Risk management: An introduction to financial engineering Chapter 24 Risk management: An introduction to financial engineering

Chapter Outline Hedging and Price Volatility Managing Financial Risk Forward Contracts Futures Contracts Option Contracts

Hedging Volatility 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

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

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 Available tools: forwards, futures, swaps, futures options, and options

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, and options

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 (depends on type of commodity): forwards, futures, swaps, futures options, and options

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

Risk Profiles Basic tool for identifying and measuring exposure to risk Graph showing the relationship between changes in price versus changes in firm value

Risk Profile for a Wheat Grower

Risk Profile for a Wheat Buyer

Reducing Risk Exposure 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 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

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.

Questions What 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?

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 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

Positions Long – agrees to buy the asset at the future date (buyer) Short – agrees to sell the asset at the future date (seller)

Payoff profiles for a forward contract

Hedging with Forwards 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

Hedging with forward contracts

Futures Contracts 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

Swaps 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

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

Option Contracts 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

Seller’s Obligation 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

Hedging with Options Unlike 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

Payoff Profiles: Calls

Payoff Profiles: Puts

Hedging with Options

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 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