FM11 Ch 23 Derivatives and Risk Management

Using derivatives to reduce interest rate risk.. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios.. Risk

Risk management and stock value maximization

Derivative securities.

Fundamentals of risk management.

Using derivatives to reduce interest rate risk.

CHAPTER 23

Derivatives and Risk Management

If volatility in cash flows is not caused by systematic risk, then stockholders can

eliminate the risk of volatile cash flows

by diversifying their portfolios

Stockholders might be able to reduce

impact of volatile cash flows by using

risk management techniques in their own portfolios.

Do stockholders care about volatile

cash flows?

How can risk management increase the

value of a corporation?

Risk management allows firms to:

 Have greater debt capacity , which

has a larger tax shield of interest

payments.

 Implement the optimal capital budget

without having to raise external

equity in years that would have had low cash flow due to volatility (More )

Risk management allows firms to:

 Avoid costs of financial distress

Weakened relationships with

suppliers.

Loss of potential customers.

Distractions to managers.

 Utilize comparative advantage in

hedging relative to hedging ability of investors.

(More )

Risk management allows firms to:

 Reduce borrowing costs by using

interest rate swaps.

Example: Two firms with different

credit ratings, Hi and Lo:

Hi can borrow fixed at 11% and

floating at LIBOR + 1%.

Lo can borrow fixed at 11.4% and

floating at LIBOR + 1.5% (More )

Hi wants fixed rate, but it will issue

floating and “swap” with Lo Lo wants

floating rate, but it will issue fixed and

swap with Hi Lo also makes “side

(More )

Risk management allows firms to:

 Minimize negative tax effects due to

convexity in tax code.

Example: EBT of $50K in Years 1 and 2,

total EBT of $100K , Tax = $7.5K each year, total tax of $15

EBT of $0K in Year 1 and $100K in Year 2, Tax = $0K in Year 1 and $22.5K in Year 2.

Corporate risk management is the

management of unpredictable

events that would have adverse

consequences for the firm.

What is corporate risk management?

Speculative risks : Those that offer the

chance of a gain as well as a loss.

Pure risks : Those that offer only the

prospect of a loss.

Demand risks : Those associated with

the demand for a firm’s products or

services.

Input risks : Those associated with a

firm’s input costs.

Definitions of Different Types of Risk

(More )

Financial risks : Those that result from

financial transactions.

Property risks : Those associated with loss

of a firm’s productive assets.

Personnel risk : Risks that result from human actions.

Environmental risk : Risk associated with

polluting the environment.

Liability risks : Connected with product,

service, or employee liability.

Insurable risks : Those which typically can

be covered by insurance.

Step 1 Identify the risks faced by the

firm.

Step 2 Measure the potential impact of

the identified risks.

Step 3 Decide how each relevant risk

should be dealt with.

What are the three steps of corporate risk management?

Transfer risk to an insurance company

by paying periodic premiums.

Transfer functions which produce risk

to third parties.

Purchase derivatives contracts to

reduce input and financial risks.

What are some actions that companies can take to minimize

or reduce risk exposures?

(More )

Take actions to reduce the

probability of occurrence of

adverse events.

Take actions to reduce the

magnitude of the loss associated

with adverse events.

Avoid the activities that give rise

to risk.

Financial risk exposure refers to the

risk inherent in the financial markets

due to price fluctuations.

Example : A firm holds a portfolio of

bonds, interest rates rise, and the

value of the bonds falls.

What is a financial risk exposure?

Derivative : Security whose value stems or

is derived from the value of other assets

Swaps, options, and futures are used to

manage financial risk exposures.

Futures : Contracts which call for the

purchase or sale of a financial (or real) asset

at some future date, but at a price determined today Futures (and other derivatives) can be used either as highly leveraged speculations

or to hedge and thus reduce risk.

Financial Risk Management Concepts

(More )

Hedging: Generally conducted where

a price change could negatively affect a

firm’s profits.

Long hedge : Involves the

purchase of a futures contract to

guard against a price increase.

Short hedge : Involves the sale of a

futures contract to protect against a

price decline in commodities or

financial securities.

(More )

Swaps : Involve the exchange of cash payment obligations between two

parties, usually because each party

prefers the terms of the other’s debt

contract Swaps can reduce each

party’s financial risk.

The purchase of a commodity

futures contract will allow a firm to make a future purchase of the input

at today’s price, even if the market price on the item has risen

substantially in the interim.

How can commodity futures markets

be used to reduce input price risk?

Risk identification and

measurement

Property loss, liability loss, and

financial loss exposures

Bond portfolio risk management

Chapter 23 Extension:

Insurance and Bond Portfolio

Risk Management

Large corporations have risk

manage-ment personnel which have the

responsibility to identify and measure

risks facing the firm.

Checklists are used to identify risks.

Small firms can obtain risk manage-ment services from insurance companies or

risk management consulting firms.

How are risk exposures identified

and measured?

Property loss exposures : Result from various perils which threaten a firm’s

real and personal properties.

Physical perils : Natural events

Social perils : Related to human

actions

Economic perils : Stem from external economic events

Describe (1) “property” loss and

(2) “liability” loss exposures.

Liability loss exposures : Result from

penalties imposed when responsi-bilities are not met.

Bailee exposure : Risks associated

with having temporary possession of another’s property while some service

is being performed (Cleaners ruin

your new suit.)

Ownership exposure : Risks inherent

in the ownership of property

(Customer is injured from fall in store.)

Business operation exposure :

Risks arising from business

practices or operations (Airline

sued following crash.)

Professional liability exposure :

Stems from the risks inherent in

professions requiring advanced

training and licensing (Doctor

sued when patient dies, or

accounting firm sued for not

detecting overstated profits.)

Both property and liability exposures can be accommodated by either self-

insurance or passing the risk on to an insurance company.

The more risk passed on to an insurer, the higher the cost of the policy

Insurers like high deductibles, both to lower their losses and to reduce moral hazard.

What actions can companies take

to reduce property and liability exposures?

By appropriately spreading business risk over several activities or

operations, the firm can significantly reduce the impact of a single random event on corporate performance

Examples : Geographic and product diversification.

How can diversification reduce

business risk?

Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations.

Example : A firm holds a portfolio of

bonds, interest rates rise, and the value

of the bonds falls.

What is a financial risk exposure?

Duration : Average time to bondholders' receipt of cash flows, including interest

and principal repayment Duration is used

to help assess interest rate and

reinvestment rate risks.

Immunization : Process of selecting

durations for bonds in a portfolio such that gains or losses from reinvestment exactly match gains or losses from price changes. Financial risk management concepts: