J. K. Dietrich - FBE 532 – Spring, 2006 Module III: Techniques for Risk Management Week 6 –...
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Transcript of J. K. Dietrich - FBE 532 – Spring, 2006 Module III: Techniques for Risk Management Week 6 –...
J. K. Dietrich - FBE 532 – Spring, 2006
Module III: Techniques for Risk Management
Week 6 – February 16, 2006
J. K. Dietrich - FBE 532 – Spring, 2006
Asset-Liability Risk
Assets Liabilities and EquityCash Short-Term Notes
Inventories Trade PayablesAccounts Receivable Other Current Liabilities
Current Assets Current Liabilities
Fixed Assets Long-Term DebtIntangible Assets Equity
Total Assets Liabilities and EquityCas
h I
nfl
ows
Cash
Ou
tflows
J. K. Dietrich - FBE 532 – Spring, 2006
Cash-Flow Risks
Period 1 2 3 4 5 6Cash Revenues 100 120 90 80 140 160Cash ExpensesCosts of Goods 60 72 54 48 84 96
Interest 10 10 10 10 10 10Net Cash Flow 30 38 26 22 46 54
Variation in Cash Flows Due to Relation Between
Inflows and Outflows
J. K. Dietrich - FBE 532 – Spring, 2006
Risk Management
PeriodCash RevenuesCash ExpensesCosts of Goods
InterestNet Cash Flow
Product Prices
Substitute PricesExchange Rates
Commodity Input PricesFixed Asset Values
Labor Costs
Short-Term BorrowingLong-Term Borrowing
J. K. Dietrich - FBE 532 – Spring, 2006
Asset-Liability Management
Focus on variability of cash flows– Main concern is to be able to make all
contractual payment to avoid defaults– Secondary concern is to minimize risk
(variability)– Third concern is to increase net cash flows by
taking advantage of predictability in variations Objective is to measure and manage
variability in cash flows
J. K. Dietrich - FBE 532 – Spring, 2006
Exposure to Risk
A general term to describe a firm’s exposure to a particular risk (e.g. a commodity price) is to classify the exposure as long or short
Long exposure means that the firm will benefit from increases in prices or values
Short exposure means that the firm will benefit from decreases in prices or values
J. K. Dietrich - FBE 532 – Spring, 2006
Long Exposure
A firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples– The firm owns assets, as in inventories of raw
materials or finished goods– The firm produces a commodity or product, as
in an agribusiness raising wheat or livestock– The firm will take possession in the future or a
commodity or an asset– The firm has bought a commodity or asset
J. K. Dietrich - FBE 532 – Spring, 2006
Short Exposure A firm (or individual) is short if at the time
of the risk assessment if it needs or will need an asset or commodity. As examples– The firm is planning or has promised to deliver
raw materials or finished goods – The firm uses a commodity or product in
production as inputs, like steel or lumber– The firm will have possession in the future or a
commodity or an asset it does not need or needs to sell
– The firm has sold a commodity or asset and must deliver
J. K. Dietrich - FBE 532 – Spring, 2006
Price Exposure in a Diagram
P0 P0
Long
Short
Profit
Loss
0 0
Profit
Loss
J. K. Dietrich - FBE 532 – Spring, 2006
Exposure to Risks
Time/ Situation
Present or inPresent Plan
Future TimePeriod
Have,Will Have, orWill Receive
LONG LONG
Need,Will Need, orWill Deliver
SHORT SHORT
J. K. Dietrich - FBE 532 – Spring, 2006
Examples of Exposure
Farmer with wheat is long wheat Honey Baked Ham is short pork before
Easter selling season Treasurer with excess cash in three months
is short investments Company needing cash in nine months is
long financial assets (its liabilities are others’ assets) to sell
J. K. Dietrich - FBE 532 – Spring, 2006
Types of Derivative Contracts Three basic types of contracts
– Futures or forwards– Options– Swaps (we discuss next week)
Many basic underlying assets– Commodities– Currencies– Fixed incomes or residual claims
J. K. Dietrich - FBE 532 – Spring, 2006
Futures Contracts
Wall Street Journal tables Standardized contracts
– Quantity and quality– Delivery date– Last trading date– Deliverables
Clearing house is counterparty Margin requirements, mark to market
J. K. Dietrich - FBE 532 – Spring, 2006
Forward vs. Futures Contracts
Bilateral contract (usually with a financial firm as counterparty)
Terms are tailor made to needs of corporate, not standardized
No exchange of cash until maturity of contract
Over-the-counter market not as liquid as organized exchange
J. K. Dietrich - FBE 532 – Spring, 2006
Managing Risk with Futures
Offset price or interest rate risk with contract which moves in opposite direction
“Cross diagonally in the box” Identify contract with price or interest rate which
moves as close as possible with the price or interest rate exposure
Imperfect correlation is basis risk Not using futures or forwards can be speculation
J. K. Dietrich - FBE 532 – Spring, 2006
Hedging
Time/Situation
Present orPresent Plan
Future TimePeriod
Have,Will Have, orWill Receive
LONG LONG
Need,Will Need, orWill Deliver
SHORT SHORT
Insurance Companywith Premiums
Insurance CompanyHedge
Bank Planning to Borrow
Borrowing Hedge
J. K. Dietrich - FBE 532 – Spring, 2006
Forward Contracts
Example 1: GE is awarded a contract to supply turbine blades to British Air. On August 1, GE will receive ₤10 million.
How should GE hedge its risk?
J. K. Dietrich - FBE 532 – Spring, 2006
Forward Market Hedge
Current spot price for ₤ 1 = $ 1.74 Six month forward rate is ₤ DM 1 = $1.75 Hedge future income by selling ₤ 10 million
for delivery in one year (short in futures or forward market)
This transaction assures future revenue of $17.5 million without any cash flows today.
J. K. Dietrich - FBE 532 – Spring, 2006
Possibilities
Say the spot price on December 1 is $1.70 per ₤ .
GE sells its ₤ 10 million for $1.75 per ₤ , yielding $17.5 million
If it had not hedged, its ₤ 10 million, at a rate of $1.70 would yield $17 million.
The forward is worth $0.5 million.
J. K. Dietrich - FBE 532 – Spring, 2006
Possible Outcomes
Spot Rate Value of Deal
Value of Forward
Total Cash Flow
$1.70 $17m $0.5m $17.5m
$1.75 $17.5m 0 $17.5m
$1.80 $18m -$0.5m $17.5m
J. K. Dietrich - FBE 532 – Spring, 2006
Key Points
Revenues are guaranteed irrespective of exchange rate movements– The cost of hedging varies depending on
exchange rate movements Futures hedging is effective when the
magnitude and timing of future currency cash flows is known
Pricing in dollars simply shifts risk
J. K. Dietrich - FBE 532 – Spring, 2006
Options (Definition)
An option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date– call is right to buy, put is right to sell
– strike or exercise price is a fixed price which determines conversion value
– expiration date
Options on stocks, commodities, real estate, and future contracts
J. K. Dietrich - FBE 532 – Spring, 2006
Call Options Profits at Maturity
0Strike Price
Profit
Asset Value
Payoffto Buyer
J. K. Dietrich - FBE 532 – Spring, 2006
Call Writer’s (Seller’s) Profits
0Strike Price
Profit
Loss
Asset Value
Possible Cost to Writer
J. K. Dietrich - FBE 532 – Spring, 2006
Option Value Sensitivityto Price Changes in Assets
Write Put Write Call
Buy Put Buy Call
S S
J. K. Dietrich - FBE 532 – Spring, 2006
Managing Risk with Options Similar to hedging risk with futures or forwards except
that you only hedge again bad or adverse outcomes Partially offset price or interest rate risk with contract
which moves in opposite direction Identify options with price or interest rate which
moves as close as possible with the price or interest rate exposure but again imperfect correlation results in basis risk
Options only hedge against adverse outcome so they are similar to insurance and cost money
J. K. Dietrich - FBE 532 – Spring, 2006
Foreign Currency Options
Useful if the timing of foreign currency cash flows is uncertain
Example 2: GE submits a bid to supply turbine blades to Lufthansa for ₤ 10 million
The funds will be received on August 1 only if GE wins
How does GE hedge this risk?
J. K. Dietrich - FBE 532 – Spring, 2006
Using Options
Selling ₤ forward is not the answer: GE may lose the bid and the ₤ may rise
Options solve the problem; GE buys put options to sell ₤ 10m on August 1 at a rate of, say, 1 ₤ = $1.70
GE pays a bank $100,000 for the puts
J. K. Dietrich - FBE 532 – Spring, 2006
Suppose GE Loses the Bid
If the rate is below $1.70, GE can buy ₤ DM in the market at a lower price and sell them for a profit by exercising the put.
If the rate is above $1.70, GE lets the option expire– Hedging costs in either event are $100,000– If the puts are fairly priced GE will not suffer
an expected loss even net of hedging costs
J. K. Dietrich - FBE 532 – Spring, 2006
Suppose GE Wins the Bid
If the rate is below $1.70, GE exercises the put for $17m, using the ₤ 10 million paid by Lufthansa.
If the rate is above $1.70, GE lets the option expire, and converts the ₤ 10 million at the market rate
GE makes at least $17 million if it wins the bid, less the $100,000 cost of the option
J. K. Dietrich - FBE 532 – Spring, 2006
Other Uses of Options
Use call options to hedge the risk of foreign tender offers
Hedge risk when quantity of cash flows is uncertain
Currency options can be used to protect profit margins and prevent frequent revisions of product prices abroad
J. K. Dietrich - FBE 532 – Spring, 2006
Interest-Rate Derivatives Interest rates and asset values move in opposite
directions Long cash means short assets Short cash means long (someone else’s) asset Basis risk comes from spreads between
exposure and hedge instrument, e.g. default risk premiums
Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown
J. K. Dietrich - FBE 532 – Spring, 2006
Caps, floors, and collars
If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note
If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call
A collar is a cap and a floor
J. K. Dietrich - FBE 532 – Spring, 2006
Collars: Cap 6%, floor 4%
Profit
0
Loss
9400 9500 9600
J. K. Dietrich - FBE 532 – Spring, 2006
Other option developments
Credit risk options Casualty risk options Requirements for developing an option
– Interest
– Calculable payoffs
– Enforceable
J. K. Dietrich - FBE 532 – Spring, 2006
Replication Futures with Options
P0 P0
LongProfit
Loss
0 0
Profit
Loss
Buy Call
Write Put
J. K. Dietrich - FBE 532 – Spring, 2006
Next Week – February 23, 2006
Review this week’s discussion to identify areas needing clarification
Read and prepare case Union Carbide Corporation Interest Rate Risk Management and identify issues in the case you have questions about
Review weekly Objectives and prepare for midterm examination due March 9, 2006