Agenda. Learning Objectives. Corporate Risk Management. Chapter 20. Learning Objectives Principles Used in This Chapter

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1 Chapter 20 Corporate Risk Management Agenda Learning Objectives Principles Used in This Chapter 1. Five-Step Corporate Risk Management Process 2. Managing Risk with Insurance Contracts 3. Managing Risk by Hedging with Forward Contracts 4. Managing Risk with Exchange-Traded Financial Derivatives 5. Valuing Options and Swaps Learning Objectives 1. Define risk management in the context of the five-step risk management process. 2. Understand how insurance contracts can be used to manage risk. 3 Use forward contracts to hedge commodity price risk 3. Use forward contracts to hedge commodity price risk. 4. Understand the advantages and disadvantages of using exchange traded futures and option contracts to hedge price risk. 5. Understand how to value option and how swaps work. 1

2 Principles Used in This Chapter Principle 2: There is a Risk-Return Tradeoff. Business is inherently risky but a lot of risk that a firm is exposed to are at least partially controllable through the use of financial contracts. Corporations are devoting increasing amounts of time and resources to the active management of their risk exposure Five Step Corporate Risk Management Process Five Step Corporate Risk Management Process 1. Identify and understand the firm s major risks. 2. Decide which type of risks to keep and which to transfer. 3. Decide how much risk to assume. 4. Incorporate risk into all the firm s decisions and processes. 5. Monitor and manage the risk that the firm assumes. 2

3 Step1: Identify and Understand the Firm s Major Risks Identifying risks relates to understanding the factors that drive the firm s cash flow volatility. For example: Demand risk - fluctuations in demand Commodity risk fluctuations in prices of raw materials Country risk unfavorable government policies Operational risk cost overruns in firm s operations Exchange rate risk changes in exchange rates Step1: Identify and Understand the Firm s Major Risks All the listed sources of risk (except operational risk) are external to the firm. Risk management generally focuses on managing external factors that cause volatility in firm s cash flows. Step 2: Decide Which Type of Risk to Keep and Which to Transfer This is perhaps the most critical step. For example, oil and gas exploration and production firms have historically i chosen to assume the risk of fluctuations ti in the price of oil and gas. However, some firms have chosen to actively manage the risk. 3

4 Step 3: Decide How Much Risk to Assume Figure 20-1 illustrates the cash flow distributions for three risk management strategies. The specific strategy chosen will depend upon the firm s attitude to risk and the cost/benefit analysis of risk management strategies. Step 4: Incorporate Risk into All the Firm s Decisions and Processes In this step, the firm must implement a system for controlling the firm s risk exposure. For example, for those risks that will be transferred, the firm must determine an appropriate means of transferring risk such as developing a hedging strategy or buying an insurance policy. 4

5 Step 5: Monitor and Manage the Risk the Firm Assumes An effective monitoring system ensures that the firm s dayto-day decisions are consistent with its chosen risk profile. This may involve centralizing the firm s risk exposure with a chief risk officer who assumes responsibility for monitoring and regularly reporting to the CEO and to the firm s board Managing grisk with Insurance Contracts Managing Risk with Insurance Contracts Insurance is a method of transferring risk from the firm to an outside party, in exchange for a premium. There are many types of insurance contracts that provide protection against various events. 5

6 20.3 Managing Risk by Hedging with Forward Contracts Managing Risk by Hedging with Forward Contracts Hedging refers to a strategy designed to offset the exposure to price risk. Example 20.1 If you are planning to purchase 1 million Euros in 6 months, you may be concerned that if Euro strengthens it will cost you more in U.S. dollars. Such risk can be mitigated with forward contracts. 6

7 Managing Risk by Hedging with Forward Contracts Forward contract is a contract wherein a price is agreedupon today for asset to be sold or purchased in the future. Since the price is locked-in today, risk from future price fluctuation is reduced. These contracts are privately negotiated with an intermediary such as an investment bank. Managing Risk by Hedging with Forward Contracts Thus in example 20.1, you could negotiate a rate today for Euros (say 1 Euro = $1.35) using a forward contract. In 6-months, regardless of whether Euro has appreciated or depreciated, your obligation will be to buy 1 million Euros at $1.35 each or $1.35 million. Managing Risk by Hedging with Forward Contracts The following table shows potential future scenarios and the cash flows. It is seen that Forward contract helps to reduce risk if Euro appreciates. However, if Euro depreciates, Forward contract obligates the firm to pay a higher amount. Future Cost with a Cost without a Effect of Exchange Rate of Euro Forward Contract Forward contract Forward Contract $1.20 $1.35 million $1.20 million Unfavorable $1.30 $1.35 million $1.30 million Unfavorable $1.40 $1.35 million $1.40 million Favorable $1.50 $1.35 million $1.50 million Favorable 7

8 Checkpoint 20.1 Hedging Crude Oil Price Risk Using Forward Contracts Progressive Refining Inc. operates a specialty refining company that refines crude oil and sells the refined by-products to the cosmetic and plastic industries. The firm is currently planning for its refining needs for one year hence. The firm s analysts estimate that Progressive will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feedstock for its refining needs for the coming year. The 1 million barrels of crude will be converted into byproducts at an average cost of $30 per barrel. Progressive will then sell the by-products for $165 per barrel. The current spot price of oil is $125 per barrel, and Progressive has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $130 per barrel. a. Ignoring taxes, if oil prices in one year are as low as $110 or as high as $140, what will be Progressive s profits (assuming the firm does not enter into the forward contract)? b. If the firm were to enter into the forward contract to purchase oil for $130 per barrel, demonstrate how this would effectively lock in the firm s cost of fuel today, thus hedging the risk that fluctuating crude oil prices pose for the firm s profits for the next year. Checkpoint 20.1 Checkpoint

9 Checkpoint 20.1 Checkpoint 20.1 Checkpoint

10 Checkpoint 20.1: Check Yourself Consider the profits that Progressive might earn if it chooses to hedge only 80% of its anticipated 1 million barrels of crude oil under the conditions above. Step 1: Picture the Problem The figure shows that the future price of crude oil could have a dramatic impact on the total cost of 1 million barrels of crude oil. If the price is not managed it will significantly affect the If the price is not managed, it will significantly affect the future profits of the firm. 10

11 Step 2: Decide on a Solution Strategy The firm can hedge its risk by purchasing a forward contract. This will lock-in the future price of oil at the forward rate of $130 per barrel. Step 3: Solve The table on the next slide contains the calculation of firm profits for the case where the price of crude oil is not hedged (column E), the payoff to the forward contract (column F) and firm profits where the price of crude is 80% hedged d (column G). Step 3: Solve 80% Hedged Price of Oil/bbl Total Cost of Oil Total Revenues Total Refining Costs Unhedged Annual Profits Profit/Loss on Forward Contract 80% Hedged Annual Profits A B=Ax1m C D=$30x1m E=C+B+D =(A- $130)x1mx%Hedge G=E+F $110 $(110,000,000) $165,000,000 $(30,000,000) $25,000,000 $(16,000,000) $9,000, (115,000,000) $165,000,000 (30,000,000) $20,000,000 $(12,000,000) 8,000, (120,000,000) $165,000,000 (30,000,000) $15,000,000 $(8,000,000) 7,000, (125,000,000) $165,000,000 (30,000,000) $10,000,000 $(4,000,000) 6,000, (130,000,000) $165,000,000 (30,000,000) $5,000,000 $ 5,000, (135,000,000) $165,000,000 (30,000,000) $0 $4,000,000 4,000, (140,000,000) $165,000,000 (30,000,000) $(5,000,000) $8,000,000 3,000,000 11

12 Step 4: Analyze The total cost of crude oil increases as the price of crude oil increases. The unhedged annual profits range from a loss of $5 million to a gain of $25 million. With 80% hedging, losses are avoided and the firm ends with profits ranging from $3 million to $5million. The forward contract obviously benefits the firm when the price of oil is higher than $130. Hedging Currency Risk Using Forward Contracts Currency risk can be hedged using forward contracts. For example, Disney expects to receive 500 million from its Tokyo operations in 3 months. Disney can lock-in the exchange rate to avoid any losses if the Yen weakens in 3 months. Hedging Currency Risk Using Forward Contracts Disney will follow a 2-step procedure to hedge its currency risk: 1. (Today): Enter into a forward contract which requires Disney to sell 500 million at the forward rate of say $0.0095/. 2. (In three months): Disney will convert its 500 million at the contracted forward rate, yielding $4,750,000 ( 500 m $0.0095=$4,750,000). With a forward contract, Disney will receive $4,750,000 regardless of the exchange rate in the market. 12

13 Limitations of Forward Contract 1. Credit or default risk: Both parties are exposed to the risk that the other party may default on their obligation. 2. Sharing of strategic information: The parties know what specific risk is being hedged. 3. It is hard to determine the market values of negotiated contracts as these contracts are not traded. Limitations of Forward Contract These limitations of forward contracts can be addressed by using exchange-traded contracts such as exchange traded futures, options, and swap contracts Managing Risk with Exchange-Traded Derivatives 13

14 Managing Risk with Exchange-Traded Derivatives A derivative contract is a security whose value is derived from the value of the underlying asset or security. In the examples considered on forward contract, the underlying assets were oil and currency. Exchange traded derivatives cannot be customized (like forward contracts) and are available only for specific assets and for limited set of maturities. Futures Contract A futures contract is a contract to buy or sell a stated commodity (such as wheat) or a financial claim (such as U.S. Treasuries) at a specified price at some future specified time. These contracts, like forward contracts, can be used to lock-in future prices. Futures Contract There are two categories of futures contracts: Commodity futures are traded on agricultural products, metals, wood products, and fibers. Financial futures include, for example, Treasuries, Eurodollars, foreign currencies, and stock indices. Financial futures dominate the futures market. 14

15 Managing Default Risk in Futures Market Default is prevented in futures contract in two ways: 1.Margin Futures exchanges require participants to post collateral called margin. 2.Marking to Market Daily gains or losses from a firm s futures contract are transferred to or from its margin account. Hedging with Futures Contract Similar to forward contracts, firms can use futures contract to hedge their price risk. If the firm is planning to buy, it can enter into a long hedge by purchasing the appropriate futures contract. If the firm is planning to sell, it can sell (or short) a futures contract. This is known as a short hedge. 15

16 Hedging with Futures Contract There are practical limitations with futures contract: It may not be possible to find a futures contract on the exact asset. The hedging firm may not know the exact date when the hedged asset will be bought or sold. The maturity of the futures contract may not match the anticipated risk exposure period of the underlying asset. Hedging with Futures Contract Basis risk is the failure of the hedge for any of the above reasons. Basis risk occurs whenever the price of the asset that underlies the futures contract is not perfectly correlated with the price risk the firm is trying to hedge. Hedging with Futures Contract If a specific asset is not available, the best alternative is to use an asset whose price changes are highly correlated with the asset. For example, hedging corn with soybean future if the prices of the two commodities are highly correlated. If a contract with exact duration is not available, the analysts must select a contract that most nearly matches the maturity of the firm s risk exposure. 16

17 Option Contracts Options are rights (not an obligation) to buy or sell a given number of shares or an asset at a specific price over a given period. The option owner s right to buy is known as a call option while the right to sell is known as a put option. Option Contracts Exercise price: The price at which the asset can be bought or sold. Option premium: The price paid for the option. Option expiration date: The date on which the option contract expires. American option: These options can be exercised anytime up to the expiration date of the contract. European option: These options can be exercised only on the expiration date. Option Contracts For example, if you buy a call option on 100 shares of XYZ stock at a premium of $4.50 and exercise price of $40 maturing in 90 days. You can buy the XYZ stock at $40 even though the You can buy the XYZ stock at $40, even though the market price of the stock maybe above $40. If the stock price is below $40, you will choose not to use your option contract and will lose the premium paid. 17

18 Option Contracts For example, if you buy a put option on 100 shares of ABC stock at a premium of $10.50 and exercise price of $70 maturing in 90 days. You can sell the ABC stock at $70, even though the market price of the stock maybe below $70. If the market price of stock is above $70, you will choose not to use your option contract and will lose the premium paid. A Graphical Look at Option Pricing Relationships Figures 20-5 to Figures 20-8 graphically illustrate the expiration date profit or loss from the following option positions: Buying a call option (figure 20-5) Selling or writing a call option (figure 20-6) Buying a put option (figure 20-7) Selling or writing a put option (figure 20-8) The graphs are based on the following assumptions: Exercise price for call and put options = $20 Call premium = $4 Put premium = $3 18

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20 A Graphical Look at Option Pricing Relationships Buy Call Write Call Buy Put Write Put Maximum Profit Unlimited Premium Exercise Price - Premium Premium Maximum Loss Premium Unlimited Premium Exercise Price - Premium Future Market Expectation Bullish Bearish Bearish Bullish Break-even Point Exercise Price + Premium Exercise Price + Premium Exercise Price Premium Exercise Price - Premium 20.5 Valuing Options and Swaps Valuing Options and Swaps The value of option can be regarded as the present value of the expected payout when the option expires. The most popular option pricing model is the Black- Scholes Option Pricing Model (BS-OPM). 20

21 Black-Scholes Option Pricing Model There are six variables that impact the price of an option: 1. The price of the underlying stock 2. The option s exercise or strike price 3. The length of time left until expiration 4. The expected stock price volatility 5. The risk free rate of interest 6. The underlying stock s dividend yield Black-Scholes Option Pricing Model What IF Value of Call option Value of Put Option Price of underlying stock increases Increases Decreases Exercise price is higher Decreases Increases Time to expiration is longer Increases Increases Stock price volatility is higher over the life of the option Increases Increases Risk-free rate of interest is higher Increases Decreases The stock pays dividend Decreases Increases Black-Scholes Option Pricing Model Black-Scholes option pricing model for call options is stated as follows: 21

22 Checkpoint 20.3 Valuing a Call Option Using the Black-Scholes Model Consider the following call option: the current price of the stock on which the call option is written is $32.00; the exercise or strike price of the call option is $30.00; the maturity of the option is.25 years; the (annualized) variance in the returns of the stock is.16; and the risk-free rate of interest is 4% per annum. Use the Black-Scholes option pricing model to estimate the value of the call option. Checkpoint 20.3 Checkpoint

23 Checkpoint 20.3: Check Yourself Estimate the value of the above call option when the exercise price is $25. Step 1: Picture the Problem Given: Current price of stock = $32 Exercise price = $25 Maturity = 90 days or 0.25 years Variance in stock returns =.16 Risk-free rate =12% per annum Step 1: Picture the Problem Stock Price Call Premium Exercise Price Exercised or Not Profit or Loss A B C D E =Max(O, A-C)-B $20 ($5) $25 No ($5) Profit when stock is $25 or $32 $25 ($5) $25 No ($5) $30 ($5) $25 Yes $0 $32 ($5) $25 Yes $2 $35 ($5) $25 Yes $5 $40 ($5) $25 Yes $10 Break-even point 23

24 Step 1: Picture the Problem $12 Profits from Buying Calls $10 $8 Profits, Exercise Pric ce =$25 $6 $4 $2 $0 $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 ($2) ($4) ($6) Stock Price Step 2: Decide on a Solution Strategy Equation 20-1 can be used to determine the value of call option using Black-Scholes option pricing model. Step 3: Solve Line d-1 (steps) Computation 1 In(S/E) R=.5(Variance) xt line 2* Numerator line 1+line txvariance.16* Sqrt(T*Variance) sqrt(line5) d-1 line 4/line

25 Step 3: Solve Line d-2 (steps) Computation o 8 txvariance.16* sqrt(t*variance) sqrt (line 8) d-2 line (7-9) N(d1) Normsdist (line7) N(d2) Normsdist (line10) Step 3: Solve Line Call value (steps) Computation o 13 S*N(d-1) $32*line R*t -0.12* exp^(-r*t) exp (line 14) E*e^RT*N(d-2) $25*line 15*line Call Value Line 13-Line Step 4: Analyze The value of this option is $7.95 using BS-OPM. The current stock price of $32 represents a $7 profit over the exercise price of $25. The additional $0.95 can be seen as the time value of the call option Premium available in the market for the possibility that stock price may rise even higher over the next 90 days. 25

26 Swap Contract A swap contract involves the swapping or trading of one set of payments for another. A currency swap involves exchange of debt obligations in different currencies. An interest rate swap involves trading of fixed interest payments for variable or floating rate interest rate payments between two currencies. A swap contract can be thought of as a series of forward contracts. Swap Contract Figure illustrates 5-year fixed for floating interest rate swap and a notational principal of $250 million. Notational principal is the amount used to calculate payments for the contract but this amount does not change hands. The floating rate = 6-month LIBOR The fixed rate = 9.75% Interest is paid semi-annually. 26