Risk Management. Matti Suominen, Aalto

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1 Risk Management Matti Suominen, Aalto 1

2 Forwards WHAT ARE FORWARDS AND FUTURES? Spot Markets: In the spot markets, is it for currencies, stocks or bonds, the transactions which take place today are actually settled two or three days after the transaction takes place. In this sense, even the spot markets are forward markets, i.e., you fix the price (or exchange rate) today but the delivery and the payment happen only two or three days later. Forward Markets: In a forward contract you make a firm commitment to buy or sell a certain quantity of, say, currency on some future date (3, 6 or 12 months ahead) at a price, the forward price, which is fixed already today. The forward price is set so that it costs nothing to enter a forward contract. There is typically no physical market place for forward markets but banks make these deals over the counter with companies who want to hedge their positions. 2

3 Forward Pricing Example: Price of GM share today = $50 Risk-free interest rate = 3% p.a. 12 months forward price of GM share = F 12 (=price such that it costs nothing to enter a forward contract) Expected dividends over the next 12 months = 0. The forward price can be understood by looking at a buyer s situation: Buying GM today costs: Buying GM using a forward contract costs: 3

4 Forward Pricing The cost of these two alternatives must be the same: PV(F 12 )=$50. a F 12 = $50 x (1+0.03) = More generally: The fair forward price is: F T t = (S t -PV[dividends]) x (1+r A )(T-t) where r A is the simple risk-free annual interest rate. 4

5 Forward prices versus expected future prices Note that all we have to know in order to determine the forward price is: The current price of the underlying. The interest rate. The length of time until delivery. In our example, the forward price is different from the expected stock price in 12 months time (if investors are risk averse) which is: E( S12) = S0 (1 + rf + βπ) For instance, if: Market risk premium π = 6% β of GM stock = 1 E(S 12 ) = $50 x ( ) = 54.5 Does the fact that today s forward price for GM stock is below the expected future price of GM mean that you should purchase GM forward contracts today? {Note: To get the expected stock price, we use CAPM: E(R GM )=r f +βπ for the expected return and multiply S 0 x (1+E(R GM ))} 5

6 Futures Futures contracts are like forwards: A contract to buy (or sell) a specified amount of a specified asset at a fixed price on a given date in the future. But: Contracts are traded on exchanges (forwards are OTC) Contracts are standardized w.r.t. quality, quantity, delivery dates etc. Contracts are marked to market, which means that gains and losses from any position are settled at the end of each trading day! Effectively, the futures contract is rewritten every day to reflect the new futures price (price at which it costs nothing to enter the position) and the difference between the yesterday s and today s futures price is exchanged between the parties of the contracts. In spite of this continuous settlement of gains and losses, the exchange also requires that you keep some assets/funds deposited at the exchange to guarantee that you can honor your commitments. These are know as margin requirements. Because of these differences, there can be small differences in price between the forward and futures. 6

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8 Reduce expected costs of financial distress: Financial distress is more likely when cash flows are volatile. By reducing the volatility of cash flows through hedging, firms can reduce the likelihood and expected costs of distress. 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Probability of default Cashflows after hedging Cashflows before hedging Costs of financial distress are large for firms that have to convince customers they are in for the long run; banks, auto manufacturers etc. 8

9 Examples of Risks and Hedging Instruments Risk Real Hedge Financial Hedge Commodity price Forward/backward integration, Commodity futures, options, long term fixed price contracts. Commodity price linked bonds. Exchange rate Foreign direct investment Foreign exchange forwards, foreign currency borrowing, currency swaps. Interest rate Interest rate swaps, options, futures, forward rate agreements. Liquidity Diversifying borrowing sources, managing maturities. Natural disaster Geographic diversification Insurance. Nationalization 9

10 Risk Management and Hedging: The Value Added Reasons for hedging Reduces risk of financial distress Avoid having to raise (costly) external funds Can increase leverage (ROE increases) Can take more business risk (growth)!! 10

11 Risk Management and Hedging Other reasons for hedging Better tax planning Better contracting for managers Possibility to use more debt financing Separating bets Suppose I have private information that Microsoft is going to report excellent quarterly earnings. I can take a bet on Microsoft but not on the US market by buying Microsoft s shares and selling the S&P 500 futures. This leaves me exposed only to the risk that I know about. I can take bigger bets 11

12 How to set up a Hedge? Suppose a small German manufacturing company has sold some auto parts to the US last week. They know they will receiver $400,000 six months from now. The value of this money is 360,000 today, evaluated at today s /$ spot rate of The company is worried about its exposure to the decline of the dollar. What can it do? Let s assume that this is the only currency exposure that the company has. Suppose that the forward exchange rate F 6 /$ = What are the different possibilities for hedging?

13 How to set up a Hedge? 1. Forward contract 2. Futures contract 3. Hedging using currency options Suppose that a put option to sell $400,000 with an exercise price 0.9 /$, expiring in 6 months time, costs 25,000 today. Euro Net Cash flow at maturity 250 Euro/Dollar

14 Other Hedging Possibilities Borrow in the currency where you have receivables. Purchase raw materials using that currency. Real Hedge: Sometimes financial hedges are not feasible or companies want to consider longer term solutions: For instance, Japanese car manufacturers exporting cars to the US. Rather than hedging, they set up plants in the US. Basis Risk: If an airline wants to hedge the price risk of jet fuel it cannot do so perfectly because no futures on jet fuel are traded. Instead, they can hedge using heating oil or crude oil futures but this subjects them to basis risk (i.e., risk that the heating oil and jet fuel prices move in different directions). In this case, the amount that is hedged should be chosen to minimize the overall variability of the hedged position.

15 Structured Products Also structured products can be used to reduce risks? Commodity linked bonds (e.g., Shell issuing a bond with coupon tied to oil price). Investors may want exposure to commodities (e.g., have opposite exposure or have restrictions to invest in commodities). Note positive tax effect! Reverse Floating Rate note (life insurance company has low returns when interest rate is high). A mutual fund may be interested to purchase. Contingent Capital: E.g., an option to issue equity at a predefined price (or option not to repay debt) in case of a predefined event: e.g., less than 1% GDP growth, Structured products for investors: capital protection

16 Financial Innovations: Contingent Capital 1. Definitions and contract design 2. Benefits of contingent capital 3. Contingent Capital vs other risk financing instruments 4. Conclusions 16

17 CONTINGENT CAPITAL is a flexible tool allowing firms to integrate risk management and capital structure. q Technically, it is an option giving the right to raise capital at predetermined terms upon the occurrence of an agreed-upon event. q The capital injected can be (subordinated) debt, preferred shares, or common equity. q Unlike usual options, the contingency is need not be based on the value of the underlying asset. q For example, triggers can be related to natural hazards, financial markets, commodity prices, the state of the economy, etc. 17

18 FT s definition of contingent capital Contingent capital is debt that converts into equity when there is a crisis or when certain triggers are met. Regulators have made no secret of their fondness for contingent capital - it keeps down the cost of capital in the short term, by classifying it as debt, but provides a buffer in case of emergencies that can be switched into lossabsorbing equity. Example Although most contingent capital will be debt that converts, in extreme circumstances, into equity, i.e., so called contingent convertible bonds or Cocos. There are other kinds of contingent capital, e.g., the equity that the Royal Bank of Scotland can raise from the government in times of stress. In that case there's nothing underpinning that in the form of debt, it is just a kind of promise. 18

19 Other Examples q Example 2: Tokyo Disneyland. Value: $200m Organized by Goldman Sachs. Disney issues $200m worth of bonds, with the provision that it will not pay them back in the case of an earthquake. q Example 3: Royal Bank of Canada. Value: $133m Organized by Swiss Re. RBC has the option to sell to Swiss Re C$200m of preferred stock, in the event of a certain deterioration of RBC s loan portfolio. 19

20 Benefits of Contingent Capital Benefits of contingent capital versus paid-in capital: 1. Saves capital: capital is raised only if and when needed; 2. Cheaper: Capital is most expensive when it is needed the most! 3. Insurance: provides insurance, without deteriorating EBIT; 4. Protects balance sheet from adverse contingencies; 5. Saves on liquidity: off balance sheet reserves ; 6. Reduces on-balance sheet capital without increasing overall risk-profile; 20

21 Some remain critical about these new financial innovations 21

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Review of Derivatives I. Matti Suominen, Aalto

Review of Derivatives I. Matti Suominen, Aalto Review of Derivatives I Matti Suominen, Aalto 25 SOME STATISTICS: World Financial Markets (trillion USD) 2 15 1 5 Securitized loans Corporate bonds Financial institutions' bonds Public debt Equity market