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Principles of Corporate Finance

Part 8 Risk Management

2011/9/17

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Part 8 Risk Management

Chapter26:Managing Risk

Chapter27: Managing International Risks

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Chapter26 Managing Risk

26-1 Why Manage Risk? 26-2 Insurance 26-3 Reducing Risk with Options 26-4 Forward and Futures Contracts 26-5 Swaps 26-6 How to Set Up a Hedge 26-7 Is "Derivative" A Four-letter Word?

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26-1 Why Manage Risk?

・Financial transactions undertaken solely to reduce risk

do not add value in perfect markets.

Reason1:Hedging is a zero-sum game

Reason2:Investors' do-it-yourself alternative

If risk management affects the value of firm,it must be because "other things" not because risk shifting is inherently valuable.

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The reason risk-reducing transactionscan make sense in practice

•  Reducing the risk of cash shortfalls or financial distress

– covenants

•  Agency costs may be mitigated by risk management

– hedging can make it easier to monitor and motivate managers.

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CRO needs to come up with answers to the following questions

1. What are the major risks that the company is facing and what are the possible consequences?

2.  Is the company being paid for taking these risks?

3. How should risk be controlled?

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26-2 Insurance

•  some advantages in bearing risk

–  considerable experience in insuring similar risks

–  skilled at providing advice

–  pool risks by holdding a large,diversified portfolio of policies

•  some disadvantages in bearing risk

–  administrative cost

–  adverse selection

–  moral hazard

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26-3 Reducing Risk with Options

・The goverment's bought put options that gave it the right to sell oil at an excercise price of $70 per barrel. ・The profile (c) should be familiar to you as the protective put strategy that we encountered in section 20-2.

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26-4 Forward and Futures Contracts Forward Contract Futures Contract

Structure: Customized to customers need. Usually no initial payment required.

Standardized. Initial margin payment required.

Method of pre-termination:

Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty.

Opposite contract on the exchange.

Risk: High counterparty risk Low counterparty risk

Market regulation: Not regulated Government regulated market

Meaning:

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time.

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.

Institutional guarantee: The contracting parties Clearing House

Contract size: Depending on the transaction and the requirements of the contracting parties. Standardized

Expiry date: Depending on the transaction Standardized

Transaction method: Negotiated directly by the buyer and seller Quoted and traded on the Exchange

Guarantees: No guranantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid

Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.

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Trading and pricing financial contract

tft yrSF )1(0 −+=

Ft=the future price for a contract lasting t periods S0=today's spot price rf=risk free interest y=dividend yield or interest rate

000,4)0.010.151(980,3 =−+×=tF

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26-5 Swaps

•  interest rate swap

•  currency swap

•  total return swap

Year 0 Years1-4 Years5

Dollars Euros Dollars Euros Dollars Euros

1Issue dollar loan +10 -0.6 -10.6

2Swap dollars for euros -10 +8 +0.6 -0.4 +10.6 -8.4

3Net cash flow 0 +8 0 -0.4 0 -8.4

dollar rate 5%

euro rate 6%

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26-6 How to set up a hedge

Expected change in value of A=a+δ(change in value of B)

・Delta(δ)：the sensitivity of A to changes in the value of B

・hedge ratio:the number of B that should be sold to hedge the purchase of B

[ ] [ ] [ ]{ }+×+×+×= 3)(2)(1)(1321 CPVCPVCPV

VDuration

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26-7 Is "derivative"A four-letter word?

•  Precoution1:Don't be takes as surprise

•  Precoution2:Place bets when you have some comparative advantage that ensure the odds are in your favor.

※Is derivative dangerous?

Suppose that a bank enters into a $10 million interest rate

swap and the other party goes bankrupt the next day.

How much has the bank lost??

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27 Managing International Risks

27-1 The Foreign Exchange Market

27-2 Some Basic Relationships

27-3 Hedging Currency Risk

27-4 Exchange Risk and International Investment Decisions

27-5 Political Risk

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27-1 The Foreign Exchange Market

•  spot rate

•  forward rate

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27-2 Some Basic Relationships

•  Problem1:Why is the dollar rate of interest rate different from,say, the yen rate?

•  Problem2:Why is the forward rate of exchange different from the spot rate?

•  Problem3:What determines next year's expected spot rate of exchange between dollars and yens?

•  Problem4:What is the relationship between the inflation rate in the United States and the inflation rate in Japan?

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Basic Relationships

Difference in interest rates

1+ryen/1+r$

Expected change in spot rate

E(syen/$)/syen/$

Expected difference in inflation rates E(1+iyen)/E(1+i$)

Difference between forward and spot rates

fyen/$/syen/$

equals

equals

equals

equals

Suppose that individuals were not worried about risk and that there were no barriers or costs to international trade on capital flows.

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Interest rates and exchange rates

•  Interest rate parity theory says that the difference in interest rates must equal the difference between the forward and spot exchange rates.

Difference in interest rates

1+ryen/1+r$

Difference between forward and spot rates

fyen/$/syen/$

equals

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The forward premium and changes in spot rate

•  The expectations theory of exchange rate tells us that the percentage difference between the forward rate today's spot rate is equal to the expected change in the spot rate.

Expected change in spot rate

E(syen/$)/syen/$

equals

Difference between forward and spot rates

fyen/$/syen/$

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Changes in the exchange rate and inflation rate

•  Purchasing power parity implies that any differences in the rates of inflation will be offset by a chan in the exchange rate.

Expected change in spot rate

E(syen/$)/syen/$

Expected difference in inflation rates E(1+iyen)/E(1+i$)

equals

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Interest rates and inflation rate

•  If the expected real interest rates are equal, then the difference in money rates must be equal to the difference in the expected inflation rates.

Difference in interest rates

1+ryen/1+r$

Expected difference in inflation rates E(1+iyen)/E(1+i$)

equals

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27-3 Hedging Currency Risk

•  Operational hedging:

Balancing production closely with sales

•  Financial hedges:

Borrowing in foreing currencies,selling currency forward,

or using foreign currency derivatives such as swaps and

options

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27-4 Exchange Risk and International Investment Decisions

0 1 2 3 4 5 capital cost

NPV

CF($) -1300 400 450 510 575 650 12% 513

CF

(Swiss francs) -1560 471 520 578 639 709 9.90% 513

・When deciding whether to invest overseas,separate out the investment decision from the decision to take on currency risk. ・Your view about future exchange rates should not enter into the investment decision.

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27-5 Political Risk •  Business in every country are exposed to the risks of unanticipated

actions by governments or the courts.

•  Calculating NPVs for investment projects becomes exceptionally difficult when political risks are significant.