Derivatives and Risk Management.24.St

7/28/2019 Derivatives and Risk Management.24.St

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Introduction to Derivatives and

Risk Management

Corporate Finance

Dr. A. DeMaskey


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Learning Objectives

Questions to be answered:

Why should a company manage its risk?

What financial techniques can be used toreduce risk?

What are derivatives?

What are the important characteristics of thevarious types of derivative securities?

How should derivatives be used to managerisk?


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Reasons to Manage Risk

Do stockholders care about volatile cashflows?

If volatility in cash flows is not caused bysystematic risk, then stockholders can eliminatethe risk of volatile cash flows by diversifyingtheir portfolios.

Stockholders might be able to reduce impact ofvolatile cash flows by using risk managementtechniques in their own portfolios.


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How can risk management increase the value of a

corporation?

Risk management allows firms to:

Have greaterdebt capacity, which has a larger tax

shield of interest payments.

Implement the optimal capital budget withouthaving to raise external equity in years that would

have had low cash flow due to volatility.


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Avoid costs offinancial distress.

Weakened relationships with suppliers.

Loss of potential customers.

Distractions to managers.Utilize comparative advantage in hedging

relative to hedging ability of investors.


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Reduceborrowing costsby using interest

rate swaps.

Minimize negative tax effects due to

convexity in tax code.


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Growth of Derivatives Market

Analytical techniques

Technology

Globalization


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Derivative Securities

Derivative: Security whose value stemsor is derived from the value of other assets.

Types of Derivatives

Forward

Futures

Options

Swaps


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Forward Contracts

An agreement where one party agrees to buy (orsell) the underlying asset at a specific future dateand a price is set at the time the contract is entered

into. Characteristics

Flexibility

Default risk

Liquidity risk

Positions in Forwards

Long position

Short position


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Futures Contracts

A standardized agreement to buy or sell aspecified amount of a specific asset at a fixed price

in the future. Characteristics

Margin Deposits

Initial margin

Maintenance margin

Marking-To-Market

Floor Trading

Clearinghouse


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Hedging with Futures

Hedging: Generally conducted where a pricechange could negatively affect a firms profits.

Long hedge: Involves the purchase of a futurescontract to guard against a price increase.

Short hedge: Involves the sale of a futures contractto protect against a price decline in commodities or

financial securities. Perfect hedge: Occurs when gain/loss on hedge

transaction exactly offsets loss/gain on unhedgedposition.


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Option Contracts

The right,but not the obligation, to buy or sell aspecified asset at a specified price within a

specified period of time. Option Terminology

Call option versus put option

Holder versus writer or grantor

Exercise or strike price Option premium

American versus European option

Market Arrangements


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Swap Contracts

Financial contracts obligating one party toexchange a set of payments it owns for another set

of payments owed by another party. Currency swaps

Interest rate swaps

Usually used because each party prefers the terms

of the others debt contract. Reduces interest rate risk or currency risk for both

parties involved.


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Different Types of Risk

Speculative risks: Thosethat offer the chance of again as well as a loss.

Pure risks: Those that offer

only the prospect of a loss. Demand risks: Those

associated with the demandfor a firms products orservices.

Input risks: Thoseassociated with a firmsinput costs.

Financial risks: Those thatresult from financial

transactions.

Property risks: Thoseassociated with loss of afirms productive assets.

Personnel risk: Risks that

result from human actions. Environmental risk: Risk

associated with polluting theenvironment.

Liability risks: Connected

with product, service, oremployee liability.

Insurable risks: Thosewhich typically can becovered by insurance.


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An Approach to Risk

Management Corporate risk management is the management of

unpredictable events that would have adverse

consequences for the firm. Firms often use the following process for

managing risks.

Step 1. Identify the risks faced by the firm.

Step 2. Measure the potential impact ofthe identified risks.

Step 3. Decide how each relevant riskshould be dealt with.


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Techniques to Minimize Risk

Transfer riskto an insurance company by paying periodic

premiums.

Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial

risks.

Take actions to reduce the probability of occurrence of

adverse events. Take actions to reduce the magnitude of the loss associated

with adverse events.

Avoidthe activities that give rise to risk.


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Nature and Purpose ofTrading in Financial

Derivatives

Financial riskexposure refers to the risk inherent

in the financial markets due to price fluctuations. Hedging

Protect Value of Securities Held

Protect the Rate of Return on a Security Investment

Reduce Risk of Fluctuations in Borrowed Costs

Speculating


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Using Derivatives to Reduce

RiskCommodity Price Exposure

The purchase of a commodity futures contract will

allow a firm to make a future purchase of the input attodays price, even if the market price on the item hasrisen substantially in the interim.

Security Price Exposure

The purchase of a financial futures contract will allow afirm to make a future purchase of the security at todaysprice, even if the market price on the asset has risensubstantially in the interim.


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Using Derivatives to Reduce

Risk Foreign Exchange Exposure

The purchase of a currency futures or options contract

will allow a firm to make a future purchase of thecurrency at todays price, even if the market price on

the currency has risen substantially in the interim.


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Risks to Corporations from

Financial Derivatives

Increases financial leverage

Derivative instruments are too complex

Risk of financial distress

Derivatives and Risk Management.24.St

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