Off-Balance SheetOff-Balance SheetManaging RiskManaging Risk

Off-Balance SheetOff-Balance Sheet

Liabilities on the balance sheet Liabilities on the balance sheet represent liabilities that are represent liabilities that are both firm and quantifiable.both firm and quantifiable.

Some “liabilities” are not on the Some “liabilities” are not on the balance sheet because they are balance sheet because they are either not firm (such as risks), or either not firm (such as risks), or not quantifiable (meaning the not quantifiable (meaning the actual dollar liability is actual dollar liability is unknown).unknown).

OBS FinancingOBS Financing

The most common off-balance The most common off-balance sheet financing is an operating sheet financing is an operating lease.lease. Capital leases show up on the Capital leases show up on the

balance sheet, but operating balance sheet, but operating leases do not.leases do not.

Analysts can estimate a value to Analysts can estimate a value to put them on the balance sheet.put them on the balance sheet.

OBS PensionOBS Pension

A long-term liability receiving A long-term liability receiving more attention today is pension more attention today is pension agreements.agreements.

There are two main types of There are two main types of pensions:pensions: Defined contributionDefined contribution Defined benefitDefined benefit

OBS Defined ContributionOBS Defined Contribution

With a defined contribution With a defined contribution pension, the company is only pension, the company is only liable for the contribution.liable for the contribution. As long as they have made the As long as they have made the

contribution to a pension fund as contribution to a pension fund as they agreed, their liability is over.they agreed, their liability is over.

OBS Defined BenefitOBS Defined Benefit

With the defined benefit plan, With the defined benefit plan, the company agreed to pay the the company agreed to pay the employee a certain living (and employee a certain living (and sometime health insurance) sometime health insurance) until they die.until they die. The amount of liability is unknown, The amount of liability is unknown,

and therefore not stated on the and therefore not stated on the balance sheet.balance sheet.

They have assets to offset some of They have assets to offset some of these costs – but they tend to be these costs – but they tend to be insufficient.insufficient.

Managing RiskManaging Risk

In a firm’s attempt to manage In a firm’s attempt to manage its risk, it can incur off-balance its risk, it can incur off-balance sheet liabilities.sheet liabilities.

These activities can (in some These activities can (in some instances must) be disclosed in instances must) be disclosed in the notes to the financial the notes to the financial statements.statements.

Managing RisksManaging Risks

Risk reduction does not add Risk reduction does not add valuevalue Hedging is a zero sum gameHedging is a zero sum game Investors’ always have a do-it-Investors’ always have a do-it-

yourself alternativeyourself alternative How?How?

Insurance (may not be disclosed)Insurance (may not be disclosed) Hedging (must be disclosed)Hedging (must be disclosed)

InsuranceInsurance

Most businesses face the Most businesses face the possibility of a hazard that can possibility of a hazard that can bankrupt the company in an bankrupt the company in an instant.instant.

These risks are neither financial These risks are neither financial or business and can not be or business and can not be diversified.diversified.

The cost and risk of a loss due The cost and risk of a loss due to a hazard, however, can be to a hazard, however, can be shared by others who share the shared by others who share the same risk. same risk.

HedgingHedging Spot Contract - A contract for Spot Contract - A contract for

immediate sale & delivery of an immediate sale & delivery of an asset. asset.

Forward Contract - A contract Forward Contract - A contract between two people for the delivery between two people for the delivery of an asset at a negotiated price on a of an asset at a negotiated price on a set date in the future. set date in the future.

Futures Contract - A contract similar Futures Contract - A contract similar to a forward contract, except there is to a forward contract, except there is an intermediary that creates a an intermediary that creates a standardized contract. Thus, the two standardized contract. Thus, the two parties do not have to negotiate the parties do not have to negotiate the terms of the contract.terms of the contract.

Futures ContractsFutures Contracts

Margins – required to put up a Margins – required to put up a portion of the purchase price portion of the purchase price now to demonstrate financial now to demonstrate financial ability.ability.

Marked to Market – The change Marked to Market – The change in market prices are adjusted in market prices are adjusted daily; you may pay more, or daily; you may pay more, or receive partial refunds receive partial refunds depending on the spot market depending on the spot market for that good.for that good.

Futures ContractFutures Contract

The basic relationship between futures prices and spot prices for equity securities.

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Futures ContractsFutures Contracts

The basic relationship between futures prices and spot prices for commodities.

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OptionsOptions

In addition to futures, firms can In addition to futures, firms can be commodity, financial and be commodity, financial and currency options.currency options.

An option allows the holder to An option allows the holder to buy (call) or sell (put) a product, buy (call) or sell (put) a product, commodity or currency at an commodity or currency at an agreed upon rate.agreed upon rate. But they do not need to exercise But they do not need to exercise

that option.that option.

SwapsSwaps

Definition - An agreement Definition - An agreement between two firms, in which between two firms, in which each firm agrees to exchange each firm agrees to exchange the “interest rate the “interest rate characteristics” of two different characteristics” of two different financial instruments of identical financial instruments of identical principal.principal.

SwapsSwaps

Key points regarding interest Key points regarding interest rate swaps:rate swaps: Know whether your company is the Know whether your company is the

fixed rate payer (usually) or the fixed rate payer (usually) or the floating rate payer.floating rate payer. Note that usually, the maturity of the Note that usually, the maturity of the

note is affected by the market rate.note is affected by the market rate. Who are the counterparties?Who are the counterparties? Swap gain = Fixed spread – Swap gain = Fixed spread –

Variable spreadVariable spread

SwapsSwaps

Currency swaps: Swapping Currency swaps: Swapping currency streams.currency streams. For example - borrowing in dollars, For example - borrowing in dollars,

and repaying in yen (via a swap and repaying in yen (via a swap arrangement).arrangement).

In some instances, a counterparty In some instances, a counterparty may be found who wants to do the may be found who wants to do the other end of the agreementother end of the agreement Sometimes it is just a speculator.Sometimes it is just a speculator.

HedgingHedging

A true hedge is one where risk is A true hedge is one where risk is reduced to zero.reduced to zero. You sell a futures contract for You sell a futures contract for

10,000 bushels of corn, and you 10,000 bushels of corn, and you have the 10,000 bushels of corn.have the 10,000 bushels of corn.

Many firms believe they are Many firms believe they are hedging, and reducing risks hedging, and reducing risks when they can in fact be when they can in fact be increasing their risks.increasing their risks.