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 [...]... 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... to a loss – Open interest is how many contracts are currently outstanding 23- 16 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...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... 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 23- 15 Futures Quotes • See Table 23. 1 • Commodity, exchange, size, quote units – The contract size is important... 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. .. 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... 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... 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... 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)... 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 23- 21 Payoff Profiles: Calls 23- 22 Payoff Profiles: Puts 23- 23 Hedging Commodity Price Risk with Options • “Commodity” options are generally futures . 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. 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. 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