1. Risk & Business Risk Sergeeva Irina Ph.D., Professor

2. Topics Covered Risk Types of Risk Risk Management Strategies Aspects of Risk Management Hedging

3. Risk Risk measures the degree of uncertainty in forecasting future profits or losses Risk management - Practices by which a firm optimizes the manner in which it takes risk Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.

4. Risk Unique Risk - Risk factors affecting only that firm. Also called “diversifiable or unsystematic risk.” Market Risk - Economy-wide sources of risk that influence to some extent all assets in the market. Also called “systematic risk.” Financial Risk – The additional risk that the firm’s stockholders bear when the firm is financed with debt as well as equity. Default risk – The chance that interest or principal will not be paid on the due date and in the promised amount. Country risk is caused by political changes, government or president elections

5. Risks in Banking Market risk is the risk arising from changes in equity prices and market rates Credit risk is the risk arising from the bank's positions in other companies where those companies may become bankrupt Liquidity risk arises from situations in which a bank cannot sell an asset because nobody in the market wants to trade that asset Operational risk is caused by failures of the infrastructure within a bank, such as a critical computer system crashing Legal and regulatory risk arises when sometimes governments change the law in a way that adversely affects a bank's position

6. Business Risks in Russia Political instability Economic outlook (economy relies on natural resources) Financial volatility Changes in the business operating environment (government intervention in business)

7. Risk Management Risk management strategies Avoidance - Includes not performing an activity that could carry risk. Reduction - Involves methods that reduce the severity of the loss. Retention - Involves accepting the loss when it occurs. Transfer - Means causing another party to accept the risk. Hedging – Includes taking a position in two or more financial instruments that are negatively correlated (taking opposite trading positions) to reduce risk.

8. Aspects of Risk Management A positive corporate culture is one which promotes individual responsibility and is supportive of risk taking Policies and procedures – board procedures, lines of reporting, risk limits Effective use of technology – financial engineering technology Independence of risk management professionals – must be independent of risk taking functions within the organization

9. Hedging Hedging involves taking on one risk to offset another. Ex - Kellogg produces cereal. A major component and cost factor is sugar. Forecasted income & sales volume is set by using a fixed selling price. Changes in cost can impact these forecasts. To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not. You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. This contract is called a “Futures Contract.” This technique of managing your sugar costs is called “Hedging.”

10. Hedging Spot Contract - A contract for immediate sale & delivery of an asset. Forward Contract - A contract for the delivery of an asset at a negotiated price on a set date in the future. Futures Contract – Obliges traders to purchase or sell an asset at an agreed-upon price on a specified future date. Futures differ from forward contracts in their standardization, exchange trading, margin requirements and daily settling (marking to market).

11. Hedging Futures Contracts are available for many commodities, foreign currencies, stock indices, interest rate instruments (T-bills and T-bonds). Futures Contracts are standardized as to the date, quantity, and specifications of the underlying asset. Futures Contracts are traded through organized exchanges and the firms are required to keep margin deposits as security for their position. Each day futures contracts are marked to market to determine profits or losses.

12. Futures Contract Concepts Not an actual sale K are “settled” every day. (Marked to Market) The long position is held by the trader who commits to purchase The short position is held by the trader who commits to sell Hedge - K used to eliminate risk by locking in prices

13. Hedge – Example An oil company should hold large inventories of petroleum to be processed into heating oil. The company could sell futures contracts in heating oil in order to lock in the sales price. In October the company expects to sell 84,000 gallons of heating oil. In August, the October heating oil futures are selling for $1.55 per gallons (1 contract K = 42,000 gallons). The company wishes to lock in this price. Show the transactions if the October spot price drops to $1.40.

14. Hedge – Example Revenue from Oil: 84,000 x 1.40 = 117,600 August: Short 2K x 1.55 = 130,200 October: Long 2K x 1.40 =117,600______ Gain on Position-------------------------- 12,600 Total Revenue $ 130,200

15. Hedge – Example Show the transactions if the Oct spot price rises to $1.70 Revenue from Oil: 84,000 x 1.70 = 142,800 August: Short 2K x 1.55 = 130,200 Oct: Long 2K x 1.70 = 142,800. Loss on Position----------------------------- ( 12,600 ) Total Revenue $ 130,200