1. copyright © 2003 McGraw Hill Ryerson Limited 26-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 26-2 Chapter 26 Risk Management Chapter Outline  Why Hedge?  Reducing Risk with Options  Futures Contracts  Forward Contracts  Swaps  Is “Derivative” a Four Letter Word

3. copyright © 2003 McGraw Hill Ryerson Limited 26-3 Why Hedge? Question of the Day: What is a cereal company in the business of doing? A. Efficient manufacture of a product and selling it for a profit. B. Speculating on the price of sugar, wheat and other inputs to its product.

4. copyright © 2003 McGraw Hill Ryerson Limited 26-4 Why Hedge? Answer to the Question of the Day:  Both! The company does A. by choice. It does B. because a company is exposed to unpredictable changes in raw material costs, tax rates, technology, and a long list of other variables.  Next “Question of the day”: Is there anything a manager can do to reduce exposure to some of these risks?

5. copyright © 2003 McGraw Hill Ryerson Limited 26-5 Why Hedge? Hedging  In the last chapter, you learned about a practice called hedging. Hedging is used to offset or eliminate risk.  In this chapter, you will learn how hedging works.  You will also learn how about some of the specialized financial instruments which are available for hedging: Futures, forwards, options and swaps.

6. copyright © 2003 McGraw Hill Ryerson Limited 26-6 Why Hedge? Derivatives  Each of these financial instruments provides a payoff which depends on the price of some underlying asset.  Because their payoffs derive from the prices of other assets, they are often known as derivative instruments or derivatives.

7. copyright © 2003 McGraw Hill Ryerson Limited 26-7 Why Hedge? Hedging is Not Free  Hedging a risk position is seldom free.  So why hedge? To make financial planning easier.  It eliminates the need to worry about the firm facing an embarrassing financial shortfall. To make operations more effective.  Instead of worrying about non-operating risks, the managers can focus on the efficient operation of the business.  This also makes it easier to distinguish bad luck from bad management for performance measurement purposes.

8. copyright © 2003 McGraw Hill Ryerson Limited 26-8 Why Hedge? Risk Management Strategy  A sensible risk management strategy should ask the following questions: What are the major risks the company faces and what are the possible consequences? Is the company being paid for taking these risks? Can the company take any measures to reduce the probability of a bad outcome or to limit its impact? Can the company purchase fairly price insurance to offset any losses? Can the company use derivatives to hedge the risk?

9. copyright © 2003 McGraw Hill Ryerson Limited 26-9 Reducing Risk with Options Puts, Calls and Risk Management  In the last chapter, you learned about puts and calls.  Puts and calls are regularly used by firms to limit their downside risk on currencies, interest rates and commodities.  Many of these options are traded on options exchanges.  However, often they are simply private deals between a firm and a bank.

10. copyright © 2003 McGraw Hill Ryerson Limited 26-10 Reducing Risk with Options Puts, Calls and Risk Management  Example: Petrochemical Parfum Inc. (PPI) is concerned about the price of oil, which is one of its major inputs. To protect itself against such price increases, PPI will purchase a 6 month option to buy 1000 barrels of oil at $20 per barrel. This transaction will lock-in the maximum price that PPI will have to pay for its oil.  That price will be $20 per barrel.

11. copyright © 2003 McGraw Hill Ryerson Limited 26-11 Reducing Risk with Options Puts, Calls and Risk Management  If the price of oil rises above $20 a barrel, then PPI will exercise its option to purchase oil.  If the price of oil is below $20 a barrel, the option will expire worthless. However, PPI will be able to buy its oil at the cheap market price. Oil Price ($/barrel)$18$20$22 Cost of 1000 barrels $18,000$20,000$22,000 - Payoff on Option 00 2,000 = Net Cost of Oil $18,000$20,000$20,000

12. copyright © 2003 McGraw Hill Ryerson Limited 26-12 Reducing Risk with Options PPI’s Position Oil Price Revenues 18 20 22 -20,000 -22,000 2,000 Buy barrels of oil in market Call option with $20 exercise price Lock-in maximum price of $20/barrel

13. copyright © 2003 McGraw Hill Ryerson Limited 26-13 Reducing Risk with Options Puts, Calls and Risk Management  Thus, PPI has acquired insurance against upward changes in oil prices, while still being able to profit from reductions in oil price.  This insurance comes at a cost though! If the option has a cost of $0.50 per barrel, then this option will cost PPI $500. Is $500 a fair price to pay for 6 months of peace of mind? That will be a question that PPI’s managers will have to answer for themselves!

14. copyright © 2003 McGraw Hill Ryerson Limited 26-14 Reducing Risk with Options Puts, Calls and Risk Management  Try Example 26.1 on page 769 of your text. You will get to see how Onnex Inc. (OI), which supplies PPI with oil, can protect its position. Its problem is the mirror image of PPI’s!  When oil prices rise, OI gains.  When oil prices fall, OI loses. See if you can design a hedge for OI using options.  Then diagram the position on a graph similar to that on the previous page. Does your answer match the answer in the text?

15. copyright © 2003 McGraw Hill Ryerson Limited 26-15 Futures Contracts Hedging with Futures  Sometimes an option is not available for the hedge you wish to institute, or it may be too costly. How do you hedge then?  You might be able to use one of the other derivatives (futures, forwards or swaps) to set- up your hedge.  In this section, we will look at using futures to hedge a risky position.

16. copyright © 2003 McGraw Hill Ryerson Limited 26-16 Futures Contracts Hedging with Futures  A future is an exchange traded promise to buy or sell an asset in the future at a pre-specified price.  Notice that a future looks like an option. However, an option holder has a choice whether to make (or take) delivery of the asset. The holder of a futures contract has no choice and is obligated to make (or take) delivery of the asset at the pre-specified price.

17. copyright © 2003 McGraw Hill Ryerson Limited 26-17 Futures Contracts Hedging with Futures  Example: It is April, and a canola farmer is worried that the price of canola will drop by the time she is ready to harvest it. A canola oil processor is in the opposite position. Both can eliminate their problem if they enter into an agreement that the farmer will deliver the canola in, say November, at a price which is agreed upon today, say $300 per tonne.

18. copyright © 2003 McGraw Hill Ryerson Limited 26-18 Futures Contracts Hedging with Futures The farmer and the oil processor have just negotiated a futures contract. Note that no money changes hands when a futures contract is entered into.  This is different from an option, where the buyer of the option must pay the seller of the option a premium.

19. copyright © 2003 McGraw Hill Ryerson Limited 26-19 Futures Contracts Hedging with Futures Both parties are now obligated to perform their part of the deal in November, regardless of what happens to the price of canola.  The farmer must deliver canola at $300/tonne, even if the market price is higher, and she would make more selling in the market.  The oil processor must take delivery of the canola at $300/tonne, even if the market price is lower, and he would be better off to purchase in the market.

20. copyright © 2003 McGraw Hill Ryerson Limited 26-20 Futures Contracts Hedging with Futures  The farmer may wait until the end of the contract and actually deliver the canola to the oil processor.  In practice, such delivery is rare.  It is more convenient for the canola farmer to buy back the contract before maturity and then deliver her canola to the market. The profit on a futures contract is the difference between the initial futures price and the ultimate price of the asset when the contract matures or is closed out.

21. copyright © 2003 McGraw Hill Ryerson Limited 26-21 Futures Contracts Hedging with Futures Profit to Seller on the Future Contract: Initial Futures Price – Ultimate Market Price Profit to Buyer on the Future Contract: Ultimate Market Price – Initial Futures Price

22. copyright © 2003 McGraw Hill Ryerson Limited 26-22 Futures Contracts Hedging with Futures  The profits (losses) on a futures contract will offset the risk of the sales price of the canola. That is, the contract locks-in total revenue equal to the futures price.  For example, if the price of canola is $340/tonne, the farmer sells her canola in the market for $340. But, she loses $40 closing out her futures contract.  Net result: the farmer sells her canola for $300/tonne, the price negotiated in the futures contract.

23. copyright © 2003 McGraw Hill Ryerson Limited 26-23 Futures Contracts Hedging with Futures  At $340/tonne, the farmer’s financial position is as follows: Cash Flow Sale of Canola:Ultimate Price of Canola Futures Profit:Futures Price – Ultimate Price of Canola Total:Futures Price

24. copyright © 2003 McGraw Hill Ryerson Limited 26-24 Futures Contracts Hedging with Futures  Similarly, the oil processor’s cost for the canola is also fixed at the futures price. Any increase in the price of canola will be offset by a commensurate increase in the profit realized on the futures contract.  Both the farmer and the oil processor have less risk than before. The farmer has hedged (offset) her risk by selling canola futures. The oil process has hedged his risk by buying canola futures.

25. copyright © 2003 McGraw Hill Ryerson Limited 26-25 Forward Contracts Forwards vs Futures  Futures are standardized, exchange traded contracts for an underlying asset. They mature on a limited number of dates each year. As well, the contract size is standardized.  If the terms of a futures contract do not suit your particular needs, you may be able to negotiate a forward contract.

26. copyright © 2003 McGraw Hill Ryerson Limited 26-26 Forward Contracts Forwards vs Futures  A forward contract is a custom-tailored futures contract. It is an agreement to buy or sell an asset in the future at an agreed price. However, all the terms of the contract are negotiated by the parties to that contract.

27. copyright © 2003 McGraw Hill Ryerson Limited 26-27 Swaps How to Convert a Fixed Rate to Floating  A swap is an arrangement by two counterparties to exchange one stream of cash flows for another.  For example, suppose Computer Parts (CP) has just issued a $100 m floating-rate bond, which pays LIBOR. LIBOR is the London Interbank Offer Rate. It is the interest rate at which banks borrow from each other. LIBOR is a floating rate which fluctuates over time.

28. copyright © 2003 McGraw Hill Ryerson Limited 26-28 LIBOR to bondholders Swaps How to Convert a Fixed Rate to Floating  The financial manager at CP is becoming increasingly concerned that interest rates are becoming more volatile. But how? CP  She would like to lock in the firm’s interest expenses … ?

29. copyright © 2003 McGraw Hill Ryerson Limited 26-29 Swaps How to Convert a Fixed Rate to Floating  Buying back the bond and issuing new, fixed rate debt would be very costly.  A cheaper alternative would be to hedge the firm’s interest rate exposure using an interest rate swap: CP agrees to pay, say, 8% fixed on a “notional principal” of $100 m to a swap dealer. In return, the swap dealer will pay CP LIBOR on the same amount of notional principal.

30. copyright © 2003 McGraw Hill Ryerson Limited 26-30 LIBOR To bondholders Swaps How to Convert a Fixed Rate to Floating  The resulting cash flows would look like this: CP Swap Dealer LIBOR 8%  The firm will pay or “swap” a fixed payment for another payment which is tied to interest rates. If rates rise, increasing the firm’s interest expense on its floating rate debt, the cash flow from the swap will rise as well, offsetting the exposure.

31. copyright © 2003 McGraw Hill Ryerson Limited 26-31 Swaps How to Convert a Fixed Rate to Floating  Table 26.3 on page 778 of your text shows CP’s payments on its loans for three possible interest rates.  Remember, the firm wanted to lock its rates at 8% on a $100 m loan. This means that regardless of how interest rates fluctuate, CP has $8 m of interest expense.  If you look at Table 26.3, you will see that the firm’s payments on its loan always total $8 m, no matter what happens to rates.

32. copyright © 2003 McGraw Hill Ryerson Limited 26-32 Swaps Variations on Swaps  There are many variations on the interest rate swap.  For example, currency swaps allow firms to exchange a series of payments in dollars (which may be fixed or floating) for … … a series of payments in another currency (which also may be fixed or floating).  These swaps can be used to manage exposure to exchange rate fluctuations. For practice, try Example 26.4 on page 779 of your text.

33. copyright © 2003 McGraw Hill Ryerson Limited 26-33 Is “Derivative” a Four-Letter Word? Insurance vs Speculation  We have seen how the farmer and the canola oil processor were able to reduce risk by using derivatives.  However, if you were to copy either of these parties, without an offsetting holding in the underlying asset, you would be speculating.  Speculation is necessary in a thriving derivatives market, but if not used carefully it can get a company into very serious difficulty.

34. copyright © 2003 McGraw Hill Ryerson Limited 26-34 Is “Derivative” a Four-Letter Word? Insurance vs Speculation  Some of the largest financial disasters of the last 20 years have involved companies (or their employees) speculating in the derivatives market. You can read about the disasters at Sumitomo Corporation, Barings Brothers and Metallgesellschaft in your text. Do these horror stories mean we should ban derivatives?

35. copyright © 2003 McGraw Hill Ryerson Limited 26-35 Is “Derivative” a Four-Letter Word? Insurance vs Speculation  No!  What they do illustrate is that derivatives need to be used with care: If you are not better informed than highly paid professionals in banks and other institutions, you should use derivatives for hedging, not for speculation!

36. copyright © 2003 McGraw Hill Ryerson Limited 26-36 Summary of Chapter 26  Companies use hedging to reduce their exposure to the risks associated with unpredictable changes in raw material costs, currencies and interest rates.  A number of specialized financial instruments have been developed to help them.  Collectively, they are known derivatives.  Options may be used in a variety of ways to hedge a firm’s risk. For example, if you own an asset, and have a put at the current price, then you have effectively insured yourself against loss.

37. copyright © 2003 McGraw Hill Ryerson Limited 26-37 Summary of Chapter 26  Futures are promises to buy or sell an asset in the future at a price which is fixed today.  They are standardized contracts which trade on an exchange.  Futures allow a firm to fix the future price it will pay for a wide range of agricultural commodities, metals and oil.  Financial futures help firms to protect themselves against unforeseen movements in interest rates, exchange rates and stock prices.

38. copyright © 2003 McGraw Hill Ryerson Limited 26-38 Summary of Chapter 26  Forward contracts are tailor-made futures contracts.  Swaps allow a firm to exchange one series of payments for another. For example, the firm might agree to make a series of regular payments in one currency in return for receiving a series of payments in another currency.  Swaps are used to hedge interest rate risk and currency risk.