Risk Management and Derivatives. Volatility Volatility in returns is a classic measure of risk Perfect Market More systematic risk leads to more return.

Risk Management

and Derivatives

Volatility Volatility in returns is a classic measure of

risk

Perfect Market More systematic risk leads to more return

But Volatility is Costly External financing

Project funding Distress

Lower debt or increased prob. of distress Taxes

Risk Management Tools Hedging

Reduce firm’s exposure to price/rate fluctuations

Financial Hedging Insurance Derivatives

Financial assets which are a claim on another asset

Operational Hedging Using other corporate decisions to manage

volatility

Sources of Volatility - 1

Interest Rate Risk Loans with floating interest rates create IR

risk Exchange Rate Risk

Reduce impact of foreign earnings volatility due to currency rate fluctuations

Commodity Price Risk Certain input costs and prices of goods sold

can be hedged

The Risk Management Process

Identify important price fluctuations Risk profiles are useful for determining the

relative impact of different types of risk Some risks may offset each other

Consider the firm as a portfolio of risks and not just look at each risk separately

Considering risk management Availability of relevant contracts Cost of contracts Cost of management/employee time

Risk Profiles

Graph of price changes relative to value changes

Risk profile slope Steeper ~ Larger exposure Potentially more need to hedge

Derivatives Change Payoff

Forward Contract What’s a forward?

Agreement to exchange an asset for a set price with delivery and payment at a set future date

Long: agree to buy the asset Short: agree to sell the asset

You want next year’s Ferrari and contract with dealer to buy at a set price in the fall P Current = P Contract

Over the summer, demand rises P Current > P Contract

What if car value is below contract price? P Current < P Contract

Future What’s a future?

Forwards traded on an exchange

Farmer expects to sell 100,000 bushels of soybeans

Wants to sell at a certain price (short position) Soybean future contracts are for 5,000

bushels Current price is $4.50/bushel

Farmer shorts 20 soybean futures Will sell 100,000 bushels Will receive $4.50/bushel*100,000 bushels

= $450,000

Commodity Future

No cost today, but margin held in farmer’s account As soybean price changes, clearinghouse

adjusts farmer’s account September

Farmer delivers soybeans and receives $450,000

Bumper Crop Receive $450,000 + Extra Crop * Market

Price Poor Harvest

Receive $450,000 – Amt to Purchase * Market Price

Interest Rate Swap Firm A can borrow at 10% fixed or LIBOR + 1%

floating Firm B can borrow at 9.5% fixed or LIBOR + 2% A prefers fixed and B prefers floating

Call (Put) Right to buy (sell) a security at a pre-specified price

Underlying Asset that you have an option to buy or sell

Option Price Market price of the contract

Exercise (or Strike) Price Price at which the security can be bought or sold

At-the-money - Exercise price is very close to stock’s

current value In-the-money - Option could be exercised at a profit

today Out-of-the-money – Can’t exercise for profit

Options

Reducing Risk Exposure Hedging changes risk profile Doesn’t eliminate risk

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)

Managed in a variety of ways Long-run exposure (economic exposure)

Difficult to hedge with derivatives

Always Hedge?

What if price shock can be passed along to customer?

What if competitors don’t hedge?

Not Perfect

Iberia Large 4th Quarter 2008 Losses Attributed, in part, to hedging

“Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of 2008.”

Wall Street Journal

Sources of Volatility - 2

Contracting with suppliers/customers Vertical integration Limiting leverage

Central employees “Key Man” Insurance

Project specific issues Diversification Project choice

Corp Fin Applications

Equity as a Call Employee Stock Options CEO Stock Options

Equity: A Call Option For leveraged firms, equity is a call option

on the company’s assets Exercise price - the face value of the debt Expiration date – the date that the debt

comes due Assets > debt

Option is exercised and the stockholders retain ownership

Assets < debt Option expires unused and assets belong to

the bondholders

Equity Payoff

DebtFirm Value

Value of Equity

All goes to Bondholders

Shareholders Collect

Asset substitution

Employee Stock Options

Options given to employees as compensation Nonqualified

Can be granted at a discount to current value

Qualified or incentive stock options Primarily for upper mgmt Special tax treatment

Often used as a bonus or incentive Huge rise in popularity Mostly still for upper management

Employee Stock Options

Designed to reduce agency problems Empirical evidence: they don’t well work

Not worth as much to the employee as to an outsider due to the lack of diversification

Reprice underwater options Other Disadvantages

Management behavior Costly compensation

Dilutes stock as firm must issue new shares Sometimes offset with repurchase (usually when

stock price is high) Expensing can hurt profits

CEO Options Use

Executives can protect their stock positions

Given stock or options as an incentive

I-bank creates individual options “Collars” position with put and call Value

Stock Price

Put Call