21 Risk Management ©2006 Thomson/South-Western

2 Introduction This chapter describes the various motives that companies have to manage firm-specific risks It also explains basic non-hedging and hedging strategies used to reduce risk

3 What is Risk? Risk is the possibility that the actual cash flows from an investment or any other business transaction will be different from expected cash flows Risk management occurs when a firm takes deliberate steps to minimize that difference

4 Why Manage Risk? True, investors can eliminate firm-specific (unsystematic) risk by holding a well- diverse portfolio But investor diversification can’t produce the important benefits that risk management within a firm creates- namely, the preservation of valuable investment opportunities

5 Risk Management Benefits Management of risk at the firm level reduces the probability of financial distress and the loss of value from forced liquidation Risk management enables firms to maintain capital expenditures by stabilizing internally generated funds Risk management allows managerial performance to be evaluated on the basis of factors under manager’s control

6 Non-Hedging Strategies Acquisition of additional information: Test marketing, consumer surveys, and market research can reduce the risk of making poor decisions Diversification of customer and supplier base reduces threat to firm viability Insurance provides cash payments designed to offset losses due to natural disasters, the death of key employees, product liability, and unforeseen business interruptions Control measures such as patents, copyright protection, use agreements, and legal action can reduce business risks Flexibility in use of assets

7 Hedging strategies for risk management A hedge is a transaction that limits the risk associated with fluctuations in the price of a commodity, currency or financial instrument Hedging results from the creation of a position in a forward contract, a futures contract, or an option

8 Forward Contracts A forward contract is an agreement to buy or sell an asset  At a specified price  At a specified time The party agreeing to buy the asset holds a “long” position The party agreeing to sell the assets holds a “short” position

9 More About Forward Contracts Forward contracts are not traded on an exchange – meaning there is no organized market for their purchase and sale Forward contracts are subject to performance risk, which is the risk that the party with losses on the contract will fail to make the required payments Forward contracts are very common in the foreign exchange market

10 Futures Contracts A futures contract is a standardized contract, traded on an organized exchange, to buy or sell an asset  At a specified price  At a specified time The party agreeing to buy the asset holds a “long” position The party agreeing to sell the asset holds a “short” position

11 More on Futures Contracts Futures contracts require:  Daily settlement between buyers and sellers (marking to market)  Maintenance of a margin account to cover potential losses Futures exchanges provide:  Standardized contracts  A clearinghouse to handle all payments between buyers and sellers

12 Long Hedge Wait until July and buy the oil Buy the oil today at $45 / barrel and store it until needed Execute a long hedge by purchasing crude oil in the futures market for delivery in July Masco Industries anticipates the need for 100,000 barrels of crude oil in July To meet this supply requirement, the company could:

13 How the Long Hedge Works If the price of oil rises to $50 by July, the company will pay $500,000 more for the oil than if purchased earlier But the long futures position generates a profit of $500,000, offsetting the impact of the price increase Masco Industries decides to execute a long hedge by taking a long futures position in 100,000 barrels of crude oil at an agreed upon price of $45 / barrel. Bottom Line: The long hedge locks in a $45 / barrel purchase price

14 Short Hedge Earthgrains has agreed to sell 50,000 bushels of wheat to another bakery in November, at the prevailing market price Fearful that the price of wheat will decline by November, Earthgrains constructs a short hedge by taking a short position in November wheat futures

15 How a Short Hedge Works If the price of wheat falls by November, Earthgrains will receive less money from the other bakery But the short futures position will produce an offsetting gain, because it allows Earthgrains to sell wheat at a higher price Net result: short futures position enables Earthgrains to “lock-in” a selling price for the wheat

16 Hedging with futures options Futures call option  A call option on futures gives the holder the right, but not the obligation, to take a long position in a futures contract Futures put option  A put option on futures gives the holder the right, but not the obligation, to take a short position in a futures contract An important difference  Futures options (unlike futures) require the payment of an option premium