23-1 Enterprise Risk Management Chapter 23 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

23-2 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-3 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-4 What Risks? Conducting business in a global economy involves risk. Much of the risk is associated with coping with the unpredictable future.

23-5 Enterprise Risk Management (ERM) ERM is the process to identify, assess, and where possible, to mitigate the risks to a firm

23-6 Risk Types 1.Hazard Risks 2.Financial Risks 3.Operational Risks 4.Strategic Risks ERM seeks to view the business holistically and understand how the pieces of risk fit together.

23-7 What Risks? Many companies address risk publically as exemplified by Disney Corporation in their annual report

23-8 Example: Disney’s Risk Management Policy Disney provides stated policies and procedures concerning risk management strategies in its annual report: The company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investments Interest rate swaps are used to manage interest rate exposure

23-9 Example: Disney’s Risk Management Policy Disney provides stated policies and procedures concerning risk management strategies in its annual report: Options and forwards are used to manage foreign exchange risk in both assets and anticipated revenues The company uses a VaR (Value at Risk) model to identify the maximum 1-day loss in financial instruments Derivative securities are used only for hedging, not speculation

23-10 Hedging Volatility Recall that volatility in returns is a classic 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

23-11 Hedging Volatility Instruments have been developed to hedge the following types of volatility: Interest Rate Exchange Rate Commodity Price Quantity Demanded

23-12 Interest Rate Volatility Debt is a key component of a firm’s capital structure Interest rates can fluctuate dramatically in short periods of time

23-13 Interest Rate Volatility Companies that hedge against changes in interest rates can stabilize borrowing costs This can reduce the overall risk of the firm Available tools: forwards, futures, swaps, futures options, and options

23-14 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

23-15 Exchange Rate Volatility If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and conduct a better analysis of future projects Available tools: forwards, futures, swaps, futures options

23-16 Commodity Price Volatility Most firms face volatility in the costs of materials and in the price that will be received when products are sold

23-17 Commodity Price Volatility 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 (depend on type of commodity): forwards, futures, swaps, futures options, options

23-18 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-19 The Risk Management Process Identify the types of price fluctuations that will impact the firm Some risks are obvious; others are not

23-20 The Risk Management Process 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

23-21 The Risk Management Process You must also look at the 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

23-22 Risk Profiles Basic tool for identifying and measuring exposure to risk Graph showing the relationship between changes in price versus changes in firm value Click on the icon to visit an online publication dealing with risk management

23-23 Risk Profiles Similar to graphing the results from a sensitivity analysis The steeper the slope of the risk profile, the greater the exposure and the greater the need to manage that risk

23-24 Reducing Risk Exposure The goal of hedging is to lessen the slope of the risk profile Hedging will not normally reduce risk completely For most situations, 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

23-25 Reducing Risk Exposure Timing Short-run exposure (transactions exposure) – can be managed in a variety of ways Long-run exposure (economic exposure) – almost impossible to hedge - requires the firm to be flexible and adapt to permanent changes in the business climate

23-26 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-27 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 tailored to meet the needs of both parties and can be quite large in size

23-28 Forward Contracts Positions Long – agrees to buy the asset at the future date Short – agrees to sell the asset at the future date Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

23-29 Forward Contracts

23-30 Hedging with Forwards Entering into a forward contract can virtually eliminate the price risk a firm faces It does not completely eliminate risk unless there is no uncertainty concerning the quantity Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor

23-31 Hedging with Forwards 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

23-32 Futures Contracts Futures contracts traded on an organized securities exchange

23-33 Futures Contracts 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

23-34 Futures Quotes Commodity, exchange, size, quote units The contract size is important when determining the daily gains and losses for marking-to-market

23-35 Futures Quotes Delivery month Open price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest Open interest is how many contracts are currently outstanding

23-36 Futures Quotes Delivery month The change in settlement price times the contract size determines the gain or loss for the day Long – an increase in the settlement price leads to a gain Short – an increase in the settlement price leads to a loss

23-37 Hedging with Futures The risk reduction capabilities of futures are similar to those of forwards The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur

23-38 Hedging with Futures Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires Credit risk is virtually nonexistent Futures contracts are available on a wide range of physical assets, debt contracts, currencies, and equities

23-39 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-40 Swaps A long-term agreement between two parties to exchange cash flows based on specified relationships Can be viewed as a series of forward contracts Generally limited to large creditworthy institutions or companies

23-41 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

23-42 Example: Interest Rate Swap Consider the following interest rate swap: Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed) Company B can borrow from a bank at 9.5% fixed or LIBOR +.5% (borrows floating) Company A prefers floating and Company B prefers fixed By entering into a swap agreement, both A and B are better off than they would be borrowing from the bank with their preferred type of loan, and the swap dealer makes.5%

Example: Interest Rate Swap PayReceiveNet Company ALIBOR +.5% 8.5%-LIBOR Swap Dealer w/A 8.5%LIBOR +.5% Company B9%LIBOR +.5% -9% Swap Dealer w/B LIBOR +.5% 9% Swap Dealer Net LIBOR + 9% LIBOR + 9.5% +.5% 23-43

23-44 Swap Process

23-45 Chapter Outline Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Swap Contracts Hedging with Option Contracts

23-46 Option Contracts The right, but not the obligation, to buy (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 Exercise or strike price –specified price Expiration date – specified date

23-47 Option Contracts Buyer has the right to exercise the option; 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 Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential The firm pays a premium for this benefit

23-48 Payoff Profiles: Calls

23-49 Payoff Profiles: Puts

23-50 Hedging Commodity Price Risk with Options “Commodity” options are generally futures options

23-51 Hedging Commodity Price Risk with Options Exercising a call: Owner of the call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures price Seller of the call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures price

23-52 Hedging Commodity Price Risk with Options Exercising a put: Owner of the put receives a short position in the futures contract plus cash equal to the difference between the futures price and the exercise price Seller of the put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price

23-53 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 U.S. companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars)

23-54 Hedging Exchange Rate Risk with Options 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

23-55 Hedging Interest Rate Risk with Options Can use futures options Large OTC market for interest rate options

23-56 Hedging Interest Rate Risk with Options Caps, Floors, and Collars Interest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates) Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)

23-57 Hedging Interest Rate Risk with Options Caps, Floors, and Collars Collar – buy a call and sell a put The premium received from selling the put will help offset the cost of buying the call If set up properly, the firm will not have either a cash inflow or outflow associated with this position

23-58 Quick Quiz What are the four major types of derivatives discussed in the chapter? How do forwards and futures differ? How are they similar? How do swaps and forwards differ? How are they similar? How do options and forwards differ? How are they similar?

23-59 Comprehensive Problem A call option has an exercise price of $50. What is the value of the call option at expiration if the stock price is $35? $75? A put option has an exercise price of $30. What is the value of the put option at expiration if the stock price is $25? $40?

23-60 Terminology Hedging Hedging Volatility Forward Contracts Future Contracts Future Quotes Swaps Option Contracts Commodities

23-61 Key Concepts and Skills Explain how companies face risk exposures and how they hedge against these risks. Define the difference between forward and futures contracts.

23-62 Key Concepts and Skills Describe how swaps and options can be used for hedging. Compute the value of a put and call option.

Firms face risk associated with changes in interest rates, exchange rates of foreign currency, costs of materials and the price that they can sell their products. 2.Firms use hedging to protect themselves against these risks. What are the most important topics of this chapter?

Forward, Futures, Swap and Option contracts are the financial instruments to deal with this volatility. 4.Risk is never removed entirely; it can be mitigated by investing in contracts. What are the most important topics of this chapter?

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