Overview of the risk management process and its impact on firm value
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Overview of the Risk Management Process and its Impact on Firm Value. Why Study Risk Management?. This area has experienced explosive growth due to the development of derivatives markets.

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Why study risk management l.jpg
Why Study Risk Management?

  • This area has experienced explosive growth due to the development of derivatives markets.

  • It is an area of finance where theory has been so quickly and completely implemented into actual practice.

  • Derivatives have become so widespread and central to business practice to gain competitive advantage and maximize shareholder value.

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One Simple Example of a Hedge:

  • You are planning to come to Villanova by car.

  • You have two choices:

    • Take the Blue route (476), which is faster if there is no traffic, or

    • Take the side roads, which is slower but doesn’t have much traffic.

  • What do you do?

  • What are the benefits and costs of hedging?

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What is a Derivative?

  • An instrument whose value is determined (or derived) from the value of some underlying variable(s).

  • What kind of underlying variables?

    • Prices of commodities (wheat, corn, lumber, gold, copper, etc.)

    • Exchange rates (price of British pound, Euro, etc.)

    • Interest rates

    • Stock prices

    • Index values (e.g. S&P 500)

    • Credit Quality of a corporate bond

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Examples of Derivatives

  • Forward contracts

  • Futures contracts

These are conceptually similar

  • Swaps

  • Options

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Derivatives and Hybrids are not new…

  • Forwards – started in 12th century

  • Futures – started in the 17th century

  • Options – started in the 17th century

  • Hybrids – at least since the 19th century

  • Swaps – started with parallel loans in the 1970s (relative to the others, these are babies!).

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But Derivatives usage also has its risks!

  • Trading Debacles: Nick Leeson at Barings PLC ($1.4 Bil. in 1995), Brian Hunter at Amaranth hedge fund ($6.6B in 2006), and at SocieteGenerale ($7.2B in 2008), etc.

  • Subprime Mortgage Mess: $1-2 Trillion losses during 2007-2009 that touched nearly all sectors of the financial services industry.

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2007-2008 Subprime Mortgage Mess in brief

  • Unintended Consequences: in 1990s, Clinton administration pushed for greater credit access for lower income borrowers.

  • Regulatory Loopholes: in 1999, Citigroup agreed to underwrite more risky mortgages if they could be kept off-balance sheet.

  • Perfect Storm hits: low interest rates and 2002-07 recovery loosens credit standards further and investors “stretch” for higher yields.

  • Incentives Misaligned: mortgage lenders/brokers, investment bankers, rating agencies, money market investors, hedge funds, politicians all have incentive to “turn a good idea into a bad one!”

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Collateralized Debt Obligation (“CDO”)– More Leverage












Pool of AA, A, BBB MBS



Loss Position

Credit Risk
























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Credit Default Swaps – InfiniteLeverage

Like an insurance contract that pays in the event of default.

FASB requires mark-to-market valuation.

Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value.

Protection Buyer

Protection Seller

Premium Payments

  • Tends to own reference asset

  • Hedging or going “short”

  • Benefits when reference asset price DECREASES

  • Does not usually own reference asset

  • Going “long”

  • Benefits when reference asset price INCREASES, max at Par

Payment upon Default of Reference Asset

Reference Asset can be a MBS, CDO, Bond, or Loan

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CDS on CDO – Infinite Leverage

Credit Default Swap ∞





CDO Structure 50X’s

Increasing Leverage





Equity $0

Equity $1.8

Mort. Securitiz 30X’s

Mortgage Debt




Homeowner 20X’s



Mortgage Debt


Equity $3.2

Equity $5

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A Note on Market Efficiency:

  • An efficient market is characterized by:

    • Homogeneous product

    • Liquid primary and secondary markets

    • Low transaction costs

    • Easy access to information about asset values

    • Ability to hedge positions (e.g., short sales are allowed)

  • An efficient market does not mean it is impossible to make “excess profits” but it does imply that it is very difficult to do so on a consistent basis.

  • Most financial markets (especially those in the U.S.) are semi-strong efficient.

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Types of Risk Management and their Impact on Firm Value

  • Tactical Risk Management

    • Acting on a “View”

    • “Arbitraging” international differences in taxation and/or regulation

    • Reducing transaction costs (B-A spread, liquidity, info costs)

  • Strategic Risk Management

    • M-M (1958) Irrelevance argument (perfect markets).

    • Long-term reduction in various costs related to market imperfections.

    • Firm can increase value via hedging because it reduces the costs related to: taxes, financial distress/external financing, agency problems, and asymmetric information.

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Effect of Market Imperfections on Firm Value

Stylized Model:

V = V* – Tax – FD – AC – AI


V* = value of firm in perfect M-M (1958) world

Tax = costs associated with tax effects

FD = costs related to financial distress / external financing

AC = costs related to agency conflicts

AI = costs associated with differences in information

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Why Market Imperfections Matter

  • Taxes – due to convexity of tax schedule.

  • Financial Distress / External Financing costs – direct and indirect deadweight costs incurred by the firm when its cash flow is low relative to its debt burden and investment plans.

  • Agency Costs – related to conflicts between managers and owners as well as between owners and bondholders.

  • Asymmetric Information – costs related to differences in information between insiders and outside investors

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A Simple Model of Firm Value

  • Stylized Income Statement:

    EBIAT = {Sales – Operating Costs – DEP}

    * (1 – T)

  • Stylized Valuation Model:

    where, INVt = Capital Expenditures,

    Othert = Change in Net Working Capital.

  • Total Firm Value and Shareholder Value (SHV) are only affected by changes in MRT (Magnitude, Riskiness, and Timing of cash flows).

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Ways to Measure the Impact of Risk Management on Firm Value

  • Three key measures:

    • RAROC – Risk-adjusted return on capital =

      Risk-adjusted Dollar Return / Economic Capital at Risk

    • EVATM / SVA – Economic Value Added =

      Annual Dollar Return – (Hurdle rate * Economic Capital)

      Shareholder Value Added =

      Economic Capital * [ {(ROA – g) / (Hurdle rate – g)} - 1 ]

    • Value-at-Risk (VaR) – VaR can be computed several ways. One “quick and dirty” way is:

      VaR = 2.33 * Standard Deviation of Percentage Return * Economic Capital

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MVA and the Four Value Drivers

  • Market Value Added (MVA) is determined by four drivers:

    • Sales growth (g)

    • Operating profitability (OP = NOPAT / Sales)

    • Capital requirements

      (CR = Operating capital / Sales)

    • Weighted average cost of capital (WACC)

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Salest(1 + g)



WACC - g

MVA for a Constant Growth Firm

MVAt =

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Discounted Cash Flow Valuation and Value-Based Management

  • Link to DCF Valuation Excel file:

  • FM 12 Ch 15 Mini Case.xls (Brigham & Ehrhardt file)

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Risk Profiles and the Fundamental Building Blocks of Risk Management

  • A Risk Profile is a simple 2-D graph of the change in firm value (DV) versus the unexpected change in a financial price (DP).

  • Thus, DV = V due to DPminus V beforeDP.

  • And, DP = P minusexpected P.

  • Building Blocks are payoff profiles of derivative and hybrid securities (Six key profiles can form all others)

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The ManagementPayoff Profiles of Building Blocks are linear or non-linear...

  • Forwards, Futures, and Swaps have twolinear payoff profiles (Upward sloping for long positions and downward sloping for short positions).

  • Options have fournon-linear payoff profiles:

    • Calls – two profiles (one for long and one for short positions)

    • Puts – two profiles (one for long and one for short positions)

  • Can create a payoff profile for any hedging strategy or hybrid security using the above six profiles in a simple Spreadsheet File.

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Three Examples of Payoff Profiles in your ManagementPersonal Life

  • What are the “Payoff Profiles” for these items?

    • Bonus Compensation(e.g., in addition to your base salary)

    • Car Insurance (e.g., the payoff when you have an accident)

    • Housing Prices (e.g., change in the value of your home)

  • Try to solve these on your own (see Solutions here).

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A Brief Overview of the Relevant Securities: Forward Contracts

  • Forward Contracts – Obligates its owner to buy (if in a “long” position) or sell (if in a “short” position) a given asset on a specified date at a specified price (the “forward price”) at the origination of the contract.

  • Two Key Features:

    • Credit risk is two-sided (i.e., both buyer and seller of the forward can default on the deal).

    • No money is exchanged until the forward’s maturity date.

  • The above features increase default risk and restricts the availability and liquidity of these contracts.

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A Brief Overview of the Relevant Securities: Futures Contracts

  • Futures Contracts – Similar to Forwards. Obligates its owner to buy (if in a “long” position) or sell (if in a “short” position) a given asset on a specified date at a specified price (the “futures price”) at the origination of the contract.

  • Key Features:

    • Credit risk is two-sided but is reduced substantially because of two mechanisms:

      1) marking-to-market (daily settling up of the account), and

      2) margin requirements (i.e., a good-faith deposit).

    • Standardized contract specifies exact details of term, asset, contract size, delivery procedures, place of trading, etc.

    • Clearinghouse reduces transaction costs and de-couples buyer from seller by providing anonymity.

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A Brief Overview of the Relevant Securities: Swaps Contracts

  • Swaps – Obligates two parties to exchange some specified cash flows at specified intervals over a specified time period. Like futures contracts, swaps can be viewed as a portfolio of forward contracts.

  • Key Features:

    • Credit risk is two-sided but a swap is less risky than a forward (and more risky than futures) because a swap reduces the “performance period” (the time interval between cash payments) but does not require posting a margin.

    • Swaps can be tailored exactly to customer needs and can be arranged for longer time periods than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures).

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A Brief Overview of the Relevant Securities: Option Contracts

  • Options – Grants its owner the right, but not the obligation, to buy (if purchasing a “call” option) or sell (if purchasing a “put” option) a given asset on a specified date at a specified price (the “strike price”) at the origination of the contract.

  • Key Features:

    • Calls allow you to bet on increases in the asset’s value.

    • Puts allow you to bet on decreases in the asset’s value.

    • The option buyer pays a premium to acquire the option.

    • The seller of the option does have an obligation to buy/sell the asset. Much riskier than buying the option.

    • Options can be: “in-the-money”, “at-the-money”, and “out-of-the-money”.

    • An option is a portfolio of forward contract and a riskless bond. Also, can create forwards from options!

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Three Fundamental Ways Contractsto Manage Risk

  • The “ART” of Risk Management:

    • Accept the risk (e.g., self-insure)

    • Remove the risk (divest, diversify)

    • Transfer the risk (hedging, insurance)