Managing Risk Certainty Equivalents Why Manage Diversifiable Risk? Types of Risk Traditional Approach to Risk Management Enterprise Risk Management

Risk and Discounted Cash Flow The risk-adjusted discount rate method discounts for time and risk simultaneously Cannot handle situations where there is risk, but no time discount Example: Space launch coverage payable at time of launch

Certainty Equivalent Method Discounts separately –risk –time value of money

PV ==  n t=1 C t (1 + r) t CEQ t (1 + r f ) t  n t=1 Certainty Equivalent Method Rather than discounting future cash flows by one risk-adjusted discount rate to account for both time and risk, reduce the future cash flow to account for risk and then discount that value for time at the risk-free rate

Example Risk-free rate is 5% Investment will pay $1 million in two years Appropriate risk-adjusted rate is 12% PV = = $797,194 1,000,000 (1.12) 2 PV = CEQ 2 (1.05) 2 CEQ 2 = $878,906 The ratio of CEQ 2 to C 2 is 87.89%

Certainty Equivalent Problem An 18th century ship-owner sends a vessel out on a 2- year voyage. The value of the cargo will not be known until it returns. The expected value of the cargo is $144,000. The present value of the voyage is $100,000. The risk-free rate is 5 percent.

Why Manage Diversifiable Risk? Based on the CAPM, investors are not willing to pay extra for companies that reduce risk that is not correlated with market risk Based on the APM, investors are not willing to pay extra for companies that reduce risk that is not correlated with one of the priced “factors” Risks such as fires, lawsuits, computer failures, employee embezzlement, or product failures are not likely tied to market risk or any macroeconomic factors Why, then, do firms pay to manage these risks?

Reasons for Managing Diversifiable Risks Nonlinear tax structure –Firms with stable earnings pay less in taxes than firms with equal but variable earnings Avoiding cash shortfalls –Missing positive NPV projects Reducing the risk of financial distress –Bankruptcy is costly Managerial self-interest –Manager compensation for potential unemployment –Rewarding managers appropriately Other economic effects –Suppliers, customers, employees

Types of Risk Common risk allocation Hazard risk Financial risk Operational risk Strategic risk Bank view – New Basel Accord Credit risk –Loan and counterparty risk Market risk (financial risk) Operational risk

Hazard Risk “Pure” loss situations Property Liability Employee related Independence of separate risks Risks can generally be handled by –Insurance, including self insurance –Avoidance –Transfer

Managing Hazard Risk Insurance –Policy terms and conditions –Premiums exceed expected losses Administrative costs Adverse selection Moral hazard (and morale hazard) –Deductibles –Policy limits Self insurance –Captives –Access to reinsurance market

Financial Risk Components –Foreign exchange rate –Equity –Interest rate –Commodity price Correlations among different risks Use of hedges, not insurance or risk transfer Securitization

Financial Risk Management Toolbox Forwards Futures Swaps Options

Forward Contracts A forward contract obligates one party to sell and another party to buy an asset The exchange takes place in the future The price is fixed today No payment is made until maturity The buyer has a gain if the asset value increases The contract price is set at origination so that the value is zero

Forward Contract Example Airline agrees to buy a fuel commodity at a fixed price several months in future When forward contract is established, airline then sets ticket prices for that period Southwest Airlines hedges fuel prices more than any other airline One reason – counterparty risk

Futures Contracts A future obligates one party to buy and another to sell a specified asset in the future at a price agreed on today Futures are standardized contracts traded on organized exchanges Price changes are settled each day Margin accounts must maintained

What is the use of a futures contract? Help reduce uncertainty in future spot price Agricultural futures were one early contract –Farmer can lock in future price of corn before harvest (protect against drop in price) –User of corn can protect against rise in price Futures are now available on many assets –Agricultural (corn, soybeans, wheat, etc.) –Financial (interest rates, FX, and equities) –Commodities (oil, gasoline, and metals)

Differences between Forwards and Futures Features reducing credit risk –Daily settlement or mark- to-market –Margin account –Clearinghouse Features promoting liquidity –Contract standardization –Traded on organized exchanges

Futures Contract Example Firm sells (shorts) S&P 500 futures contracts for June 2007 representing a portion of its equity investments As the S&P 500 index increases, the firm incurs a loss and has to mark its position to market each day, reducing the effect of the equity gain If the S&P 500 index declines, the firm gains from the futures contract, offsetting some of its investment losses

Swap Contracts An agreement between two parties to exchange (or swap) periodic cash flows At each payment date, only the net value of cash flows is exchanged The cash flows are based on a notional principal or notional amount The notional amount is only used to determine the cash flows

Currency Swap On each settlement date, the US company pays a fixed foreign currency interest rate on a notional amount of another currency and receives a dollar amount of interest on a notional amount in dollars Since the interest rate is fixed, the only change in value is due to change in FX rate Using netting, only one party pays the difference between cash flow values

Other Swaps Currency-coupon or cross-currency interest rate swap –Still two different currencies –One interest rate is a fixed rate, one rate is floating Interest rate swap –Special case of currency-coupon swap: there is only one currency –Two interest rates: one fixed and one floating –Very useful to insurers Equity swap –One party pays the return on an equity index (such as the S&P 500) while receiving a floating interest rate

Credit Derivatives Total return swap –One party pays interest and capital gains/losses –Other party pays floating (or fixed) interest rate Credit default swap –Fastest growing derivative –Insurers and reinsurers heavily involved –One party pays a periodic fee –Other party pays any losses incurred in default or from credit downgrade –Similar to insurance, but risk could be highly correlated

Operational Risk Causes of operational risk Internal processes People Systems Examples Product recall Customer satisfaction Information technology Labor dispute Management fraud

Strategic Risk Examples Competition Regulation Technological innovation Political impediments

Traditional Approach to Risk Management Risks are handled separately (silos) –Corporate risk manager handles hazard risks –CFO or investment department handles financial risks –Managers handle operating risk –CEO (or C-suite) handles strategic risk Each area has its own approach –Terminology –Risk tolerance –Reports No overall coordination or aggregation

ERM Approach Aggregate Risk Management Hazard Risk - Hurricanes - Lawsuits - Injuries Financial Risk - Credit Risk - Market Risk - Interest Rates Operational Risk - Internal Fraud - Recalls Strategic Risk - Regulation - Reputation - Competition

What is Driving ERM? Board of Directors concern about what can go wrong Need for one person or group to be responsible for risk oversight –Chief Risk Officer Technological advances –Computing power –Analytical techniques ERM is moving from risk control to risk optimization

Next Class Beyond NPV – Simulation, Options and Trees Read Chapters 10 and 11