23
Risk Management:
An Introduction to
Financial
Engineering
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand the types of volatility that
companies can manage
 Understand how to develop risk profiles
 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
23-1
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
23-2
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
23-3
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
23-4
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
23-5
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 do a better analysis of future projects
 Available tools: forwards, futures, swaps,
futures options
23-6
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
23-7
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
23-8
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
23-9
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
23-10
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
23-11
Figure 23.7
23-12
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
23-13
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
23-14
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
23-15
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
23-16
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
23-17
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%
23-18
Figure 23.10
23-19
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
23-20
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
23-21
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
23-22
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
23-23
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
23-24
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
23-25
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?
23-26
End of Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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