Introduction to Derivatives and Risk Management

Corporate Finance

Dr. A. DeMaskey

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Learning Objectives

Questions to be answered:– Why should a company manage its risk?– What financial techniques can be used to

reduce risk?– What are derivatives?– What are the important characteristics of the

various types of derivative securities?– How should derivatives be used to manage

risk?

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Reasons to Manage Risk

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.

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Reasons to Manage Risk

How can risk management increase the value of a corporation?

Risk management allows firms to: Have greater debt capacitydebt capacity, which has a larger tax

shield of interest payments. Implement the optimal capital budgetoptimal capital budget without

having to raise external equity in years that would have had low cash flow due to volatility.

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Reasons to Manage Risk

Risk management allows firms to: Avoid costs of financial distressfinancial distress.

– Weakened relationships with suppliers.

– Loss of potential customers.

– Distractions to managers. Utilize comparative advantage in hedgingcomparative advantage in hedging

relative to hedging ability of investors.

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Reasons to Manage Risk

Risk management allows firms to: Reduce borrowing costsborrowing costs by using interest

rate swaps. Minimize negative tax effectstax effects due to

convexity in tax code.

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Growth of Derivatives Market

Analytical techniques

Technology

Globalization

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Derivative Securities

Derivative: Security whose value stems or is derived from the value of other assets.

Types of Derivatives– Forward– Futures– Options– Swaps

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Forward Contracts An agreement where one party agrees to buy (or

sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into.

Characteristics– Flexibility– Default risk– Liquidity risk

Positions in Forwards– Long position– Short position

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Futures Contracts

A standardized agreement to buy or sell a specified amount of a specific asset at a fixed price in the future.

Characteristics– Margin Deposits

• Initial margin• Maintenance margin

– Marking-To-Market– Floor Trading– Clearinghouse

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Hedging with Futures

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.

– Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

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Option Contracts

The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time.

Option Terminology– Call option versus put option– Holder versus writer or grantor– Exercise or strike price– Option premium– American versus European option

Market Arrangements

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Swap Contracts

Financial contracts obligating one party to exchange a set of payments it owns for another set of payments owed by another party.

– Currency swaps– Interest rate swaps

Usually used because each party prefers the terms of the other’s debt contract.

Reduces interest rate risk or currency risk for both parties involved.

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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.

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An Approach to Risk Management

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

Firms often use the following process for managing risks.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.

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Techniques to Minimize Risk

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.

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Nature and Purpose of Trading in Financial

Derivatives Financial risk exposure refers to the risk inherent

in the financial markets due to price fluctuations. Hedging

– Protect Value of Securities Held– Protect the Rate of Return on a Security Investment– Reduce Risk of Fluctuations in Borrowed Costs

Speculating

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Using Derivatives to Reduce Risk

Commodity Price Exposure– 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.

Security Price Exposure– The purchase of a financial futures contract will allow a

firm to make a future purchase of the security at today’s price, even if the market price on the asset has risen substantially in the interim.

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Using Derivatives to Reduce Risk

Foreign Exchange Exposure– The purchase of a currency futures or options contract

will allow a firm to make a future purchase of the currency at today’s price, even if the market price on the currency has risen substantially in the interim.

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Risks to Corporations from Financial Derivatives

Increases financial leverage

Derivative instruments are too complex

Risk of financial distress