Thales of Miletus Thales of Miletus 624 -547 BC624 -547 BCThales used his skills to deduce that the

next season's olive crop would be a very large one. He therefore bought all the olive presses(or options) and then was able to make a fortune when the bumper olive crop did indeed arrive.

Thales was gazing at the sky as he walked and fell into a ditch. A pretty servant girl lifted him out and said to him "How do you expect to understand what is going on up in the sky if you do not even see what is at your feet“- the first absent-minded professor joke

QUIZ 3 p.QUIZ 3 p.Derivatives (definition)Futures vs. Forwards - DefinitionA) SimilaritiesB) Differences

http://video.ca.msn.com/watch/video/hedging-inflation-11-23-10-2-05-pm/jvb7iicb?from=gallery_enca_money_investing_related

http://www.cmegroup.com/http://www.pbs.org/itvs/openoutcry/th

epit.htmlP.753 problem 7

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The Balance Sheet The Balance Sheet LO1

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Income StatementIncome StatementLO1

RISK MANAGEMENT: AN RISK MANAGEMENT: AN INTRODUCTION TO INTRODUCTION TO FINANCIAL ENGINEERINGFINANCIAL ENGINEERING

Chapter 24

Chapter OutlineChapter OutlineHedging and Price VolatilityManaging Financial Risk Forward ContractsFutures ContractsOption

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Hedging VolatilityHedging VolatilityVolatility in returns is a measure

of riskVolatility in day-to-day business

factors often leads to volatility in cash flows and returns

If a firm can reduce that volatility, it can reduce its business risk

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Hedging (immunization) – reducing a firm’s exposure to price or rate fluctuations

Managing Financial Risk Managing Financial Risk Instruments have been developed

to hedge the following types of volatility◦Interest Rate◦Exchange Rate◦Commodity Price

Derivative – A financial asset that represents a claim to another asset. It derives its value from that other asset’s price volatility.

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Interest Rate VolatilityInterest Rate VolatilityDebt is a key component of a

firm’s capital structureInterest rates can fluctuate

dramatically in short periods of time

Companies that hedge against changes in interest rates can stabilize borrowing costs

Available tools: forwards, futures, swaps, futures options, and options

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Exchange Rate VolatilityExchange Rate VolatilityCompanies that do business

internationally are exposed to exchange rate risk

The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency

If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and do a better analysis of future projects

Available tools: forwards, futures, swaps, futures options, and options

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Commodity Price VolatilityCommodity Price VolatilityMost firms face volatility in the costs of

materials and in the price that will be received when products are sold

Depending on the commodity, the company may be able to hedge price risk using a variety of tools

This allows companies to make better production decisions and reduce the volatility in cash flows

Available tools (depends on type of commodity): forwards, futures, swaps, futures options, and options

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The Risk Management ProcessThe Risk Management Process

Identify the types of price fluctuations that will impact the firm

Some risks may offset each other, so it is important to look at the firm as a portfolio of risks and not just look at each risk separately

Cost of managing the risk relative to the benefit derived

Risk profiles are a useful tool for determining the relative impact of different types of risk

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Risk ProfilesRisk ProfilesBasic tool for identifying and

measuring exposure to risk

Graph showing the relationship between changes in price versus changes in firm value

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Risk Profile for a Wheat Risk Profile for a Wheat GrowerGrower

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Risk Profile for a Wheat Risk Profile for a Wheat BuyerBuyer

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Reducing Risk ExposureReducing Risk ExposureHedging will not normally reduce

risk completely◦Only price risk can be hedged, not

quantity risk◦You may not want to reduce risk

completely because you miss out on the potential upside as well

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TimingTimingShort-run exposure (transactions

exposure) – can be hedged

Long-run exposure (economic exposure) – almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate

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Forward ContractsForward ContractsA contract where two parties

agree on the price of an asset today to be delivered and paid for at some future date

Forward contracts are legally binding on both parties

They can be customized to meet the needs of both parties and can be quite large in size

Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

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PositionsPositionsLong – agrees to buy the asset at the future date (buyer)

Short – agrees to sell the asset at the future date (seller)

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Payoff profiles for a forward Payoff profiles for a forward contractcontract

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Hedging with ForwardsHedging with ForwardsEntering into a forward contract can virtually

eliminate the price risk a firm faces It does not completely eliminate risk

because both parties still face credit riskSince it eliminates the price risk, it prevents

the firm from benefiting if prices move in the company’s favor

The firm also has to spend some time and/or money evaluating the credit risk of the counterparty

Forward contracts are primarily used to hedge exchange rate risk

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Hedging with forward Hedging with forward contractscontracts

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Futures ContractsFutures ContractsFutures vs. ForwardsFutures contracts trade publicly on

organized securities exchangeRequire an upfront cash payment called

margin◦ Small relative to the value of the contract◦ “Marked-to-market” on a daily basis

Clearinghouse guarantees performance on all contracts

The clearinghouse and margin requirements virtually eliminate credit risk

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SwapsSwapsA long-term agreement between two parties to exchange (or swap) cash flows at specified times based on specified relationships

Can be viewed as a series of forward contracts

Generally limited to large creditworthy institutions or companies

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Types of SwapsTypes of SwapsInterest rate swaps – the net cash flow

is exchanged based on interest rates

Currency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates

Commodity swaps – fixed quantities of a specified commodity are exchanged at fixed times in the future

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OptionOptionThe right, but not the obligation, to buy (or sell) an asset for a set price on or before a specified date

◦Call – right to buy the asset◦Put – right to sell the asset◦Specified exercise or strike price◦Specified expiration date

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Seller’s ObligationSeller’s ObligationBuyer has the right to exercise

the option, but the seller is obligated◦Call – option writer is obligated to

sell the asset if the option is exercised

◦Put – option writer is obligated to buy the asset if the option is exercised

Option seller can also be called the writer

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Hedging with OptionsHedging with OptionsUnlike forwards and futures,

options allow the buyer to hedge their downside risk, but still participate in upside potential

The buyer pays a premium for this benefit

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Payoff Profiles: CallsPayoff Profiles: Calls

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Payoff Profiles: PutsPayoff Profiles: Puts

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Hedging with OptionsHedging with Options

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Hedging Exchange Rate Risk with Hedging Exchange Rate Risk with OptionsOptionsMay use either futures options on

currency or straight currency optionsUsed primarily by corporations that do

business overseasCanadian companies want to hedge

against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars)

Buy puts (sell calls) on foreign currency◦ Protected if the value of the foreign

currency falls relative to the dollar◦ Still benefit if the value of the foreign

currency increases relative to the dollar◦ Buying puts is less risky

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