Risk Management: An Introduction to Financial Engineering

Chapter Twenty- Four Risk Management: An Introduction to Financial Engineering

Chapter Outline • Hedging and Price Volatility • Managing Financial Risk • Hedging with Forward Contracts • Hedging with Futures Contracts • Hedging with Swap Contracts • Hedging with Option Contracts

Hedging & Price Volatility 24.1 • Recall that volatility in returns is a classic measure of risk • Volatility 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 risk • Hedging (immunization) – Reducing a firm’s exposure to price or rate fluctuations

Hedging & Price Volatility (cont.) • Instruments have been developed to hedge the following types of volatility • Interest Rate • Exchange Rate • Commodity Price • Financial Engineering - is the use of existing financial instruments to create new ones that allow firms to hedge against specific risks.

Hedging & Price Volatility (cont.) • Derivative – A financial asset that represents a claim to another financial asset. It derives its value from that other asset Example A stock option gives the owner the right to buy or sell stock, a financial asset, so stock options are derivative securities.

Hedging & Price Volatility (cont.) • The process of financial engineering often involves creating new derivative securities or combining existing derivatives to accomplish the firm’s hedging goals.

Interest Rate Volatility • Debt is a key component of a firm’s capital structure • Interest rates are a key component of a firm’s cost of capital • Interest rates can fluctuate dramatically in short periods of time • Companies that hedge against changes in interest rates can stabilize borrowing costs • This can reduce the overall risk of the firm

Interest Rate Volatility (cont.) • Available tools: forwards, futures, swaps, futures options, and options • In March 1980, the Bank of Canada dropped its discretionary interest rate policy for a system that allows floating interest rates. This led to an increase in the volatility of interest rates.

Exchange Rate Volatility • Companies 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

Exchange Rate Volatility (cont.) • The exchange rate volatility for the U.S. dollar and Canadian dollar has increased enormously since the early 1970s. • The reason for that was the breakdown of the Bretton Woods accord that guaranteed that exchange rates were fixed for the most part and significant changes rarely occurred.

Commodity Price Volatility • Most firms face volatility in the costs of basic goods and materials and in the price that will be received when products are sold (sale price) • 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

Commodity Price Volatility (cont.) • Example: - Oil is one of the most important commodities. Oil prices have become increasingly uncertain since the early 1970s (why?)

The Risk Management Process 24.2 • Identify the types of price fluctuations that will impact the firm • Some risks are obvious, others are not • 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 • You must also look at the 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

The Risk Management Process (cont.) • Example • An all-equity firm would not be concerned about interest rate fluctuations as a highly leveraged firm. • A firm with little or no international activity would not be overly concerned about exchange rate fluctuations.

Risk Profiles • Basic tool for identifying and measuring exposure to risk • A firm’s risk profile shows the relationship between changes in the price of a particular good, service, or rate and changes in the firm’s value • The steeper the slope of the risk profile, the greater the exposure and the more a firm needs to manage that risk

Figure 24.6 – Risk Profile for a Wheat Grower

Risk Profile for a Wheat Grower (cont.) • Because the risk profile slopes up, increases in wheat prices will increase the value of the firm. • Because the risk profile has a steep slope, the wheat grower has a significant exposure to wheat price fluctuations and they should take steps to reduce that exposure.

Figure 24.7 – Risk Profile for a Wheat Buyer

Reducing Risk Exposure • The goal of hedging is to lessen the slope of the risk profile • Hedging 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

Reducing Risk Exposure (cont.) • Example • Consider a firm that uses rice to make a popular brand of cereal. If the price of rice increases, the firm that raises and processes the rice will benefit; the firm that uses the rice in its cereal will lose. • By signing a contract specifying that the rice producer will deliver a certain quantity of rice at a certain price, the cereal manufacturer has reduced (or eliminated) the uncertainty about the cost of rice. At the same time, the rice producer has eliminated uncertainty about the price they will receive for the processed rice.

Reducing Risk Exposure (cont.) • Timing • Short-run exposure (transactions exposure) – short-term price fluctuations due to unexpected events or shocks are referred to as transitory changes. These changes can be managed in a variety of ways

Reducing Risk Exposure (cont.) • Timing • Long-run exposure (economic exposure) – some price fluctuations may reflect permanent changes due to a fundamental shift in the underlying economics of a business. Almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate

Forward Contracts 24.3 • Forward contracts are among the oldest tools for risk management • A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date • The delivery date of the goods is called the settlement date • The agreed-upon price is called the forward price • If prices increase before the delivery date, the buyer benefits • If prices decrease before the delivery date, the seller benefits

Forward Contracts (cont.) • Forward contracts are legally binding on both parties • They can be tailored to meet the needs of both parties and can be quite large in size • Positions • Long – agrees to buy the asset at the future date • Short – agrees to sell the asset at the future date • Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

Payoff profiles for a forward contract • The payoff profile – is a plot that depicts the gains and losses on a forward contract that result from unexpected price changes

Figure 24.8 – Payoff profiles for a forward contract

Hedging with Forwards • The basic idea is to use a risk profile to identify the firm’s exposure to a given type of financial risk. • Financial managers try to find a financial arrangement (e.g., forward contract) that that has a offsetting payoff profile. • Entering 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 risk

Hedging with Forwards (cont.) • Credit risk • There is a credit risk involved because no money changes hands until a forward contract is actually completed • The party on the losing end of the deal has an incentive to default on the agreement

Hedging with Forwards (cont.) • Since it eliminates the price risk , it prevents the firm from benefiting if prices move in the company’s favor (i.e., favorable price adjustments) • The firm also has to spend some time and/or money evaluating the credit risk of the counterparty

Hedging with Forwards (cont.) • Forward contracts are primarily used to hedge exchange rate risk • Example Jaguar, the U.K. auto manufacturer, historically hedged the U.S. dollar-British pound exchange rate for six months into the future.

Figure 24.10 – Hedging with forward contracts

Futures Contracts 24.4 • Future contracts are identical to forward contract with one exception • With a forward contract, gains and losses are recognized only on the settlement date • With futures contracts, gains and losses to the buyer or seller are recognized on a daily basis. This daily settlement feature is referred to as marking-to-market • This daily settlement greatly reduces the default risk associated with forward contracts • Because of this, organized trading in futures contracts is much more common than in forwards contracts

Trading in Futures • Future contracts for many items are routinely bought and sold around the world • There are two main types of futures contracts: commodity futures and financial futures • The underlying asset in a commodity future is essentially anything except a financial asset • The underlying asset in a financial future is any type of financial asset (e.g., stock, bond, etc.)

Futures Exchanges • The largest futures exchange is the Chicago Board of Trade (CBOT) • Other major exchanges include: • The Chicago Mercantile Exchange (COMEX) • The London International Financial Futures Exchange (LIFFE) • The New York Futures Exchange (NYFE) • The Winnipeg Commodity Exchange (WPG)

Hedging with Futures • A hedge created with futures contracts is conceptually the same as a hedge created with forward contracts. • The payoff profiles are drawn in the same way. • The only difference is that a firm hedging with futures must maintain an account with an investment dealer. • The account will be debited or credited every day. • Although there is a large variety of futures contracts available, many firms may not be able to hedge the exact quantity, quality, and/or delivery date they desire

Hedging with Futures (cont.) • Example – a firm may produce a certain grade of oil and find that no contract exists for exactly that grade. However, all oil prices tend to move together, so the firm can hedge its output using future contracts on other grades of oil. • This process is called cross-hedging. The firms buy contracts on a related, but not identical asset, to establish their hedge. • Credit risk is virtually nonexistent • Futures contracts are available on a wide range of physical assets, debt contracts, currencies and equities

Hedging with Futures (cont.) • In practice, future contracts are very rarely held to maturity. • Firms usually sell and buy contracts, reversing their financial position before the contracts mature.

Swaps 24.5 • A swap contract is an agreement between two parties to exchange specified cash flows at specified intervals based on specified relationships • The swap contract can be viewed as a series of forward contracts • The major difference is that there are multiple exchanges, whereas forward contracts involve only one exchange • Generally limited to large creditworthy institutions or companies

Currency Swaps • The two parties agree to exchange a specific amount of one currency for a specific amount of another currency at a specified future date

Interest Rate Swaps • In an interest rate swap, firms typically exchange fixed-rate loans for floating rate loans (and vice-versa). • Frequently, interest rate swaps are combined with currency swaps. • In this case, one firm will obtain fixed-rate financing in one currency and then swap it for floating rate financing in another currency.

Commodity swaps • A commodity swap is an agreement to exchange a specified quantity of some commodity at a specified future date • This is the newest type of swap and, to date, the market for commodity swaps is relatively small compared to the other swap markets

The Swap Dealer • Unlike futures contracts, swap contracts are not traded on organized exchanges • When a firm enters into a swap contract, the dealer takes the opposite side of the agreement • The swap dealer will then try to find an offsetting transaction with some other party • If this is not possible, dealers hedge their positions with futures contracts • A dealer’s contracts are detailed in a swap book. • In general, dealers try to keep a balanced book (called a matched book) to limit their net exposure

Option Contracts 24.6 • An option contract differs from forward, futures, and swap contracts in that the owner of the contract has the right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date • Call option – right to buy the asset • Put option – right to sell the asset • Exercise or strike price –specified price at which the asset is bought or sold • Expiration date – last date at which the option may be exercised • Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential

Options versus Forwards • There are two main differences between option contracts and forward contracts: 1- The transaction associated with an option contract is only completed if the owner of the option chooses to exercise it 2- The buyer of the option obtains the right to purchase the underlying asset, that right is valuable. Therefore, the buyer of an option must pay an option premium for that right. In a forward contract, no money exchanges hands until the transaction is completed.

Option Payoff Profiles • The horizontal axis shows the difference between the asset’s value and the strike price on the option • For a call option • the owner begins to make a profit when the price of the underlying asset rises above the strike price • from the seller’s viewpoint, any gain to the owner of the option is a loss to the seller of the option For a put option • the owner begins to make a profit when the price of the underlying asset falls below the strike price • a gain to the buyer of a put option is a loss to the seller of the option

Figure 24.14 A & B – Payoff Profiles: Calls

Figure 24.14 C & D – Payoff Profiles: Puts

Option Hedging • It works in the same way as hedging with a forward or futures contract • Use options to create a payoff profile exactly the opposite of the cash flow expected • Because of the nature of options, firms can use option contracts to hedge against the downside risk caused by adverse price movements • At the same time, they can retain the potential for upside benefits if prices move in the desired direction

Figure 24.15 – Hedging with Options

Hedging Commodity Price Risk with Options • In addition to futures contracts on commodities, there are now options available on the same commodities • The options traded on commodities are really options on futures contracts; they are referred to as futures options • The owner of a futures call option receives a futures contract on the underlying commodity; in addition the owner receives the difference between the strike price on the option and the current futures price • This difference is paid in cash

Risk Management: An Introduction to Financial Engineering