First Day of Class! FIN 441 Prof. Rogers Spring 2012

Framework for course Derivatives are “tools” for managing risks associated with “underlying” variables. –First goal: Develop fundamental understanding of basic tools. –Second goal: Develop basic understanding of how to use tools to manage risks. –Final goal: Begin to understand why businesses/investors might find derivatives “useful” from a value maximizing perspective.

Corporate risk defined Business risks –Part of “doing business” in the chosen markets. –Company should have “core competencies” in managing its business risks. –NPV of project accounts for business risk. Financial risks –Companies typically do not have core competency in managing financial risks. –What are these?

Financial risks Examples –Currency fluctuations –Interest rate changes –Commodity price changes –Equity price fluctuations Can (should) companies manage these risks (using derivatives, as well as by other means)?

Financial risk exposures “Natural” financial risks arising from company’s choice of business model –Creates “preferred” direction of financial variables (i.e., “long” or “short”) Some examples: –“Traditional” banking: “short” interest rates –US-based importer: “long” US dollar –Airlines: “short” oil prices –Most “non-indexed” mutual funds: “long” stock index

Measurement of exposure CAPM  effect of “market” risk Are companies exposed to other financial risks? No “perfect” methods (because we can’t measure exposure “before effect of risk management methods used during measurement period”) How can we measure exposure? Augment market model –R i,t = a + b*(R m,t ) + c*(R f,t ) + error –Coefficient, c, reflects stock I’s market value exposure to risk factor, f. –Exxon Mobil: c = 0.30 (13% change in crude oil price implies 3.9% change in equity value) Cash flow (or profit) risk –CF i,t = a + b*(CF f,t ) + error –Could (should?) use % changes instead –Exxon Mobil: b= (30.7% increase in crude oil price implies negative incremental effect of 11.5% ratio of operating cash flow-to-sales)

What’s a “derivative?” The answer to the question from 3 slides ago (“Can (should) companies manage financial risks?” is “YES!” and “(MAYBE!)” –If the firm is economically exposed (see prior two slides) AND there are real benefits to the firm (wait for WEEK 10) AND benefits outweigh costs, then answer is more likely “YES” than “MAYBE.” A derivative is a contract between a buyer and a seller in which payment terms (and the contract’s value) are derived from the value of some underlying asset.

Classifying derivatives By underlying –Interest rate (largest) –Currency (foreign exchange) –Credit –Equity –Commodity By payoff structure –Linear (forwards, futures, swaps) –Non-linear (options) By trading mechanism –Exchange –OTC

What are “underlying assets?” Any asset used to create a derivative contract. Examples: –Oil –Wheat –Currencies –Stock index –Treasury bonds Underlyings don’t have to be assets –Weather, NCAA tournament results, etc.

Real risk management problems faced by companies Multinational manufacturer Gold mining firm Diesel fuel distributor Airline Fixed-rate lender

What’s this class going to be about? The overriding goal of the course is to develop your understanding as to how businesses can manage risk using derivative instruments. To achieve that goal, we need to: –Gain basic understanding of forward, futures, and option markets. –Learn how options are valued (weeks 1 – 3). –Understand how futures are priced and valued and how they are used in hedging strategies (weeks 4 - 6) –Develop an understanding of how options are used to affect investment profile risk using stock options (week 7). –Learn about swaps (week 8) –Finally, we’ll close out the course with some qualitative discussion about “lessons of risk management” (week 9).

How did I get into derivatives? Undergraduate & MBA courses. –Led to: Buying jet fuel for an airline. –Led to: Designing and implementing diesel price risk management program. –Led to: Research in corporate usage of derivatives.

Next Class Next class: –Chapter 2: Structure of option markets –Chapter 3: Principles of option pricing –Chapter 4: Binomial model of option pricing (one-period)