ENTERPRISE RISK
MANAGEMENT
CHAPTER 23
LEARNING OBJECTIVES
• Outline the exposures to risk in a company’s business and how a
company could choose to hedge these risks
• Describe the similarities and differences between futures and
forward contracts and how these contracts are used to hedge risk
• Define the basics of swap contracts and how they are used to
hedge interest rates
• Explain the payoffs of option contracts and how they are used to
hedge risk
23-2
CHAPTER OUTLINE
• Managing Financial Risk
• Hedging with Forward Contracts
• Hedging with Futures Contracts
• Hedging with Swap Contracts
• Hedging with Option Contracts
23-3
ENTERPRISE RISK MANAGEMENT (ERM)
• Enterprise risk management is the process of identifying and
assessing risks and seeking to mitigate potential damage
• ERM requires risks to be viewed in the context of the entire company
• Broadly speaking, risks fall into four types:
1. Hazard risks: damage done by outside forces, e.g. natural
disasters, theft, and lawsuits (typically managed using insurance)
2. Financial risks: adverse exchange rate changes, commodity price
fluctuations, and interest rate movements
3. Operational risks: impairments or disruptions in operations from a
wide variety of business-related sources, e.g. human resources;
product development, distribution, and supply chain management
4. Strategic risks: large-scale issues such as competition, changing
customer needs, social and demographic changes, regulatory and
political trends, and technological innovation
23-4
MANAGING FINANCIAL RISK
• Hedging (i.e., immunization) is a process that reduces a firm’s
exposure to price or rate fluctuations
• Financial manager’s job is to create a hedge by using
available financial instruments to create new ones (i.e.,
financial engineering)
• May be direct or indirect hedging
• Financial risk management often involves the buying and
selling of derivative securities, a financial asset that represents
a claim to another financial asset
• Financial engineering frequently involves creating new
derivative securities or using existing derivatives to meet
specific hedging goals
23-5
THE RISK PROFILE
• Basic tool for identifying and measuring a firm’s exposure to financial
risk is the risk profile, a plot showing how the value of the firm is
affected by changes in prices or rates
• Question: How do changes in the price of a particular commodity
affect the firm?
• Consider an agricultural products company that has a large-scale
wheat farming operation
• Because wheat prices can be very volatile, we might wish to
investigate the firm’s exposure to wheat price fluctuations
• To do this, we plot changes in the value of the firm (ΔV) versus
unexpected changes in wheat prices (ΔPwheat)
23-6
THE RISK PROFILE
(CONTINUED)
• Risk profile tells us two things:
• Because the line slopes up,
increases in wheat prices will
increase the value of the firm
• Wheat is an output, so this
is not surprising
• Because the line has a fairly
steep slope, this firm has a
significant exposure to wheat
price fluctuations, and it may
wish to take steps to reduce
that exposure
23-7
REDUCING RISK EXPOSURE
• Consider the case of a food
processing operation. The food
processor buys large quantities
of wheat and has a risk profile
illustrated to the right.
• As with the agricultural
products firm, value of this
firm is sensitive to wheat
prices; but wheat is an input,
so increases in wheat prices
lead to decreases in firm value
• Both firms are exposed to
wheat price fluctuations, but
such fluctuations have opposite
effects for the two firms
23-8
SHORT-RUN VS LONG-RUN EXPOSURE
• Short-run, temporary changes in prices result from unforeseen
events or shocks (i.e., transitory changes)
• Transactions exposure is short-run financial risk arising from
the need to buy or sell at uncertain prices or rates in the
near future
• Can be managed in a variety of ways
• Longer-run, more permanent changes in prices result from
fundamental shifts in the underlying economics of a business
• More difficult to hedge on a permanent basis
• By managing financial risks, firm can:
1. Insulate itself from transitory price fluctuations
2. Give itself time to adapt to changes in market conditions
23-9
DERIVATIVE SECURITIES
• Hedging is typically done using derivative securities
• Derivatives are financial instruments whose values or
cash flows are derived from that of another
instrument
Types of derivatives:
• Forwards
• Futures
• Swaps
• Options
23-10
FORWARD CONTRACT
• Forward contract: legally binding agreement between two
parties calling for the sale of an asset at an agreed-upon price
• Terms of contract:
• Transaction occurs on a future date (settlement date)
• Transaction completed at the forward or delivery price (K)
• Buyer (long position) has the obligation to take delivery
• Seller (short position) has the obligation to make delivery
• Prevailing market delivery price is known as the settlement
price (SP)
• No $ is exchanged today
23-11
FORWARD CONTRACT
I, _Aseni______, agree to buy one share of
__Apple_____ stock from MRT for $K on 4/1/22
(one month from today).
Stock is currently trading at around $_166__ per
share.
23-12
FORWARD CONTRACT
K
$1
$5
$10
Sign Contract?
Bribe
23-13
FORWARD CASH FLOWS
Payoffs at Maturity: Cash flow exchanged upon
maturity of the contract
• Long Position (Buyer) Payoff = PT - K
• Short Position Payoff = K – PT
Where PT is the future price of the asset being
bought/sold at time T (settlement date)
23-14
SHORT FORWARD HEDGE
Short Hedge: Short forward position taken by a
company that knows it is due to sell an asset in the
future.
• Example: Farmer has 5000 bushels of wheat to be
harvested one month from today. Risk is that the
price of wheat will fall. Forward contracts on wheat
are available at today’s settlement price of $3.00 per
bushel. Each contract is for the delivery of 5,000
bushels.
23-15
SHORT FORWARD HEDGE
Unhedged
Hedged
Cash Flow
Cash Flow
3.00 - PT
PT
From Sale
From Sale
+
Short Forward
=
Total
1.00
1.00 ($5,000)
1.00
+
2.00
=
3.00 ($15,000)
2.00
2.00 ($10,000)
2.00
+
1.00
=
3.00 ($15,000)
3.00
3.00 ($15,000)
3.00
+
0.00
=
3.00 ($15,000)
4.00
4.00 ($20,000)
4.00
+
-1.00
=
3.00 ($15,000)
5.00
5.00 ($25,000)
5.00
+
-2.00
=
3.00 ($15,000)
• Short Forward guarantees a sale price
• Price changes produce offsetting gains and losses
23-16
FORWARD HEDGE
Long Hedge: Long forward position taken by a
company that knows it is due to purchase an asset
in the future.
• Example: A company must purchase 5000 bushels
of wheat one month from today. They are
concerned that the price of wheat will rise.
23-17
LONG FORWARD HEDGE
Unhedged
Hedged
PT - 3.00
Cost of
Cost of
PT
Purchase
Purchase
-
Long Forward
=
Net Cost
1.00
1.00 ($5,000)
1.00
-
-2.00
=
3.00 ($15,000)
2.00
2.00 ($10,000)
2.00
-
-1.00
=
3.00 ($15,000)
3.00
3.00 ($15,000)
3.00
-
0.00
=
3.00 ($15,000)
4.00
4.00 ($20,000)
4.00
-
1.00
=
3.00 ($15,000)
5.00
5.00 ($25,000)
5.00
-
2.00
=
3.00 ($15,000)
• Long Forward guarantees a purchase price
• Price changes produce offsetting gains and losses
23-18
FORWARD CONTRACTS:
THE PAYOFF PROFILE
• Payoff profile is a plot showing the gains and losses that will occur
on a contract as the result of unexpected price changes
• Suppose we were examining a forward contract on oil, where the
buyer of the forward contract is obligated to accept delivery of a
specified quantity of oil at a future date and pay a set price
23-19
HEDGING WITH FORWARDS
• Consider the case of a public
utility that uses oil to generate
power. The prices that our
utility can charge are regulated
and cannot be changed
rapidly. As a result, sudden
increases in oil prices are a
source of financial risk.
• Compare the risk profile for
the utility company to the
buyer’s payoff profile on a
forward contract (shown on
the previous slide)
• Payoff profile for the buyer of
a forward contract on oil is
exactly the opposite of the
utility’s risk profile with
respect to oil
23-20
HEDGING WITH FORWARDS
• If the utility buys a forward
contract, its exposure to
unexpected changes in oil
prices will be eliminated
• Utility’s net exposure to oil
price fluctuations is zero
• If oil prices rise, gains on
forward contract will offset
damage from increased costs
• If oil prices decline, benefit
from lower costs will be
offset by losses on forward
contract
23-21
HEDGING WITH FORWARDS
• What’s the cost of Hedging?
• Risk associated with an adverse price change is eliminated,
but so is the potential gain from a favorable move
• No money changes hands when the forward contract is
initiated
• No up-front cost, but there is credit risk
• When the settlement date arrives, party on losing end of
contract has a significant incentive to default on the
agreement
• Where are forward contracts commonly used to hedge?
• Firms with significant import or export operations
frequently use forwards to hedge exchange rate risk
23-22
FORWARD PRICING RELATIONSHIPS
• If the underlying asset on a forward contract is traded in the
spot market, then it may be possible to:
• Buy the asset in the spot market (at time 0)
• Make delivery on the forward contract (at time T)
• This is called cash and carry.
• Carrying costs: storage, insurance, transportation, financing.
• Financing costs are generally the most significant
• After accounting for carrying charges investors should not be
able to profit by buying the asset in the spot market and
delivering it in the futures market.
23-23
FORWARD PRICING RELATIONSHIPS
Example:
Spot Price of Gold
Forward Price of Gold (in 1 year)
Interest Rate
$2,000
$2,300
10%
Consider what happens if an investor buys in the spot
market today, sells the forward contract, and delivers
the gold in one year
23-24
CASH AND CARRY ARBITRAGE
Today
(t=0)
Borrow $2,000 for one year @ 10%
Buy 1 ounce of gold in the spot market for $2,000
Sell a forward contract for $2,300 delivery in one year
Total Cash Flow
1 Year
(t=T)
Remove the gold from storage
Deliver gold against the forward
Repay loan, including interest
+2,000
-2,000
0
0
0
+2,300
-2,200
Total Cash Flow +100
• This investor can make a riskless profit by
exploiting the mispricing that exists
• Transactions will drive prices back into line
23-25
FORWARD PRICING RELATIONSHIPS
Suppose the forward price was $2,100:
Spot Price of Gold
Forward Price of Gold (in 1 year)
Interest Rate
$2,000
$2,100
10%
Consider what happens if an investor sells gold short,
buys the forward contract, and takes delivery of gold
in one year (Reverse Cash and Carry)
23-26
REVERSE CASH AND CARRY ARBITRAGE
Today
(t=0)
Sell gold short in spot market
+2,000
Invest the $2,000 for one year @ 10%
-2,000
Buy a forward contract for $2,100 delivery in one year
0
0
Total Cash Flow
1 Year
(t=T)
Collect proceeds from the investment (loan)
+2,200
Take delivery on forward contract
-2,100
0
Use gold from forward delivery to repay (cover) short sale
Total Cash Flow +100
This investor can make a riskless profit by exploiting
the mispricing that exists
Transactions will drive prices back into line
23-27
FORWARD PRICING RELATIONSHIPS
• There is no arbitrage opportunity if the following
relationship holds:
SP0 T
P0 =
1+ C
Where C is the carrying cost of gold. Since the only
carrying cost is financing, this is often written as:
SP0 T
P0 =
1 + RF
23-28
FORWARD PRICING RELATIONSHIPS
Example: Suppose a forward contract is traded on a stock index. The closing price of
the index is $100 and the forward contract expires in one year. The riskless rate of
interest is 5% for the next year and the settlement price on the forward contract is $105.
Cash and Carry Arbitrage:
Buy the stock index
Borrow $100 @ 5%
Sell the forward contract
Reverse Cash and Carry Arbitrage
Short sell the stock index
Invest $100 @ 5%
Buy the forward contract
t=0
-P0 = -100
SP0 T
= 1 + R =+100
F
0
SP0 T
− P0 =0
1 + RF
P0 = +100
SP0 T
= - 1 + R =-100
F
0
P0 −
SP0 T
1 + RF =0
t=T
PT
-105
105-PT
0
-PT
+105
PT - 105
0
23-29
FUTURES CONTRACTS
• Futures contract is a forward contract with the feature
that gains and losses are realized each day rather than
only on the settlement date
• Daily resettlement feature is called marking-tomarket, which greatly reduces risk of default
• Organized trading is much more common in futures
contracts than in forward contracts (outside of
international trade)
• Futures contracts are agreements to exchange cash
flows as if a transaction is being made
23-30
FUTURES COMPARED TO FORWARDS
• Forwards are different from futures because:
• Forwards are not marketable
• Once a firm enters into a forward contract there is no
convenient way to trade out of it
• Forwards contracting parties exchange assets on
the settlement date with no intervening cash
flows
• Futures are standardized, forwards are customized
23-31
TYPES OF FUTURES CONTRACTS
• Two Groups:
• Commodity futures use nearly anything (except
financial assets) as underlying goods
• Wide variety of agricultural products (corn,
orange juice, and fertilizer), precious metals
(gold and silver), basic goods (copper and
lumber), and petroleum products (crude oil,
heating oil, and gasoline)
• Financial futures use financial assets (e.g., stocks,
bonds, or currencies) as underlying goods
23-32
FUTURES EXCHANGES
• Many futures exchanges exist in the U.S. and elsewhere
• Chicago Board of Trade (CBT) is among the largest
• Other exchanges include Chicago Mercantile Exchange (CME), Ice
Futures Europe, and New York Mercantile Exchange (NYMEX)
• Below is a partial WSJ listing for selected futures contracts
• Note the corn contracts trade on CBT, one contract calls for
delivery of 5,000 bushels, and prices are quoted in cents per bushel
• Months in which the contracts mature are given in the first column
23-33
TRADING MECHANICS
• Most futures contracts are eliminated before the
delivery month
• The speculator with a long position would sell a
contract, thereby canceling the long position
• The hedger with a short position would buy a
contract, thereby canceling the short position
23-34
HEDGING WITH FUTURES
• Conceptually identical to hedging with forward
contracts
• Payoff profile on a futures contract is drawn just
like the profile for a forward contract
• Hedging with futures requires the firm to maintain
an account with a broker so gains and losses can be
credited or debited each day as a part of the
marking-to-market process
23-35
HEDGING WITH FUTURES
Suppose you establish a short hedge on day 0 and measure the
value of your hedged position every day. The net value of
your position on day t is equal to the cash value of selling the
asset plus the gain on the futures contract.
This can also be expressed as the futures sale price plus the
basis:
Vt = Pt + F0 − Ft = F0 + bt
23-36
HEDGING WITH FUTURES
Example: On January 2,, RPM Corporation determines that it
will have € 10,000,000 to convert into U.S. dollars in 60 days
(on March 1). The current spot price is $0.903/€.
• RPM decides to hedge its risk by selling the March futures
contracts on euros, which expire on March 18. Since each
contract is for the delivery of 125,000 euros, the company
shorts 80 contracts.
• The futures price quotation on the March contract is
$0.901/€ on January 2. On March 1, the spot exchange rate
is $0.866/€ and the futures price is $0.865/€.
23-37
HEDGING WITH FUTURES
Short Futures Hedge on Euros
Date
Position
Ft (USD/€)
Payoff
1/2
Short 80 Euro Futures
Contracts
$0.901
$0.901-Pt
3/1
Buy 80 Euro Futures
Contracts
$0.865
Pt-$0.865
Payoff at Maturity
10,000,000($0.901-0.865) = $360,000
23-38
HEDGING WITH FUTURES
• The gain of $360,000 on the futures position is an
offset to the drop in value of the company’s position
in euros associated with the change in spot
exchange rates.
• In the absence of hedging, the value of the
company’s position decreased by $0.037/€ ($0.903$0.866), or $370,000, while the hedged position
decreased by $10,000.
23-39
HEDGING WITH FUTURES
Value of 10,000,000 Euros
U.S. Dollar Value of Hedged and Unhedged
Position in 10,000,000 Euros
$9,000,000
$8,750,000
$8,500,000
1/1
2/1
Hedged
3/1
Unhedged
23-40
HEDGING WITH FUTURES
• While we have locked in a futures price (our initial short
position), the net value of our position on any given day
fluctuates because the spot and futures price are not
perfectly correlated.
• The fluctuations due to differences in spot and futures prices
is known as basis risk.
• Basis risk is low if the spot futures prices are strongly related.
23-41
HEDGING WITH FUTURES
• Firm may not find an exact hedging instrument
• Cross-hedging is hedging an asset with contracts
written on a closely related asset
• When a firm cross-hedges, it does not actually
want to buy or sell the underlying asset; firm can
reverse its futures position at some point before
maturity
• Firm may wish to hedge over a relatively long period
of time, but available contracts might have shorter
maturities
• Firm could roll over short-term contracts, but this
entails some risks
23-42
HEDGING WITH SWAP CONTRACTS
• Swap contract is an agreement by two parties to
exchange, or swap, specified cash flows at specified
intervals in the future
• First used in 1981 when IBM and the World Bank
entered into a swap agreement
• Swap contract is simply a portfolio, or series, of
forward contracts
23-43
HEDGING WITH SWAP CONTRACTS
• Swap contracts usually fall into one of the following
categories:
• Currency Swap: two parties agree to exchange a
specific amount of one currency for a specific
amount of another at specific dates in the future
• Interest Rate Swap: interest rates are exchanged
between firms
• Commodity Swap: agreement to exchange a fixed
quantity of a commodity at fixed times in the
future
23-44
THE SWAP DEALER
• Swap contracts are customized and not traded on
organized exchanges
• Swap dealer plays a key role in the swaps market
• Firm wishing to enter into a swap agreement
contacts a swap dealer, and the swap dealer takes
the other side of the agreement
• Swap dealer will then try to find an offsetting
transaction with some other party or parties
(perhaps another firm or another dealer)
• If unable to find an offsetting transaction, swap
dealer hedges its exposure using futures contracts
23-45
THE SWAP DEALER
• Commercial banks are the dominant swap dealers in
the U.S.
• Total collection of contracts in which a dealer is
involved is called the swap book
• Dealer will try to keep a balanced book (i.e.,
matched book) to limit its net exposure
23-46
EXAMPLE: INTEREST RATE SWAP
• Suppose two companies can borrow at the following
terms:
Floating Rate Fixed Rate
Company A
Prime + 1%
10.0%
Company B
Prime + 2%
9.50%
• Company A desires a fixed-rate loan
• Company B desires a floating-rate loan
• Note that A has better floating terms, B better fixed terms
23-47
EXAMPLE: INTEREST RATE SWAP
• Company A
• Borrows at prime plus 1%
• Company agrees to make fixed-rate payments to
the swap dealer at a rate of 9.75%, Swap dealer
agrees to cover the floating loan payments
• Company B
• Borrows at fixed rate of 9.5%
• Company agrees to make floating-rate payments to
the swap dealer at a rate of prime plus 1.5%, Swap
dealer agrees to cover the fixed loan payments
23-48
EXAMPLE: INTEREST RATE SWAP
23-49
EXAMPLE: INTEREST RATE SWAP
Company A
Loan Rate
PR + 1%
Less Pmt from Dealer (PR + 1%)
+ Pmt to Dealer
9.75%
Net Cost
9.75%
Pmt from A
Pmt to A
Pmt from B
Pmt to B
Net Profit
Company B
9.50%
(9.50%)
PR + 1.5%
PR + 1.5%
Swap Dealer
9.75%
(PR + 1%)
PR + 1.5%
(9.50%)
0.75%
• A saves 25 bps, B saves 50 bps, dealer makes 75 bps
• Net Effect: Everyone is better off
23-50
EXAMPLE: INTEREST RATE SWAP
• Why does this work?
Floating Rate Fixed Rate
Company A
Prime + 1%
10.0%
Company B
Prime + 2%
9.50%
1. If A borrows fixed and B borrow floating, total cost
is Prime + 12%
2. If A borrows floating and B borrows fixed, total cost
is Prime + 10.5%
• Total borrowing costs are 150 bps lower with #2
23-51
HEDGING WITH OPTION CONTRACTS
• Option contract is an agreement that gives the owner the
right, but not the obligation, to buy or sell a specific asset at a
specific price (strike price, E) for a set period of time
• Call option is the right to buy an asset for $E during a
particular period
• Buyer has right to buy underlying asset by paying $E
• Seller is obligated to sell the asset for $E if option is
exercised
• Put option is the right to sell an asset for $E during a
particular period of time
• Buyer has right to sell underlying asset for $E
• Seller has obligation to buy the asset and pay $E
23-52
HEDGING WITH OPTION CONTRACTS
• Act of buying or selling the underlying asset using the
option contract is called exercising the option
• “American” options, the more popular type, can be
exercised anytime up to and including the
expiration date (the last day)
• “European” options can be exercised only on the
expiration date
23-53
OPTIONS VERSUS FORWARDS
• Key differences between options and forwards
1. Obligation to transact
• Forward Contract: both parties are obligated to transact;
• Option Contract: transaction occurs only if the owner of
the option chooses to exercise it
2. Money changing hands
• No money changes hands when a forward contract is
created
• Buyer of an option contract gains a valuable right and
must pay the seller for that right
• Price of the option is frequently called the option
premium
23-54
HEDGING EXAMPLE WITH OPTIONS
• Suppose your company has a risk profile that looks like this:
• This is identical to the risk profile of a company with an asset
to sell (i.e. already has a long position)
23-55
OPTION PAYOFF PROFILES
• If the firm wishes to hedge against adverse price movements
using options, it should buy the put
• By buying a put option, the firm will eliminate downside risk,
while retaining upside potential (kind of insurance policy)
• Company has an asset to sell and the right to sell it for a
certain price (Put Option)
• Combination of an asset and a put is called a protective put 23-56
HEDGING COMMODITY PRICE RISK AND
EXCHANGE RATE RISK
• Options typically traded on commodities are actually options on
futures contracts; for this reason, they are called futures options
• When a futures call option on wheat, for example, is exercised, the
owner of the option receives two things:
1. Futures contract on wheat at the current futures price, which can
be immediately closed at no cost
2. Difference between strike price on option and current futures
price, where the difference is paid in cash
• Futures options are available on foreign currencies, as well, and
they work the same way as commodities futures options
• Firms with significant exposure to exchange rate risk often
purchase put options to protect against adverse exchange rate
changes
23-57
HEDGING INTEREST RATE RISK
• Some interest rate options are options on interest-bearing
assets, whereas others are options on interest rates
• Interest rate cap: call option on an interest rate
• Buyer receives pmts when the interest rate > some level
• Example: borrower is paying LIBOR rate (2.5%) on a loan.
Can protect against rate increases by buying a cap at 3%
• Interest rate floor: put option on an interest rate
• Buyer receives pmts when interest rate below some level
• Example: lender has loaned money at LIBOR (2.5%). Can
protect against rate drops by buying a floor at 2%
• If a firm buys a cap and sells a floor, the result is a collar.
23-58
HEDGING INTEREST RATE RISK
• Swap options are called swaptions
• For example, if a firm has a floating-rate loan and
would like to have the right (but not the
obligation) to convert it to a fixed-rate loan in the
future, a swaption would be appropriate
• Compound options are options on options
• For example, an option on a cap is called a
caption, and there is a large market for these
instruments
23-59