Chapter 24
Derivatives and Risk Management
1
Topics in Chapter

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Risk management and stock value
maximization.
Derivative securities.
Fundamentals of risk management.
Using derivatives to reduce interest rate
risk.
2
Do stockholders care about
volatile cash flows?


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.
3
How can risk management increase
the value of a corporation?

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
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...
)
4
Risk management allows firms
to:

Avoid costs of financial distress.
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Weakened relationships with suppliers.
Loss of potential customers.
Distractions to managers.
Utilize comparative advantage in
hedging relative to hedging ability of
investors.
(More...
)
5
Risk management allows firms
to (Continued):
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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...
6
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 payment” of
0.45% to Hi.
Hi
CF to lender
Lo
-(LIBOR+1%)
-11.40%
CF Hi to Lo
-11.40%
+11.40%
CF Lo to Hi
+(LIBOR+1%)
-(LIBOR+1%)
CF Lo to Hi
+0.45%
-0.45%
Net CF
-10.95%
-(LIBOR+1.45%)
(More…)
7
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.
8
What is corporate risk
management?

Corporate risk management is the
management of unpredictable events
that would have adverse consequences
for the firm.
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Different Types of Risk

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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.
(More...
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)
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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.
11
What are the three steps of
corporate risk management?



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.
12
What are some actions that companies
can take to minimize or reduce risk
exposures?



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.
(More...
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)
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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.
14
What is financial risk
exposure?


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.
15
Financial Risk Management
Concepts

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.
(More...16

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.
17

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...
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)

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.
19
How can commodity futures markets
be used to reduce input price 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.
20
Chapter 24 Extension: Insurance and
Bond Portfolio Risk Management

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Risk identification and measurement
Property loss, liability loss, and financial
loss exposures
Bond portfolio risk management
21
How are risk exposures identified
and measured?

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Large corporations have risk management personnel which have the
responsibility to identify and measure
risks facing the firm.
Checklists are used to identify risks.
Small firms can obtain risk management services from insurance
companies or risk management
consulting firms.
22
Describe (1) “property” loss and
(2) “liability” loss exposures.

Property loss exposures: Result from
various perils which threaten a firm’s
real and personal properties.

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Physical perils: Natural events
Social perils: Related to human actions
Economic perils: Stem from external
economic events
23

Liability loss exposures: Result from
penalties imposed when responsi-bilities are
not met.

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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.)
24
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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.)
(More…)
25
What actions can companies take
to reduce property and liability
exposures?

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Both property and liability exposures
can be accommodated by either selfinsurance 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.
26
How can diversification reduce
business risk?


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.
27
What is financial risk
exposure?


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.
28
Financial risk management
concepts


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.
29
Hedging a bond issue with TBond Futures

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It is January, Tennessee Sunshine will
issue $5 million in bonds in June. TS is
worried interest rates will rise between
now and then.
Current interest rates are 7% for the
20-year issue. But TS fears rates might
rise by 1% by June.
June T-bond futures are 111-25.
30
What are risks of not hedging?

Interest rates might increase before the
bonds are issued. At a yield of 8%, how
much will the $5 million worth of 20-year
7% semi-annual coupon bonds be worth?
31

Pmt = $5 million x 7%/2 = $175,000
INPUTS
OUTPUT
40
N
4
I/YR
175000 5000000
PV
PMT
FV
-4,505,181
32


The bonds will be worth only $4,505,181 so
TS will lose $5,000,000 - $4,505,181 =
$494,819 if interest rates decline.
Actually, TS might just issue $5,000,000 of
8% bonds if it waits and interest rates
increase, but the cost of this higher interest
rate is the $494,819 we calculated.
33
How can Tennessee Sunshine
hedge this risk?


T-Bond futures represent a contract on
a hypothetical 20-year 6% bond with
semiannual payments.
A futures price of 111’25 means 111%
plus 25/32 percent of par, or for a
$1,000 par bond, a price of $1,117.81.
34
T-bond futures contract


One T-bond futures contract is for
$100,000 par value of underlying
bonds, which is 100 of the $1,000 parvalue bonds. Since each bond is worth
$1,117.81, one contract is for $111,781
worth of bonds.
TS will sell $5,000,000/$111,781 = 44.7
= 45 contracts.
35
Implied yield on futures
contract

A price of $1,117.81 gives a semiannual yield of 2.5284% or an annual
yield of about 5.057%:
INPUTS
OUTPUT
40
N
-1117.81 30
I/YR
PV
PMT
2.5284
1000
FV
36
Futures price changes

T-bond futures prices change every day
as interest rates change. If interest
rates increase, bond prices decrease
and so does the T-bond futures price.
If interest rates decrease, then bond
prices increase, and so does the T-bond
futures price.
37
What happens if interest rates
increase 1%?


The yield on the bond underlying the futures
contract will increase to 5.057% + 1% =
6.057%. This gives a new price of $993.44
(N=40, I/YR=6.057/2, PMT = -30, FV = 1000; solving gives PV = 993.44 per
underlying bond, or a contract price of
$99,344.
This is a decrease of $111,781 - $99,344 =
$12,437 for each contract.
38
Profit or loss from contract


Since TS sold futures contracts, then it
makes money when the futures price
declines. In this case, TS will make
$12,437 on each of its 45 contracts.
Since TS sold the futures contracts and
the price went down, it earns a positive
profit of $12,437 x 45 contracts =
$559,665.
39
What is the effectiveness of
the hedge?


TS will lose $494,819 on its own bonds
when it issues them at the higher
coupon rate, but it earns $559,665 on
its futures contracts.
Net result = 559,665 – 494,819 =
$64,846 profit from the hedge.
40
Suppose interest rates fall
instead of rise?

If interest rates fall, then:


TS gains on its bond issue
TS loses on its futures contracts
41