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Corporate Risk Management

Chapter 20

Slide Contents

• Learning Objectives• Principles Used in This Chapter

1. Five-Step Corporate Risk Management Process2. Managing Risk with Insurance Contracts3. Managing Risk by Hedging with Forward

Contracts4. Managing Risk with Exchange-Traded Financial

Derivatives5. Valuing Options and Swaps

• Key Terms

Learning Objectives

1. Define risk management in the context of the five-step risk management process.

2. Understand how insurance contracts can be used to manage risk.

3. Use forward contracts to hedge commodity price risk.

Learning Objectives (cont.)

4. Understand the advantages and disadvantages of using exchange traded futures and option contracts to hedge price risk.

5. Understand how to value option and how swaps work.

Principles Used in This Chapter

• Principle 2: There is a Risk-Return Tradeoff.– Business is inherently risky but a lot of risk that

a firm is exposed to are at least partially controllable through the use of financial contracts. Corporations are devoting increasing amounts of time and resources to the active management of their risk exposure.

20.1 Five Step Corporate Risk Management Process

Five Step Corporate Risk Management Process

1. Identify and understand the firm’s major risks.

2. Decide which type of risks to keep and which to transfer.

3. Decide how much risk to assume.4. Incorporate risk into all the firm’s decisions

and processes.5. Monitor and manage the risk that the firm

assumes.

Step1: Identify and Understand the Firm’s Major Risks

• Identifying risks relates to understanding the factors that drive the firm’s cash flow volatility. For example:– Demand risk - fluctuations in demand – Commodity risk – fluctuations in prices of raw

materials – Country risk – unfavorable government policies– Operational risk – cost overruns in firm’s

operations– Exchange rate risk – changes in exchange rates

Step1: Identify and Understand the Firm’s Major Risks (cont.)

• All the listed sources of risk (except operational risk) are external to the firm.

• Risk management generally focuses on managing external factors that cause volatility in firm’s cash flows.

Step 2: Decide Which Type of Risk to Keep and Which to Transfer

• This is perhaps the most critical step.

• For example, oil and gas exploration and production firms have historically chosen to assume the risk of fluctuations in the price of oil and gas. However, some firms have chosen to actively manage the risk.

Step 3: Decide How Much Risk to Assume

• Figure 20-1 illustrates the cash flow distributions for three risk management strategies.

• The specific strategy chosen will depend upon the firm’s attitude to risk and the cost/benefit analysis of risk management strategies.

Step 4: Incorporate Risk into All the Firm’s Decisions and Processes

• In this step, the firm must implement a system for controlling the firm’s risk exposure.

• For example, for those risks that will be transferred, the firm must determine an appropriate means of transferring risk such as buying an insurance policy.

Step 5: Monitor and Manage the Risk the Firm Assumes

• An effective monitoring system ensures that the firm’s day-to-day decisions are consistent with its chosen risk profile.

• This may involve centralizing the firm’s risk exposure with a chief risk officer who assumes responsibility for monitoring and regularly reporting to the CEO and to the firm’s board.

20.2 Managing Risk with Insurance Contracts

Managing Risk with Insurance Contracts

• Insurance is a method of transferring risk from the firm to an outside party, in exchange for a premium.

• There are many types of insurance contracts that provide protection against various events.

20.3 Managing Risk by Hedging with Forward Contracts

Managing Risk by Hedging with Forward Contracts

• Hedging refers to a strategy designed to offset the exposure to price risk.

• Example 20.1 If you are planning to purchase 1 million Euros in 6 months, you may be concerned that if Euro strengthens it will cost you more in U.S. dollars. Such risk can be mitigated with forward contracts.

Managing Risk by Hedging with Forward Contracts (cont.)

• Forward contract is a contract wherein a price is agreed-upon today for asset to be sold or purchased in the future. Since the price is locked-in today, risk from future price fluctuation is reduced.

• These contracts are privately negotiated with an intermediary such as an investment bank.

• Thus in example 20.1, you could negotiate a rate today for Euros (say 1 Euro = $1.35) using a forward contract.

• In 6-months, regardless of whether Euro has appreciated or depreciated, your obligation will be to buy 1 million Euros at $1.35 each or $1.35 million.

• The following table shows potential future scenarios and the cash flows. It is seen that Forward contract helps to reduce risk if Euro appreciates. However, if Euro depreciates, Forward contract obligates the firm to pay a higher amount.

Future Exchange Rate

of Euro

Cost with a Forward Contract

Cost without a Forward contract

Effect of Forward Contract

$1.20 $1.35 million $1.20 million Unfavorable

$1.30 $1.35 million $1.30 million Unfavorable

$1.40 $1.35 million $1.40 million Favorable

$1.50 $1.35 million $1.50 million Favorable

Checkpoint 20.1

Hedging Crude Oil Price Risk Using Forward ContractsProgressive Refining Inc. operates a specialty refining company that refines crude oil and sells the refined by-products to the cosmetic and plastic industries. The firm is currently planning for its refining needs for one year hence. The firm’s analysts estimate that Progressive will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feedstock for its refining needs for the coming year. The 1 million barrels of crude will be converted into by-products at an average cost of $30 per barrel. Progressive will then sell the by-products for $165 per barrel. The current spot price of oil is $125 per barrel, and Progressive has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $130 per barrel.

a. Ignoring taxes, if oil prices in one year are as low as $110 or as high as $140, what will be Progressive’s profits (assuming the firm does not enter into the forward contract)?

b. If the firm were to enter into the forward contract to purchase oil for $130 per barrel, demonstrate how this would effectively lock in the firm’s cost of fuel today, thus hedging the risk that fluctuating crude oil prices pose for the firm’s profits for the next year.

Checkpoint 20.1

Checkpoint 20.1: Check Yourself

Consider the profits that Progressive might earn if it chooses to hedge only 80% of its anticipated 1 million barrels of crude oil under the conditions above.

Step 1: Picture the Problem

• The figure shows that the future price of crude oil could have a dramatic impact on the total cost of 1 million barrels of crude oil.

• If the price is not managed, it will significantly affect the future profits of the firm.

Step 2: Decide on a Solution Strategy

• The firm can hedge its risk by purchasing a forward contract. This will lock-in the future price of oil at the forward rate of $130 per barrel.

Step 3: Solve

• The table on the next slide contains the calculation of firm profits for the case where the price of crude oil is not hedged (column E), the payoff to the forward contract (column F) and firm profits where the price of crude is 80% hedged (column G).

Step 3: Solve (cont.)

80% Hedged

Price of Oil/bbl

Total Cost of Oil

Total Revenues

Total Refining Costs

Unhedged Annual Profits

Profit/Loss on Forward Contract

80% Hedged Annual Profits

A B=Ax1m C D=$30x1m E=C+B+D =(A-$130)x1mx%Hedge G=E+F

$110 $(110,000,000) $165,000,000 $(30,000,000) $25,000,000 $(16,000,000) $9,000,000

115 (115,000,000) $165,000,000 (30,000,000) $20,000,000 $(12,000,000) 8,000,000

120 (120,000,000) $165,000,000 (30,000,000) $15,000,000 $(8,000,000) 7,000,000

125 (125,000,000) $165,000,000 (30,000,000) $10,000,000 $(4,000,000) 6,000,000

130 (130,000,000) $165,000,000 (30,000,000) $5,000,000 $— 5,000,000

135 (135,000,000) $165,000,000 (30,000,000) $0 $4,000,000 4,000,000

140 (140,000,000) $165,000,000 (30,000,000) $(5,000,000) $8,000,000 3,000,000

Step 4: Analyze

• The total cost of crude oil increases as the price of crude oil increases.

• The unhedged annual profits range from a loss of $5 million to a gain of $25 million. With 80% hedging, losses are avoided and the firm ends with profits ranging from $3 million to $5million. The forward contract obviously benefits the firm when the price of oil is higher than $130.

Hedging Currency Risk Using Forward Contracts

• Currency risk can be hedged using forward contracts.

• For example, Disney expects to receive ¥500 million from its Tokyo operations in 3 months. Disney can lock-in the exchange rate to avoid any losses if the Yen weakens in 3 months.

Hedging Currency Risk Using Forward Contracts (cont.)

• Disney will follow a 2-step procedure to hedge its currency risk:1. (Today): Enter into a forward contract which

requires Disney to sell ¥500 million at the forward rate of say $0.0095/ ¥.

2. (In three months): Disney will convert its ¥500 million at the contracted forward rate, yielding $4,750,000 (¥500 m × $0.0095=$4,750,000).

Hedging Currency Risk Using Forward Contracts (cont.)

• With a forward contract, Disney will receive $4,750,000 regardless of the exchange rate in the market.

Limitations of Forward Contract

1. Credit or default risk: Both parties are exposed to the risk that the other party may default on their obligation.

2. Sharing of strategic information: The parties know what specific risk is being hedged.

3. It is hard to determine the market values of negotiated contracts as these contracts are not traded.

Limitations of Forward Contract

• These limitations of forward contracts can be addressed by using exchange-traded contracts such as exchange traded futures, options, and swap contracts.

20.4 Managing Risk with Exchange-Traded Derivatives

Managing Risk with Exchange-Traded Derivatives

• A derivative contract is a security whose value is derived from the value of the underlying asset or security.

• In the examples considered on forward contract, the underlying assets were oil and currency.

Managing Risk with Exchange-Traded Derivatives (cont.)

• Exchange traded derivatives cannot be customized (like forward contracts) and are available only for specific assets and for limited set of maturities.

Futures Contract

• A futures contract is a contract to buy or sell a stated commodity (such as wheat) or a financial claim (such as U.S. Treasuries) at a specified price at some future specified time.

• These contracts, like forward contracts, can be used to lock-in future prices.

Futures Contract (cont.)

• There are two categories of futures contracts:– Commodity futures – are traded on

agricultural products, metals, wood products, and fibers.

– Financial futures – include, for example, Treasuries, Eurodollars, foreign currencies, and stock indices.

– Financial futures dominate the futures market.

Managing Default Risk in Futures Market

• Default is prevented in futures contract in two ways:

1.Margin – Futures exchanges require participants to post collateral called margin.

2.Marking to Market – Daily gains or losses from a firm’s futures contract are transferred to or from its margin account.

Hedging with Futures Contract

• Similar to forward contracts, firms can use futures contract to hedge their price risk.

• If the firm is planning to buy, it can enter into a long hedge by purchasing the appropriate futures contract.

• If the firm is planning to sell, it can sell (or short) a futures contract. This is known as a short hedge.

Hedging with Futures Contract (cont.)

• There are two practical limitations with futures contract:– It may not be possible to find a futures

contract on the exact asset.– The hedging firm may not know the exact date

when the hedged asset will be bought or sold.– The maturity of the futures contract may not

match the anticipated risk exposure period of the underlying asset.

• Basis risk is the failure of the hedge for any of the above reasons.

• Basis risk occurs whenever the price of the asset that underlies the futures contract is not perfectly correlated with the price risk the firm is trying to hedge.

• If a specific asset is not available, the best alternative is to use an asset whose price changes are highly correlated with the asset.

• For example, hedging corn with soybean future if the prices of the two commodities are highly correlated.

• If a contract with exact duration is not available, the analysts must select a contract that most nearly matches the maturity of the firm’s risk exposure.

Option Contracts

• Options are rights (not an obligation) to buy or sell a given number of shares or an asset at a specific price over a given period.

• The option owner’s right to buy is known as a call option while the right to sell is known as a put option.

Option Contracts (cont.)

• Exercise price: The price at which the asset can be bought or sold.

• Option premium: The price paid for the option.• Option expiration date: The date on which the

option contract expires.• American option: These options can be exercised

anytime up to the expiration date of the contract.• European option: These options can be exercised

only on the expiration date.

• For example, if you buy a call option on 100 shares of XYZ stock at a premium of $4.50 and exercise price of $40 maturing in 90 days.

• You can buy the XYZ stock at $40, even though the market price of the stock maybe above $40.

• If the stock price is below $40, you will choose not to use your option contract and will lose the premium paid.

• For example, if you buy a put option on 100 shares of ABC stock at a premium of $10.50 and exercise price of $70 maturing in 90 days.

• You can sell the ABC stock at $70, even though the market price of the stock maybe below $70.

• If the market price of stock is above $70, you will choose not to use your option contract and will lose the premium paid.

A Graphical Look at Option Pricing Relationships

• Figures 20-5 to Figures 20-8 graphically illustrate the expiration date profit or loss from the following option positions:– Buying a call option (figure 20-5)– Selling or writing a call option (figure 20-6)– Buying a put option (figure 20-7)– Selling or writing a put option (figure 20-8)

A Graphical Look at Option Pricing Relationships (cont.)

• The graphs are based on the following assumptions:

– Exercise price for call and put options = $20– Call premium = $4– Put premium = $3

A Graphical Look at Option Pricing Relationships (cont.)

Buy Call Write Call Buy Put Write Put

Maximum Profit

Unlimited Premium Exercise Price -

Premium

Maximum Loss

Premium Unlimited Premium Exercise Price -

Premium

Future Market Expectation

Bullish Bearish Bearish Bullish

Break-even Point

Exercise Price +

Premium

Exercise Price +

Premium

Exercise Price

– Premium

Exercise Price

- Premium

Checkpoint 20.2

Determining the Break-Even Point and Profit or Loss on a Call OptionYou are considering purchasing a call option on CROCS, Inc. (CROX) common stock. The exercise price on this call option is $10 and you purchased the option for $3. What is the break-even point on this call option (ignoring any transaction costs but considering the price of purchasing the option—the option premium)? Also, what would be the profit or loss on this option at expiration if the price dropped to $9, if it rose to $11, or if it rose to $25?

Checkpoint 20.2

• If you paid $5 for a call option with an exercise price of $25, and the stock is selling for $35 at expiration, what are your profits and losses? What is the break-even point on this call option?

BreakEven Point

Maximum Loss=Premium

Stock Price

Call Premium

Exercise Price

Exercised or Not

Profit or Loss

A B C D E

=Max(O, A-C)-B

$20 ($5) $25 No ($5)

$25 ($5) $25 No ($5)

$30 ($5) $25 Yes $0

$35 ($5) $25 Yes $5

$40 ($5) $25 Yes $10

Step 1: Picture the Problem (cont.)

• Break-even Point = Exercise price + Premium

• Profit = (Stock price – Exercise price) – Premium– If (stock price – exercise price) is negative, the profit or

losses is equal to $0 – Premium.– In other words, Profit = Max (0, or Stock Price –

Exercise Price) – Premium.

Step 3: Solve

• Break-even Point = Exercise price + Premium

= $25 + $5 = $30

• Profit (at stock price of $35) = (Stock Price – Exercise Price) – Premium= ($35 - $25) - $5= $5

Step 4: Analyze

• The graph in Step 1 shows that the option buyer will start exercising the option once it crosses $25.

• The option buyer will earn $1 (before considering option premium) for every $1 that the stock price rises above $25.

• Since the option premium is $5, at a stock price of $30, the option position earns $5 that covers the premium and leads to a no profit/no loss situation.

Reading Option Price Quotes

20.5 Valuing Options and Swaps

Valuing Options and Swaps

• The value of option can be regarded as the present value of the expected payout when the option expires.

• The most popular option pricing model is the Black-Scholes Option Pricing Model (BS-OPM).

Black-Scholes Option Pricing Model

• There are six variables that impact the price of an option:1. The price of the underlying stock2. The option’s exercise or strike price3. The length of time left until expiration4. The expected stock price volatility5. The risk free rate of interest6. The underlying stock’s dividend yield

Black-Scholes Option Pricing Model (cont.)

What IF Value of Call option

Value of Put Option

Price of underlying stock increases

Increases Decreases

Exercise price is higher Decreases Increases

Time to expirat ion is longer Increases Increases

Stock price volat i l i ty is higher over the l i fe of the option

Increases Increases

Risk-free rate of interest is higher

Increases Decreases

The stock pays dividend Decreases Increases

Black-Scholes Option Pricing Model (cont.)

• Black-Scholes option pricing model for call options is stated as follows:

Checkpoint 20.3

Valuing a Call Option Using the Black-Scholes ModelConsider the following call option:

• the current price of the stock on which the call option is written is $32.00;

• the exercise or strike price of the call option is $30.00;• the maturity of the option is .25 years;• the (annualized) variance in the returns of the stock is .

16; and• the risk-free rate of interest is 4% per annum.

Use the Black-Scholes option pricing model to estimate the value of the call option.

Checkpoint 20.3

Estimate the value of the above call option when the exercise price is only $25.

• Given:– Current price of stock = $32– Exercise price = $25– Maturity = 90 days or 0.25 years– Variance in stock returns = .16– Risk-free rate =12% per annum

Stock Price

Call Premium

Exercise Price

Exercised or Not

Profit or Loss

A B C D E

=Max(O, A-C)-B

$20 ($5) $25 No ($5)

$25 ($5) $25 No ($5)

$30 ($5) $25 Yes $0

$32 ($5) $25 Yes $2

$35 ($5) $25 Yes $5

$40 ($5) $25 Yes $10

Profit when stockis $25 or $32

Break-even point

• Equation 20-1 can be used to determine the value of call option using Black-Scholes option pricing model.

Step 3: Solve

Line d-1 (steps) Computation

1 In(S/E) 0.246860078

2 R=.5(Variance) 0.2

3 xt line 2*.25 0.05

4 Numerator line 1+line3 0.296860078

5 tXvariance .16*.25 0.04

6 Sqrt(T*Variance) sqrt(line5) 0.2

7 d-1 line 4/line 6 1.4843004

Line d-2 (steps) Computation

8 tXvariance .16*.25 0.04

9 sqrt(T*Variance) sqrt (line 8) 0.2

10 d-2 line (7-9) 1.2843004

11 N(d1)Normsdist

(line7) 0.931135325

12 N(d2)Normsdist

(line10) 0.900481497

Line Call value (steps) Computation

13 S*N(d-1) $32*line 11 29.79633039

14 -R*t -0.12*0.25 -0.03

15 exp^(-R*T) exp (line 14) 0.970445534

16 E*e^RT*N(d-2)$25*line

15*line 12 21.84670616

Call Value Line 13-Line 16 7.9496242

Step 4: Analyze

• The value of this option is $7.95 using BS-OPM.

• The current stock price of $32 represents a $7 profit over the exercise price of $25. The additional $0.95 can be seen as time value of call option i.e. premium available in the market for the possibility that stock price may rise even higher over the next 90 days.

Swap Contract

• A swap contract involves the swapping or trading of one set of payments for another.

• A currency swap involves exchange of debt obligations in different currencies.

Swap Contract (cont.)

• An interest rate swap involves trading of fixed interest payments for variable or floating rate interest rate payments between two currencies.

Swap Contract (cont.)

• Figure 20-10 illustrates 5-year fixed for floating interest rate swap and a notational principal of $250 million. – Notational principal is the amount used to calculate

payments for the contract but this amount does not change hands.

• The floating rate = 6-month LIBOR• The fixed rate = 9.75%• Interest is paid semi-annually.

Key Terms

• American options• Basis risk• Call options• Commodity futures• Credit risk• Currency swap• Derivative contract

Key Terms (cont.)

• European option• Exercise price• Financial futures• Futures contract• Hedging• Insurance• Interest rate swap

Key Terms (cont.)

• Futures margin• Marking to market• Notional principal• Option contract• Option expiration date• Option premium• Option writing

Key Terms (cont.)

• Put option• Risk profile• Self insurance• Spot contract• Strike price• Swap contract

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