risk management and derivatives. volatility volatility in returns is a classic measure of risk...
TRANSCRIPT
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Risk Management
and Derivatives
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Volatility Volatility in returns is a classic measure of
risk
Perfect Market More systematic risk leads to more return
But Volatility is Costly External financing
Project funding Distress
Lower debt or increased prob. of distress Taxes
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Risk Management Tools Hedging
Reduce firm’s exposure to price/rate fluctuations
Financial Hedging Insurance Derivatives
Financial assets which are a claim on another asset
Operational Hedging Using other corporate decisions to manage
volatility
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Sources of Volatility - 1
Interest Rate Risk Loans with floating interest rates create IR
risk Exchange Rate Risk
Reduce impact of foreign earnings volatility due to currency rate fluctuations
Commodity Price Risk Certain input costs and prices of goods sold
can be hedged
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The Risk Management Process
Identify important price fluctuations Risk profiles are useful for determining the
relative impact of different types of risk Some risks may offset each other
Consider the firm as a portfolio of risks and not just look at each risk separately
Considering risk management Availability of relevant contracts Cost of contracts Cost of management/employee time
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Risk Profiles
Graph of price changes relative to value changes
Risk profile slope Steeper ~ Larger exposure Potentially more need to hedge
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Derivatives Change Payoff
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Forward Contract What’s a forward?
Agreement to exchange an asset for a set price with delivery and payment at a set future date
Long: agree to buy the asset Short: agree to sell the asset
You want next year’s Ferrari and contract with dealer to buy at a set price in the fall P Current = P Contract
Over the summer, demand rises P Current > P Contract
What if car value is below contract price? P Current < P Contract
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Future What’s a future?
Forwards traded on an exchange
Farmer expects to sell 100,000 bushels of soybeans
Wants to sell at a certain price (short position) Soybean future contracts are for 5,000
bushels Current price is $4.50/bushel
Farmer shorts 20 soybean futures Will sell 100,000 bushels Will receive $4.50/bushel*100,000 bushels
= $450,000
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Commodity Future
No cost today, but margin held in farmer’s account As soybean price changes, clearinghouse
adjusts farmer’s account September
Farmer delivers soybeans and receives $450,000
Bumper Crop Receive $450,000 + Extra Crop * Market
Price Poor Harvest
Receive $450,000 – Amt to Purchase * Market Price
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Interest Rate Swap Firm A can borrow at 10% fixed or LIBOR + 1%
floating Firm B can borrow at 9.5% fixed or LIBOR + 2% A prefers fixed and B prefers floating
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Call (Put) Right to buy (sell) a security at a pre-specified price
Underlying Asset that you have an option to buy or sell
Option Price Market price of the contract
Exercise (or Strike) Price Price at which the security can be bought or sold
At-the-money - Exercise price is very close to stock’s
current value In-the-money - Option could be exercised at a profit
today Out-of-the-money – Can’t exercise for profit
Options
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Reducing Risk Exposure Hedging changes risk profile Doesn’t eliminate risk
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)
Managed in a variety of ways Long-run exposure (economic exposure)
Difficult to hedge with derivatives
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Always Hedge?
What if price shock can be passed along to customer?
What if competitors don’t hedge?
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Not Perfect
Iberia Large 4th Quarter 2008 Losses Attributed, in part, to hedging
“Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of 2008.”
Wall Street Journal
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Sources of Volatility - 2
Contracting with suppliers/customers Vertical integration Limiting leverage
Central employees “Key Man” Insurance
Project specific issues Diversification Project choice
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Corp Fin Applications
Equity as a Call Employee Stock Options CEO Stock Options
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Equity: A Call Option For leveraged firms, equity is a call option
on the company’s assets Exercise price - the face value of the debt Expiration date – the date that the debt
comes due Assets > debt
Option is exercised and the stockholders retain ownership
Assets < debt Option expires unused and assets belong to
the bondholders
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Equity Payoff
DebtFirm Value
Value of Equity
All goes to Bondholders
Shareholders Collect
Asset substitution
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Employee Stock Options
Options given to employees as compensation Nonqualified
Can be granted at a discount to current value
Qualified or incentive stock options Primarily for upper mgmt Special tax treatment
Often used as a bonus or incentive Huge rise in popularity Mostly still for upper management
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Employee Stock Options
Designed to reduce agency problems Empirical evidence: they don’t well work
Not worth as much to the employee as to an outsider due to the lack of diversification
Reprice underwater options Other Disadvantages
Management behavior Costly compensation
Dilutes stock as firm must issue new shares Sometimes offset with repurchase (usually when
stock price is high) Expensing can hurt profits
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CEO Options Use
Executives can protect their stock positions
Given stock or options as an incentive
I-bank creates individual options “Collars” position with put and call Value
Stock Price
Put Call