profit = 500

• I deliver on futures contract:

Purchase price = 3,700Cash outlay = 4,200Loss = 500

Payoffs

Lose if share price falls

Win if share price rises

Payoff

Share price

No hedging

Payoffs

No downside

No upside

Payoff

Share price

Hedging with futures contract

Interest Rate Futures • Used in transactions which involve borrowing

and lending.• Borrowers will normally choose to sell interest

rate futures to hedge against a rise in interest rates and fall in bond prices.

• Investors (lenders) on the other hand, wishing to buy bonds in the future could buy interest rate futures so as to hedge against a future fall in interest rates and a rise in bond prices.

Using interest rates futures – Borrowing-

A company has obtained a loan of £1million from the money markets at 12%. This loan is rolled over every three months and is due to be rolled over 1 June. The company is afraid that interest rates will change and that the loan will be rolled over at a rate which is higher than 12%.

Using interest rates futures Borrowing

CASH MARKET • £1 million at 12% anticipates

interest rates to rise.

• 1 June- Interest rates have risen to 14%.

• The company makes a loss which is 2% extra interest on £1million for the next 3 months. This amounts to £5000

FUTURES MARKET • The company sells interest

rate futures (2). which are due for delivery after June 1 a price of 88 (100-12).

• The company closes out the contract by buying 2 interest rate futures. Buys back the contracts at 86, implying an interest of 14%.

• The company makes a gain of 200 ticks per contract. 400 * 12.50 =£5000

SwapAn arrangement between two parties to exchange a series of cash flows, for example future interest payments, at specified intervals known as settlement days.

• Cash flows of a swap are either fixed or variable (floating). For floating cash flows these are calculated at each settlement date by multiplying the quantity of the underlying by specified reference rates such as LIBOR

Swaps

• Swaps are usually used to transform the market exposure ( interest rate exposure, foreign exchange exposure) associated with a loan or a bond.

• For a swap to take place the two counterparties must exchange equal values. Each party must exchange payments with equal present value as determined by the market at the time the swap is agreed.

Interest Rate Swap• An agreement between two parties to pay

each other’s interest for an agreed period• Most common arrangement involves an

agreement to exchange fixed interest payments for floating interest payments.

• There is no exchange of principal. • The interest rates are based on a “notional”

underlying principal sum of money

Using fixed for floating swaps to hedge interest rate exposure

Example information: Company A has issued floating rate debt at a cost of LIBOR ( 6 month) + 0.75% but is averse to the risk that interest rate will increase. To avoid this risk , A enters into a swap in which it agrees to pay the swap dealer (a financial intermediary) a fixed rate of interest equal to 3% (offer rate) and receive a floating rate equal to LIBOR for the first coupon.

Illustration of a fixed for floating swap

Company A pays 3% to the swap dealer , receives 6 month LIBOR from the swap dealer and pays 6month LIBOR+0.75 to the bondholders. A’s overall position is to pay a fixed rate of 3.75% By becoming a fixed rate payer, A will gain if interest rates rise because the compamy will continue to pay interest at a lower rate but will lose if interest rates fall.

The example in BMM Table 24-3 p also illustrates how an interest rate swap can transform floating rate debt to fixed rate debt.

Company A Swap Dealer

Fixed rate payment 3%

‘Floating’ LIBOR payment

LIBOR payment +0.75 to bondholders

Currency Swaps • To manage exchange rate risk, two parties can

agree to swap both principal and interest denominated in two different currencies for an agreed period.

• Counterparties can use their ability to borrow cheaply in certain markets and in their local currencies. Each counterparty can meet its foreign currency requirement and reduce borrowing costs over time.

• Can take place between a company and swap dealer. See BMM Example 24.3

Example Information • A UK company issues bonds with a face value of

£50 million and coupon of 11.5% per annum paid semi-annually with a maturity of 7 years. The UK company would prefer to have dollars and make interest payments in dollars and enters into a foreign currency swap with a US company. Assume exchange rate £1 = $1.45. The coupon rate on the US company’s bonds is 9.35%

• See also example 24. 3 in BMM

Stages in currency swap deal • Stage 1 - Initial exchange of principal amount The UK

company receives $72.5m, US company receives £50m.

• Stage 2- Exchange of interest UK company makes dollar interest payments of 9.35% on

$72.5m for 7 years, UK company receives £ interest payment from US company 11.5% on £50m for 7years

Stage 3- Re exchange of principal at maturity • UK co. receives principal £50 m. and the US co.

receives principal $72.5 million.

Options - definitionsA financial option gives the owner the right to

buy or sell a specified quantity of an underlying asset at a fixed price (called a strike or exercise price) on or before a specified date ( called the expiration date) .

• Note that it gives the holder (buyer) a right. Can exercise the option or allow to expire

Call option – Gives holder the right to buy an asset and the writer an obligation to sell

Put option-Gives holder the right to sell an asset and the writer an obligation to buy

Options - more definitions

European option• Option that can be exercised only on the final

exercise dateAmerican option• Option that can be exercised at any time

before the final exercise date• Exchange traded v Over the counter options

Options - more definitions

• Premium or Option Value - The sum of money paid for the right of the option.

• Exercise Or Strike Price - The fixed price at which an option holder has the right to buy the financial instrument covered by the option (call option) or to sell ( put option)

Hedging with options

• Options allow a risk to be reduced and also allow gains to be made from favourable movements in the prices or rates underlying the instrument

• Call options are used when it is anticipated prices may rise.

• Put options are used when it is anticipated prices may fall.

Option payoffs

• In the Money - There is a net financial gain to be received from exercising the option immediately. For a call on shares Stock price > call option strike price.

• Out of the Money There is no benefit to be derived from exercising the option. For a call on shares Stock price < call option strike price

• At the money The exercise or strike price is the same as the spot or cash price of the underlying.

Options

Example• I buy call options with an exercise price of 4,000

4,000

Share price

Pay off

0

Options

Example• I buy put options with an exercise price of 4000

4,000

Share price

Pay off

0

Option Price (red) versusIntrinsic Value (black)

• Strike price = $100

Intrinsic Value

Share Price

100 105

5

0104

Value of call

Hedging with Options- Example information See BMM pg 672

Onnex sells crude oil. Fluctuations in the sale price of crude oil can cause unexpected profits or losses. How might Onnex hedge this risk for sales of 1000 barrels of oil ?

A put option can protect against a fall in prices by locking in a minimum sale price of $90. A put option will allow Onnex to insure its sales revenues a market fall but at the same time makes it possible for the company to participate in any market rise.

• At a market price of $100 per barrel, Onnex will allow the option to expire out of the money and will benefit from the full upside potential less the put premium.

• At a market price of $80 per barrel, Onnex will exercise the option since the oil can be sold at $90.

Hedging with options: example

Buy shares, buy put options

4,000

Share price

Profit

0

- 4,000

+ 4,000Unlimited upside