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Chapter 24 Enterprise Risk Management (ERP):
(or…. Everything You Wanted to Know about Derivatives …
….but were afraid to ask)
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Chapter Outline
• ERP & The Firm
• Hedging and Price Volatility
• Managing Financial Risk• Hedging ith Forard Contracts
• Hedging ith Futures Contracts
• Hedging ith Option Contracts
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ERP & The Firm
• !hat type o" risks does ERP encompass#
• Hazard risks $ damage due to outside "orces
• %atural disasters ind' ater' "ire
• Human related lasuits' the"t' etc(
• Financial risks $ sudden une)pected price changes• E)ternal Foreign e)change' interest rates' commodity P*s
• Operational risks $ impairments o" normal +usiness• %atural Ha,ard ind' "ire' ater (not earthquake, terrorism, war)
• Human -upply chain mgmt' distri+ution channels' and
human resource issues' con"licts em+argo & ar
• Strategic risks $ large scale disruptions
• E)ternal competition' changing needs' social or demographicchange' regulatory' political' technological
• .nternal "raud' +ad pu+licity and reputational issues
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ERP
• !hat is +est ay to ensure ERP#
PREVENTION IS ETTER !"
t#an RE$%TION
• Very dependant on the nature o" the +usiness
• Eg(' -a"ety "actors /ary ith each industry
• %o rule o" thum+ e)ist0((you cannot out1guesse/ery possi+le risk that might occur
• .%-2R3%CE is a key tool "or Ha,ard Risks4
• Commercial lia+ility' 5i, .nterruption' 6eyMan' !Comp
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Managing Financial Risks
• Ins&rance %o'erage(
• Co/ers ide assortment o" ha,ard risks
• These are PRO535.7.T8 +ased e/ents
• The "re9uency & se/erity can +e estimated +asedon some historic pattern
• Hedging :or .mmuni,ing; risks4
• 7imiting the "inancial risk to the "irm o"
unanticipated e/ents that are not pro+a+ility +ased
• Volatility o" input<output prices can a""ect cash"los
• Hedging reduces the .MP3CT o" any change
• Most hedging directed at -HORT1TERM impacts
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Managing Financial Risks
• .nstruments ha/e +een de/eloped to hedge the"olloing types o" /olatility4
• .nterest Rate
• E)change Rate• Commodity Price
• Credit risk
• +eri'ati'e4
• 3 "inancial asset that represents a claim toanother asset
• .n other ords' it deri/es its entire /alue "romthat other asset
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.nterest Rate Risk
• =e+t is o"ten a key component o" a "irm*s capitalstructure' especially "or esta+lished "irms
• .nterest rates can "luctuate dramatically in the -T:"or e)ample' >?@AB' >?D>@(((((>G >;
• Firms that hedge against changes in interest ratescan sta+ili,e +orroing costs' hich can reduce
the o/erall risk o" the "irm
• 3/aila+le tools4 or.ards/ &t&res/ saps' "uturesoptions' and options
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E)change Rate Risk
• Companies that do +usiness internationally are e)posedto e)change rate risk :C3=' 2-3' Euro' 8en' Pound;
• The more /olatile the e)change rates' the more di""icult
it is to predict the "irm*s cash "los in its domesticcurrency :eg(' in G 2-=<C3=>(@0(in >G I atpar0( today I>(A;
• ." a "irm can manage its e)change rate risk' it can
reduce the /olatility o" its "oreign earnings and do a+etter analysis o" "uture proJects
• 3/aila+le tools4 or.ards/ &t&res/ saps' "uturesoptions' and options
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Commodity Price Risk
• Most "irms ha/e price /olatility in the input costs o"aterials and "inal prices recei/ed "or productssold
• =epending on the commodity' the "irm may +e a+leto hedge price risk using a /ariety o" tools( Thisallos them to make4
• +etter production decisions
• reduce the /olatility in cash "los
• 3/aila+le tools4 or.ards/ &t&res/ saps' "uturesoptions' and options
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The Risk Management Process
• .denti"y the types o" price "luctuations thatcould impact "irm and cause unmanaged risks
• Certain risks actually o""set each other( -o do
not look at each risk independently(
• .nstead' look at "irm*s risk in a 5portolio orisks6 conte)t( 7ook at cost o" managing the
risk /s( the 7eneit that might +e deri/ed
• Risk pro"iles are a use"ul tool "or determiningthe relati/e impact o" di""erent types o" risk
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The Risk Management Process
Step ( .denti"y the source o" the risk e)posure
Step 2( Kuanti"y the risk e)posure
Step 3( 3ssess the impact o" the e)posure:s; on the"irm*s +usiness and "inancial strategies
Step 4( 3ssess your "irm*s a+ility to design andimplement a risk management program
Step )( -elect the appropriate risk managementproducts
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Risk Pro"iles
• This is a +asic tool "or identi"ying andmeasuring e)posure to risk
• 2ses grap#s that sho the relationship
+eteen changes in price /s( changes in"irm /alue
• -imilar to graphing the results "rom a
sensiti'it8 anal8sis
• The steeper the slope o" the risk pro"ile' thegreater the e)posure and the more a "irmneeds to manage that particular risk
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Risk Pro"ile "ora !heat Lroer :the seller;
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Risk Pro"ile "ora !heat 5uyer :a cereal maker;
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Reducing Risk E)posure
• The goal o" hedging is to lessen the slope o"the risk pro"ile
• %ormally' hedging ill not reduce risk entirely• Only price risk can +e hedged
• Kuantity risk :/olume; cannot +e hedged
• 8ou may decide not to reduce risk completely+ecause i" you do' you could miss out on thepotential upside :management decision;(
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Timing
• -hort1run e)posure :transactionse)posure; can +e managed in a/ariety o" ays and ith se/eral tools
• 7ong1run e)posure :economice)posure; this is /ery di""icult tohedge permanently(
• .nstead' 7T re9uires the "irm to +eadapta+le to permanent changes in the+usiness climate0(thus' "irm mustadapt and change the +usiness model(
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For.ard Contracts
• 3 contract here parties agree on the price o" anasset today "or deli/ery and payment in the "uture
• Forard contracts are legall8 7inding on +othparties( The contracts are a/aila+le OTC(
• They can +e c&sto tailored to meet the needs o"+oth parties and can +e large in si,e
• They are negotiated contracts/ so no e)change o"cash up"ront' +ut "orards usually limited to large'creditorthy corporations(
• Ha/e u e/er done a "orard contract #
Eg., ordering a i!!a, de"ivered to your home in #$ minutes
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Terminology
• 9ong agrees to +uy the asset atthe "uture date :+uyer;
• S#ort agrees to sell the asset atthe "uture date :seller;
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Payo"" Pro"iles"or a "orard contract
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Hedging ith Forards
• Entering into a "orard contract can /irtuallyeliminate the price risk a "irm "aces4
• &t!"it does not copletel8 eliinate all ors orisk since 7ot# parties still enco&nter credit risk:.#ic# is t#at eit#er part8 co&ld dea< on t#e
contract o7ligation prior to at&rit8;
• 5y eliminating price risk' it pre/ents the "irm "rom+ene"iting i" prices mo/e in the company*s "a/or
• The "irm also has to spend some time and<or moneye/aluating the credit risk o" the counterparty
• Forard contracts are primarily used to hedgee)change rate risk( Trade mainly OTC(
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Hedgingith "orard contracts
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F&t&res Contracts
• -ame payo"" pro"ile as "orard contracts
• <T!&t&res contracts trade p&7licl8 onorganized sec&rities e=c#ange and oer onl8standardized prod&cts
• Futures =O re9uire an up"ront cash paymentN• This is called the initial margin• Margin is small relati/e to /alue o" the contract• Contract then Marked1to1market daily
• Central clearinghouse guarantees per"ormance onall contracts :acts as other side on all trades;
• Ha/ing a clearinghouse and daily MM marginre9uirements' you /irtually eliminate credit risk
Eg., Standardized pizza (only has pepperoni and mushrooms)
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Hedging ith Futures
• The risk reduction capa+ilities o" "utures is /erysimilar to that o" "orards
• The margin re9uirements and mark1to1marketre9uire an up"ront cash out"lo and li9uidity to meetany margin calls that may occur later
• Futures contracts are standardized' so the "irmmay not +e a+le to hedge the e)act 9uantity'9uality' and<or deli/ery date it desires
• Credit risk is /irtually none)istent :daily settlement;
• Futures contracts are a/aila+le on a ide range o""inancial assets' currencies and commodities
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Option Contracts
• The right' +ut not the o+ligation' to +uy :orsell; an asset "or a set price on or +e"ore aspeci"ied date4
• Call right to +uy the asset :eg( House purchase<closing;
• Put right to sell the asset :eg( car insurance;
• -peci"ied e)ercise or strike price
• -peci"ied e)piration date
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-eller*s O+ligation
• 5uyer has the right to e)ercise the option'+ut the seller is o+ligated4
• Call option riter is o+ligated to sell theasset i" the option is e)ercised +y holder
• Put option riter is o+ligated to +uy theasset i" the option is e)ercised
• Option seller is also called The !riter
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Hedging ith Options
• 2nlike "orards and "utures' options allo the+uyer to hedge their donside risk' +ut stillparticipate in upside potential
• -o it is attracti/e "or protecting against certainrisk' ithout o+ligating the +uyer to do anything
• The +uyer pays a "ee :called the premium; "orthis +ene"it :to the seller' aka The !riter' horecei/es the premium as income;
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Payo"" Pro"iles"or Calls
"" "
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Payo"" Pro"iles"or Puts
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Hedging ith Options
H d i C dit P i Ri k
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Hedging Commodity Price Riskith Options
• Commodity options are no generally doneusing "utures options
• E)ercising a call4• Oner o" call recei/es a long position in the
"utures contract plus cash e9ual to thedi""erence +eteen the e)ercise price on theoption and the current "utures price(
• -eller o" call recei/es a short position in the"utures contract and pays cash e9ual to thedi""erence +eteen the e)ercise price o" theoption and the "utures price today
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Hedging Commodity Price Risk:continued;
• E)ercising a put4
• Oner o" put recei/es a short position in the"utures contract plus cash e9ual to thedi""erence +eteen the "utures price and the
e)ercise price
• -eller o" put recei/es a long position in the"utures contract and pays cash e9ual to the
di""erence +eteen the "utures price and thee)ercise price
H d i E h R t Ri k
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Hedging E)change Rate Riskith Options
• May use either "utures options on currency orstraight currency options
• 2sed mainly +y corporations ith o/erseas deals
•Eg( Canadian e)porters ant to hedge against astrengthening QC3= :since they ould recei/e"eer QC3= hen con/erting F +ack to QC3=;
• 5uy puts :sell calls; on "oreign currency4• Protected i" the /alue o" the "oreign currency "alls
relati/e to the dollar • -till +ene"it i" the /alue o" the "oreign currency increases
relati/e to the dollar
• 5uying puts is less risky
H d i . t t R t Ri k
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Hedging .nterest Rate Riskith Options
• Can use "utures options
• 7arge OTC market "or interest rate options
• Caps' Floors' and Collars4
• .nterest rate cap pre/ents a "loating rate "rom going
a+o/e a certain i le/el :+uy a call on interest rates;• .nterest rate "loor pre/ents a "loating rate "rom going
+elo a certain le/el :sell a put on interest rates;
• Collar +uy a C377 and sell a P2T at same time4
• The premium recei/ed "rom selling the put ill help o""set
the cost o" +uying a call
• ." set up properly' the "irm ill not ha/e either a cash in"loor out"lo associated ith this position
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-ummary
• The moti/ation "or risk management stems "romthe "act that "irms "ace e)posure to undesira+le risk
• Firm*s risk pro"ile is altered through the use o"
deri/ati/es "orards' "utures' saps' options and"utures options
• Hedging can help enhance the /alue o" a "irm +ysta+ili,ing short1term cash "los' gi/ing the "irm
time to react and adapt to changing marketconditions' and alloing the "irm to take on neproJects that ould otherise +e considered toorisky
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Pro+lem >
• -uppose you purchased a %o/em+er ? canola "utures contracton Sune >D' ?( !hat as your pro"it or loss +e i" cocoa pricesturned out to +e QB> per metric ton at e)piration#
The initial contract /alue is e9ual to4(ri%e er ton) & (number of tons se%ified in the %ontra%t)
.nitial contract /alue :QA per ton;: tons per contract; Q?'
Final contract /alue :QB> per ton;: tons per contract; Q>'
-o our gain on the "utures contract is Q>' 1 Q?' QG'GD
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Pro+lem
•-uppose a "inancial manager +uys call options on A' +arrelso" oil ith an e)ercise price o" QB per +arrel(
•-he simultaneously sells a put option on A' +arrels o" oil iththe same e)ercise price o" QB per +arrel(
•Consider her gains and losses i" oil prices are QA' QAB' QB' QB'
and QBD( !hat do you notice a+out the payo"" pro"ile#
The call options gi/e the manager the right :+ut not the o+ligation;to purchase oil "utures contracts at a "utures price o" QB per+arrel( The manager ill e)ercise the option i" the price risesa+o/e QB(
-elling put options o+ligates the manager to +uy oil "uturescontracts at a "utures price o" QB per +arrel( The put holder ille)ercise the option i" the price "alls +elo QB( The payo""s are4
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-olution to Pro+lem
Oil price4 >) >)* >* >*4 >*0
Value o" call option position4 D
Value o" put option position4 1> 1 Total 'al&e 1Q> 1Q Q Q QD
%OT.CE4 The payo"" pro"ile is identical to that o" a "orard contractith a QB strike price(