Chapter 24
RISK MANAGEMENT: AN
INTRODUCTION TO
FINANCIAL ENGINEERING
Chapter Outline
Hedging and Price Volatility
 Managing Financial Risk
 Forward Contracts
 Futures Contracts
 Option Contracts

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Hedging Volatility
Volatility in returns is a 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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Managing Financial Risk

Instruments have been developed to
hedge the following types of volatility
◦ Interest Rate
◦ Exchange Rate
◦ Commodity Price

Derivative – A financial asset that
represents a claim to another asset. It
derives its value from that other asset’s
price volatility
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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
 Available tools: forwards, futures, swaps,
futures options, and options

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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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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 (depends on type of commodity):
forwards, futures, swaps, futures options, and
options
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The Risk Management Process
Identify the types of price fluctuations that
will impact the firm
 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
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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Risk Profiles

Basic tool for identifying and measuring
exposure to risk

Graph showing the relationship between
changes in price versus changes in firm
value
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Risk Profile for a Wheat Grower
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Risk Profile for a Wheat Buyer
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Reducing Risk Exposure

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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Timing

Short-run exposure (transactions
exposure) – can be hedged

Long-run exposure (economic exposure)
– almost impossible to hedge, requires
the firm to be flexible and adapt to
permanent changes in the business
climate
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DEF stockholders are paid the current market value of
their firm in the form of ABC stock. Both firms are 100%
equity-financed. The total earnings of the combined firm
are $227,920.
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Questions
What is the number of shares in the new
firm?
 What are the earnings per share after the
merger?
 What is the total value of the merged
firm?
 What is the price per share after the
merger?
 What is the value of synergy?

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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 customized to meet the
needs of both parties and can be quite
large in size
 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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Positions
 Long
– agrees to buy the asset at the
future date (buyer)
 Short
– agrees to sell the asset at the
future date (seller)
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Payoff profiles for a forward contract
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Hedging with Forwards
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
 Since 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

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Hedging with forward contracts
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Futures Contracts
Futures vs. Forwards
 Futures contracts trade publicly on 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

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Swaps
A
long-term agreement between two
parties to exchange (or swap) cash
flows at specified times based on
specified relationships
 Can be viewed as a series of forward
contracts
 Generally limited to large
creditworthy institutions or
companies
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Types of Swaps

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

Commodity swaps – fixed quantities of a
specified commodity are exchanged at fixed
times in the future
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Option Contracts
 The
right, but not the obligation, to
buy (or 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
◦ Specified exercise or strike price
◦ Specified expiration date
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Payoff graph
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Seller’s Obligation

Buyer has the right to exercise the option,
but 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

Option seller can also be called the
writer
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Hedging with Options

Unlike forwards and futures, options
allow the buyer to hedge their downside
risk, but still participate in upside
potential

The buyer pays a premium for this benefit
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Payoff Profiles: Calls
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Payoff Profiles: Puts
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Hedging with Options
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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
 Canadian 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
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