23-1 Enterprise Risk Management Chapter 23 Copyright © 2013 by The McGraw-Hill Companies, Inc. All...

23-1

Enterprise Risk Management

Chapter 23

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

23-2

Chapter Outline

•Hedging and Price Volatility

•Managing Financial Risk

•Hedging with Forward Contracts

•Hedging with Swap Contracts

•Hedging with Option Contracts

23-3

Chapter Outline






23-4

What Risks?Conducting business in a global economy involves risk.

Much of the risk is associated with coping with the unpredictable future.

23-5

Enterprise Risk Management (ERM)

ERM is the process to identify, assess, and where possible, to mitigate the risks to a firm

23-6

Risk Types

1. Hazard Risks2. Financial

Risks3. Operational

Risks4. Strategic

Risks

ERM seeks to view the business holistically and understand how the pieces of risk fit together.

23-7

What Risks?

Many companies address risk publically as exemplified by Disney Corporation in their annual report

23-8

Example: Disney’s Risk Management Policy

Disney provides stated policies and procedures concerning risk management strategies in its annual report:The company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investments

Interest rate swaps are used to manage interest rate exposure

23-9

Example: Disney’s Risk Management PolicyDisney provides stated policies and procedures concerning risk management strategies in its annual report:Options and forwards are used to manage foreign exchange risk in both assets and anticipated revenues

The company uses a VaR (Value at Risk) model to identify the maximum 1-day loss in financial instruments

Derivative securities are used onlyfor hedging, not speculation

http://corporate.disney.go.com/investors/annual_reports.html

23-10

Hedging VolatilityRecall 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

23-11

Hedging VolatilityInstruments have been developed to hedge the following types of volatility:Interest RateExchange RateCommodity PriceQuantity Demanded

23-12

Interest Rate Volatility

Debt is a key component of a firm’s capital structure

Interest rates can fluctuate dramatically in short periods of time

23-13

Interest Rate Volatility

Companies that hedge against changes in interest rates can stabilize borrowing costs

This can reduce the overall risk of the firm

Available tools: forwards, futures, swaps, futures options, and options

23-14

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

23-15

Exchange Rate Volatility

If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and conduct a better analysis of future projects

Available tools: forwards, futures, swaps, futures options

23-16

Commodity Price Volatility

Most firms face volatility in the costs of materials and in the price that will be received when products are sold

23-17

Commodity Price Volatility

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 (depend on type of commodity): forwards, futures, swaps, futures options, options

23-18

Chapter Outline






23-19

The Risk Management Process

Identify the types of price fluctuations that will impact the firm

Some risks are obvious; others are not

23-20

The Risk Management ProcessSome 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

23-21

The Risk Management ProcessYou 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

23-22

Risk ProfilesBasic tool for identifying and measuring exposure to risk

Graph showing the relationship between changes in price versus changes in firm value

Click on the icon to visit an online publication dealing with risk management

http://www.erisk.com/

23-23

Risk ProfilesSimilar to graphing the results from a sensitivity analysis

The steeper the slope of the risk profile, the greater the exposure and the greater the need to manage that risk

23-24

Reducing Risk Exposure

The goal of hedging is to lessen the slope of the risk profile

Hedging will not normally reduce risk completelyFor most situations, 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

23-25

Reducing Risk Exposure

TimingShort-run exposure (transactions exposure) – can be managed in a variety of ways

Long-run exposure (economic exposure) – almost impossible to hedge - requires the firm to be flexible and adapt to permanent changes in the business climate

23-26

Chapter Outline






23-27

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 tailored to meet the needs of both parties and can be quite large in size

23-28

Forward ContractsPositionsLong – 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

23-29

Forward Contracts

23-30

Hedging with Forwards

Entering into a forward contract can virtually eliminate the price risk a firm facesIt does not completely eliminate risk

unless there is no uncertainty concerning the quantity

Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor

23-31

Hedging with Forwards

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

23-32

Futures ContractsFutures contracts traded on an organized securities exchange

23-33

Futures ContractsRequire an upfront cash payment called marginSmall 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

23-34

Futures Quotes

Commodity, exchange, size, quote units

The contract size is important when determining the daily gains and losses for marking-to-market

23-35

Futures QuotesDelivery monthOpen price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest

Open interest is how many contracts are currently outstanding

23-36

Futures QuotesDelivery monthThe change in settlement price times the contract size determines the gain or loss for the day

Long – an increase in the settlement price leads to a gain

Short – an increase in the settlement price leads to a loss

23-37

Hedging with Futures

The risk reduction capabilities of futures are similar to those of forwards

The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur

23-38

Hedging with Futures

Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires

Credit risk is virtually nonexistentFutures contracts are available on a

wide range of physical assets, debt contracts, currencies, and equities

23-39

Chapter Outline






23-40

SwapsA long-term agreement between two parties to exchange cash flows based on specified relationships

Can be viewed as a series of forward contracts

Generally limited to large creditworthy institutions or companies

23-41

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

23-42

Example: Interest Rate Swap

Consider the following interest rate swap:

Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed)

Company B can borrow from a bank at 9.5% fixed or LIBOR + .5% (borrows floating)

Company A prefers floating and Company B prefers fixed

By entering into a swap agreement, both A and B are better off than they would be borrowing from the bank with their preferred type of loan, and the swap dealer makes .5%

Example: Interest Rate SwapPay Receive Net

Company A LIBOR + .5%

8.5% -LIBOR

Swap Dealer w/A

8.5% LIBOR + .5%

Company B 9% LIBOR + .5%

-9%

Swap Dealer w/B

LIBOR + .5%

9%

Swap Dealer Net

LIBOR + 9%

LIBOR + 9.5%

+.5%

23-43

23-44

Swap Process

23-45

Chapter Outline






23-46

Option ContractsThe right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date

Call – right to buy the assetPut – right to sell the assetExercise or strike price –specified price

Expiration date – specified date

23-47

Option ContractsBuyer has the right to exercise the option;

the seller is obligatedCall – option writer is obligated to sell the

asset if the option is exercisedPut – option writer is obligated to buy the

asset if the option is exercisedUnlike forwards and futures, options allow

a firm to hedge downside risk, but still participate in upside potential

The firm pays a premium for this benefit

23-48

Payoff Profiles: Calls

Buy a

call with E = $40

Stock

Price

Pa

yo

ffSell

a Call E = $40

Stock

Price

Payo

ff

23-49

Payoff Profiles: PutsBuy a Put with E = $40

Stock Price

Pay

off

Sell a Put E = $40

Stock Price

Pa

yo

ff

23-50

Hedging Commodity Price Risk with

Options “Commodity” options are generally

futures options

23-51


OptionsExercising a call:Owner of the call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures price

Seller of the call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures price

23-52


OptionsExercising a put:Owner of the put receives a short position in the futures contract plus cash equal to the difference between the futures price and the exercise price

Seller of the put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price

23-53

Hedging Exchange Rate

Risk with OptionsMay use either futures options on

currency or straight currency options

Used primarily by corporations that do business overseas

U.S. companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars)

23-54

Hedging Exchange Rate

Risk with OptionsBuy puts (sell calls) on foreign currencyProtected 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

23-55

Hedging Interest Rate

Risk with Options

Can use futures optionsLarge OTC market for interest rate options

23-56


Risk with Options

Caps, Floors, and CollarsInterest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates)

Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)

23-57


Risk with OptionsCaps, Floors, and Collars

Collar – buy a call and sell a putThe premium received from selling the put will help offset the cost of buying the call

If set up properly, the firm will not have either a cash inflow or outflow associated with this position

23-58

Quick Quiz

What are the four major types of derivatives discussed in the chapter?

How do forwards and futures differ? How are they similar?

How do swaps and forwards differ? How are they similar?

How do options and forwards differ? How are they similar?

23-59

Comprehensive Problem

A call option has an exercise price of $50.

What is the value of the call option at expiration if the stock price is $35? $75?

A put option has an exercise price of $30.

What is the value of the put option at expiration if the stock price is $25? $40?

23-60

Terminology

•Hedging•Hedging Volatility•Forward Contracts•Future Contracts•Future Quotes•Swaps•Option Contracts•Commodities

23-61

Key Concepts and Skills

•Explain how companies face risk exposures and how they hedge against these risks.

•Define the difference between forward and futures contracts.

23-62

Key Concepts and Skills

•Describe how swaps and options can be used for hedging.

•Compute the value of a put and call option.

23-63

1. Firms face risk associated with changes in interest rates, exchange rates of foreign currency, costs of materials and the price that they can sell their products.

2. Firms use hedging to protect themselves against these risks.

What are the most important topics of this chapter?

23-64

3. Forward, Futures, Swap and Option contracts are the financial instruments to deal with this volatility.

4. Risk is never removed entirely; it can be mitigated by investing in contracts.

What are the most important topics of this chapter?

23-65

Questions?

23-1 Enterprise Risk Management Chapter 23 Copyright © 2013 by The McGraw-Hill Companies, Inc. All...

Documents

Transcript of 23-1 Enterprise Risk Management Chapter 23 Copyright © 2013 by The McGraw-Hill Companies, Inc. All...