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RIMS 2007 Webinar Series “Speak Finance Like a Native” Module 3 April 17, 2007 The Other Face or Risk Management – The Art and Science of Hedging Dan McGarvey, CPCU, ARM Managing Director, Marsh Your Webcast Host • Dan McGarvey, CPCU, ARM • Greenville, SC Office Head • Retired (old) Naval Officer • 17 Yr Marsh Veteran •MBA Univ. of Rhode Island 2 My Other Job… 3 4 Thanks for your terrific feedback from Session 2… “It was a little less boring than the first module” Unnamed Risk Manager 5 Your questions are most welcome… …and will be answered in short order 6 In Our Last Episodes... Who are your owners? What is their appetite for risk? Digging to find the answers Building a business case Converting your good ideas to “finance-speak” Don’t miss the exciting conclusion at: www.RIMS.org 7 The value of a dollar, depends on whose it is… 8 A dollar received today is worth more than one promised in the future… 9 Expected Reward The Risk-Reward Continuum Equity Risk Premium Where is your firm? 3.7% (historical T-bill average) Level of Risk 10 Expected Reward The Beta Factor and the Volatility Continuum Where is your firm? Volatility (Beta) 11 Today’s Theme: Sometimes I will pay a dollar today to avoid maybe taking a beating tomorrow… 12 Today’s Theme: This may be in the form of insurance premium, but other times the insurance market may not offer an optimal solution 13 What is Risk? Fundamentally, the exposure to unfavorable variances in any expected outcome 14 Some Types of Risk • Hazard/Casualty • Systematic • Unsystematic • Basis Risk • Counterparty Risk 15 What is a “Hedge” The concept is really quite simple… The Suit Example 16 A Typical Business Cycle... It’s Feast or Famine! 17 A Typical Business Cycle... Impact of a Typical Hedge “Volatility is not our friend” 18 19 Overview of Pop’s • Sells in Southwestern US and approximately 20% in Mexico • Four flavors of popsicles • Differentiators: • Low cost • Family owned • Strong brand 20 Pop’s Risk Analysis Start with “pro-forma” annual business plan and evaluate: Potential sources of raw material cost increases Potential sources of demand reduction Other potential sources of profitability disruption 21 Raw Materials • Sugar • Orange Juice • Wood • Paper • Citric Acid 22 Raw MaterialsProjected Impact • Sugar • Oranges • Wood • Paper • Acid Highly volatile, a significant ingredient – major impact Mitigation strategy established Volatility exists, but per unit price not sufficient to generate concern Material impact, but historically not a volatile commodity Limited impact but some volatility 23 The Spring Water Issue • Part of our marketing since ’62 • A neighbor-owned spring has always provided us water at very reasonable prices • Change is in the air… 24 Demand Factors • Economic outlook • Temperature variances • Foreign exchange rates (Peso) • Pricing and elasticity of demand 25 Demand Factors • Economic outlook Who doesn’t face this variable? (This is clearly a systematic risk) • Temperature variances Very material - but what can we do about the weather besides talk about it? • Foreign exchange rates (Peso) This is an issue – exceeds 20% of sales •Changing deman 26 Orange Juice • Modeling of regional “degree days” and OJ prices yields a strong correlation • This is known as a “natural hedge” • Further mitigation is . likely needed • Why? 27 “Basis Risk” This is what correlation looks like… 50 40 OJ Price 30 20 10 0 0 Degree days in exces 5 10 15 20 25 28 “Basis Risk” A hedge is only as effective as the reliability of the correlation upon which it is based … 50 40 30 20 10 0 0 5 10 15 20 25 29 Operational Mitigation • Pops produces four flavors – only the orange variety contains real juice • Adjusting the mix contained in a box can help mitigate an OJ price spike impact • Orange is historically . the favorite flavor • Impact on demand? 30 Decision Tree Analysis OJ Price Our Impact on Respon Demand Increase se No mitigation +2 cents Subtract one Subtract two No change 10% reduction 20% reduction 31 Monte Carlo Analysis • Allows for “stochastic” (nondeterministic) analysis using multiple variables and randomly generated “real world” trials • Useful when one has modeled a series of decisions and outcomes that rely upon one another 32 Monte Carlo Analysis 33 Sticks • Though the price is volatile, large numbers of popsicle sticks may be safely stored in inventory • A perfect candidate for the use of forward purchasing • Stockpiling is an option too 34 “Forward” Purchase • Any agreement with another party to purchase some item at a future date for a pre-agreed price • In its most simple form, a forward need not be traded on any exchange. This can reduce frictional cost. • A forward normally implies an obligation to purchase on the agreed date 35 Stockpiling Another option t Razors – A rea $ Month 36 Sugar • Highly volatile with no natural hedge • Spoilable and difficult to stockpile • Actively traded on an established exchange • Our demand is variable 37 Options/Futures Markets 38 Using “Options” • For a premium payment, I receive the right (but not the obligation) to purchase a given quantity at a pre-agreed price • This “call” will help me meet future commodity needs at predictable prices • Effective for meeting surge needs 39 Option vs. Insurance • Premium • Commission • ISDA form • Strike price • Option limit • Expiration • Counterparty credit rating 40 Terminology… In the Money Out of the Money Strike Price 41 “Puts” and “Calls” These terms represent the identical options transaction as viewed from the two sides of the transaction mirror… .. 42 Option – 2000 pork bellies at $100 per – expiring June 30th Sell a “Put” Buy a “Call” 43 I What is a Collar? kn ow th is one ! Buy a “call” Sell a “put” 44 Option Variations • American Option – Can be exercised at any time prior to expiration • European Option – Exercisable only on a specified date • Bermudian Option – Exercisable only on certain specified dates • Asian Option – Exercisable at the average price over a specified period 45 Paper and Cartons • Too much volume to make storage of large quantities practical • Many qualified suppliers exist • “Safety stock out” quantity is always kept on hand • Demand is predictable • Active exchange exists 46 Using “Futures” • Obligate you to accept delivery on a given date at a pre-agreed price • Lower frictional cost than Options due to this lesser amount of flexibility • Effective for meeting baseline needs 47 Peso Conversion • As the dollar gets stronger against the Peso, our foreign revenue stream shrinks • What is the most efficient way to hedge this while minimizing frictional cost? • Could a “Swap” work? 48 Similar is size to us, but based in Mexico - with 20% of sales in Texas. 49 “Counterparty Risk” • The effectiveness of a hedge is only as solid as the willingness and capability of your counterparty to the transaction to hold up its end of the bargain • This is very similar to requiring an A- VII or better AM Best rating of your insurers 50 Citric Acid • No active options/futures exchange • Can’t find anyone who profits when the cost of citric acid increases (except for the manufacturer) • Need a willing partner • Can my bank help? 51 A “Derivative” • A financial instrument whose value is derived from an underlying index • The issuer may have no intrinsic interest in this commodity or index • “I don’t care about the price of citric acid, but for a premium I will pretend that I do” • A very viable risk management tool 52 Pure Spring Water • Why not acquire the spring? • Also known as Vertical Integration • Guarantees availability • What do you think? 53 Sensitivity Analysis Sensitivity analysis uses economic modeling to evaluate the potential bottom line impact of volatility involving key business variables 54 Sensitivity Analysis In this case, as simple spreadsheet that includes all the elements of the Income Statement (revenues and expenses) for Pop’s could be used as a starting point… 55 Evaluating Overall Impacts… Standard Deviations Raw mater potential pr variatio Good Bad 56 Parametric Hedge • A financial instrument whose payout is not tied to any loss amount actually sustained, but fixed in advance and based on a specified event that is logically projected to create a loss • Treating a breakdown in the natural orange juice hedge involving heat with extended drought 57 Hedge Valuation • You may strike an agreement to purchase a commodity that you find out you do not need • If your hedge is “in the money”, it is likely worth something to someone else • You may even buy options and futures for pure speculation • Caution – do not try this at home 58 Value The Value of an Option Strike Price 90 Day 30 Day 1 min. “One minute option” Price of underlying commodity 59 Value The Value of an Option Strike Price 30 day option Beta = 1.2 Beta = 1.0 30 day option ce of underlying commodit 60 Black and Scholes Valuation • Current price relative to exercise price How far in the money am I today? • Standard Deviation of underlying price How volatile is the underlying index? • Time remaining until expiration How much time left for this to go South? An increase in any of the above increases the PV of an option 61 The “Greeks” • Delta • Gamma • Vega • Theta Change in option price with change in underlying commodity price Change in Delta with change in underlying commodity price Change in option price with change in volatility of underlying commodity Change in option price with change in time to expiration 62 “Delta” Today’s Spot Price is $90 Our Option (30 day) Strike Price is $90 Does our option have any value? Slope = Delta Option Value 80 90 100 Today’s Price 63 Delta Rules The difference between the underlying commodity price right now and the strike price of the option is the largest determinant of option market price 64 So How Do You Lose Lots? Example: Pop’s manages its exposure to volatile sugar prices with an open ended sugar swap with a Hawaiian cruise line. ($1 million per inch off expected) 95% confidence Interval Out of the Money In the Money 40” 45” 50” 56” !!! 65 Dan the “Rogue Trader” Did I mention this gets worse? 56” or rain is so heavy, it washes away much of the sugar cane crop!!! • “Lightening can’t strike twice” • Bank half the loss for next year • We’ll pay double if out of the money How do you manage this risk? 66 Value at Risk (VAR) • A single figure estimate of possible loss potential in a portfolio • Monte Carlo analysis used to identify “perfect storm” loss conditions within anticipated trading ranges • Confidence interval must be stipulated • • Akin to MPL in property analysis VAR limitations are a board level issue 67 Value at Risk (VAR) Traders view VAR guidelines the way you may view your “insurance budget” Board members may view it differently 68 Bonus Term “Wearing” the Risk – A colloquial term traders use to describe what we might call risk allocation. They view risk as a hot potato to be passed among parties to a deal until some poor sap (by design or by default) ends up “wearing” it. 69 The Secrets to Becoming Conversant in Finance and Accounting • Finance and Accounting have a language all their own • Risk management also has its own set of terms - which can generate frustration • Actively listen and ask questions to increase your vocabulary • Its not all about numbers and math! 70 Shameless Plug: Thanks to Marsh and RIMS for their sponsorship of this series All three modules will be archived at www.RIMS.org and available for your access I hope to see you in New Orleans! 71 You are most welcome to join my Wednesday sessions at RIMS national.. 72 Thank You for Your Kind Attention 73