BASICS OF FINANCIAL RISK MANAGEMENT CAS / ARIA Financial Risk Management Seminar -- Denver, CO April, 1999 Rick Gorvett, FCAS, Ph.D. The College of Insurance

BACKGROUND AND MOTIVATION

WHY SHOULD WE STUDY FINANCIAL RISK MANAGEMENT? To better understand the nature and volatility of financial markets To understand the development of new financial products -- e.g., derivatives and hybrid securities To understand how these products can be used to change a firm’s risk profile and protect its financial condition

UNPREDICTABILITY Interest rates Commodity prices FX rates Inflation, cash flows (investing / lending), asset and liability values Late 1970s -- Volcker / FED policy change Commodity prices Costs, substitute products Price shocks -- OPEC, Kuwait FX rates International cash flows, relative competitiveness Early 1970s -- Breakdown of Bretton Woods

FINANCIAL RISKS -- EXAMPLES Interest rates Savings & Loans Inversion of yield curve around 1980 Commodity prices Continental Airlines Price of fuel after Iraq invaded Kuwait Foreign exchange Laker Airlines Strengthening of US$ relative to pound in 1981

FINANCIAL RISK MANAGEMENT: A BROAD FRAMEWORK FRM can take several (familiar and unfamiliar) forms Asset hedges Liability hedges Asset-liability management Contingent financing Post-loss financing and recapitalization

WHY DO CORPORATIONS USE FINANCIAL DERIVATIVES? Transaction hedges FX; debt Currency and interest rate risk Strategic (economic) hedges Protect cash flows or company value from movements in financial prices Reduce funding costs FX; synthetic debt Trading derivatives for profit

WHY DON’T CORPORATIONS USE MORE DERIVATIVES? Credit risk No suitable instrument Lack of knowledge Accounting / legal issues Transaction costs Resistance by Board / upper management

VOCABULARY Financial derivative: a financial instrument whose value is a function of another (“underlying”) financial instrument Financial engineering: the creation and use of financial derivatives to aid in the management of risk Risk profile: describes the effect of changes in a financial price on the value of a firm

FORWARDS AND FUTURES

FORWARD CONTRACTS Obligation / agreement to buy/sell in the future Contract price is the “exercise price”; no payment until maturity Physical delivery or cash-settled Buyer (holder) is “long”; seller (writer) is “short OTC -- can be tailored Two-sided risk

FUTURES CONTRACTS Obligation; agree to a future transaction Traded on organized exchanges Standardized Daily settlement (marking to market) Reduces default risk: essentially, a series of one-day contracts Margins (performance bonds) Initial margin Maintenance margin Margin call Exchange clearinghouse

EXCHANGES VS. OTC Exchanges Advantages Disadvantages OTC Markets Clearinghouse Liquidity Standardization Disadvantages Lack of flexibility Regulation Trading costs Public OTC Markets Disadvantages Credit risk Low liquidity Non-standardization Advantages Flexible Less regulation Lower regulatory costs Private

TYPES OF CONTRACTS Agricultural commodities Other commodities Wheat, corn, soybeans Farmer (supplier) can lock in sales price before harvest (short futures) Consumer (user) can lock in purchase price (long futures) Other commodities Metals, petroleum Financial assets FX, stock market indices, interest rates

EXAMPLE Ann agrees to buy from Bill one barrel of oil, five months from now, for $20 Ann is in the “long” position Bill is in the “short” position If the price of oil is $25 five months from now, who pays to whom, and how much? If the price of oil is $12 five months from now, who pays to whom, and how much?

OPTIONS

OPTIONS Option to buy or sell the underlying asset Right, not obligation Call option: right to buy the U/L asset Put option: right to sell the U/L asset Buyer = holder = long position (option to exercise) Seller = writer = short position

PARAMETERS OF OPTIONS Exercise price = strike price = price at which the holder of the option can exercise the option (and thus buy or sell the underlying asset) Expiration date Premium = amount paid for the option American option: can exercise any time up to and including expiration date European option: can exercise only on expiration date

EXAMPLES OF OPTIONS -- THEY’RE EVERYWHERE Traded options On stocks, indices, FX, interest rates, futures, swaps, options,... Convertible bonds Call provisions on bonds On projects To expand, abandon, postpone Insurance

EXAMPLE Amy sells Bob a January European call option on one share of Compaq stock Suppose Compaq stock is trading at 32.5 Exercise price = 35 Premium = 3 In January, suppose: ST=30 ST=40 Total payoff [profit/loss] Amy: 0 [3] -5 [-2] Bob: 0 [-3] 5 [2]

OPTION VALUES (cont.) Prior to expiration: Call Put In-the-money St > X St < X At-the-money St = X St = X Out-of-the-money St < X St > X Intrinsic value - profit that could be made if the option was immediately exercised Call: stock price - exercise price Put: exercise price - stock price Time value - the difference between the option price and the intrinsic value

OPTION VALUES: PAYOFF CHART Call -- long position Call -- short position Put -- long position Put -- short position Payoff ST X

PUT-CALL PARITY Arbitrage implies a certain relationship between put, call, and underlying asset prices Two portfolios have, at payoff, identical values: One European call option + cash of PV(X) One European put option + one share of stock C + PV(X) = P + S

BLACK-SCHOLES FORMULA VC = S N(d1) - X e-rt N(d2) d1 = [ln(S/X)+(r+0.5s2)t] / st0.5 d2 = d1 - st0.5

PURPOSES OF DERIVATIVES Speculative Highly risky Highly leveraged Very volatile Hedging Combine with other securities Hedge (minimize) risk from other securities

HEDGING “Hedge”: Take a position that offsets a risk Risk: Uncertainty regarding the value of the underlying asset By hedging, one changes the risk inherent in owning the underlying asset The return distribution of the underlying asset is not changed

USING OPTIONS TO HEDGE Combine the underlying asset with an option or options Can reduce or eliminate downside risk while retaining upside potential Can protect against falls in held asset values, or against increases in input prices

OPTION STRATEGIES Protective put Covered call Straddle Spread Own stock (long position) Own put (long position) Covered call Sell call (short position) Straddle Spread

PROTECTIVE PUT Investor owns asset Investor also buys (holds) a put on the asset Guarantees investment portfolio proceeds at least equal to the exercise price of the put + =

PROTECTIVE PUT EXAMPLE Suppose you own a share of stock, and you purchase a put option with an exercise price of 22.5 on that stock, for a premium of $ 0.75 ST : 30 25 20 15 Premium: -0.75 -0.75 -0.75 -0.75 Put Payoff: 0 0 2.50 7.50 === === === === Overall: 29.25 24.25 21.75 21.75

COVERED CALL Investor purchases stock Investor also sells (writes) a call option on the stock Option position is “covered” by owning the underlying stock itself (vs. “naked option”) Provides additional (premium) income = +

COVERED CALL EXAMPLE Suppose you own a share of stock, and you write a call option with an exercise price of 35 on that stock, for a premium of $ 2.00 ST : 30 35 40 45 Premium: 2 2 2 2 Call Payoff: 0 0 -5 -10 === === === === Overall: 32 37 37 37

STRADDLE (Long) Straddle: buy both a call and a put on a stock Each option has the same exercise price and expiration date Believe stock will be relatively volatile Worst-case: no movement in stock price

SPREAD Combination of options Two or more calls, or Two or more puts Vertical spread: simultaneous sale and purchase of options with different exercise prices Horizontal spread: sale and purchase of options with different expiration dates

INTEREST RATE OPTIONS Cap: a call option on an interest rate Floor: a put option on an interest rate Collar: simultaneously buying a cap and selling a floor These options can be used to hedge rate-sensitive debt and assets

INTEREST RATE OPTIONS: TERMINOLOGY Underlying index: interest rate being hedged or speculated upon; e.g., LIBOR, prime rate Strike rate: determines cash flows (similar to exercise price) Settlement frequency: how often the strike rate and underlying index are compared Notional amount: principal to which the interest rate is applied Up-front premium: paid by purchaser to seller for the option

INTEREST RATE CAPS At each settlement date, check whether index rate is greater than strike rate If not, cap purchaser does not receive cash flows If so, purchaser receives from seller: [ (index rate - strike rate) x (days in settlement period / 360) x notional amount ]

INTEREST RATE CAPS: EXAMPLE $20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8% Cost: 150 basis points Up-front premium = 0.015 x $20M = $300,000 If 3-month LIBOR = 9%, seller pays (.09-.08) x 90/360 x $20M = $50,000 (for that quarter)

INTEREST RATE FLOORS At each settlement date, check whether index rate is greater than strike rate If so, floor purchaser does not receive cash flows If not, purchaser receives from seller: [ (strike rate - index rate) x (days in settlement period / 360) x notional amount ]

INTEREST RATE COLLARS Purchase a cap to hedge floating-rate liabilities Sell a floor at a lower strike rate Sale of floor helps finance purchase of cap Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates Can achieve zero-premium collar

SWAPS

SWAPS Agreement between two parties Two major types “Counterparties” Exchange sets of future cash flows Two major types Interest rate swaps Currency swaps Relatively new FRM tool

SWAPS VS. FUTURES Futures Swaps Standardized Exchange-traded Short horizons Swaps Custom tailored between counterparties Little regulation; potential for privacy Term flexibility

INTEREST RATE SWAPS One party pays a fixed interest rate and receives a floating rate The other party pays a floating rate and receives a fixed rate Floating rates involve greater exposure to interest rate risk “Notional principal” is amount on which the interest payments are determined

INTEREST RATE SWAPS (cont.) Principal is not actually exchanged -- only interest payments Generally, only net interest payments are transacted Avoids unnecessary transactions Helps credit risk At each “settlement date,” a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

CURRENCY SWAPS One party holds one currency, and desires a different currency Three sets of cash flows: Exchange principal at inception of swap Periodic interest payments Exchange principal at termination of swap Interest rates fixed ==> only change in value is from FX change Generally, only make net payments

LIMITATIONS OF SWAPS Counterparties must find each other Meet specific needs Cost, time; facilitators Lack of “liquidity”; difficult to unwrap / trade / change without consent of other party Credit risk of counterparty

DEVELOPMENT OF SWAP MARKET Originally: Unique contracts Had to search for counterparty Investment banks were dominant intermediaries More recently: More standardized and liquid Intermediaries accept contract, then lay off risk More highly capitalized firms -- e.g., commercial banks