Chapter
TwentyThree
Risk Management:
An Introduction to
Financial
Engineering
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
23.1
Key Concepts and Skills
• Understand the types of volatility that
companies can manage
• Understand how to develop risk profiles
• Understand the difference between forward
contracts and futures contracts and how they
are used for hedging
• Understand how swaps can be used for
hedging
• Understand how options can be used for
hedging
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23.2
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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23.3
Example: Disney’s Risk Management Policy
• Disney provides stated policies and procedures
concerning risk management strategies in its annual
report
– The company tries to manage exposure to interest rates,
foreign currency, and the fair market value of certain
investments
– Interest rate swaps are used to manage interest rate
exposure
– Options and forwards are used to manage foreign exchange
risk in both assets and anticipated revenues
– Derivative securities are used only for hedging, not
speculation
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23.4
Hedging Volatility
• 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
• Instruments have been developed to hedge the
following types of volatility
– Interest Rate
– Exchange Rate
– Commodity Price
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23.5
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
• This can reduce the overall risk of the firm
• Available tools: forwards, futures, swaps,
futures options and options
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23.6
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
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23.7
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 (depend on type of commodity):
forwards, futures, swaps, futures options, options
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23.8
The Risk Management Process
• 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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23.9
Risk Profiles
• Basic tool for identifying and measuring
exposure to risk
• Graph showing the relationship between
changes in price versus changes in firm value
• Similar to graphing the results from a
sensitivity analysis
• 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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23.10
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
• Timing
– Short-run exposure (transactions exposure) – can be
managed in a variety of ways
– 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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23.11
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 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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23.12
Figure 23.7
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23.13
Hedging with Forwards
• Entering into a forward contract can virtually
eliminate the price risk a firm faces
– It does not completely eliminate risk unless there is no
uncertainty concerning the quantity
• Because 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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23.14
Futures Contracts
• Forward contracts traded on an 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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23.15
Futures Quotes
• See Table 23.1
• Commodity, exchange, size, quote units
– The contract size is important when determining the daily
gains and losses for marking-to-market
• Delivery month
– Open price, daily high, daily low, settlement price, change
from previous settlement price, contract lifetime high and
low prices, open interest
– The change in settlement price times the contract size
determines the gain or loss for the day
• Long – an increase in the settlement price leads to a gain
• Short – an increase in the settlement price leads to a loss
– Open interest is how many contracts are currently
outstanding
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23.16
Hedging with Futures
• The risk reduction capabilities of futures is similar to
that of forwards
• The margin requirements and marking-to-market
require an upfront cash outflow and liquidity to meet
any margin calls that may occur
• Futures contracts are standardized, so the firm may
not be able to hedge the exact quantity it desires
• 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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23.17
Swaps
• A long-term agreement between two parties to
exchange cash flows based on specified
relationships
• Can be viewed as a series of forward contracts
• Generally limited to large creditworthy
institutions or companies
• 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
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23.18
Example: Interest Rate Swap
• Consider the following interest rate swap
– Company A can borrow from a bank at 8% fixed or LIBOR + 1%
floating (borrows fixed)
– Company B can borrow from a bank at 9.5% fixed or LIBOR + .5%
(borrows floating)
– Company A prefers floating and Company B prefers fixed
– By entering into the swap agreements, both A and B are better off then
they would be borrowing from the bank and the swap dealer makes .5%
Pay
Receive
Net
LIBOR + .5%
8.5%
-LIBOR
8.5%
LIBOR + .5%
9%
LIBOR + .5%
Swap Dealer w/B
LIBOR + .5%
9%
Swap Dealer Net
LIBOR + 9%
LIBOR + 9.5%
Company A
Swap Dealer w/A
Company B
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-9%
+.5%
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23.19
Figure 23.10
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23.20
Option Contracts
• The right, but not the obligation, to buy (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
Exercise or strike price –specified price
Expiration date – specified date
• Buyer has the right to exercise the option, 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
• Unlike forwards and futures, options allow a firm to hedge
downside risk, but still participate in upside potential
• Pay a premium for this benefit
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23.21
Payoff Profiles: Calls
Sell a Call E = $40
Buy a call with E = $40
0
-10 0
70
60
40
60
80 100
-20
Payoff
50
Payoff
20
40
30
20
-30
-40
-50
10
-60
0
0
20
40
60
Stock Price
McGraw-Hill/Irwin
80 100
-70
Stock Price
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23.22
Payoff Profiles: Puts
Sell a Put E = $40
0
-5 0
-10
45
40
35
30
25
20
15
10
5
0
20
40
60
80 100
-15
Payoff
Payoff
Buy a put with E = $40
-20
-25
-30
-35
-40
0
20
40
60
Stock Price
McGraw-Hill/Irwin
80 100
-45
Stock Price
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23.23
Hedging Commodity Price Risk with Options
• “Commodity” options are generally futures options
• Exercising a call
– Owner of call receives a long position in the futures contract plus cash
equal to the difference between the exercise price and the futures price
– Seller of call 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 put receives a short position in the futures contract plus cash
equal to the difference between the futures price and the exercise price
– Seller of put 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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23.24
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
• US 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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23.25
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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23.26
Quick Quiz
• What are the four major types of derivatives
discussed in the chapter?
• How do forwards and futures differ? How are
they similar?
• How do swaps and forwards differ? How are
they similar?
• How do options and forwards differ? How are
they similar?
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