Post on 03-Apr-2018
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Introduction to Derivatives and
Risk Management
Corporate Finance
Dr. A. DeMaskey
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Learning Objectives
Questions to be answered:
Why should a company manage its risk?
What financial techniques can be used toreduce risk?
What are derivatives?
What are the important characteristics of thevarious types of derivative securities?
How should derivatives be used to managerisk?
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Reasons to Manage Risk
Do stockholders care about volatile cashflows?
If volatility in cash flows is not caused bysystematic risk, then stockholders can eliminatethe risk of volatile cash flows by diversifyingtheir portfolios.
Stockholders might be able to reduce impact ofvolatile cash flows by using risk managementtechniques in their own portfolios.
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Reasons to Manage Risk
How can risk management increase the value of a
corporation?
Risk management allows firms to:
Have greaterdebt capacity, which has a larger tax
shield of interest payments.
Implement the optimal capital budget withouthaving to raise external equity in years that would
have had low cash flow due to volatility.
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Reasons to Manage Risk
Risk management allows firms to:
Avoid costs offinancial distress.
Weakened relationships with suppliers.
Loss of potential customers.
Distractions to managers.Utilize comparative advantage in hedging
relative to hedging ability of investors.
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Reasons to Manage Risk
Risk management allows firms to:
Reduceborrowing costsby using interest
rate swaps.
Minimize negative tax effects due to
convexity in tax code.
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Growth of Derivatives Market
Analytical techniques
Technology
Globalization
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Derivative Securities
Derivative: Security whose value stemsor is derived from the value of other assets.
Types of Derivatives
Forward
Futures
Options
Swaps
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Forward Contracts
An agreement where one party agrees to buy (orsell) the underlying asset at a specific future dateand a price is set at the time the contract is entered
into. Characteristics
Flexibility
Default risk
Liquidity risk
Positions in Forwards
Long position
Short position
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Futures Contracts
A standardized agreement to buy or sell aspecified amount of a specific asset at a fixed price
in the future. Characteristics
Margin Deposits
Initial margin
Maintenance margin
Marking-To-Market
Floor Trading
Clearinghouse
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Hedging with Futures
Hedging: Generally conducted where a pricechange could negatively affect a firms profits.
Long hedge: Involves the purchase of a futurescontract to guard against a price increase.
Short hedge: Involves the sale of a futures contractto protect against a price decline in commodities or
financial securities. Perfect hedge: Occurs when gain/loss on hedge
transaction exactly offsets loss/gain on unhedgedposition.
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Option Contracts
The right,but not the obligation, to buy or sell aspecified asset at a specified price within a
specified period of time. Option Terminology
Call option versus put option
Holder versus writer or grantor
Exercise or strike price Option premium
American versus European option
Market Arrangements
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Swap Contracts
Financial contracts obligating one party toexchange a set of payments it owns for another set
of payments owed by another party. Currency swaps
Interest rate swaps
Usually used because each party prefers the terms
of the others debt contract. Reduces interest rate risk or currency risk for both
parties involved.
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Different Types of Risk
Speculative risks: Thosethat offer the chance of again as well as a loss.
Pure risks: Those that offer
only the prospect of a loss. Demand risks: Those
associated with the demandfor a firms products orservices.
Input risks: Thoseassociated with a firmsinput costs.
Financial risks: Those thatresult from financial
transactions.
Property risks: Thoseassociated with loss of afirms productive assets.
Personnel risk: Risks that
result from human actions. Environmental risk: Risk
associated with polluting theenvironment.
Liability risks: Connected
with product, service, oremployee liability.
Insurable risks: Thosewhich typically can becovered by insurance.
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An Approach to Risk
Management Corporate risk management is the management of
unpredictable events that would have adverse
consequences for the firm. Firms often use the following process for
managing risks.
Step 1. Identify the risks faced by the firm.
Step 2. Measure the potential impact ofthe identified risks.
Step 3. Decide how each relevant riskshould be dealt with.
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Techniques to Minimize Risk
Transfer riskto an insurance company by paying periodic
premiums.
Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial
risks.
Take actions to reduce the probability of occurrence of
adverse events. Take actions to reduce the magnitude of the loss associated
with adverse events.
Avoidthe activities that give rise to risk.
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Nature and Purpose ofTrading in Financial
Derivatives
Financial riskexposure refers to the risk inherent
in the financial markets due to price fluctuations. Hedging
Protect Value of Securities Held
Protect the Rate of Return on a Security Investment
Reduce Risk of Fluctuations in Borrowed Costs
Speculating
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Using Derivatives to Reduce
RiskCommodity Price Exposure
The purchase of a commodity futures contract will
allow a firm to make a future purchase of the input attodays price, even if the market price on the item hasrisen substantially in the interim.
Security Price Exposure
The purchase of a financial futures contract will allow afirm to make a future purchase of the security at todaysprice, even if the market price on the asset has risensubstantially in the interim.
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Using Derivatives to Reduce
Risk Foreign Exchange Exposure
The purchase of a currency futures or options contract
will allow a firm to make a future purchase of thecurrency at todays price, even if the market price on
the currency has risen substantially in the interim.
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Risks to Corporations from
Financial Derivatives
Increases financial leverage
Derivative instruments are too complex
Risk of financial distress