Topic 8 Managing Risk

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Risk Management

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Outline

Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Futures Contracts Hedging with Swap Contracts Hedging with Option Contracts

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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

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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

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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

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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

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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

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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 more a firm needs to manage that risk

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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

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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

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Forward contract payoff

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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

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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

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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

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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

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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%

Pay Receive Net

Company A LIBOR + .5% 8.5% -LIBOR

Swap Dealer w/A 8.5% LIBOR + .5%

Company B 9% LIBOR + .5% -9%

Swap Dealer w/B LIBOR + .5% 9%

Swap Dealer Net LIBOR + 9% LIBOR + 9.5% +.5%

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Interest rate Swap

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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

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Payoff Profiles: Calls

Buy a call with E = $40

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Stock Price

Pay

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Sell a Call E = $40

-70

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-40

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Payo

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Payoff Profiles: Puts

Buy a put with E = $40

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1015202530354045

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Stock Price

Pay

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Sell a Put E = $40

-45

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-20

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Stock Price

Payo

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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

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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

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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

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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?