23-1 enterprise risk management chapter 23 copyright © 2013 by the mcgraw-hill companies, inc. all...
TRANSCRIPT
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Enterprise Risk Management
Chapter 23
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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What Risks?Conducting business in a global economy involves risk.
Much of the risk is associated with coping with the unpredictable future.
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Enterprise Risk Management (ERM)
ERM is the process to identify, assess, and where possible, to mitigate the risks to a firm
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Risk Types
1. Hazard Risks2. Financial
Risks3. Operational
Risks4. Strategic
Risks
ERM seeks to view the business holistically and understand how the pieces of risk fit together.
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What Risks?
Many companies address risk publically as exemplified by Disney Corporation in their annual report
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Example: Disney’s Risk Management Policy
Disney provides stated policies and procedures concerning risk management strategies in its annual report:The company tries to manage exposure to interest rates, foreign currency, and the fair market value of certain investments
Interest rate swaps are used to manage interest rate exposure
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Example: Disney’s Risk Management PolicyDisney provides stated policies and procedures concerning risk management strategies in its annual report:Options and forwards are used to manage foreign exchange risk in both assets and anticipated revenues
The company uses a VaR (Value at Risk) model to identify the maximum 1-day loss in financial instruments
Derivative securities are used onlyfor hedging, not speculation
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Hedging VolatilityRecall that volatility in returns is a classic measure of risk
Volatility in day-to-day business factors often leads to volatility in cash flows and returns
If a firm can reduce that volatility, it can reduce its business risk
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Hedging VolatilityInstruments have been developed to hedge the following types of volatility:Interest RateExchange RateCommodity PriceQuantity Demanded
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Interest Rate Volatility
Debt is a key component of a firm’s capital structure
Interest rates can fluctuate dramatically in short periods of time
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Interest Rate Volatility
Companies that hedge against changes in interest rates can stabilize borrowing costs
This can reduce the overall risk of the firm
Available tools: forwards, futures, swaps, futures options, and options
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Exchange Rate Volatility
Companies that do business internationally are exposed to exchange rate risk
The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency
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Exchange Rate Volatility
If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and conduct a better analysis of future projects
Available tools: forwards, futures, swaps, futures options
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Commodity Price Volatility
Most firms face volatility in the costs of materials and in the price that will be received when products are sold
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Commodity Price Volatility
Depending on the commodity, the company may be able to hedge price risk using a variety of tools
This allows companies to make better production decisions and reduce the volatility in cash flows
Available tools (depend on type of commodity): forwards, futures, swaps, futures options, options
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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The Risk Management Process
Identify the types of price fluctuations that will impact the firm
Some risks are obvious; others are not
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The Risk Management ProcessSome risks may offset each other, so it is important to look at the firm as a portfolio of risks and not just look at each risk separately
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The Risk Management ProcessYou must also look at the cost of managing the risk relative to the benefit derived
Risk profiles are a useful tool for determining the relative impact of different types of risk
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Risk ProfilesBasic tool for identifying and measuring exposure to risk
Graph showing the relationship between changes in price versus changes in firm value
Click on the icon to visit an online publication dealing with risk management
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Risk ProfilesSimilar to graphing the results from a sensitivity analysis
The steeper the slope of the risk profile, the greater the exposure and the greater the need to manage that risk
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Reducing Risk Exposure
The goal of hedging is to lessen the slope of the risk profile
Hedging will not normally reduce risk completelyFor most situations, only price risk can be hedged, not quantity risk
You may not want to reduce risk completely because you miss out on the potential upside as well
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Reducing Risk Exposure
TimingShort-run exposure (transactions exposure) – can be managed in a variety of ways
Long-run exposure (economic exposure) – almost impossible to hedge - requires the firm to be flexible and adapt to permanent changes in the business climate
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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Forward ContractsA contract where two parties
agree on the price of an asset today to be delivered and paid for at some future date
Forward contracts are legally binding on both parties
They can be tailored to meet the needs of both parties and can be quite large in size
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Forward ContractsPositionsLong – agrees to buy the asset at the future date
Short – agrees to sell the asset at the future date
Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations
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Forward Contracts
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Hedging with Forwards
Entering into a forward contract can virtually eliminate the price risk a firm facesIt does not completely eliminate risk
unless there is no uncertainty concerning the quantity
Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor
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Hedging with Forwards
The firm also has to spend some time and/or money evaluating the credit risk of the counterparty
Forward contracts are primarily used to hedge exchange rate risk
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Futures ContractsFutures contracts traded on an organized securities exchange
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Futures ContractsRequire an upfront cash payment called marginSmall relative to the value of the contract
“Marked-to-market” on a daily basis
Clearinghouse guarantees performance on all contracts
The clearinghouse and margin requirements virtually eliminate credit risk
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Futures Quotes
Commodity, exchange, size, quote units
The contract size is important when determining the daily gains and losses for marking-to-market
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Futures QuotesDelivery monthOpen price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest
Open interest is how many contracts are currently outstanding
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Futures QuotesDelivery monthThe change in settlement price times the contract size determines the gain or loss for the day
Long – an increase in the settlement price leads to a gain
Short – an increase in the settlement price leads to a loss
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Hedging with Futures
The risk reduction capabilities of futures are similar to those of forwards
The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur
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Hedging with Futures
Futures contracts are standardized, so the firm may not be able to hedge the exact quantity it desires
Credit risk is virtually nonexistentFutures contracts are available on a
wide range of physical assets, debt contracts, currencies, and equities
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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SwapsA long-term agreement between two parties to exchange cash flows based on specified relationships
Can be viewed as a series of forward contracts
Generally limited to large creditworthy institutions or companies
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SwapsInterest rate swaps – the net cash flow is exchanged based on interest rates
Currency swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates
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Example: Interest Rate Swap
Consider the following interest rate swap:
Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed)
Company B can borrow from a bank at 9.5% fixed or LIBOR + .5% (borrows floating)
Company A prefers floating and Company B prefers fixed
By entering into a swap agreement, both A and B are better off than they would be borrowing from the bank with their preferred type of loan, and the swap dealer makes .5%
Example: Interest Rate SwapPay Receive Net
Company A LIBOR + .5%
8.5% -LIBOR
Swap Dealer w/A
8.5% LIBOR + .5%
Company B 9% LIBOR + .5%
-9%
Swap Dealer w/B
LIBOR + .5%
9%
Swap Dealer Net
LIBOR + 9%
LIBOR + 9.5%
+.5%
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Swap Process
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Chapter Outline
•Hedging and Price Volatility
•Managing Financial Risk
•Hedging with Forward Contracts
•Hedging with Swap Contracts
•Hedging with Option Contracts
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Option ContractsThe right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date
Call – right to buy the assetPut – right to sell the assetExercise or strike price –specified price
Expiration date – specified date
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Option ContractsBuyer has the right to exercise the option;
the seller is obligatedCall – option writer is obligated to sell the
asset if the option is exercisedPut – option writer is obligated to buy the
asset if the option is exercisedUnlike forwards and futures, options allow
a firm to hedge downside risk, but still participate in upside potential
The firm pays a premium for this benefit
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Payoff Profiles: Calls
Buy a
call with E = $40
Stock
Price
Pa
yo
ffSell
a Call E = $40
Stock
Price
Payo
ff
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Payoff Profiles: PutsBuy a Put with E = $40
Stock Price
Pay
off
Sell a Put E = $40
Stock Price
Pa
yo
ff
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Hedging Commodity Price Risk with
Options “Commodity” options are generally
futures options
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Hedging Commodity Price Risk with
OptionsExercising a call:Owner of the call receives a long position in the futures contract plus cash equal to the difference between the exercise price and the futures price
Seller of the call receives a short position in the futures contract and pays cash equal to the difference between the exercise price and the futures price
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Hedging Commodity Price Risk with
OptionsExercising a put:Owner of the put receives a short position in the futures contract plus cash equal to the difference between the futures price and the exercise price
Seller of the put receives a long position in the futures contract and pays cash equal to the difference between the futures price and the exercise price
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Hedging Exchange Rate
Risk with OptionsMay use either futures options on
currency or straight currency options
Used primarily by corporations that do business overseas
U.S. companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars)
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Hedging Exchange Rate
Risk with OptionsBuy puts (sell calls) on foreign currencyProtected if the value of the foreign currency falls relative to the dollar
Still benefit if the value of the foreign currency increases relative to the dollar
Buying puts is less risky
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Hedging Interest Rate
Risk with Options
Can use futures optionsLarge OTC market for interest rate options
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Hedging Interest Rate
Risk with Options
Caps, Floors, and CollarsInterest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates)
Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates)
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Hedging Interest Rate
Risk with OptionsCaps, Floors, and Collars
Collar – buy a call and sell a putThe premium received from selling the put will help offset the cost of buying the call
If set up properly, the firm will not have either a cash inflow or outflow associated with this position
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Quick Quiz
What are the four major types of derivatives discussed in the chapter?
How do forwards and futures differ? How are they similar?
How do swaps and forwards differ? How are they similar?
How do options and forwards differ? How are they similar?
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Comprehensive Problem
A call option has an exercise price of $50.
What is the value of the call option at expiration if the stock price is $35? $75?
A put option has an exercise price of $30.
What is the value of the put option at expiration if the stock price is $25? $40?
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Terminology
•Hedging•Hedging Volatility•Forward Contracts•Future Contracts•Future Quotes•Swaps•Option Contracts•Commodities
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Key Concepts and Skills
•Explain how companies face risk exposures and how they hedge against these risks.
•Define the difference between forward and futures contracts.
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Key Concepts and Skills
•Describe how swaps and options can be used for hedging.
•Compute the value of a put and call option.
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1. Firms face risk associated with changes in interest rates, exchange rates of foreign currency, costs of materials and the price that they can sell their products.
2. Firms use hedging to protect themselves against these risks.
What are the most important topics of this chapter?
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3. Forward, Futures, Swap and Option contracts are the financial instruments to deal with this volatility.
4. Risk is never removed entirely; it can be mitigated by investing in contracts.
What are the most important topics of this chapter?
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Questions?