Chapter24light CMD

8/19/2019 Chapter24light CMD

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Chapter 24 Enterprise Risk Management (ERP):

(or…. Everything You Wanted to Know about Derivatives …

….but were afraid to ask)



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Chapter Outline

• ERP & The Firm

• Hedging and Price Volatility

• Managing Financial Risk• Hedging ith Forard Contracts

• Hedging ith Futures Contracts

• Hedging ith Option Contracts



ERP & The Firm

• !hat type o" risks does ERP encompass#

• Hazard risks $ damage due to outside "orces

• %atural disasters ind' ater' "ire

• Human related lasuits' the"t' etc(

• Financial risks $ sudden une)pected price changes• E)ternal Foreign e)change' interest rates' commodity P*s

• Operational risks $ impairments o" normal +usiness• %atural Ha,ard ind' "ire' ater (not earthquake, terrorism, war)

• Human -upply chain mgmt' distri+ution channels' and

human resource issues' con"licts em+argo & ar

• Strategic risks $ large scale disruptions

• E)ternal competition' changing needs' social or demographicchange' regulatory' political' technological

• .nternal "raud' +ad pu+licity and reputational issues

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ERP

• !hat is +est ay to ensure ERP#

PREVENTION IS ETTER !"

t#an RE$%TION

• Very dependant on the nature o" the +usiness

• Eg(' -a"ety "actors /ary ith each industry

• %o rule o" thum+ e)ist0((you cannot out1guesse/ery possi+le risk that might occur

• .%-2R3%CE is a key tool "or Ha,ard Risks4

• Commercial lia+ility' 5i, .nterruption' 6eyMan' !Comp

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Managing Financial Risks

• Ins&rance %o'erage(

• Co/ers ide assortment o" ha,ard risks

• These are PRO535.7.T8 +ased e/ents

• The "re9uency & se/erity can +e estimated +asedon some historic pattern

• Hedging :or .mmuni,ing; risks4

• 7imiting the "inancial risk to the "irm o"

unanticipated e/ents that are not pro+a+ility +ased

• Volatility o" input<output prices can a""ect cash"los

• Hedging reduces the .MP3CT o" any change

• Most hedging directed at -HORT1TERM impacts

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Managing Financial Risks

• .nstruments ha/e +een de/eloped to hedge the"olloing types o" /olatility4

• .nterest Rate

• E)change Rate• Commodity Price

• Credit risk

• +eri'ati'e4

• 3 "inancial asset that represents a claim toanother asset

• .n other ords' it deri/es its entire /alue "romthat other asset


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.nterest Rate Risk

• =e+t is o"ten a key component o" a "irm*s capitalstructure' especially "or esta+lished "irms

• .nterest rates can "luctuate dramatically in the -T:"or e)ample' >?@AB' >?D>@(((((>G >;

• Firms that hedge against changes in interest ratescan sta+ili,e +orroing costs' hich can reduce

the o/erall risk o" the "irm

• 3/aila+le tools4 or.ards/ &t&res/ saps' "uturesoptions' and options


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E)change Rate Risk

• Companies that do +usiness internationally are e)posedto e)change rate risk :C3=' 2-3' Euro' 8en' Pound;

• The more /olatile the e)change rates' the more di""icult

it is to predict the "irm*s cash "los in its domesticcurrency :eg(' in G 2-=<C3=>(@0(in >G I atpar0( today I>(A;

• ." a "irm can manage its e)change rate risk' it can

reduce the /olatility o" its "oreign earnings and do a+etter analysis o" "uture proJects




Commodity Price Risk

• Most "irms ha/e price /olatility in the input costs o"aterials and "inal prices recei/ed "or productssold

• =epending on the commodity' the "irm may +e a+leto hedge price risk using a /ariety o" tools( Thisallos them to make4

• +etter production decisions

• reduce the /olatility in cash "los



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The Risk Management Process

• .denti"y the types o" price "luctuations thatcould impact "irm and cause unmanaged risks

• Certain risks actually o""set each other( -o do

not look at each risk independently(

• .nstead' look at "irm*s risk in a 5portolio orisks6 conte)t( 7ook at cost o" managing the

risk /s( the 7eneit that might +e deri/ed

• Risk pro"iles are a use"ul tool "or determiningthe relati/e impact o" di""erent types o" risk


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The Risk Management Process

Step ( .denti"y the source o" the risk e)posure

Step 2( Kuanti"y the risk e)posure

Step 3( 3ssess the impact o" the e)posure:s; on the"irm*s +usiness and "inancial strategies

Step 4( 3ssess your "irm*s a+ility to design andimplement a risk management program

Step )( -elect the appropriate risk managementproducts



Risk Pro"iles

• This is a +asic tool "or identi"ying andmeasuring e)posure to risk

• 2ses grap#s that sho the relationship

+eteen changes in price /s( changes in"irm /alue

• -imilar to graphing the results "rom a

sensiti'it8 anal8sis

• The steeper the slope o" the risk pro"ile' thegreater the e)posure and the more a "irmneeds to manage that particular risk



Risk Pro"ile "ora !heat Lroer :the seller;



Risk Pro"ile "ora !heat 5uyer :a cereal maker;


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Reducing Risk E)posure

• The goal o" hedging is to lessen the slope o"the risk pro"ile

• %ormally' hedging ill not reduce risk entirely• Only price risk can +e hedged

• Kuantity risk :/olume; cannot +e hedged

• 8ou may decide not to reduce risk completely+ecause i" you do' you could miss out on thepotential upside :management decision;(


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Timing

• -hort1run e)posure :transactionse)posure; can +e managed in a/ariety o" ays and ith se/eral tools

• 7ong1run e)posure :economice)posure; this is /ery di""icult tohedge permanently(

• .nstead' 7T re9uires the "irm to +eadapta+le to permanent changes in the+usiness climate0(thus' "irm mustadapt and change the +usiness model(


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For.ard Contracts

• 3 contract here parties agree on the price o" anasset today "or deli/ery and payment in the "uture

• Forard contracts are legall8 7inding on +othparties( The contracts are a/aila+le OTC(

• They can +e c&sto tailored to meet the needs o"+oth parties and can +e large in si,e

• They are negotiated contracts/ so no e)change o"cash up"ront' +ut "orards usually limited to large'creditorthy corporations(

• Ha/e u e/er done a "orard contract #

Eg., ordering a i!!a, de"ivered to your home in #$ minutes



Terminology

• 9ong agrees to +uy the asset atthe "uture date :+uyer;

• S#ort agrees to sell the asset atthe "uture date :seller;



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Payo"" Pro"iles"or a "orard contract



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Hedging ith Forards

• Entering into a "orard contract can /irtuallyeliminate the price risk a "irm "aces4

• &t!"it does not copletel8 eliinate all ors orisk since 7ot# parties still enco&nter credit risk:.#ic# is t#at eit#er part8 co&ld dea&lt on t#e

contract o7ligation prior to at&rit8;

• 5y eliminating price risk' it pre/ents the "irm "rom+ene"iting i" prices mo/e in the company*s "a/or

• The "irm also has to spend some time and<or moneye/aluating the credit risk o" the counterparty

• Forard contracts are primarily used to hedgee)change rate risk( Trade mainly OTC(



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Hedgingith "orard contracts



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F&t&res Contracts

• -ame payo"" pro"ile as "orard contracts

• <T!&t&res contracts trade p&7licl8 onorganized sec&rities e=c#ange and oer onl8standardized prod&cts

• Futures =O re9uire an up"ront cash paymentN• This is called the initial margin• Margin is small relati/e to /alue o" the contract• Contract then Marked1to1market daily

• Central clearinghouse guarantees per"ormance onall contracts :acts as other side on all trades;

• Ha/ing a clearinghouse and daily MM marginre9uirements' you /irtually eliminate credit risk

Eg., Standardized pizza (only has pepperoni and mushrooms)



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Hedging ith Futures

• The risk reduction capa+ilities o" "utures is /erysimilar to that o" "orards

• The margin re9uirements and mark1to1marketre9uire an up"ront cash out"lo and li9uidity to meetany margin calls that may occur later

• Futures contracts are standardized' so the "irmmay not +e a+le to hedge the e)act 9uantity'9uality' and<or deli/ery date it desires

• Credit risk is /irtually none)istent :daily settlement;

• Futures contracts are a/aila+le on a ide range o""inancial assets' currencies and commodities



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Option Contracts

• The right' +ut not the o+ligation' to +uy :orsell; an asset "or a set price on or +e"ore aspeci"ied date4

• Call right to +uy the asset :eg( House purchase<closing;

• Put right to sell the asset :eg( car insurance;

• -peci"ied e)ercise or strike price

• -peci"ied e)piration date



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-eller*s O+ligation

• 5uyer has the right to e)ercise the option'+ut the seller is o+ligated4

• Call option riter is o+ligated to sell theasset i" the option is e)ercised +y holder

• Put option riter is o+ligated to +uy theasset i" the option is e)ercised

• Option seller is also called The !riter



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Hedging ith Options

• 2nlike "orards and "utures' options allo the+uyer to hedge their donside risk' +ut stillparticipate in upside potential

• -o it is attracti/e "or protecting against certainrisk' ithout o+ligating the +uyer to do anything

• The +uyer pays a "ee :called the premium; "orthis +ene"it :to the seller' aka The !riter' horecei/es the premium as income;



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Payo"" Pro"iles"or Calls

"" "



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Payo"" Pro"iles"or Puts



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Hedging ith Options

H d i C dit P i Ri k



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Hedging Commodity Price Riskith Options

• Commodity options are no generally doneusing "utures options

• E)ercising a call4• Oner o" call recei/es a long position in the

"utures contract plus cash e9ual to thedi""erence +eteen the e)ercise price on theoption and the current "utures price(

• -eller o" call recei/es a short position in the"utures contract and pays cash e9ual to thedi""erence +eteen the e)ercise price o" theoption and the "utures price today



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Hedging Commodity Price Risk:continued;

• E)ercising a put4

• Oner o" put recei/es a short position in the"utures contract plus cash e9ual to thedi""erence +eteen the "utures price and the

e)ercise price

• -eller o" put recei/es a long position in the"utures contract and pays cash e9ual to the

di""erence +eteen the "utures price and thee)ercise price

H d i E h R t Ri k



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Hedging E)change Rate Riskith Options

• May use either "utures options on currency orstraight currency options

• 2sed mainly +y corporations ith o/erseas deals

•Eg( Canadian e)porters ant to hedge against astrengthening QC3= :since they ould recei/e"eer QC3= hen con/erting F +ack to QC3=;

• 5uy puts :sell calls; on "oreign currency4• Protected i" the /alue o" the "oreign currency "alls

relati/e to the dollar • -till +ene"it i" the /alue o" the "oreign currency increases

relati/e to the dollar

• 5uying puts is less risky

H d i . t t R t Ri k



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Hedging .nterest Rate Riskith Options

• Can use "utures options

• 7arge OTC market "or interest rate options

• Caps' Floors' and Collars4

• .nterest rate cap pre/ents a "loating rate "rom going

a+o/e a certain i le/el :+uy a call on interest rates;• .nterest rate "loor pre/ents a "loating rate "rom going

+elo a certain le/el :sell a put on interest rates;

• Collar +uy a C377 and sell a P2T at same time4

• The premium recei/ed "rom selling the put ill help o""set

the cost o" +uying a call

• ." set up properly' the "irm ill not ha/e either a cash in"loor out"lo associated ith this position



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-ummary

• The moti/ation "or risk management stems "romthe "act that "irms "ace e)posure to undesira+le risk

• Firm*s risk pro"ile is altered through the use o"

deri/ati/es "orards' "utures' saps' options and"utures options

• Hedging can help enhance the /alue o" a "irm +ysta+ili,ing short1term cash "los' gi/ing the "irm

time to react and adapt to changing marketconditions' and alloing the "irm to take on neproJects that ould otherise +e considered toorisky



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Pro+lem >

• -uppose you purchased a %o/em+er ? canola "utures contracton Sune >D' ?( !hat as your pro"it or loss +e i" cocoa pricesturned out to +e QB> per metric ton at e)piration#

The initial contract /alue is e9ual to4(ri%e er ton) & (number of tons se%ified in the %ontra%t)

.nitial contract /alue :QA per ton;: tons per contract; Q?'

Final contract /alue :QB> per ton;: tons per contract; Q>'

-o our gain on the "utures contract is Q>' 1 Q?' QG'GD



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Pro+lem

•-uppose a "inancial manager +uys call options on A' +arrelso" oil ith an e)ercise price o" QB per +arrel(

•-he simultaneously sells a put option on A' +arrels o" oil iththe same e)ercise price o" QB per +arrel(

•Consider her gains and losses i" oil prices are QA' QAB' QB' QB'

and QBD( !hat do you notice a+out the payo"" pro"ile#

The call options gi/e the manager the right :+ut not the o+ligation;to purchase oil "utures contracts at a "utures price o" QB per+arrel( The manager ill e)ercise the option i" the price risesa+o/e QB(

-elling put options o+ligates the manager to +uy oil "uturescontracts at a "utures price o" QB per +arrel( The put holder ille)ercise the option i" the price "alls +elo QB( The payo""s are4



-olution to Pro+lem

Oil price4 >) >)* >* >*4 >*0

Value o" call option position4 D

Value o" put option position4 1> 1 Total 'al&e 1Q> 1Q Q Q QD

%OT.CE4 The payo"" pro"ile is identical to that o" a "orard contractith a QB strike price(

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