2 corporate risk mgmt

04/18/23 1

Corporate Risk Management

Dr. Narayan Baser,

Assistant Professor,

National Institute of Cooperative Management,

GandhinagarNICM, Gandhinagar

2

IncreasedRisk

Introduction

The rising importance of risk management In financial institutions

More complex markets Global markets Greater product Complexity New businesses (e-banking,

merchant banking,…) Increasing competition New players Regulatory imbalances

Global trends are leading to …

04/18/23 NICM, Gandhinagar

3

The leading institutions will be distinguished by their intelligent management of risk.

In the future . . .

Introduction


Introduction

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CLASSIFICATION OF RISKS

•Technological risks

• Economic risks

• Financial risks

• Performance risks

• Legal and regulatory risks

5

FinancialRisks Operational Risk

Reputational Risk

Business and strategic risks

Market Risk

Credit Risk

Introduction

Risk is multidimensional


6

Introduction One can “slice and dice” these multiple dimensions of risk*

PortfolioConcentration

Risk

Transaction Risk

CounterpartyRisk

Issuer Risk

Trading Risk

Gap Risk

Equity Risk

Interest Rate Risk

Currency Risk

Commodity Risk

FinancialRisks

OperationalRisk

Reputational Risk

Business and strategic risks

Market Risk

Credit Risk

“SpecificRisk”

GeneralMarket Risk

Issue Risk

* For more details, see Chapter-1, “Risk Management” by Crouhy, Galai and Mark



What is Risk? No single definition. Risk is defined as uncertainty

concerning the occurrence of a loss. In finance, risk is defined as

variability of returns. Measure of financial risk:

Standard Deviation


Nature of Risk The word “Risk” can be used to

describe any situation in which there is an uncertainty about the outcome

In financial world, risk can be defined as “any possibility of an event which can impair corporate earning or cash flow over short/medium/long term horizon


Is risk bad? No, risk is not bad. Risk-return framework.

No gain without pain. One cannot expect higher return unless one

exposes oneself to higher level of risks. Investors differ in their risk bearing

capacity. Risk averse Risk neutral Risk seeker


Types of Risk Objective Risk

Relative variation of actual loss from expected loss.

It varies inversely with square root of number of cases under observation.

Law of large numbers: As number of exposures increases the actual loss will approach the expected loss.

Measures: Standard deviation, coefficient of variation


Types of Risk Subjective Risk

Uncertainty based on a person’s mental condition or state of mind.

High subjective risk leads to more conservative behavior.

Impact of subjective risk varies depending on the individual.

Low subjective risk leads to less conservative behavior.


Categories of Risk Pure Risk: situation in which possibilities

are loss and no loss. Speculative Risk: either profit or loss is

possible. Differences:

Law of large numbers can be easily applied to pure risks.

Insurers typically insure pure risks. Society may benefit from speculative risks.


Categories of Risk Fundamental Risk: affects entire

economy or large sections of it. Examples: War, inflation, etc.

Particular Risk: affects individuals. Enterprise Risk: encompasses all

major risks faced by a firm. Pure, speculative, strategic,

operational & financial risks.


Categories of Risk Systematic Risk: Risk that cannot

be diversified. Also called market risk.

Non-systematic Risk: Risk that can be eliminated by diversification. Also called Unique/Specific risk.


Types of Pure Risk Personal Risk:

Premature death. Insufficient income after retirement. Poor health or disability. Unemployment.

Property Risk: Direct – physical damage or Indirect -

consequential Liability Risk – legally liable


Sources of Risk Economic policies of the

government Technological factors Corporate governance Political and Social Issues Market related factors Demographic factors


Need for the Risk Mgmt. To deal with Globalization which has

resulted pressure on margins To ensure wealth maximization To deal with Agency cost To deal with increasing complexities of

the businesses Managing reasonable and well

understood risk is necessary in order to earn adequate returns


Benefits of the Risk Mgmt. Brings order and system to the process of

risk quantification Enable the assigning of value of estimated

risk of loss, e.g. VaR Flags extreme risky situations for

necessary mitigative actions Improve risk awareness Increases valuations and reduce cost of

capital More objective performance appraisal

based on risk adjusted capital employed


Value At Risk VAR is the method of assessing risk using

standard statistical technique It is the maximum loss over a target horizon

such that there is a low, predetermined probability that the actual loss will be larger

e.g. a bank say that the daily VAR of its trading portfolio is INR 35 million at the 99% confidence level

This means there is only 1% chance that the loss will exceed INR 35 million in one day


Risk Policy Policy needs to identify issues in RM

Defining RM framework in context of organisation background, polices and regulatory framework

The level of organisation at which RM is expected to be implemented

Identifications of risk and its consequences Risk preference of the stakeholders Clarity of objectives Identification of external and internal factors that

limits the application of RM strategies Tools and techniques to be adopted Establishing ground rules for successful RM


Methods of handling risk Avoidance – avoid the risk of divorce by not marrying!!!!! Loss Control

Loss prevention – “Durghatna se der bhali !!!!!!!!” Loss reduction

Retention Active retention: Individual is aware of risk and

deliberately plans to retain it. Passive retention: Ignorance, indifference.

Non-insurance Transfers Transfer of risks by contracts. Hedging price risks with the help of derivatives Limited liability company.

Insurance


Risk Classification Managerial Perspective

Risk that need to be avoided Risk that should be transferred Risk that to be actively managed

Functional Perspective Credit Risk Market Risk Operational Risk


Credit Risk Credit risk or counter-party risk is the risk

to each party of a contract that the other will not live up to its contractual obligations

It is also known as default risk Default may be due to its inability or

unwillingness of debtor to meet commitments in relation to trading, lending, settlement and other financial transactions


Market Risk It is the risk of fluctuations in the

portfolio value because of movements in such variables

Price Risk Unfavourable movements in price of a

security, commodity or any other obligation

It can be classified into different categories


Operational Risk Basel Committee has defined

operational risk as “the risk of default or indirect loss resulting from an inadequate or failed internal processes, people, systems or from external events.”


What is Risk Management? Does it mean ‘reduction of risk’? Risk Management (RM) is a process

that identifies loss exposure faced by a firm and selects the most appropriate techniques for treating such exposures.

Points to note: It is a dynamic process. Does not talk about risk reduction.


Objectives of Risk Management

Pre-loss objectives: Economy: Firm should prepare for potential

losses in most economical manner. Reduction of anxiety. Meeting legal obligations.

Post loss objectives: Survival Continued operations Stability of earnings Growth Social responsibility


Steps in RM process Identify loss exposures. Analyze the loss exposures. Select appropriate technique for

treating the loss exposures. Implement and monitor the risk

management program.


Steps in RM process-1 Identify loss exposures.

Property loss: buildings, plants, inventory, etc.

Liability loss: defective products, pollution, law suits, etc.

Business income loss. Human resources loss: death of key

employees, injuries, etc. Crime loss: theft, fraud, cyber crimes, etc.


Steps in RM process-1 Identify loss exposures.

Employee benefit loss: failure to comply with govt. regulations, etc.

Foreign loss: currency risks, kidnapping, nationalization, etc.

Reputation. Sources: inspections, financial statements,

historical loss data, analysis of operations, etc.


Steps in RM process-2 Analyze the loss exposures.

Estimation of frequency and severity. Loss frequency: probable number of losses in

a given time frame. Loss severity: probable size of loss.

Maximum possible loss: worst loss that could happen.

Maximum probable loss: worst loss that is likely to happen.


Steps in RM process-3 Selecting the appropriate technique.

Risk Control: techniques that reduce frequency and severity of losses.

Avoidance: means a loss exposure is not acquired or existing loss exposure is abandoned.

Loss prevention: measures that reduce frequency of a particular loss.

Loss reduction: measures that reduce severity of a loss after it occurs.



Risk Financing: techniques that provide for funding of losses:

Retention: active or passive. Can be used if no other method is available, losses

are highly predictable, worst possible loss is not serious.

Advantages: save money, lower expenses, encourage loss prevention, increase cash flow.

Disadvantages: possible higher losses, higher expenses, higher taxes.



Non-insurance transfers: pure risk & its potential financial consequences are transferred to another party. Examples: leases, hold-harmless agreements.

Insurance: appropriate for loss exposures that have a low probability but high severity.

Advantages: indemnification, reduction of uncertainty, tax deductible, risk management services provided by insurers.

Disadvantages: cost of premiums, time & effort in negotiating insurance, less incentive to follow loss-control program.


Steps in RM process-4 Implement and monitor the RM

program. Policy statement. Cooperation with other departments. Periodic review and Evaluation.

Derivatives as Risk Management Tools


What is a derivative? A derivative is an instrument whose

value depends on the values of other more basic underlying variables.

Underlying could be a stock, commodity, index, etc.

Example: NSE allows trading in derivatives on stocks like HDFC Bank, ACC, etc and indices like Nifty.

04/18/23 37NICM, Gandhinagar

Uses of Derivatives To hedge risks.

Hedging: An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security.

To speculate (take a view on the future direction of the market).

Speculation: A trading strategy where one side of a position is taken (and thus risk bearing) where the trader expects to make a positive profit.

To lock in an arbitrage profit. Arbitrage: A trading strategy which generates

(weakly) positive profits with probability one.


Types of Traders Hedgers: Use derivatives to reduce the

risks they face from potential future movements in a market variable.

Speculators: Use them to bet on future movements of a market variable.

Arbitrageurs: Use them to lock in a risk-less profit.


Role of different types of traders

Hedgers: provide depth to the market.

Speculators: provide liquidity and volume to the market.

Arbitrageurs: assist in price discovery and correct price abnormalities.


Hedging Example- Futures An investor owns 1,000 MT Soya Oil

currently worth Rs. 280 per MT. A two-month futures contract of Rs. 290

per MT is available. The investor decides to hedge by taking

short position. If after 2 months spot price is below Rs.

290 per MT, investor is protected. But if after 2 months spot price is above

Rs. 290 per MT, investor doesn’t benefit.


Hedging Example- Options An investor owns 1,00 MT of Soya

Oil currently worth Rs. 280 per MT. A two-month put with a strike price

of Rs. 270 costs Rs 10. The investor decides to hedge by buying 10 contracts (of 10 MT each).


Value of Soya Oil with and without Hedging

20,000

25,000

30,000

35,000

40,000

200 250 300 350 400

Soya Price

Value of Holding

No Hedging

Hedging


Quiz

Futures can be used for either speculation or hedging. How?

If you have an exposure to the price of an asset, futures can be used for hedging.

If you don’t have an exposure to the price of an asset, entering into futures is speculation.


Arbitrage Example-1 Suppose that:

The spot price of gold is Rs.10000. The quoted 1-year futures price of gold

is Rs. 11100. The 1-year interest rate is 10 % per

annum. No income or storage costs for gold. No transaction costs.

Is there an arbitrage opportunity?


Arbitrage Example-1 If the spot price of gold is S & the futures

price is for a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year risk-free rate of interest.In our examples, S=10000, T=1, and r=0.10 so that

F = 10000(1+0.10) = 11000


Arbitrage Example-1 What will you do? Borrow Rs. 10000 @ 10% p.a from bank. Buy gold. Go short on gold futures contract of price Rs.

11100. At end of one year, sell gold at Rs. 11100,

give Rs. 1000 as interest to bank and walk away with Rs. 100 as risk free profit!

So you have found a Money Making Machine!


Arbitrage Example-2 Suppose that:

The spot price of gold is Rs.10000. The quoted 1-year futures price of gold

is Rs. 10900. The 1-year interest rate is 10 % per

annum. No income or storage costs for gold. No transaction costs.

Is there an arbitrage opportunity?


Arbitrage Example-2 What will you do? Sell gold at Rs. 10000. Invest Rs. 10000 @ 10% p.a in a bank. Go long on gold futures contract of price Rs.

10900. At end of one year, get Rs. 11000 from bank. Buy gold at Rs. 10900 and walk away with Rs.

100 as risk free profit! So you have again found a Money Making

Machine!


Do such machines exist? Yes, they do. But for very short periods. As soon as traders start building up

positions the price of futures contracts will change to eliminate the arbitrage opportunity.

Another important consideration are transactions costs.


Speculation Example An trader with Rs 4,000 to invest

feels that “X” commodity price will increase over the next 2 months.

The current price is Rs. 800 Per MT and the price of a 2-month call option with a strike of Rs. 815 is Rs. 10.

What alternative strategies are available?


Speculation Example Strategy 1 Buy 5 MT of “X” commodity. After 2 months price becomes Rs.

830. Trader sells 5 MT. Trader makes profit of Rs. 5*30 =

Rs. 150.


Speculation Example Strategy 2 Buy 400 two-month call options of

“X” After 2 months price becomes Rs.

830. Trader exercises call options. Makes profit of Rs. 400*15 - 4000 =

Rs. 2000


Speculation Example Use of derivatives amplifies the

profits which can be had from directly dealing in the market variable.

What about losses? They too get amplified!


Futures Contracts Available on a wide range of underlyings:

Indices Stocks Commodities

Exchange traded. Specifications designed by exchange:

What can be delivered, Where it can be delivered, & When it can be delivered

Settled daily: Marked to market.


Futures Contracts Most futures contracts are closed out before

maturity. Closing out a futures position involves

entering into an offsetting trade. A few contracts (for example, those on

stock indices) are settled in cash. If a futures contract is not closed out before

maturity, it is usually settled by delivering the assets underlying the contract.


Newspaper Quotes Prices:

Open, High, Low Close: Average of the prices at which the

contract traded immediately before close of trading.

Open Interest: This is the total number of outstanding contracts. Equal to number of long (short) positions.

Trading Volume: Volume of trading in the contract during the day.


The relationship between the prevailing price trend and open interest

Price Open Interest Interpretation

Rising Rising Market is Strong

Rising Falling Market is Weakening

Falling Rising Market is Weak

Falling Falling Market is Strengthening


Specification of futures contracts

Asset: Financial assets are generally well defined &

unambiguous. In case of commodities variation in quality is possible.

Exchanges stipulate the grades that are acceptable. When there are alternatives about what is delivered,

where it is delivered, and when it is delivered, the party with the short position chooses.

Contract Size: Specifies the amount of the asset that has to be

delivered. Differs from commodity to commodity, stock to stock.


Specification of futures contracts

Delivery arrangements: Place and mode need to be specified in detail.

Delivery month: Futures contract is referred to by its delivery month. The delivery period is fixed by exchange. For

example, In NSE, last Thursday of the expiry month is expiry day.

Price steps: Are fixed by exchange. In NSE, Price steps are Rs. .05.

Price Bands: The maximum upward/downward movement allowed by exchange in one day. In NSE, for stock futures operating range is 20% of base price.


Convergence of Futures to Spot

Time

FP

SP

SP

FP

Price


Profit from a Long Forward or Futures Position

Profit

Price of Underlying at Maturity


Profit from a Short Forward or Futures Position

Profit

Price of Underlying at Maturity


Futures vs. Forwards Exchange traded Standardized contracts Range of delivery

dates

Settled daily

Contract is usually closed out prior to maturity

Private contract Not standardized Usually one

specified delivery date

Settled at end of contract

Delivery or final cash settlement usually takes place.


Margins The cleaning member will be required to post a

certain amount of money, known as a margin, on all trades cleared

This margin will be based on the value of the contract cleared

The margin account will be updated daily, using marking-to-market procedure

If the margin account balance falls below a certain level, a margin call will be issued by the clearing corporation and the member will have to put up additional costs as margin


Cost of Carry Relationship between future and spot prices

can be summarized in terms of cost of carry. Cost of carry = storage cost + interest paid

to finance the asset - the income earned on the asset.

If cost of carry = c, For investment assets: F0 = S0 ecT

For consumption assets: F0 = S0 e(c-y)T


Practice question Suppose that the spot price of a

commodity is Rs. 291 per kg. The interest rate is 2.5% p.a. and storage costs are assumed to be zero.

A futures contract of Rs. 300 that expires six months from now is available.

Is there an arbitrage opportunity? Explain the steps involved in earning an

arbitrage profit and compute the profit/loss per contract.


Practice question: Answer Compute the price, F0 of this futures contract

that does not give rise to arbitrage. F0=S0e(r+u)T

F0 = 291e .025(.5) = Rs. 294.66 Clearly the spot price is too cheap and the

future is too expensive. Borrow Rs. 291, Buy the commodity and short

a future. After 6 months sell the asset for Rs. 300 and

return to lender Rs.294.66. Make an arbitrage profit of Rs. 5.34 for every

kg.


What is hedging? An investment made in order to reduce the

risk of adverse price movements in a security, by taking an offsetting position in a related security.

Perfect Hedge: Is one that completely eliminates the risk.

Hedge & Forget: No attempt is made to adjust the hedge once it has been put in place.

In practice the risk manager keeps adjusting the hedges.


Long Hedge It is a hedge that involves taking a

long position in a futures contract. A long futures hedge is appropriate

when you know you will purchase an asset in the future and want to lock in the price.


Long Hedge- Example Example: It is 1st August now. A Flour miller

requires 100,000 kgs of wheat on 1st January. Spot price is Rs. 14/kg. January futures price is Rs. 12/kg.

Strategy: Take a long position in a futures contract. Close the position on/before 1st January.

Outcome: Suppose in January spot price is Rs. 12.5/kg.

Cost of wheat will be Rs. 12.5/kg in spot market Company gains Rs. 0.50/kg from futures

Suppose in January spot price is Rs. 11.5/kg. Cost of wheat will be Rs. 11.5/kg in spot market Company loses Rs. 0.50/kg from futures

Result: Company locks a price of Rs. 12/kg.04/18/23 71NICM, Gandhinagar

Long Hedge- Example The company could have bought wheat on

1st August but this would have meant: Paying Rs. 2 per kg more. Incurring storage costs. Foregoing interest on blocked money.


Short Hedge It is a hedge that involves taking a

short position in a futures contract. A short futures hedge is

appropriate when you know you will sell an asset in the future & want to lock in the price.


Short Hedge- Example Example: It is 1st August now. A wheat farmer

knows that he will sell 100,000 kgs of wheat on 1st January. Spot price is Rs. 14/kg. January futures price is Rs. 12/kg.

Strategy: Take a short position in a futures contract. Close the position on/before 1st January.

Outcome: Suppose in January spot price is Rs. 11.5/kg.

Company gets Rs. 0.50/kg from futures and Rs. 11.5/kg from sale of wheat in spot market

Suppose in January spot price is Rs. 12.5/kg. Company loses Rs. 0.50/kg from futures and gets Rs.12.50/kg

on sale of wheat in spot market. Result: Farmer locks a price of Rs. 12/kg.


Arguments for/against hedging

For: Companies should focus on the main business they

are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables.

Against: Shareholders are usually well diversified and can

make their own hedging decisions. It may increase risk to hedge when competitors do

not. Explaining a situation where there is a loss on the

hedge and a gain on the underlying can be difficult.


Basis Risk Hedging is not straight-forward because:

Asset to be hedged is different from asset underlying the futures contract.

Hedger is uncertain about exact date when asset is sold/bought.

Futures contract may be closed well before expiration.

This leads to basis risk. Basis is the difference between spot price of

the asset & futures price of contract Basis risk arises because of the uncertainty

about the basis when the hedge is closed out.


Basis Risk What should be the basis at the expiration of

contract if asset to be hedged and asset underlying the futures contract are the same.

The basis should be zero. Prior to expiration basis could be +ve or –ve.

Strengthening of basis: When spot price increases by more than futures price, the basis increases.

Weakening of basis: When futures price increases by more than spot price, the basis decreases.


Minimum Variance Hedge Ratio

Hedge Ratio: Is ratio of size of position taken in futures contract to size of exposure.

If objective is to minimize risk hedge ratio of 1.0 is not necessarily optimal.

Proportion of the exposure that should optimally be hedged is

where S is the standard deviation of S, the change in the spot

price during the hedging period. F is the standard deviation of F, the change in the futures price during the hedging period. is the coefficient of correlation between S and F.

h S

F


Minimum Variance Hedge Ratio

The parameters S and F are estimated from historical data.

If and S = F , the h is always 1 as future prices mirror the spot prices perfectly

If and 2S = F , the h is always 0.5 as future prices changes by twice the spot prices

Hedge Effectiveness is defined as the proportion of variance that is eliminated by by hedging.

This is equal to 2


Optimal number of contracts NA : Size of position being hedged

(units). QF: Size of one futures contract

(units). N*: Optimal number of futures

contracts for hedging. N* = h * NA / QF


Optimal number of contracts

Suppose size of copper contracts traded on MCX is 1000 Mt. A company wants to purchase 12,000 Mt of copper one month from now. As per historical data, h = 0.6.

Then, N* = h * NA / QF

N* = 0.6 * 12,000 / 1000 = 7.2 Or rounding to nearest whole number 7

contracts.04/18/23 81NICM, Gandhinagar

Rolling The Hedge Forward We can use a series of futures contracts

to increase the life of a hedge. Each time we switch from one futures

contract to another we incur a type of basis risk.

Works well when there is close correlation between changes in futures prices and changes in spot prices.


Quiz Time Assume that you enter into a long position in a January

gold futures (100 grams) contract at INR 10,079 on October 15, 2007. On January 16, 2008, you decide to close your position when the futures price is INR11,269. One contract is for 10 grams of gold. What is your profit?


Quiz Time Jet Airways requires 2,000,000 barrels of aviation fuel every month. Since

the price of aviation fuel depends on the price of crude oil, Jet Airways faces price risk. At the beginning of each month, Jet Airways goes for a long hedge in crude oil futures contract for 2,000,000 barrels, with expiry by the end of that month.

What is meant by a long hedge? What is the purpose of the long hedge undertaken by Jet Airways? Would Jet Airways be able to completely eliminate the price risk of aviation fuel? Explain

assume that the standard deviation of the crude oil futures is USD 2.5 and the standard deviation of aviation oil price is USD 3.2. The correlation coefficient between crude oil futures price and aviation oil price is 0.96.

Calculate the optimal hedge ratio. Explain what Jet Airways needs to do to hedge the price risk.

What is the hedging effectiveness of this hedge undertaken by Jet Airways on the basis of the optimal hedge ratio?

If the size of a crude oil futures contract is 100 barrels, calculate the number of contracts that Jet Airways should enter into.


Solution A long hedge means that the hedger needs to purchase a

commodity or asset at a future time, and is using futures contracts to hedge the risk of price increase.

Jet Airways requires aviation fuel every month, and fuel prices are highly volatile. In order to forecast future cash flows more efficiently, Jet Airways will undertake a long hedge using futures.

Jet Airways cannot completely eliminate the price risk, because it requires aviation fuel—on which no futures are available. They would be required to cross-hedge using crude oil futures; as a result, price risk will remain, but it will be small on account of the high correlation between crude oil and aviation fuel prices.


Solution


This means that, for each barrel of aviation oil required, a long position in 1.2288 barrels of crude oil futures should be taken. Since Jet Airways requires 2,000,000 barrels of aviation oil, the position in futures should be

This means that 92.16% of the variation in aviation fuel price will be hedged.

•If the contract size of crude oil futures is 100 barrels, Jet Airways should take a long position in 24,576 crude oil futures contracts.

Options vs. Futures Option holder has the right to do

something while in a Futures contract certain action has to be performed.

Option holder may not exercise his right.

Futures contract can be entered at no cost while Option buyer has to pay some money up-front.


Types of Options A call is an option to buy. A put is an option to sell. A European option can be

exercised only at the end of its life. An American option can be

exercised at any time.


Call & Put Options A holder of call option expects

stock price to become higher than strike price.

A holder of put option expects stock price to become lower than strike price.


Option Positions Long Position: One who has bought the

option. Short Position: One who has sold (or

written) the option. Different combinations are possible:

Long call Long put Short call Short put


Long Call on eBay Profit from buying one eBay European call

option: option price = $ 5, strike price = $100, option life = 2 months30

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)


Short Call on eBay Profit from writing one eBay European call

option: option price = $5, strike price = $100

-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)



Long Put on IBM Profit from buying an Oracle European put


30

20

10

0

-770605040 80 90 100

Profit ($)



Short Put on IBM Profit from writing an IBM European put


-30

-20

-10

7

070

605040

80 90 100

Profit ($)Terminal

stock price ($)


Call Options

Buy

Sell

Long CallRight to buy the underlying at strike price

Short CallObligation to sell the underlying at strike price

Benefit if the underlying rises. Profits substantial

Lose if the underlying is steady/ falling.Loss limited to Premium

Lose if the underlying rises. Loss substantial

Benefit if the underlying is steady/ falling. Profit limited to Premium


Put Options

Buy

Sell

Long PutRight to sell the underlying at strike price

Short PutObligation to Buy the underlying at strike price

Benefit if the underlying falls. Profits substantial

Lose if the underlying is steady/ rising.Loss limited to Premium

Lose if the underlying falls. Loss substantial

Benefit if the underlying is steady/ rising. Profit limited to Premium


It is vital to know who has the Right to transact vs. who may be Obliged to transact in order to determine the direction of cash flows at expiry

BUYER SELLER

CALL

Has the Right to Buy the Asset

Has the Potential Obligation to Sell the Asset if

Exercised

PUT

Has the Right to Sell the Asset

Has the Potential Obligation to Buy the Asset if

Exercised


Money-ness : At-the-money option: Would give the holder a zero cash flow if

the option is exercised immediately. In-the-money option: Would give the holder a positive cash flow

if the option is exercised immediately. Out-of-the-money option: Would give the holder a negative cash

flow if the option is exercised immediately.

Call Options Put Options

In the money Spot price > Strike price Spot price < Strike price

At the money Spot price = Strike price Spot price = Strike price

Out of the money

Spot price < Strike price Spot price > Strike price


Intrinsic Value and Time Value

An option premium or value of the option can be broken in to two partsIntrinsic Value:

Intrinsic value of option is the amount by which the option is ITM (in the money)If option is ATM and OTM, the intrinsic value is zeroFor call = Max {0, S-K}, For Put = Max {0, K-S}

Time Value:Time value of option is the difference between its premium and intrinsic valueCall/Put Premium - Max {0, S-K}/ Max {0, K-S}


Example On October 25, company’s stock price closed at

Rs. 5000 The following option prices were quoted. Compute

intrinsic and time value of these options

Strike Price Call Premium

Put Premium

4900 120 10

5000 35 40

5100 5 125


Example

Strike Intrinsic Value

Time Value

Call 4900 100 20

Call 5000 0 35

Call 5100 0 5

Put 4900 0 10

Put 5000 0 40

Put 5100 100 25


Factor affecting option pricing

Variable Effect of Increase in each variable on

Value of call Value of Put

Spot Price Increase Decrease

Strike Price Decrease Increase

Volatility Increase Increase

Time to Expiry Increase Increase

Interest rate Increase Decrease

Dividend Decrease Increase


Forward Market Hedge: an Example

You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year.

Question: How can you fix the cash outflow in dollars?

Answer: One way is to put yourself in a position that delivers £100M in one year—a long forward contract on the pound. 04/18/23 103NICM, Gandhinagar

Forward Market Hedge

$1.50/£

Value of £1 in $ in one

year

Suppose the forward exchange rate is $1.50/£.

If he does not hedge the £100m payable, in one year his gain (loss) on the unhedged position is shown in green.

$0

$1.20/£

$1.80/£–

$30m

$30m

Unhedged

payable

The importer will be better off if the pound depreciates:

he still buys £100m but at an exchange rate of only

$1.20/£ he saves $30 million relative to $1.50/£

But he will be worse off if the pound appreciates.



$1.50/£


year$1.80/

£

If he agrees to buy £100m in one year at $1.50/£ his gain (loss) on the forward are shown in blue.

$0

$30m

$1.20/£–

$30m

Long forward

If you agree to buy £100 million at a price of $1.50 per pound, you will lose

$30 million if the price of a pound is only $1.20.

If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80.



$1.50/£


year$1.80/

£

The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position.

$0

$30 m

$1.20/£–$30

m

Long forward

Unhedged

payable

Hedged payable


Options Market Hedge Options provide a flexible hedge against the

downside, while preserving the upside potential.

To hedge a foreign currency payable buy calls on the currency. If the currency appreciates, your call option lets you

buy the currency at the exercise price of the call. To hedge a foreign currency receivable buy

puts on the currency. If the currency depreciates, your put option lets you

sell the currency for the exercise price.


Options Market Hedge

$1.50/£


year

Suppose the forward exchange rate is $1.50/£.

If an importer who owes £100m does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green.

$0

$1.20/£

$1.80/£–

$30m

$30m

Unhedged payable

The importer will be better off if the pound depreciates:

he still buys £100m but at an exchange rate of only

$1.20/£ he saves $30 million relative to $1.50/£

But he will be worse off if the pound appreciates.


Options Markets HedgeProfit

loss

–$5m$1.55/£

Long call on £100m

Suppose our importer buys a call option on £100m with an exercise price of $1.50 per pound.

He pays $.05 per pound for the call.

$1.50/£


year



year


loss

–$5m

$1.45 /£

Long call on £100m

The payoff of the portfolio of a call and a payable is shown in red.

He can still profit from decreases in the exchange rate below $1.45/£ but has a hedge against unfavorable increases in the exchange rate. $1.50/£ Unhedged

payable

$1.20/£

$25m


–$30 m

$1.80/£


year


loss

–$5 m

$1.45/£

Long call on £100m If the exchange

rate increases to $1.80/£ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million.

This can be thought of as an insurance premium.

$1.50/£

Unhedged payable

$25 m


Options Markets Hedge

IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS.

If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports.

If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.

EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS.

If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports.

If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.


Hedging Exports with Put Options

Show the portfolio payoff of an exporter who is owed £1 million in one year.

The current one-year forward rate is £1 = $2.

Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. The cost of this option is $0.05 per pound.


S($/£)360

–$2m

$2

Long

rec

eiva

ble Long put

$1,950,00

0

–$50k

Options Market Hedge:Exporter buys a put option to protect the dollar value of his receivable.

–$50k

$2.05

Hedge

d re

ceivab

le


115

Swaps A swap is an agreement to exchange

cash flows at specified future times according to certain specified rules.

Usually the calculation of cash flows involves the future values of one or more market variables.

Used for converting a liability/investment from: fixed rate to floating rate. floating rate to fixed rate.


116

Definitions In a swap, two counterparties agree to a

contractual arrangement wherein they agree to exchange cash flows at periodic intervals.

There are two types of interest rate swaps: Single currency interest rate swap

“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.

In this a company agrees to pay a fixed rate on a notional principal in return of a floating rate from another company on same notional principal for same period.

Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed

rate debt service in two (or more) currencies.04/18/23 NICM, Gandhinagar

117

An Example of an Interest Rate Swap

Consider this example of a “plain vanilla” interest rate swap.

Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate loan. Bank A is considering issuing 5-year fixed-

rate bonds at 10 percent. It would make more sense to for the bank to

issue floating-rate bonds at LIBOR to finance floating-rate loans.


118


Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-

rate bonds at 11.75 percent. Alternatively, firm B can raise the money by

issuing 5-year floating rate bond at LIBOR + ½ percent.

Firm B would prefer to borrow at a fixed rate.


119


The borrowing opportunities of the two firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%

QSD = 1.25%


120

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%


121

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of

-10 3/8 + 10 + (LIBOR – 1/8) =

LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years.


122

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B

The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%


123

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

They can borrow externally at LIBOR + ½ % and have a net borrowing position of

10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap.

LIBOR + ½%

Here’s what’s in it for B:½ % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.


124

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %


Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes money too.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

¼ % of $10 million = $25,000 per year

for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼


125

Example Companies A and B have offered following rates for 5 yr loan

Fixed Rate

Floating Rate

A 12.0% LIBOR + 0.1%

B 13.4% LIBOR + 0.6%A requires floating rate loan and B requires

fixed rate loan. Design a swap which is equally attractive for both companies and Bank will get 0.1% margin04/18/23 NICM, Gandhinagar

126

Example: Solution ‘A’ has comparative advantage in fixed

rate market but wants to borrow floating. ‘B’ has comparative advantage in

floating rate market but wants to borrow fixed.

Difference between spreads = 1.4 – 0.5 = 0.9% p.a.

Bank wants 0.1%. So remaining 0.8% will be shared.


Surveys suggest the following:

• Managing risk is considered important; it comes next only to minimizing borrowing costs and maintaining /improving the firm’s credit. However, formal statements of risk management policy are rare.

• Firms often reduce some exposure, leaving others un-hedged. The principal emphasis is on hedging transaction exposures.

• While banks and financial institutions use gap analysis and duration analysis, non-financial companies commonly use simulation analysis.

• The most widely used instrument is the foreign exchange forward contract. Futures contract are used mainly by companies where the treasury is run as a profit centre.

• Companies which do not manage risk cite lack of knowledge and understanding, non- availability of suitable instruments, and resistance by senior management as the principal reasons.

RISK MANAGEMENT PRACTICES

• Align risk management with corporate strategy

• Proactively manage uncertainties

• Employ a mix of real and financial methods

• Know the limits of risk management tools

• Don’t put undue pressure on corporate treasuries to generate profits

• Learn when it is worth reducing risk

GUIDELINES FOR RISK

MANGEMENT

Risk

Exposures

Risk Management Tools

Off-B/S On-B/S

Financial Production

Firm

Specific

Fire Insurance Loss

Prevention

and Control

Law suit Payoffs to R& D Projects

Warrants Convertible

Debentures

Joint

Ventures

Commodity Prices Forwards Hybrids Technology Choice

Interest Rates Futures Oil Indexed Notes

Plant

Siting

Foreign Exchange Rates

Swaps

Options

Vertical Integration

RISK MANAGEMENT TOOLS

2 corporate risk mgmt

Economy & Finance

categories of risk pure

nature of risk

word risk

speculative risk

measure of financial

corporate risk management

intelligent management

increased risk introduction