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Risk Management
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Outline
Hedging and Price Volatility Managing Financial Risk Hedging with Forward Contracts Hedging with Futures Contracts Hedging with Swap Contracts Hedging with Option Contracts
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Hedging Volatility
Recall that volatility in returns is a classic measure of risk
Volatility 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
Instruments have been developed to hedge the following types of volatility Interest Rate Exchange Rate Commodity Price Quantity Demanded
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Interest Rate Volatility
Debt is a key component of a firm’s capital structure
Interest rates can fluctuate dramatically in short periods of time
Companies that hedge against changes in interest rates can stabilize borrowing costs
This can reduce the overall risk of the firm Available tools: forwards, futures, swaps,
futures options and options
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Exchange Rate Volatility
Companies 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
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Commodity Price Volatility
Most 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 (depend on type of commodity): forwards, futures, swaps, futures options, options
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The Risk Management Process
Identify the types of price fluctuations that will impact the firm
Some risks are obvious; others are not 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
You must also look at the 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 Profiles
Basic tool for identifying and measuring exposure to risk
Graph showing the relationship between changes in price versus changes in firm value
Similar to graphing the results from a sensitivity analysis
The steeper the slope of the risk profile, the greater the exposure and the more a firm needs to manage that risk
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Reducing Risk Exposure
The goal of hedging is to lessen the slope of the risk profile
Hedging will not normally reduce risk completely For most situations, 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 Timing
Short-run exposure (transactions exposure) – can be managed in a variety of ways
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 Contracts A 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 tailored to meet the needs of both
parties and can be quite large in size Positions
Long – agrees to buy the asset at the future date Short – agrees to sell the asset at the future date
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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Forward contract payoff
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Hedging with Forwards
Entering into a forward contract can virtually eliminate the price risk a firm faces It does not completely eliminate risk unless there is no
uncertainty concerning the quantity Because 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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Futures Contracts Futures contracts traded on an organized
securities exchange Require 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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Hedging with Futures
The risk reduction capabilities of futures are similar to those of forwards
The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur
Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires
Credit risk is virtually nonexistent Futures contracts are available on a wide range of physical
assets, debt contracts, currencies and equities
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Swaps
A long-term agreement between two parties to exchange cash flows based on specified relationships
Can be viewed as a series of forward contracts Generally limited to large creditworthy institutions or
companies Interest 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
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Example: Interest Rate Swap Consider the following interest rate swap
Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed)
Company B can borrow from a bank at 9.5% fixed or LIBOR + .5% (borrows floating)
Company A prefers floating and Company B prefers fixed By entering into a swap agreement, both A and B are better off than they
would be borrowing from the bank with their preferred type of loan and the swap dealer makes .5%
Pay Receive Net
Company A LIBOR + .5% 8.5% -LIBOR
Swap Dealer w/A 8.5% LIBOR + .5%
Company B 9% LIBOR + .5% -9%
Swap Dealer w/B LIBOR + .5% 9%
Swap Dealer Net LIBOR + 9% LIBOR + 9.5% +.5%
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Interest rate Swap
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Option Contracts The right, but not the obligation, to buy (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 Exercise or strike price –specified price Expiration date – specified date
Buyer has the right to exercise the option; 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 Unlike forwards and futures, options allow a firm to hedge
downside risk, but still participate in upside potential Pay a premium for this benefit
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Payoff Profiles: Calls
Buy a call with E = $40
0
10
20
30
40
50
60
70
0 20 40 60 80 100
Stock Price
Pay
off
Sell a Call E = $40
-70
-60
-50
-40
-30
-20
-10
0
0 20 40 60 80 100
Stock Price
Payo
ff
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Payoff Profiles: Puts
Buy a put with E = $40
05
1015202530354045
0 20 40 60 80 100
Stock Price
Pay
off
Sell a Put E = $40
-45
-40
-35
-30
-25
-20
-15
-10
-5
0
0 20 40 60 80 100
Stock Price
Payo
ff
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Hedging Commodity Price Risk with Options
“Commodity” options are generally futures options Exercising a call
Owner of the call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures price
Seller of the call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures price
Exercising a put Owner of the put receives a short position in the futures contract
plus cash equal to the difference between the futures price and the exercise price
Seller of the put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price
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Hedging Exchange Rate Risk with Options
May use either futures options on currency or straight currency options
Used primarily by corporations that do business overseas
U.S. 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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Hedging Interest Rate Risk with Options
Can use futures options Large OTC market for interest rate options Caps, Floors, and Collars
Interest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates)
Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)
Collar – buy a call and sell a put The premium received from selling the put will help offset
the cost of buying the call If set up properly, the firm will not have either a cash inflow
or outflow associated with this position
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Quick Quiz
What are the four major types of derivatives discussed in the chapter?
How do forwards and futures differ? How are they similar?
How do swaps and forwards differ? How are they similar?
How do options and forwards differ? How are they similar?
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