RISK MANAGEMENT: AN
INTRODUCTION TO
FINANCIAL ENGINEERING

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Hedging and Price Volatility
Managing Financial Risk
Forward Contracts
Futures Contracts
Option Contracts
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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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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
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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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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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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
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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
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Cost of managing the risk relative to the benefit derived
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Risk profiles are a useful tool for determining the relative impact of different types of risk
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Basic tool for identifying and measuring exposure to risk
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Graph showing the relationship between changes in price versus changes in firm value
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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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Short-run exposure (transactions exposure) – can be hedged
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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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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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Long – agrees to buy the asset at the future date (buyer)
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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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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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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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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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Interest rate swaps – the net cash flow is exchanged based on interest rates
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Currency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates
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Commodity swaps – fixed quantities of a specified commodity are exchanged at fixed times in the future
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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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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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Unlike forwards and futures, options allow the buyer to hedge their downside risk, but still participate in upside potential
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The buyer pays a premium for this benefit
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Hedging Exchange Rate Risk with Options
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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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