Risk Management and Derivatives

Volatility Volatility in returns is a classic measure of risk Perfect Market More systematic risk leads to more return But Volatility is Costly External financing Project funding Distress Lower debt or increased prob. of distress Taxes

Risk Management Tools Hedging Reduce firms exposure to price/rate fluctuations Financial Hedging Insurance Derivatives Financial assets which are a claim on another asset Operational Hedging Using other corporate decisions to manage volatility

Sources of Volatility - 1 Interest Rate Risk Loans with floating interest rates create IR risk Exchange Rate Risk Reduce impact of foreign earnings volatility due to currency rate fluctuations Commodity Price Risk Certain input costs and prices of goods sold can be hedged

The Risk Management Process Identify important price fluctuations Risk profiles are useful for determining the relative impact of different types of risk Some risks may offset each other Consider the firm as a portfolio of risks and not just look at each risk separately Considering risk management Availability of relevant contracts Cost of contracts Cost of management/employee time

Risk Profiles Graph of price changes relative to value changes Risk profile slope Steeper ~ Larger exposure Potentially more need to hedge

Derivatives Change Payoff

Forward Contract Whats a forward? Agreement to exchange an asset for a set price with delivery and payment at a set future date Long: agree to buy the asset Short: agree to sell the asset You want next years Ferrari and contract with dealer to buy at a set price in the fall P Current = P Contract Over the summer, demand rises P Current > P Contract What if car value is below contract price? P Current < P Contract

Future Whats a future? Forwards traded on an exchange Farmer expects to sell 100,000 bushels of soybeans Wants to sell at a certain price (short position) Soybean future contracts are for 5,000 bushels Current price is $4.50/bushel Farmer shorts 20 soybean futures Will sell 100,000 bushels Will receive $4.50/bushel*100,000 bushels = $450,000

Commodity Future No cost today, but margin held in farmers account As soybean price changes, clearinghouse adjusts farmers account September Farmer delivers soybeans and receives $450,000 Bumper Crop Receive $450,000 + Extra Crop * Market Price Poor Harvest Receive $450,000 – Amt to Purchase * Market Price

Interest Rate Swap Firm A can borrow at 10% fixed or LIBOR + 1% floating Firm B can borrow at 9.5% fixed or LIBOR + 2% A prefers fixed and B prefers floating

Call (Put) Right to buy (sell) a security at a pre-specified price Underlying Asset that you have an option to buy or sell Option Price Market price of the contract Exercise (or Strike) Price Price at which the security can be bought or sold At-the-money - Exercise price is very close to stocks current value In-the-money - Option could be exercised at a profit today Out-of-the-money – Cant exercise for profit Options

Reducing Risk Exposure Hedging changes risk profile Doesnt eliminate risk 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) Managed in a variety of ways Long-run exposure (economic exposure) Difficult to hedge with derivatives

Always Hedge? What if price shock can be passed along to customer? What if competitors dont hedge?

Not Perfect Iberia Iberia Large 4 th Quarter 2008 Losses Large 4 th Quarter 2008 Losses Attributed, in part, to hedging Attributed, in part, to hedging Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of Wall Street Journal

Sources of Volatility - 2 Contracting with suppliers/customers Vertical integration Limiting leverage Central employees Key Man Insurance Project specific issues Diversification Project choice

Corp Fin Applications Equity as a Call Equity as a Call Employee Stock Options Employee Stock Options CEO Stock Options CEO Stock Options

Equity: A Call Option For leveraged firms, equity is a call option on the companys assets Exercise price - the face value of the debt Expiration date – the date that the debt comes due Assets > debt Option is exercised and the stockholders retain ownership Assets < debt Option expires unused and assets belong to the bondholders

Equity Payoff Debt Firm Value Value of Equity All goes to BondholdersShareholders Collect Asset substitution

Employee Stock Options Options given to employees as compensation Nonqualified Can be granted at a discount to current value Qualified or incentive stock options Primarily for upper mgmt Special tax treatment Often used as a bonus or incentive Huge rise in popularity Mostly still for upper management

Employee Stock Options Designed to reduce agency problems Empirical evidence: they dont well work Not worth as much to the employee as to an outsider due to the lack of diversification Reprice underwater options Other Disadvantages Management behavior Costly compensation Dilutes stock as firm must issue new shares Sometimes offset with repurchase (usually when stock price is high) Expensing can hurt profits

CEO Options Use Executives can protect their stock positions Given stock or options as an incentive I-bank creates individual options Collars position with put and call Value Stock Price PutCall