Module III: Techniques for Risk Management

1
Module III Techniques for Risk Management

• Week 7 October 7 and 9, 2002

2
Asset-Liability Risk
Cash Outflows
Cash Inflows
3
Cash-Flow Risks
Variation in Cash Flows Due to Relation Between
Inflows and Outflows
4
Risk Management
Product Prices Substitute Prices Exchange Rates
Commodity Input Prices Fixed Asset Values Labor
Costs
Short-Term Borrowing Long-Term Borrowing
5
Asset-Liability Management

• Focus on variability of cash flows
• Main concern is to be able to make all
  contractual payment to avoid defaults
• Secondary concern is to minimize risk
  (variability)
• Third concern is to increase net cash flows by
  taking advantage of predictability in variations
• Objective is to measure and manage variability in
  cash flows

6
Exposure to Risk

• A general term to describe a firms exposure to a
  particular risk (e.g. a commodity price) is to
  classify the exposure as long or short
• Long exposure means that the firm will benefit
  from increases in prices or values
• Short exposure means that the firm will benefit
  from decreases in prices or values

7
Long Exposure

• A firm (or individual) is long if at the time of
  the risk assessment if it has or will have an
  asset or commodity. As examples
• The firm owns assets, as in inventories of raw
  materials or finished goods
• The firm produces a commodity or product, as in
  an agribusiness raising wheat or livestock
• The firm will take possession in the future or a
  commodity or an asset
• The firm has bought a commodity or asset

8
Short Exposure

• A firm (or individual) is short if at the time of
  the risk assessment if it needs or will need an
  asset or commodity. As examples
• The firm is planning or has promised to deliver
  raw materials or finished goods
• The firm uses a commodity or product in
  production as inputs, like steel or lumber
• The firm will have possession in the future or a
  commodity or an asset it does not need or needs
  to sell
• The firm has sold a commodity or asset and must
  deliver

9
Price Exposure in a Diagram
Profit
Profit
Long
0
0
P0
P0
Loss
Loss
Short
10
Exposure to Risks
11
Examples of Exposure

• Farmer with wheat is long wheat
• Honey Baked Ham is short pork before Easter
  selling season
• Treasurer with excess cash in three months is
  short investments
• Company needing cash in nine months is long
  financial assets (its liabilities are others
  assets) to sell

12
Types of Derivative Contracts

• Three basic types of contracts
• Futures or forwards
• Options
• Swaps (we discuss next week)
• Many basic underlying assets
• Commodities
• Currencies
• Fixed incomes or residual claims

13
Futures Contracts

• Wall Street Journal tables
• Standardized contracts
• Quantity and quality
• Delivery date
• Last trading date
• Deliverables
• Clearing house is counterparty
• Margin requirements, mark to market

14
Forward vs. Futures Contracts

• Bilateral contract (usually with a financial firm
  as counterparty)
• Terms are tailor made to needs of corporate, not
  standardized
• No exchange of cash until maturity of contract
• Over-the-counter market not as liquid as
  organized exchange

15
Managing Risk with Futures

• Offset price or interest rate risk with contract
  which moves in opposite direction
• Cross diagonally in the box
• Identify contract with price or interest rate
  which moves as close as possible with the price
  or interest rate exposure
• Imperfect correlation is basis risk
• Not using futures or forwards can be speculation

16
Hedging
Bank Planning to Borrow
Insurance Company Hedge
Borrowing Hedge
Insurance Company with Premiums
17
Forward Contracts

• Example 1 GE is awarded a contract to supply
  turbine blades to Lufthansa. On December 1, GE
  will receive DM 25 million.
• How should GE hedge its risk?

18
Forward Market Hedge

• Current spot price for DM 1 0.40
• One year forward rate is DM 1 0.3828
• Hedge future income by selling DM 25 million for
  delivery in one year (short in futures or forward
  market)
• This transaction assures future revenue of 9.57
  million without any cash flows today.

19
Possibilities

• Say the spot price on December 1 is 0.36 per DM.
• GE sells its DM 25 million for 0.3828 per DM,
  yielding 9.57 million
• If it had not hedged, its DM 25 million, at a
  rate of 0.36, would yield 9 million.
• The forward is worth 0.57 million.

20
Possible Outcomes
21
Key Points

• Revenues are guaranteed irrespective of exchange
  rate movements
• The cost of hedging varies depending on exchange
  rate movements
• Futures hedging is effective when the magnitude
  and timing of future currency cash flows is known
• Pricing in dollars simply shifts risk

22
Options (Definition)

• An option is the right (not the obligation) to
  buy or sell an asset at a fixed price before a
  given date
• call is right to buy, put is right to sell
• strike or exercise price is a fixed price which
  determines conversion value
• expiration date
• Options on stocks, commodities, real estate, and
  future contracts

23
Call Options Profits at Maturity
Profit
Payoff to Buyer
0
Asset Value
Strike Price
24
Call Writers (Sellers) Profits
Profit
Strike Price
Asset Value
0
Possible Cost to Writer
Loss
25
Option Value Sensitivityto Price Changes in
Assets
Buy Call
Buy Put
S
S
Write Call
Write Put
26
Managing Risk with Options

• Similar to hedging risk with futures or forwards
  except that you only hedge again bad or adverse
  outcomes
• Partially offset price or interest rate risk with
  contract which moves in opposite direction
• Identify options with price or interest rate
  which moves as close as possible with the price
  or interest rate exposure but again imperfect
  correlation results in basis risk
• Options only hedge against adverse outcome so
  they are similar to insurance and cost money

27
Foreign Currency Options

• Useful if the timing of foreign currency cash
  flows is uncertain
• Example 2 GE submits a bid to supply turbine
  blades to Lufthansa for DM 25 million
• The funds will be received on December 1 only if
  GE wins
• How does GE hedge this risk?

28
Using Options

• Selling DM forward is not the answer GE may
  lose the bid and the DM may rise
• Options solve the problem GE buys put options to
  sell DM 25m on December 1 at a rate of, say, 1 DM
  0.40
• GE pays a bank 100,000 for the puts

29
Suppose GE Loses the Bid

• If the rate is below 0.40, GE can buy DM in the
  market at a lower price and sell them for a
  profit by exercising the put.
• If the rate is above 0.40, GE lets the option
  expire
• Hedging costs in either event are 100,000
• If the puts are fairly priced GE will not suffer
  an expected loss even net of hedging costs

30
Suppose GE Wins the Bid

• If the rate is below 0.40, GE exercises the put
  for 10m, using the DM 25 million paid by
  Lufthansa.
• If the rate is above 0.40, GE lets the option
  expire, and converts the DM 25 million at the
  market rate
• GE makes at least 10 million if it wins the bid,
  less the 100,000 cost of the option

31
Other Uses of Options

• Use call options to hedge the risk of foreign
  tender offers
• Hedge risk when quantity of cash flows is
  uncertain
• Currency options can be used to protect profit
  margins and prevent frequent revisions of product
  prices abroad

32
Interest-Rate Derivatives

• Interest rates and asset values move in opposite
  directions
• Long cash means short assets
• Short cash means long (someone elses) asset
• Basis risk comes from spreads between exposure
  and hedge instrument, e.g. default risk premiums
• Problem with production risk, e.g. interest rates
  up, needs for funds may be down with slowdown

33
Caps, floors, and collars

• If a borrower has a loan commitment with a cap
  (maximum rate), this is the same as a put option
  on a note
• If at the same time, a borrower commits to pay a
  floor or minimum rate, this is the same as
  writing a call
• A collar is a cap and a floor

34
Collars Cap 6, floor 4

• Profit

0
9400
9500
9600
Loss
35
Other option developments

• Credit risk options
• Casualty risk options
• Requirements for developing an option
• Interest
• Calculable payoffs
• Enforceable

36
Replication Futures with Options
Profit
Profit
Buy Call
Long
0
0
P0
P0
Loss
Loss
Write Put
37
Next Week October 14, 2002

• Review this weeks discussion to identify areas
  needing clarification
• Review weekly Objectives and prepare for midterm
  examination on October 16, 2002
• After exam, read and prepare case Union Carbide
  Corporation Interest Rate Risk Management and
  identify issues in the case you have questions
  about