Chapter 24

1. Chapter 24 Derivatives and Risk Management

2. Topics in Chapter • Corporate risk exposure • Reasons to manage risk • Derivative securities and hedging • Some examples

3. Different Types of Risk • Demand risks: Those associated with the demand for a firm’s products or services. • Input risks: Those associated with a firm’s input costs. • Financial risks: Those that result from price fluctuations or transactions in the financial markets. • Speculative risks: Those that offer the chance of a gain as well as a loss. • Pure risks: Those that offer only the prospect of a loss.

4. Different Types of Risk • Property risks: Those associated with loss of a firm’s productive assets. • Personnel risks: Risks that result from human actions. • Environmental risks: Risk associated with polluting the environment. • Liability risks: Connected with product, service, or employee liability. • Insurable risks: Those which typically can be covered by insurance. • Risks of risk management ?

5. General rule of corporate risk management • Step 1. Identify the risks faced by the firm. • Step 2. Measure the potential impact of the identified risks. • Step 3. Decide how each relevant risk should be dealt with.

6. How to minimize or reduce risk exposures? • Avoid the activities that give rise to risk. • Take actions to reduce the probability of occurrence of adverse events. • Take actions to reduce the magnitude of the loss associated with adverse events. • Transfer functions which produce risk to third parties. • Transfer risk to an insurance company by paying premiums. • Purchase derivatives contracts to reduce input and financial risks.

7. But! Do stockholders care about corporate risk management? • If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. 7

8. How can risk management increase firm value? Risk management allows firms to: • Avoid costs of financial distress. • Reduce cost of debt and increase debt capacity. • Minimize negative tax effects due to convexity in tax. • Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. • Utilize comparative advantage in hedging relative to hedging ability of investors.

9. Risk management reduces expected tax: If we suppose risk management strategy can smooth firm performance, then it can minimize negative tax effects due to convexity in tax code. Example: • EBT of $50K in Years 1 and 2, total EBT of $100K, • Tax = $7.5K each year, total tax of $15. • EBT of $0K in Year 1 and $100K in Year 2, • Tax = $0K in Year 1 and $22.5K in Year 2.

10. Derivative securities and risk management • Futures/Forwards: Contracts which call for the purchase or sale of a financial (or real) asset at some future date, but at a price determined today. • Swaps: Involve the exchange of cash payment obligations between two parties, usually because each party prefers the terms of the other’s debt contract. Swaps can reduce each party’s financial risk. • Others: options, caps, floors , collars, swaptions, treasury lock or other customized contracts. • The prices of currency derivatives and interest rate derivative are available Chicago Mercantile Exchange (CME) at http://www.cmegroup.com/

11. Hedging • Corporate hedging refers to the use of off-balance-sheet instruments (forwards, futures, swaps, and options) to reduce the volatility of firm value. (Nance et al., 1993) • Hedging: Generally conducted where a price change could negatively affect a firm’s profits. • Long hedge: Involves the purchase of a futures contract to guard against a price increase. • Short hedge: Involves the sale of a futures contract to protect against a price decline. • Perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position

12. Alternative ways? • By appropriately spreading business risk over several activities or operations, the firm can significantly reduce the impact of a single random event on corporate performance. Examples: Geographic and product diversification (Operating hedging ). • Keeping cash is also a natural way to avoid the risk from uncertainty.

13. Use Swaps to reduce cost of debt: Reduce borrowing costs by using interest rate swaps. • Example: Two firms with different credit ratings (Hi and Lo): • Hi can borrow fixed at 11% and floating at LIBOR + 1%. • Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%.

14. Use Swaps to reduce cost of debt: Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of 0.45% to Hi

15. Reduce the interest rate risk in bonds • Duration: Average time to bondholders' receipt of cash flows, including interest and principal repayment. Duration is used to help assess interest rate and reinvestment rate risks. • Immunization: Process of selecting durations for bonds in a portfolio such that gains or losses from reinvestment exactly match gains or losses from price changes.

16. Interest Rate Hedging with T-Bond Futures • It is January, Tennessee Sunshine will issue $5 million in bonds in June. TS is worried interest rates will rise between now and then. • Current interest rates are 7% for the 20-year issue. But the CEO fears rates might rise by 1% by June. • June T-bond futures (on a hypothetical 20-year 6% T-bond )are 111-25.

17. What are risks of not hedging? • Interest rates might increase before the bonds are issued. At a yield of 8%, how much will the $5 million worth of 20-year 7% semi-annual coupon bonds be worth?

18. INPUTS 40 4 175000 5000000 N I/YR PV PMT FV -4,505,181 OUTPUT What are risks of not hedging? • Pmt = $5 million x 7%/2 = $175,000 The bonds will be worth only $4,505,181!! So if TS waits and interest rates increase, TS will lose $5,000,000 - $4,505,181 = $494,819.

19. How can Tennessee Sunshine hedge this risk? • T-Bond futures represent a contract on a hypothetical 20-year 6% bond with semiannual payments. • A futures price of 111’25 means 111% plus 25/32 percent of par, or for a $1,000 par bond, a price of $1,117.81. • One T-bond futures contract is for $100,000 par value of underlying bonds, which is 100 of the $1,000 par-value bonds. Since each bond is worth $1,117.81, one contract is for $111,781 worth of bonds. • TS should sell $5,000,000/$111,781=44.7=45contracts.

20. INPUTS 40 -1117.81 30 1000 N I/YR PV PMT FV 2.5284 OUTPUT Implied yield on futures contract • A price of $1,117.81 gives a semi-annual yield of 2.5284% or an annual yield of about 5.057%:

21. Futures price changes • T-bond futures prices change every day as interest rates change. If interest rates increase, bond prices decrease and so does the T-bond futures price. If interest rates decrease, then bond prices increase, and so does the T-bond futures price.

22. What happens if interest rates increase 1%? • The yield on the bond underlying the futures contract will increase to 5.057% + 1% = 6.057%. This gives a new price of $993.44 (N=40, I/YR=6.057/2, PMT = -30, FV = -1000; solving gives PV = 993.44 per underlying bond, or a contract price of $99,344. • This is a decrease of $111,781 - $99,344 = $12,437 for each contract.

23. Profit or loss from contract • Since TS sold futures contracts, then it makes money when the futures price declines. In this case, TS will make $12,437 on each of its 45 contracts. • Since TS sold the futures contracts and the price went down, it earns a positive profit of $12,437 x 45 contracts = $559,665.

24. What is the effectiveness of the hedge? • TS will lose $494,819 on its own bonds when it issues them at the higher coupon rate, but it earns $559,665 on its futures contracts. • Net result = 559,665 – 494,819 = $64,846 profitfrom the hedge.

25. Suppose interest rates fall instead of rise? • If interest rates fall, then: • TS gains on its bond issue • TS loses on its futures contracts

26. Example of Foreign Currency Hedging A U.S. firm must pay 500 million yen to a Japanese firm in 30 days, and the current spot rate is 125.54 yen per dollar. Unless spot rates change, the U.S. firm will pay the Japanese firm the equivalent of $3.983 million (500 million yen divided by 125.54 yen per dollar) in 30 days. But if the spot rate falls to 100 yen per dollar, for example, the U.S. firm will have to pay the equivalent of $5 million. 26

27. Example of Foreign Currency Hedging • The financial manager of this U.S. firm plans to buy a 30-day forward exchange contract. • This contract promises delivery of yen to the U.S. firm in 30 days at a guaranteed price of 125.339 yen per dollar. • The counterparty to the forward contract must deliver the yen to the U.S. firm in 30 days, and the U.S. firm is obligated to purchase the 500 million yen at the previously agreed-upon rate of 125.339 yen per dollar. • Therefore, the treasurer of the U.S. firm is able to lock in a payment equivalent to $3.989 million, no matter what happens to spot rates. 27