RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

30
RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24

Transcript of RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

Page 1: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING

Chapter 24

Page 2: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-2

Chapter OutlineHedging and Price VolatilityManaging Financial Risk Forward ContractsFutures ContractsOption Contracts

Page 3: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-3

Hedging VolatilityVolatility in returns is a measure

of riskVolatility 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 riskHedging (immunization) – reducing a firm’s exposure to price or rate fluctuations

Page 4: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-4

Managing Financial Risk 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

Page 5: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-5

Interest Rate VolatilityDebt is a key component of a

firm’s capital structureInterest 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

Page 6: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-6

Exchange Rate VolatilityCompanies 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

Page 7: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-7

Commodity Price VolatilityMost 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

Page 8: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-8

The Risk Management Process

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

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

Page 9: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-9

Risk ProfilesBasic tool for identifying and

measuring exposure to risk

Graph showing the relationship between changes in price versus changes in firm value

Page 10: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-10

Risk Profile for a Wheat Grower

Page 11: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-11

Risk Profile for a Wheat Buyer

Page 12: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-12

Reducing Risk ExposureHedging 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

Page 13: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-13

TimingShort-run exposure (transactions

exposure) – can be hedged

Long-run exposure (economic exposure) – almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate

Page 14: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

DEF stockholders are paid the current market value of their firm in the form of ABC stock. Both firms are 100% equity-financed. The total earnings of the combined firm are $227,920.

24-14

Page 15: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

QuestionsWhat is the number of shares in

the new firm? What are the earnings per share

after the merger?What is the total value of the

merged firm? What is the price per share after

the merger? What is the value of synergy?

24-15

Page 16: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-16

Forward ContractsA 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

Page 17: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-17

PositionsLong – agrees to buy the asset at the future date (buyer)

Short – agrees to sell the asset at the future date (seller)

Page 18: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-18

Payoff profiles for a forward contract

Page 19: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-19

Hedging with ForwardsEntering 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 riskSince 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

Page 20: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-20

Hedging with forward contracts

Page 21: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-21

Futures ContractsFutures vs. ForwardsFutures contracts trade publicly on

organized securities exchangeRequire 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

Page 22: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-22

SwapsA 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

Page 23: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-23

Types of SwapsInterest 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

Commodity swaps – fixed quantities of a specified commodity are exchanged at fixed times in the future

Page 24: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-24

Option ContractsThe 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

Page 25: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-25

Seller’s ObligationBuyer 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

Page 26: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-26

Hedging with OptionsUnlike forwards and futures,

options allow the buyer to hedge their downside risk, but still participate in upside potential

The buyer pays a premium for this benefit

Page 27: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-27

Payoff Profiles: Calls

Page 28: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-28

Payoff Profiles: Puts

Page 29: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-29

Hedging with Options

Page 30: RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Chapter 24.

24-30

Hedging Exchange Rate Risk with OptionsMay use either futures options on

currency or straight currency optionsUsed primarily by corporations that do

business overseasCanadian 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