1. Presented by Meiting Liu
The New Risk Management: The Good, the Bad, and the Ugly by Philip H. Dybvig, Pierre Jinghong Liang, and William J. Marshall
Presented by Meiting Liu

2. Motivation
At one time, risk management meant buying corporate insurance, implementing procedures to avoid lawsuits and accidents, and installing safety equipment.
The new risk management uses financial markets to hedge different sources of risk within the firm.
The new risk management can be good, bad and even ugly(Examples?).
This article provides an introduction to the new risk management and some policy choices firms should be considering.

3. Outline Tools For The New Risk Management Four Fundamental Questions
Option Pricing
An example: Risk Management In Manufacturing
Four Fundamental Questions
Accounting Issues
Cost Issues
Risk Management Policy
Conclusions

4. Background The Black- Scholes model
𝑐= 𝑒 −𝑞𝑇 𝑆 0 𝑁 𝑑 1 − 𝑒 −𝑟𝑇 𝐾𝑁 𝑑 2
𝑝= 𝑒 −𝑟𝑇 𝐾𝑁 −𝑑 2 − 𝑒 −𝑞𝑇 𝑆 0 𝑁 −𝑑 1
𝑑 1 = log 𝑆 0 𝐾 + 𝑟−𝑞 𝜎 2 Τ σ Τ , 𝑑 2 = 𝑑 1 −σ Τ
An example of B-S extensions – Caplets:
𝑐𝑎𝑝𝑙𝑒𝑡𝑠(0, 𝑇 𝑖−1 , 𝑇 𝑖 ,𝐾, 𝑣 𝑖 )= 𝑃 0, 𝑇 𝑖 𝜏 𝑖 ( 𝐹 𝑖 0 𝑁 𝑑 1 (𝐾, 𝐹 𝑖 0 , 𝑣 𝑖 ) − 𝐾𝑁 𝑑 2 (𝐾, 𝐹 𝑖 0 , 𝑣 𝑖 ) )
𝑑 1 = log 𝐹 𝐾 + 𝑣 2 𝑣 , 𝑑 2 = 𝑑 1 − 𝑣 2
𝑣 𝑖 2 = 𝑇 𝑖−1 𝑣 𝑇 𝑖−1 −𝑐𝑎𝑝𝑙𝑒𝑡𝑠 2
𝑣 𝑇 𝑖−1 −𝑐𝑎𝑝𝑙𝑒𝑡𝑠 2 = 1 𝑇 𝑖− 𝑇 𝑖−1 𝜎 𝑖 (𝑡 ) 2 𝑑𝑡

5. Background Hedging Strategy
An investment policy with an investment equal to the model’s option price and a terminal value equal to the terminal value of the option.
To make an arbitrage profit if market prices are out of line with the model.
If the model price of a Call is lower than the price in the economy:
Selling Call + Buying Shares + Borrowing
If the model price is higher than the price in the economy:
Buying Call + Shorting Shares + Lending

6. An Example: Risk Management in Manufacturing
Settings
A manufacturer uses significant amounts of copper as an input
The expected output is 1,000 units, which will sell for $100 per unit
The price has been committed to in advance because of long-term contract
The quantity may vary around this expectation.
Each unit will use an amount of copper that would cost $20 purchased forward (in a firm commitment to buy one year from now).
If purchased in the spot market, the copper in the unit might cost $25 (with probability 1/4), $20 (with probability 1/2), or $15 (with probability 1/4).
Assumes no taxes and sources of risk that are not related to the price of copper.

7. Approach Panel A: Unhedged Cash Flows
Prob
Copper
price ($)
Units sold
Output
Total
Sales ($)
Copper Expense ($)
Other Expense($)
Profit (loss) ($) 25
1,200
100
120,000
30,000
82,000
8,000 20
1,000
100,000
20,000
78,000
2,000 15
800
80,000
12,000
74,000
(6,000)
The expected unhedged profit = ¼ * ½ * 2000 – ¼ * 6000 = 1500

8. Hedged Profit (loss) ($)
Approach
Panel B: Naive Hedge of the Expected Quantity Required
Probability
Unhedged ($)
Hedged ($)
Hedged Profit (loss) ($)
8,000
5,000
13,000
2,000
(6,000)
(5,000)
(11,000)
The expected naïve hedged profit = ¼ * ½ * 2000 – ¼ * = 1500

9. Hedged Profit (loss) ($)
Approach
Panel C: Fully Hedged Cash Flows
Probability
Unhedged ($)
Hedged ($)
Hedged Profit (loss) ($)
8,000
(6,500)
1,500
2,000
(500)
(6,000)
7,500
How to realize that? By simply buying or selling forwards?

10. Approach: The Dynamic Hedge
Why ?
Assume that the firm is using copper futures contracts to hedge and the reinvestment rate is 5% over 6 months
Assume information arrival and trading occur now, in six months, and again in a year
Future Price Dynamics for the Copper Hedge
Now months months
$25
$ $20
$15
$22.5
$17.5

11. The Dynamic Hedge
Strategy: At the start, the firm sells 1,400/1.05 ≈ 1,333 futures at the futures price of $20. In 6 months, if the futures price goes up to $22.50, the short position will decrease to 1,200 contracts. If the futures price goes down to $17.5, the position will increase to 1,600 contracts.
In 6 months, the futures price goes up to $22.50, the firm loses $3,333 on the short futures and borrows at the riskless rate, agreeing to pay back $3,333 * 1.05 = 3,500 in 1 year.
To make sure a full hedge, the short position in 6 months reduces to Δloss/ Δprice= (6,500 – 3,500) / (25 – 22.5) = 1,200 contracts.
In a year, the hedged cash flows = 1,500

12. Four Fundamental Questions
Why Should We Hedge?
What Risks Should We Hedge?
With What Instruments Should We Hedge?
Support Your Investment Banker

13. Question 1: Why Should We Hedge?
Increase the firm value
Reduces the volatility of the value received by shareholders?
Reduce the bankruptcy cost and costs of financial distress
The reduction of risk can maintain more leverage to reduce taxes and avoid double taxation
Reduce earnings volatility
Give managers incentives to produce profits

14. Question 2: What Risks Should We Hedge?
suppose we are hedging a bank’s exposure to interest rate risk. Should we hedge:
the direct interest mismatch of existing assets and liabilities?
or the full economic value?
If the purpose of hedging is to eliminate sources of noise beyond the manager’s control, it may even be appropriate to hedge particular accounting numbers used in computing compensation rather than hedging cash flow or economic value.

15. Question 3: With What Instruments Should We Hedge?
To hedge U.S. interest rates
Bonds, repurchase agreements, Treasury bond futures, swaps, caps, or collars.
With which should we hedge?
pricing
transaction costs
accounting implications

16. Accounting Issues Hedge accounting is a new and technical area
The guide for hedge accounting standards
SFAS No. 133: Accounting for Derivative Instruments and Hedging Activities
Two hedge accounting methods:
Fair value hedge: hedge the fluctuation of the fair value
Cash flow hedge: hedge the fluctuation of the cash flow
What method should we used in the manufacturing example?
Cash flow hedge

17. Accounting Issues
Several conditions must be met to qualify for cash flow hedge accounting treatment:
The nature of the risk to be hedged
The hedge must be deemed effective
Formal and complete documentation of hedging activities
The forecasted future transactions: single/similar
Likelihood of the forecasted future transactions must be “probable”
Question: Is the hedge in our example qualified for it?
Interesting accounting challenge

18. Cost Issues
Cost of hedging is the cost of any securities purchased in the hedge program.
Transaction Cost
Commissions
Bid-ask spread
Any internal costs of trading
Marginal Cost
Hedged price or Spot price?
The price has been locked in for a fixed quantity
The profit/loss will be collected on the hedged quantity regardless of how much or little is actually used.
If more is needed, the shortfall will be purchased at the spot price.
If less is needed, the excess will be sold at the spot price.
Spot price!

19. Risk Management Policy
Specify the goal and scope of any hedging activity
Dictate the degree of centralization
The control systems
Ex post evaluation
Monitor and limit the amount of risk taken

20. Conclusion Risk management in corporate policy
Derivatives in risk management
Implementing new accounting standards in risk management
Internal controls and policies

21. Thoughts about the Paper
Merits
The framework of the paper is clear and complete
The manufacturing hedging example is useful to understand the dynamic hedging and its advantage
The conclusion is proved by the real-world firms
Improvements
Issues can be further updated: Financial technology, regulation and legislations
The bias of the theory: B-S Formula

22. Further Reading Risk Management Information Hedging with Options
Hedging Programs That Failed
Value at Risk
Hedge Accounting Sources