Chapter
TwentyFour
Risk Management:
An Introduction to
Financial
Engineering
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
24.1
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
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24.2
Hedging & Price Volatility 24.1
• 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
• Hedging (immunization) – Reducing a firm’s
exposure to price or rate fluctuations
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24.3
Hedging & Price Volatility (cont.)
• Instruments have been developed to hedge the
following types of volatility
– Interest Rate
– Exchange Rate
– Commodity Price
• Financial Engineering - is the use of existing
financial instruments to create new ones that
allow firms to hedge against specific risks.
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24.4
Hedging & Price Volatility (cont.)
• Derivative – A financial asset that represents a
claim to another financial asset. It derives its
value from that other asset
Example
A stock option gives the owner the right to buy
or sell stock, a financial asset, so stock options
are derivative securities.
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24.5
Hedging & Price Volatility (cont.)
• The process of financial engineering often
involves creating new derivative securities or
combining existing derivatives to accomplish
the firm’s hedging goals.
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24.6
Interest Rate Volatility
• Debt is a key component of a firm’s capital
structure
• Interest rates are a key component of a firm’s
cost of capital
• 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
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24.7
Interest Rate Volatility (cont.)
• Available tools: forwards, futures, swaps,
futures options, and options
• In March 1980, the Bank of Canada dropped
its discretionary interest rate policy for a
system that allows floating interest rates. This
led to an increase in the volatility of interest
rates.
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24.8
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, and options
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24.9
Exchange Rate Volatility (cont.)
• The exchange rate volatility for the U.S. dollar
and Canadian dollar has increased enormously
since the early 1970s.
• The reason for that was the breakdown of the
Bretton Woods accord that guaranteed that
exchange rates were fixed for the most part
and significant changes rarely occurred.
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24.10
Commodity Price Volatility
• Most firms face volatility in the costs of basic goods
and materials and in the price that will be received
when products are sold (sale price)
• 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 (depends on type of commodity):
forwards, futures, swaps, futures options, and options
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24.11
Commodity Price Volatility (cont.)
• Example:
- Oil is one of the most important commodities.
Oil prices have become increasingly uncertain
since the early 1970s (why?)
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24.12
The Risk Management Process 24.2
• 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
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24.13
The Risk Management Process (cont.)
• Example
- An all-equity firm would not be concerned
about interest rate fluctuations as a highly
leveraged firm.
- A firm with little or no international activity
would not be overly concerned about
exchange rate fluctuations.
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24.14
Risk Profiles
• Basic tool for identifying and measuring
exposure to risk
• A firm’s risk profile shows the relationship
between changes in the price of a particular
good, service, or rate and changes in the firm’s
value
• The steeper the slope of the risk profile, the
greater the exposure and the more a firm needs
to manage that risk
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24.15
Figure 24.6 – Risk Profile for a Wheat Grower
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24.16
Risk Profile for a Wheat Grower (cont.)
• Because the risk profile slopes up, increases in
wheat prices will increase the value of the
firm.
• Because the risk profile has a steep slope, the
wheat grower has a significant exposure to
wheat price fluctuations and they should take
steps to reduce that exposure.
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24.17
Figure 24.7 – Risk Profile for a Wheat Buyer
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24.18
Reducing Risk Exposure
• The goal of hedging is to lessen the slope of
the risk profile
• Hedging will not normally reduce risk
completely
– 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
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24.19
Reducing Risk Exposure (cont.)
• Example
- Consider a firm that uses rice to make a popular brand of
cereal. If the price of rice increases, the firm that raises and
processes the rice will benefit; the firm that uses the rice in its
cereal will lose.
- By signing a contract specifying that the rice producer will
deliver a certain quantity of rice at a certain price, the cereal
manufacturer has reduced (or eliminated) the uncertainty
about the cost of rice. At the same time, the rice producer has
eliminated uncertainty about the price they will receive for the
processed rice.
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24.20
Reducing Risk Exposure (cont.)
• Timing
– Short-run exposure (transactions exposure) –
short-term price fluctuations due to unexpected
events or shocks are referred to as transitory
changes. These changes can be managed in a
variety of ways
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24.21
Reducing Risk Exposure (cont.)
• Timing
– Long-run exposure (economic exposure) – some
price fluctuations may reflect permanent changes
due to a fundamental shift in the underlying
economics of a business. Almost impossible to
hedge, requires the firm to be flexible and adapt to
permanent changes in the business climate
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24.22
Forward Contracts 24.3
• Forward contracts are among the oldest tools for risk
management
• A contract where two parties agree on the price of an
asset today to be delivered and paid for at some
future date
• The delivery date of the goods is called the settlement
date
• The agreed-upon price is called the forward price
• If prices increase before the delivery date, the buyer
benefits
• If prices decrease before the delivery date, the seller
benefits
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24.23
Forward Contracts (cont.)
• 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
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24.24
Payoff profiles for a forward contract
• The payoff profile – is a plot that depicts the
gains and losses on a forward contract that
result from unexpected price changes
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24.25
Figure 24.8 – Payoff profiles for a forward contract
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24.26
Hedging with Forwards
• The basic idea is to use a risk profile to identify the
firm’s exposure to a given type of financial risk.
• Financial managers try to find a financial
arrangement (e.g., forward contract) that that has a
offsetting payoff profile.
• Entering into a forward contract can virtually
eliminate the price risk a firm faces
– It does not completely eliminate risk because both
parties still face credit risk
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24.27
Hedging with Forwards (cont.)
• Credit risk
- There is a credit risk involved because no
money changes hands until a forward contract
is actually completed
- The party on the losing end of the deal has an
incentive to default on the agreement
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24.28
Hedging with Forwards (cont.)
• Since it eliminates the price risk , it prevents
the firm from benefiting if prices move in the
company’s favor (i.e., favorable price
adjustments)
• The firm also has to spend some time and/or
money evaluating the credit risk of the
counterparty
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24.29
Hedging with Forwards (cont.)
• Forward contracts are primarily used to hedge
exchange rate risk
• Example
Jaguar, the U.K. auto manufacturer, historically
hedged the U.S. dollar-British pound exchange
rate for six months into the future.
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24.30
Figure 24.10 – Hedging with forward contracts
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24.31
Futures Contracts 24.4
• Future contracts are identical to forward contract
with one exception
• With a forward contract, gains and losses are
recognized only on the settlement date
• With futures contracts, gains and losses to the buyer
or seller are recognized on a daily basis. This daily
settlement feature is referred to as marking-to-market
• This daily settlement greatly reduces the default risk
associated with forward contracts
• Because of this, organized trading in futures contracts
is much more common than in forwards contracts
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24.32
Trading in Futures
• Future contracts for many items are routinely bought
and sold around the world
• There are two main types of futures contracts:
commodity futures and financial futures
• The underlying asset in a commodity future is
essentially anything except a financial asset
• The underlying asset in a financial future is any type
of financial asset (e.g., stock, bond, etc.)
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24.33
Futures Exchanges
• The largest futures exchange is the Chicago Board of
Trade (CBOT)
• Other major exchanges include:
- The Chicago Mercantile Exchange (COMEX)
- The London International Financial Futures
Exchange (LIFFE)
- The New York Futures Exchange (NYFE)
- The Winnipeg Commodity Exchange (WPG)
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24.34
Hedging with Futures
• A hedge created with futures contracts is
conceptually the same as a hedge created with
forward contracts.
• The payoff profiles are drawn in the same way.
• The only difference is that a firm hedging with
futures must maintain an account with an investment
dealer.
• The account will be debited or credited every day.
• Although there is a large variety of futures contracts
available, many firms may not be able to hedge the
exact quantity, quality, and/or delivery date they
desire
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24.35
Hedging with Futures (cont.)
• Example – a firm may produce a certain grade of oil
and find that no contract exists for exactly that grade.
However, all oil prices tend to move together, so the
firm can hedge its output using future contracts on
other grades of oil.
• This process is called cross-hedging. The firms buy
contracts on a related, but not identical asset, to
establish their hedge.
• Credit risk is virtually nonexistent
• Futures contracts are available on a wide range of
physical assets, debt contracts, currencies and
equities
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24.36
Hedging with Futures (cont.)
• In practice, future contracts are very rarely held to
maturity.
• Firms usually sell and buy contracts, reversing their
financial position before the contracts mature.
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24.37
Swaps 24.5
• A swap contract is an agreement between two parties
to exchange specified cash flows at specified
intervals based on specified relationships
• The swap contract can be viewed as a series of
forward contracts
• The major difference is that there are multiple
exchanges, whereas forward contracts involve only
one exchange
• Generally limited to large creditworthy institutions or
companies
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24.38
Currency Swaps
• The two parties agree to exchange a specific amount
of one currency for a specific amount of another
currency at a specified future date
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24.39
Interest Rate Swaps
• In an interest rate swap, firms typically exchange
fixed-rate loans for floating rate loans (and viceversa).
• Frequently, interest rate swaps are combined with
currency swaps.
• In this case, one firm will obtain fixed-rate financing
in one currency and then swap it for floating rate
financing in another currency.
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24.40
Commodity swaps
• A commodity swap is an agreement to exchange a
specified quantity of some commodity at a specified
future date
• This is the newest type of swap and, to date, the
market for commodity swaps is relatively small
compared to the other swap markets
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24.41
The Swap Dealer
• Unlike futures contracts, swap contracts are not
traded on organized exchanges
• When a firm enters into a swap contract, the dealer
takes the opposite side of the agreement
• The swap dealer will then try to find an offsetting
transaction with some other party
• If this is not possible, dealers hedge their positions
with futures contracts
• A dealer’s contracts are detailed in a swap book.
• In general, dealers try to keep a balanced book
(called a matched book) to limit their net exposure
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24.42
Option Contracts 24.6
• An option contract differs from forward, futures, and
swap contracts in that the owner of the contract has
the right, but not the obligation, to buy (sell) an asset
for a set price on or before a specified date
– Call option – right to buy the asset
– Put option – right to sell the asset
– Exercise or strike price –specified price at which the asset is bought or
sold
– Expiration date – last date at which the option may be exercised
• Unlike forwards and futures, options allow a firm to
hedge downside risk, but still participate in upside
potential
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24.43
Options versus Forwards
• There are two main differences between
option contracts and forward contracts:
1- The transaction associated with an option contract is
only completed if the owner of the option chooses to
exercise it
2- The buyer of the option obtains the right to purchase
the underlying asset, that right is valuable. Therefore,
the buyer of an option must pay an option premium
for that right. In a forward contract, no money
exchanges hands until the transaction is completed.
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24.44
Option Payoff Profiles
• The horizontal axis shows the difference between the
asset’s value and the strike price on the option
• For a call option
- the owner begins to make a profit when the price of the
underlying asset rises above the strike price
- from the seller’s viewpoint, any gain to the owner of the
option is a loss to the seller of the option
For a put option
- the owner begins to make a profit when the price of the
underlying asset falls below the strike price
- a gain to the buyer of a put option is a loss to the seller of the
option
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24.45
Figure 24.14 A & B – Payoff Profiles: Calls
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24.46
Figure 24.14 C & D – Payoff Profiles: Puts
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24.47
Option Hedging
• It works in the same way as hedging with a forward
or futures contract
• Use options to create a payoff profile exactly the
opposite of the cash flow expected
• Because of the nature of options, firms can use option
contracts to hedge against the downside risk caused
by adverse price movements
• At the same time, they can retain the potential for
upside benefits if prices move in the desired direction
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24.48
Figure 24.15 – Hedging with Options
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24.49
Hedging Commodity Price Risk with Options
• In addition to futures contracts on commodities, there
are now options available on the same commodities
• The options traded on commodities are really options
on futures contracts; they are referred to as futures
options
• The owner of a futures call option receives a futures
contract on the underlying commodity; in addition
the owner receives the difference between the strike
price on the option and the current futures price
• This difference is paid in cash
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24.50
Hedging Commodity Price Risk with Options (cont.)
• Example
- When a futures call option on wheat is exercised, the owner of
the option receives two things
- The first is a futures contract on wheat at the current futures
price
- This contract can be immediately closed at no cost
- The second thing the owner of the option receives is the
difference between the strike price on the option and the
current futures price
- This difference is paid in cash
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24.51
Hedging Commodity Price Risk with Options (cont.)
• “Commodity” options are generally futures options
• Exercising a call
-
-
Owner of a call option receives a long position in the futures contract plus
cash equal to the difference between the exercise price and the futures
price
Seller of a call option 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 a put option receives a short position in the futures contract plus
cash equal to the difference between the futures price and the exercise
price
Seller of a put option receives a long position in the futures contract and
pays cash equal to the difference between the futures price and the exercise
price
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24.52
Hedging Exchange Rate Risk with Options
• Future options are also available on foreign
currencies
• Future options allow firms to create additional
hedges against exchange rate risk
• May use either futures options on currency or straight
currency options
• Used primarily by corporations that do business
overseas
• Canadian companies want to hedge against a
strengthening dollar (receive fewer dollars when you
convert foreign currency back to dollars)
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24.53
Hedging Exchange Rate Risk with Options (cont.)
• 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
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24.54
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 a call
• If set up properly, the firm will not have either a cash inflow or
outflow associated with this position
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24.55
Hedging Interest Rate Risk with Options (cont.)
• Interest Rate Caps – if interest rate rise above an
agreed upon ceiling, the bank pays the cash
difference between the actual payment and the
interest rate ceiling
• Interest Rate Floor – the firm’s rate will never drop
below the floor price
• Collar – the firm knows its interest rate will always
be between the floor and ceiling rates
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24.56
Summary 24.7
• The motivation for risk management stems from the
fact that firms face exposure to undesirable risk
• Firm’s risk profile is altered through the use of
derivatives – forwards, futures, swaps, options and
futures options
• Hedging can help enhance the value of a firm by
stabilizing short-term cash flows, giving the firm
time to react and adapt to changing market
conditions, and allowing the firm to take on new
projects that would otherwise be considered too risky
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