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Chapter 23
Risk Management:
An introduction to
Financial Engineering
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
• Understand the risk exposure companies
face and how to hedge these risks
• 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 conduct 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
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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
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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
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%
Pay
Receive
Net
LIBOR + .5%
8.5%
-LIBOR
8.5%
LIBOR + .5%
9%
LIBOR + .5%
Swap Dealer w/B
LIBOR + .5%
9%
Swap Dealer Net
LIBOR + 9%
LIBOR + 9.5%
Company A
Swap Dealer w/A
Company B
-9%
+.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
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Payoff Profiles: Calls
Sell a Call E = $40
Buy a call with E = $40
0
70
-10 0
60
40
60
80 100
-20
Payoff
50
Payoff
20
40
30
-30
-40
20
-50
10
-60
0
-70
0
20
40
60
80 100
Stock Price
Stock Price
23-22
Payoff Profiles: Puts
Sell a Put E = $40
0
45
40
35
30
25
20
15
10
5
0
-5 0
-10
20
40
60
80 100
-15
Payoff
Payoff
Buy a put with E = $40
-20
-25
-30
-35
-40
-45
0
20
40
60
80 100
Stock Price
Stock Price
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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
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?
23-27
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?
23-28
End of Chapter
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