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RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING
Chapter 24
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Chapter OutlineHedging and Price VolatilityManaging Financial Risk Forward ContractsFutures ContractsOption Contracts
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Hedging 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 riskHedging (immunization) – reducing a firm’s exposure to price or rate fluctuations
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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
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Interest 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 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 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 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 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 Grower
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Risk Profile for a Wheat Buyer
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Reducing 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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TimingShort-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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DEF stockholders are paid the current market value of their firm in the form of ABC stock. Both firms are 100% equity-financed. The total earnings of the combined firm are $227,920.
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QuestionsWhat is the number of shares in
the new firm? What are the earnings per share
after the merger?What is the total value of the
merged firm? What is the price per share after
the merger? What is the value of synergy?
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Forward 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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PositionsLong – 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 contract
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Hedging 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 contracts
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Futures 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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SwapsA 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 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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Option ContractsThe 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 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 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: Calls
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Payoff Profiles: Puts
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Hedging with Options
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Hedging Exchange Rate Risk with OptionsMay 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