Research " Financial Derivatives in Corporate Risk Management " potx

The Dissertation Committee for Mulong Wang Certifies that this is the approved version of the following dissertation: Financial Derivatives in Corporate Risk Management Committee: Patrick L. Brockett Supervisor’s name, Supervisor Richard D. MacMinn Co-Supervisor’s name, Co-Supervisor Jonathan F. Bard Member’s name Douglas J. Morrice Member’s name Thomas W. Sager Member’s name Financial Derivatives in Corporate Risk Management by Mulong Wang, B.S. Dissertation Presented to the Faculty of the Graduate School of the University of Texas at Austin in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy The University of Texas at Austin August 2001 UMI Number: 3036610 ________________________________________________________ UMI Microform 3036610 Copyright 2002 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ____________________________________________________________ ProQuest Information and Learning Company 300 North Zeeb Road PO Box 1346 Ann Arbor, MI 48106-1346 Dedicated to Helen, My wife Acknowledgements I want to thank all those kind people who advised or helped my dissertation research. I am greatly indebted to my supervisors, Drs. Patrick Brockett and Richard MacMinn. This dissertation would not have been finished without their kind guidance, discussion, and encouragements. It has been an extremely valuable experience to study and work under their supervision. I also would like to thank my dear wife, Helen. With her consistent encouragements and help, I can dedicate to this research. Drs. Jonathan Bard, Douglas Morrice and Thomas Sager provided numerous comments on this dissertation. Their service on my dissertation committee is greatly appreciated. Colleagues in Center of Risk Management and Insurance and Center of Management and Operations for Logistics also provided a lot of help in my PhD student career. Their discussions inspired a lot of this dissertation research and other research projects. v Financial Derivatives in Corporate Risk Management Publication No. Mulong Wang, Ph.D. The University of Texas at Austin, 2001 Supervisors: Patrick L. Brockett and Richard D. MacMinn This dissertation addresses how the weather derivative hedges the corporate risk, how to price the indexed derivative as an exotic derivative instrument, and the implications of basis risk embedded in the weather derivative. The traditional one-dimension financial market framework is expanded to include the weather index. Under this expanded framework, the stock market values of the unhedged and hedged firms are studied first. This provides the base to investigate the pricing formula for weather derivative under the expanded framework. It is found that both financial and actuarial approaches are integrated vi to price the weather derivative. A positive risk management paradigm must provide the criteria to choose the optimal hedging instrument(s) for separable risks. This dissertation provides the criteria to choose optimal hedging contract set to hedge the weather risk, under different corporate leverage levels. It has been found that weather derivative outperforms the traditional commodity forward in most of the scenarios. When corporate leverage levels increase, the positive role of the weather derivative or the commodity forward diminishes. Basis risk arises by introducing the standard weather index, and providing the industry-standard payment when the weather derivative is exercised. The implication of basis risk is investigated under the same expanded framework. It is found that in most of the scenarios, basis risk is innocuous. vii TABLE OF CONTENTS Chapter I. Introduction…………………………………………………1 1.1 Background……………………………………………….2 1.2 Literature on Risk and Risk Management………….7 1.3 The Frontier of Risk Management ………………….11 1.4 Weather Risk and Weather Derivatives ……………13 Chapter II. Weather Derivative and Its Valuation……………….17 2.1 Introduction…………………………………………………17 2.2 Basic Model …………………………………………………28 2.3 Valuation of Weather Derivative……………………… 38 Chapter III. Weather Derivative and Commodity Forward…… 48 3.1 Scenario sets…………………………………………………49 3.2 Optimal Hedging…… …………………………………….58 Chapter IV. Basis Risk and Its Implications……………………….86 4.1 Introduction………………………………………………….86 4.2 Implications of Basis Risk…………………………………89 viii Appendix I. Figures ………………………………………………………106 Appendix II. Extensions of Principle of Increasing Uncertainty…125 Reference…………………………………………………………………….135 Vita……………………………………………………………………………142 ix Chapter I Introduction This dissertation addresses how the weather derivative hedges the corporate risk, how to price the indexed derivative as an exotic derivative instrument, and the implications of basis risk. These topics are summarized in an expanded uncertainty model. Under this framework, different hedging instruments for studying the optimal hedging portfolios are compared. In economics and finance literature, risk has been a subject of interest and study in many fields including management science, decision science, and psychology. With the new risks being continuously discovered, innovative strategies and tools were created to manage them or transfer them. In this chapter, the background of risk creation, identification and the importance of risk management are discussed first. In the second chapter, the economic and financial literature on risk and risk management, most of which concentrates on the mechanism of financial derivatives to hedge the risk, or insurance contract to transfer the individual risk or corporate risk, is reviewed. The third chapter studies the new frontier of risk management strategies and tools. In the last part, the weather 1 [...]... the investors, but also a hedging vehicle for the cedents, which represents a vehicle combining both pure risk and speculative risk With the discovery of new risks, new hedging instruments will be developed to further blur the line of pure risk and speculative risk, making the distinction between insurance and finance even more 3 ambiguous Nowadays, the risk- management process is becoming an increasingly... Schlesinger (1983a); Doherty and Schlesinger (1983b); Mayers and Smith (1982); Mayers and Smith (1983)] In general, insurance has been demonstrated to be an indispensable risk- management instrument It was found that insurance should be included in the optimal investment portfolio when pure risk is present The role that insurance plays in financial markets can be explained by distinguishing between risks... continuously This dissertation is an attempt to examine how weather derivatives are incorporated into the corporate contract sets, how to price the indexed derivatives, and the implications of the basis risk The Appendix is an expansion of the uncertainty model [c.f., MacMinn and Holtmann (1983)], including more stochastic inputs, to examine whether the widely cited Principle of Increasing Uncertainty... financial industries solve the problem of risk management In general, the property/casualty insurance industry uses the principle of diversification, pooling many uncorrelated risks and charging a premium based on actuarial probabilities of occurrence of different risks and their correlations Financial derivatives in risk management are based on the option pricing and hedging algorithms, which were originally... of financial markets is to efficiently allocate the risk and facilitate the redistribution of risk The development of financial markets has been benefited from the better understanding of separable risks When the risk becomes more transparent, it facilitates the redistribution process in the financial market Insurance contract is a subset of financial contracts If the combination of insurance and financial. .. of business have skyrocketed, making risk management even more important for businesses These types of costs of uncontrolled risk can, and have, bankrupted corporations while clearly focusing other corporations on the importance of managing and controlling their own 5 1 See George Rejad’s Principle of Risk Management and Insurance risks An integral part of managing risk is to transfer the financial. .. instruments and insurance contracts was largely ignored The main purpose of risk management is to preserve or create values by selecting optimal contract sets For firms, corporate value is preserved by the inclusion of hedging instruments in the financial contracts For individual investors, more expected utility is created by the inclusion of insurance and/or other hedging contracts in the investment portfolio... homeowners, and other insurance to stabilize their financial conditions, and prepare for uncontrollable risks such as accidents, death or illness 6 1.2 Literature on Risk and Risk Management In the economics and finance literature, risk and risk management have drawn considerable attention One of the major instruments to manage risk is insurance At the corporate level, the role and impact of using insurance to... weather risk is its independence with most other risks Consequently, it may be considered as a second source of risk, in addition to other existing risk in the corporate finance literature Another implication of using the weather derivative is from the basis risk Though basis risk has been extensively interpreted recently [c.f., MacMinn (2000)], few studies quantified basis risk according to the corporate. .. efficient risk management program may be a lower cost of employment, since workers are more willing to be employed in a financially stable firm with a lower wage than work in a risky firm In summary, an efficient risk management program will not only reduce the level of losses incurred by a firm, but it will also 4 help the firm improve its financial performance and employee morale From a corporate finance . indispensable risk- management instrument. It was found that insurance should be included in the optimal investment portfolio when pure risk is present. The role that insurance plays in financial. hedging instruments for studying the optimal hedging portfolios are compared. In economics and finance literature, risk has been a subject of interest and study in many fields including management. of risk management are discussed first. In the second chapter, the economic and financial literature on risk and risk management, most of which concentrates on the mechanism of financial derivatives