risk management and derivatives
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Risk Management
and Derivatives
Volatility Volatility in returns is a classic measure of
risk
Perfect Market More systematic risk leads to more return
But Volatility is Costly External financing
Project funding Distress
Lower debt or increased prob. of distress Taxes
Risk Management Tools Hedging
Reduce firm’s exposure to price/rate fluctuations
Financial Hedging Insurance Derivatives
Financial assets which are a claim on another asset Operational Hedging
Using other corporate decisions to manage volatility
Sources of Volatility - 1 Interest Rate Risk
Loans with floating interest rates create IR risk
Exchange Rate Risk Reduce impact of foreign earnings volatility
due to currency rate fluctuations Commodity Price Risk
Certain input costs and prices of goods sold can be hedged
The Risk Management Process
Identify important price fluctuations Risk profiles are useful for determining the
relative impact of different types of risk Some risks may offset each other
Consider the firm as a portfolio of risks and not just look at each risk separately
Considering risk management Availability of relevant contracts Cost of contracts Cost of management/employee time
Risk Profiles Graph of price changes relative to
value changes Risk profile slope
Steeper ~ Larger exposure Potentially more need to hedge
Derivatives Change Payoff
Forward Contract What’s a forward?
Agreement to exchange an asset for a set price with delivery and payment at a set future date
Long: agree to buy the asset Short: agree to sell the asset
You want next year’s Ferrari and contract with dealer to buy at a set price in the fall P Current = P Contract
Over the summer, demand rises P Current > P Contract
What if car value is below contract price? P Current < P Contract
Future What’s a future?
Forwards traded on an exchange
Farmer expects to sell 100,000 bushels of soybeans
Wants to sell at a certain price (short position) Soybean future contracts are for 5,000
bushels Current price is $4.50/bushel
Farmer shorts 20 soybean futures Will sell 100,000 bushels Will receive $4.50/bushel*100,000 bushels
= $450,000
Commodity Future No cost today, but margin held in
farmer’s account As soybean price changes, clearinghouse
adjusts farmer’s account September
Farmer delivers soybeans and receives $450,000
Bumper Crop Receive $450,000 + Extra Crop * Market
Price Poor Harvest
Receive $450,000 – Amt to Purchase * Market Price
Interest Rate Swap Firm A can borrow at 10% fixed or LIBOR + 1%
floating Firm B can borrow at 9.5% fixed or LIBOR + 2% A prefers fixed and B prefers floating
Call (Put) Right to buy (sell) a security at a pre-specified price
Underlying Asset that you have an option to buy or sell
Option Price Market price of the contract
Exercise (or Strike) Price Price at which the security can be bought or sold
At-the-money - Exercise price is very close to stock’s current value
In-the-money - Option could be exercised at a profit today
Out-of-the-money – Can’t exercise for profit
Options
Reducing Risk Exposure Hedging changes risk profile Doesn’t eliminate risk
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
Timing Short-run exposure (transactions exposure)
Managed in a variety of ways Long-run exposure (economic exposure)
Difficult to hedge with derivatives
Always Hedge? What if price shock can be passed
along to customer? What if competitors don’t hedge?
Not Perfect Iberia
Large 4th Quarter 2008 Losses Attributed, in part, to hedging
“Iberia has in place a complex system of fuel cost hedges that prevented it from benefiting from the fall in fuel prices at the end of 2008.”
Wall Street Journal
Sources of Volatility - 2 Contracting with suppliers/customers
Vertical integration Limiting leverage
Central employees “Key Man” Insurance
Project specific issues Diversification Project choice
Corp Fin Applications Equity as a Call Employee Stock Options CEO Stock Options
Equity: A Call Option For leveraged firms, equity is a call option
on the company’s assets Exercise price - the face value of the debt Expiration date – the date that the debt
comes due Assets > debt
Option is exercised and the stockholders retain ownership
Assets < debt Option expires unused and assets belong to
the bondholders
Equity Payoff
DebtFirm Value
Value of Equity
All goes to Bondholders
Shareholders Collect
Asset substitution
Employee Stock Options Options given to employees as
compensation Nonqualified
Can be granted at a discount to current value
Qualified or incentive stock options Primarily for upper mgmt Special tax treatment
Often used as a bonus or incentive Huge rise in popularity Mostly still for upper management
Employee Stock Options Designed to reduce agency problems
Empirical evidence: they don’t well work Not worth as much to the employee as to an
outsider due to the lack of diversification Reprice underwater options
Other Disadvantages Management behavior Costly compensation
Dilutes stock as firm must issue new shares Sometimes offset with repurchase (usually when
stock price is high) Expensing can hurt profits
CEO Options Use Executives can protect their stock
positions Given stock or options as an
incentive I-bank creates individual options
“Collars” position with put and call Value
Stock PricePut Call
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