CORPORATE RISK MANAGEMENT

The wide array of risks that a management firms exposed can be classified into 5 categories:

1.Technological Risk: arise mostly in the R&D and Operations stage of the value chain.

2.Economic Risks: arise from fluctuations in the revenues(output price and demand) and production cost ( Raw material cost, energy cost and labor cost)

3.Financial Risks: arise from volatility of Interest rates, currency rates, commodity prices and stock prices.

4.Performance risks: arise when contracting counterparties do not fulfill their obligations.

5.Legal and Regulatory risks: change in laws and regulations

CLASSIFICATION OF RISK

To assess the Financial price risk we may:a)Examine the financial statements to get an idea of the risk exposureb)Assess the sensitivity of the firms value or cash flow to changes in the financial prices andc)Conduct Monte Carlo simulation.

MEASUREMENT OF RISK IN NON FINANCIAL FIRMS

Examining the Balance sheet and Profit & loss account throw light on a number of questions like:•Does the firm have a strong liquidity position as per high Current ratio and Quick ratio? A strong liquidity position cushions against the volatility of cash flows caused by changes in Financial prices.•Does the firm have a low gearing ratio (leverage)? A low gearing ration provides greater financial flexibility to cope with volatility in financial prices.•What is the Foreign exchange transaction exposure? If the balances of receivables and payables are high, their values would change in response to shifts in the exchange rates.•Is the firm exposed to interest rate risk? If the firm relies mainly on free floating debt it has a high interest rate exposure.

EXAMINE THE FINANCIAL STATEMENTS

Determine the sensitivity of Firm’s Value or Cash Flow by:

•Analyzing the Historical data on firm value, cash flows and financial prices

e.g. – The sensitivity of a firm’s value to exchange rate may be estimated as

Firm Value = a + b Exchange rate

ASSESS THE SENSITIVITY

•Monte carlo methods are used in finance to value and analyze (complex) instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes.

•The advantage of monte carlo methods over other techniques increases as the dimensions (sources of uncertainty) of the problem increase.

MONTE CARLO SIMULATION

• The Monte Carlo method is just one of many methods for analyzing uncertainty propagation, where the goal is to determine how random variation, lack of knowledge, or error affects the sensitivity, performance, or reliability of the system that is being modeled.

• Monte Carlo simulation is categorized as a sampling method because the inputs are randomly generated from probability distributions to simulate the process of sampling from an actual population. So, we try to choose a distribution for the inputs that most closely matches data we already have, or best represents our current state of knowledge. The data generated from the simulation can be represented as probability distributions (or histograms) or converted to error bars, reliability predictions, tolerance zones, and confidence intervals.

MONTE CARLO SIMULATION

• Normal – Or “bell curve.”  The user simply defines the mean or expected value and a standard deviation to describe the variation about the mean.  Values in the middle near the mean are most likely to occur.  It is symmetric and describes many natural phenomena such as people’s heights.  Examples of variables described by normal distributions include inflation rates and energy prices.

• Lognormal – Values are positively skewed, not symmetric like a normal distribution.  It is used to represent values that don’t go below zero but have unlimited positive potential.  Examples of variables described by lognormal distributions include real estate property values, stock prices, and oil reserves.

COMMON PROBABILITY DISTRIBUTIONS

• PERT- The user defines the minimum, most likely, and maximum values, just like the triangular distribution.  Values around the most likely are more likely to occur.  However values between the most likely and extremes are more likely to occur than the triangular; that is, the extremes are not as emphasized.  An example of the use of a PERT distribution is to describe the duration of a task in a project management model.

• Discrete – The user defines specific values that may occur and the likelihood of each.  An example might be the results of a lawsuit: 20% chance of positive verdict, 30% change of negative verdict, 40% chance of settlement, and 10% chance of mistrial.

MONTE CARLO SIMULATION

•One way to manage these risks and uncertainties is to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity’s other risks and uncertainties, transactions known as ‘hedges’. •The instrument acquired to offset risk or uncertainty is known as ‘hedging instrument’ and the risk or uncertainty hedged is known as ‘hedged item’.•There are predominantly two motivations for a company to hedge:

To lock-in a future price which is attractive, relative to an organisation’s costs.

To secure a commodity price fixed against an external contract

PRINCIPLE OF HEDGING

•Forward contract is an OTC agreement between two parties, to buy or sell an asset at a certain time in the future for a certain price. •The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. •This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. •The forward price is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. •The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit or loss, by the purchasing party.

HEDGING WITH FORWARD CONTRACTS

What Does Futures Contract Mean?

A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.

Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.

Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

HEDGING WITH FUTURE CONTRACTS

There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes.

1.Foreign exchange market

2.Money market

3.Bond market

4.Equity market

5.Soft Commodities market

TYPES OF FUTURE CONTRACTS

FUTURES HEDGING

What Does Swap Mean?

If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms.

For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate.

These firms could swap to take advantage of the lower rates.

HEDGING WITH SWAPS

• Interest rate swaps• Currency swaps• Commodity swaps• Equity swap• Credit default swaps• Other variations

TYPES OF SWAPS

•Spread compression•Market segmentation•Market saturation•Difference in financial norms

REASON FOR SWAPS

An option contract is an agreement under which the seller of the option grants the buyer the right, but not the obligation, to buy or sell(depending on whether it is a call option or a put option) some asset at a predetermined price during the specified period. The buyer of the option has to pay a premium to enjoy the right.

Forward vs options:

•In forwards contract both parties agree to act in the future whereas in an option transaction occurs only if the buyer of the option chooses to exercise it.

•In forward contract no money exchanges hands whereas in options the buyer of the contract pays option premium.

Hedging with options:diagrams

HEDGING WITH OPTION CONTRACTS

Imagine a firm going for a long term floating rate loan

The risks involved are the interest rates rising sharply increasing the debt service

burden

OPTIONS IN DEBT CONTRACTS

Main advantages offered by Insurance companies:

•They can price the risks reasonably accurately

•Provides low cost administration service due to specialisation and economies of scale.

•Provides advice on measures to reduce risks

•Pools risks by holding large diversified pool of assets

Disadvantages of Insurance:

•It incurs administrative costs

•Problem of adverse selection- cant differentiate between good and bad risks

•Exposed to problem of moral hazard

•Loading fee- diff between insurance premium and expected payoff.

HEDGING WITH INSURANCE

•Option contract on debt instruments- options on treasury bill•Option contract on foreign currencies– options with British pounds •Option contract on stock market indices-option on S&P 500 index•Option contract on stock index futures.

TYPES OF OPTION CONTRACTS

Real options-

•Diversify product line and services to reduce risks

•Invest in preventive maintenance

•Emphasise quality control to reduce product liability

•Build flexible production systems

•Shorten time to introduce product to market

•Delay investment until uncertainty is resolved

•Carry extra liquidity on the balance sheet to tide over difficult periods

•Maintain reserve borrowing power to meet contingencies.

HEDGING WITH REAL TOOLS AND OPTIONS

• Real options cost a great deal. • In some cases real options may be the only viable

means to handle risks• Real options are far less liquid• Firm with real options may profit from assuming

more risk – a firm with flexible production facilities can benefit more by manufacturing products subject to high price volatility.

REAL VS. FINANCIAL OPTIONS

The financial and operating environment today is more riskier than in the past –•Substantial increase in the average rate as well as volatility of inflation•Greater volatility in interest rates , exchange rates, and commodity prices•Increased global competition.

EVOLUTION OF RISK MANAGEMENT TOOLS

•Exchange rate volatility- currency futures, currency swaps, currency options•Interest rate volatility- floating rate loans, T-Bill futures, T-Bond futures, options on T-Bonds, caps floors and collars.•Petroleum prices- futures in heating oil, futures in WTI, hybrids, option in WTI•Metal price volatility- fwds, futures, options,hybrids.

VOLATILITY AND RISK MANAGEMENT TOOLS:

Corporate strategy – bricks and mortar

TVA

RISK MANAGEMENT PRACTICES

•Align risk management with corporate strategy•Proactively manage uncertainties•Employ mix of real and financial methods•Know the limits of risk management tools•Don’t put undue pressure on corporate treasury to generate profits•Learn when it is worth reducing risk

GUIDELINES FOR RISK MANAGEMNET