Lecture 14 - Derivatives and Risk Management Derivatives are financial weapons of mass destruction. Warren Buffett Warren BuffettWarren Buffett

2 Do stockholders care about volatile cash flows? If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios.

3 How can risk management increase the value of a corporation? Risk management allows firms to: Have greater debt capacity, which has a larger tax shield of interest payments. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. Avoid costs of financial distress. Weakened relationships with suppliers. Loss of potential customers. Distractions to managers. Utilize comparative advantage in hedging relative to hedging ability of investors. (More...)

4 Risk management allows firms to (Continued): Reduce borrowing costs by using interest rate swaps. Example: Two firms with different credit ratings, Hi and Lo: Hi can borrow fixed at 11% and floating at LIBOR + 1%. Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%. (More...)

Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of 0.45% to Hi. Hi Lo CF to lender-(LIBOR+1%)-11.40% CF Hi to Lo-11.40%+11.40% CF Lo to Hi+(LIBOR+1%)-(LIBOR+1%) CF Lo to Hi+0.45%-0.45% Net CF-10.95%-(LIBOR+1.45%)

6 Risk management allows firms to: Minimize negative tax effects due to convexity in tax code. Example: EBT of $50K in Years 1 and 2, total EBT of $100K, Tax = $7.5K each year, total tax of $15. EBT of $0K in Year 1 and $100K in Year 2, Tax = $0K in Year 1 and $22.5K in Year 2.

7 Another Example There is a neat example from the bond-world of a derivative that is used to move non-diversifiable risk from one set of investors to another set that are, presumably, more willing to bear that risk. Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park. They financed the park through the issuance of earthquake bonds. If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park.

8 Example Normally this could have been handled in the insurance (and re-insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs. Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies. Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all. This was not a “free” insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate.

9 Example This example illustrates an interesting notion – that insurance contracts (for property insurance) are really derivatives! They allow the owner of the asset to “sell” the insured asset to the insurer in the event of a disaster.

10 What is corporate risk management? Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm.

11 Different Types of Risk Speculative risks: Those that offer the chance of a gain as well as a loss. Pure risks: Those that offer only the prospect of a loss. Demand risks: Those associated with the demand for a firm’s products or services. Input risks: Those associated with a firm’s input costs. Financial risks: Those that result from financial transactions. Property risks: Those associated with loss of a firm’s productive assets. Personnel risk: Risks that result from human actions. Environmental risk: Risk associated with polluting the environment. Liability risks: Connected with product, service, or employee liability. Insurable risks: Those which typically can be covered by insurance.

12 What are the three steps of corporate risk management? Step 1.Identify the risks faced by the firm. Step 2.Measure the potential impact of the identified risks. Step 3.Decide how each relevant risk should be dealt with.

13 What are some actions that companies can take to minimize or reduce risk exposures? Transfer risk to an insurance company by paying periodic premiums. Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial risks. Take actions to reduce the probability of occurrence of adverse events. Take actions to reduce the magnitude of the loss associated with adverse events. Avoid the activities that give rise to risk.

14 What is financial risk exposure? Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls. Can you think of others?

15 Financial Risk Management Concepts Derivative: Security whose value stems or is derived from the value of other assets. Swaps, options, and futures are used to manage financial risk exposures. Futures: Contracts which call for the purchase or sale of a financial (or real) asset at some future date, but at a price determined today. Futures (and other derivatives) can be used either as highly leveraged speculations or to hedge and thus reduce risk.

16 Hedging: Generally conducted where a price change could negatively affect a firm’s profits. Long hedge: Involves the purchase of a futures contract to guard against a price increase. Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities. Swaps: Involve the exchange of cash payment obligations between two parties, usually because each party prefers the terms of the other’s debt contract. Swaps can reduce each party’s financial risk. Financial Risk Management Concepts

17 How can commodity futures markets be used to reduce input price risk? The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at today’s price, even if the market price on the item has risen substantially in the interim.

21 What are Credit Derivatives? “ Credit derivatives are derivative instruments that seek to trade in credit risks. ” Types of credit derivatives – Credit default swap – Credit spread option – Credit linked note

Source:BBA Credit Derivatives Report 2006 Growth in Credit Derivatives Source:BBA Credit Derivatives Report 2006

23 What is Credit default swap? Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits). The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

24 Example Suppose Bank A buys a bond which issued by a Steel Company. To hedge the default of Steel Company: Bank A buys a credit default swap from Insurance Company C. Bank A pays a fixed periodic payments to C, in exchange for default protection.

25 Exhibit Credit Default Swap Bank A Buyer Insurance Company C Seller Steel company Reference Asset Contingent Payment On Credit Event Premium Fee Credit Risk

26 Credit-linked notes A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor. The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral. If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity ’ s debt.

27 Example Refer to the Steel company case again. Bank A would extend a $1 million loan to the Steel Company. At same time Bank A issues to institutional investors an equal principal amount of a credit- linked note, whose value is tied to the value of the loan. If a credit event occurs, Bank A ’ s repayment obligation on the note will decrease by just enough to offset its loss on the loan.

28 Exhibit Bank A Institutional investors Steel Company $1 Million fixed or floating coupon, if the steel company defaults or declares bankruptcy the investors receive an amount equal to the recovery rate $1million $500,000 Steel Company

29 A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price. Forward contracts are normally not exchange traded. The party that agrees to buy the asset in the future is said to have the long position. The party that agrees to sell the asset in the future is said to have the short position. The specified future date for the exchange is known as the delivery (maturity) date. Forward contracts

30 The specified price for the sale is known as the delivery price, we will denote this as K. Note that K is set such that at initiation of the contract the value of the forward contract is 0. Thus, by design, no cash changes hands at time 0 As time progresses the delivery price doesn’t change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time. Consider the situation at the maturity date of the contract. If the spot price is higher than the delivery price, the long party can buy at K and immediately sell at the spot price S T, making a profit of (S T -K). The short position could have sold the asset for S T, but is obligated to sell for K, earning a profit (negative) of (K-S T ). Forward contracts

31 Let’s say that you entered into a forward contract to buy wheat at $4.00/bushel, with delivery in December Let’s say that the delivery date was December 14 and that on December 14 th the market price of wheat is unlikely to be exactly $4.00/bushel, but that is the price at which you have agreed (via the forward contract) to buy your wheat. If the market price is greater than $4.00/bushel, you are pleased, because you are able to buy an asset for less than its market price. If, however, the market price is less than $4.00/bushel, you are not pleased because you are paying more than the market price for the wheat. Indeed, we can determine your net payoff to the trade by applying the formula: payoff = S T – K, since you gain an asset worth S T, but you have to pay $K for it. Forward contracts

32 Forward contracts

33 Example: In this example you were the long party, but what about the short party? They have agreed to sell wheat to you for $4.00/bushel on December 14. Their payoff is positive if the market price of wheat is less than $4.00/bushel – they force you to pay more for the wheat than they could sell it for on the open market. Indeed, you could assume that what they do is buy it on the open market and then immediately deliver it to you in the forward contract. Their payoff is negative, however, if the market price of wheat is greater than $4.00/bushel. They could have sold the wheat for more than $4.00/bushel had they not agreed to sell it to you. So their payoff function is the mirror image of your payoff function: Forward contracts

34 Forward contracts

35 Forward contracts Long Position Net Position Short Position Clearly the short position is just the mirror image of the long position, and, taken together the two positions cancel each other out:

36 Futures contracts A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards. The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.

37 Futures contracts The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Futures are traded on a wide range of commodities and financial assets. Usually an exact delivery date is not specified, but rather a delivery range is specified. The short position has the option to choose when delivery is made. This is done to accommodate physical delivery issues. Harvest dates vary from year to year, transportation schedules change, etc.

38 Futures contracts The exchange will usually place restrictions and conditions on futures. These include: Daily price (change) limits. For commodities, grade requirements. Delivery method and place. How the contract is quoted. Note however, that the basic payoffs are the same as for a forward contract.

39 Financial engineering Financial engineering is the notion that you can use a combination of assets and financial derivatives to construct cash flow streams that would otherwise be difficult or impossible to obtain. Financial engineering can be used to “break apart” a set of cash flows into component pieces that each have different risks and that can be sold to different investors. Collateralized Bond Obligations do this for “junk” bonds. Collateralized Mortgage Obligations do this for residential mortgages. Financial engineering can also be used to create cash flows streams that would otherwise be difficult to obtain.

40 Financial engineering The Schwab/First Union equity-linked CD is a good example of financial engineering. When it was issued (in 1999), the stock market was (and had been) incredibly “hot” for several years. Many investors wanted to be in the market, but did not want to risk the market going down in value. The equity-linked CD was designed to meet this need. As we will demonstrate, an investor could “roll their own” version of this, but in doing so would have incurred significant transaction costs. Plus, many small investors (to whom this was targeted) probably could not get approval to trade options.

Financial engineering The Contract: An investor buys the CD (Certificate of Deposit) today, and then earns 70% of the simple rate of return on S&P 500 index over the next 5.5 years. If the S&P index ended up below the initial index level (so that the appreciation was negative), then the investor received their full initial investment back, but nothing else. So let’s say that you invested $10,000, and that in June of 1999 the index was 1300 (so that you were, in essence, buying $10,000/1,300 or 7.69 units of the index).

42 Financial Engineering In 5.5 years your payoff will be based upon the index level. Potential index levels and payoffs include: IndexSimple Rate of ReturnCash Received %$10, %$10, %$10, %$10, %$11, %$13,769 (Note that on 12/30/2004 the S&P 500 was at !)