Risk Management

1
Risk Management

• Brealey and Myers Chapter 27

2
Key Points / Overview

• Risks to be managed, and the methods used to
  finance them.
• Interest rate exposure (swaps)
• Commodity price risk (futures)
• FX exposure (derivatives)

3
Volatility in Interest Rates
4
Volatility in US/ Deutsche FX
5
Volatility in Oil Prices
6
Forward Contracts

• Lets say I have 100 yen coming in at T1, and I
  expect the spot exchange rate next year to be 100
  yen per dollar.
• I expect to have one dollar, but my cash flows
  are risky.
• I enter a futures contract to exchange 100 yen
  for a dollar.
• Find unhedged payoff if spot FX rate is 50, 100,
  1000.

My unhedged risk profile

100 Exchange rate (yen/ dollar)
7
Payoffs to my forward contract (by itself)
Hedged position payoffs


100 Exchange rate (yen/ dollar)
100 Exchange rate (yen/ dollar)
Reminder what is the payoff of the forward
contract in isolation if the spot price at T1 is
100?
8
Forwards

• Hedged with forwards is imperfect, since you do
  not know the quantity you will have to trade.
• There is credit risk with forward contracts.
• In the previous example, if the yen dramatically
  depreciated, my forward contract would be very
  valuable. Losses to the contract seller would be
  large. He might default.

9
Futures

• Very similar to forwards in payoff profile, but
  addresses credit risk problem by
  marking-to-market every day.
• Highly standardized contracts, which permit
  exchange trading.
• www.cbot.com

10
Futures cont.

• There are commodities futures and financial
  futures (stocks, bonds and currencies).
• For long-term risks, we cannot hedge. Futures
  markets are only liquid for a couple of years
  out.
• It is possible to create balance sheet hedges.
  If revenues are in yen, then issue debt in Japan.
  Revenues and costs are then both in yen, to some
  degree canceling out FX risk.

11
Interest rate risk

• Reminder the present value of any stream of
  payments changes when your discount rate changes.
• The market value of a bond changes, even when the
  coupons are guaranteed.

12
Interest Rate Risk in Corporate Finance

• An investor cares because the value of his bonds
  fluctuates with interest rate movements.
• A firm cares because the present value of
  existing liabilities and expected future
  borrowing costs depend upon interest rate
  movements.

13
Personal Finance Aside

• ARMs versus fixed-rate mortgages.
• Some argue that you should always take the
  fixed-rate mortgage. If you take the ARM, you
  bear more risk. Who is a more efficient
  risk-bearer you or the bank?
• Not true! ARM rates are lower to reflect this
  fact.
• Good reasons to take ARMs
• You know you are going to move soon
• You expect your income to rise
• otherwise do take a fixed-rate to avoid this
  risk.

14
Interest Rate Risk in Corporate Finance

• By choosing the structure of your liabilities,
  you determine your interest rate risk.
• And since nominal rates R r i, most of the
  changes in nominal interest rates are probably
  dues to changes in expected inflation.
• For example, a REIT that was heavily invested in
  long-term leases would have much more inflation
  risk than one invested in short-term leases.
• If inflation goes up, the rate discount rate goes
  up.
• The value of assets (i.e. the NPV) goes down.
• You partially offset this by raising rents (since
  prices are up!)

15
Balance Sheet Hedges

• Lets say you are a firm with significant
  inflation/interest rate risk.
• The REIT with pre-committed rent levels.
• The value of your assets drops when inflation
  increases.
• You prefer the value of your liabilities to drop
  also (to partially offset this risk).
• Choose a fixed rate loan.

16
Swaps

• What if you have an adjustable rate mortgage, but
  you decide that a fixed-rate better suits your
  risk-profile?
• Arrange a swap through an intermediary with a
  party that prefers the opposite.
• Swaps are also useful for hedging currency risk.
• If you have revenue coming in yen, you wish to
  hedge on the balance sheet by raising
  yen-denominated debt.
• Problem you might have better access to US debt
  markets. Issue US debt and swap for Japanese
  debt.

17
A Swap
18
Options

• The last risk management tool we study!
• Options are useful for managing any type of risk
  commodities, FX, or interest rate.
• However, unlike futures, they manage only one
  side of your risk exposure.

19
Hedging one side of risk

• User of wheat (cereal manufacturers) can
  eliminate downside risk by buying call options.
• If the price drops below (say) 34, buy on the
  market rather than through your contract.
• Producer of wheat may elect to buy a put option
  (the right to sell at 34)
• If the market price is above 34, sell on the
  open market at the higher price.

20
Options and Interest Rate Risk

• If your operations are sensitive to interest rate
  risk / inflation risk, then you can hedge this
  risk using options on govt bonds.
• What is your strategy?
• Recalling that value of outstanding bonds goes
  down if interest rates go up.
• Buy a put option on a govt bond.

21
Speculation

• A bad motive (from a corporate finance
  perspective) for forwards, futures, options, etc.
  is to speculate.
• Loans can be fixed-rate, ARM, or inverse floaters
  (rate on the loan falls when interest rates
  rise).
• If you expect interest rates to rise, you
  preferences are (in order)
• Inverse floater, fixed-rate, ARM

22
Orange County

• In December 1994, Orange County, Cal
• Fourth wealthiest county government in the US.
• Robert Citron lost 1.7B buying inverse floaters.
• He was betting interest rates would fall.
  Greenspan raised interest rates.
• Orange County filed for bankruptcy.
• Froze the funds of 185 Southern California school
  districts, towns and local agencies, casting
  doubt on pensions and payrolls for everyone from
  teachers to trash haulers.
• Largest US government bankruptcy in history.

23
Double Trouble

• 1 When interest rates rise, the coupon payments
  paid by inverse floaters declines.
• 2 The smaller payments are now discounted at a
  higher rate.

24
How to recognize speculation

• If a portfolio consistently earns higher returns
  than it should then either
• 1. The portfolio manager is better than average
• 2. The portfolio manager is taking more risk than
  average.
• Robert Citron had been betting on inverse
  floaters for some time. The strategy worked well
  as Greenspan loosened monetary policy in the
  early 90s.

25
Risk managementnon-speculative motives

• Think back to my earlier comments about the CAPM.
• Would your investors profit from reduction in
  idiosyncratic risk? No, theyre already
  diversified.
• Would your investors profit from reduction in
  systematic risk? Not if you pay a fair price for
  this reduction.
• Other motives
• reduction of risk reduces financial distress
  costs
• reduction of non-core risks allows the firm to
  focus on the underlying business rather than
  external surprises (currency shocks, etc.) This
  is probably the best justification for risk
  management.