FIN226 Chapter 11 An introduction to risk management and derivatives

1. Risk management is important to the long-term survival of a corporation. (a) Define and explain the nature of risk. Risk is the possibility or probability that something may occur that is unexpected, not anticipated. Risk adds uncertainty to the business management and forecasting processes. A business is exposed to both operational risks and financial risks. Operational risks impact upon the normal day-to-day functions of a business. Financial risks affect business cash flows and the value of balance sheet assets and liabilities.

(b) What is the purpose of risk management? To ensure an organisation is aware of the risks associated with all aspects of its business operations. To ensure personnel consider the risk outcomes that derive from their business decisions. To establish robust risk management objectives, policies, procedures and strategies that result in all risk exposures being identified, measured and managed. To mitigate potential negative operational and financial impacts of risk. To protect personnel.

(c) Discuss who is responsible for the establishment of risk management objectives, policies, procedures and strategies in a corporation? The board of directors of an organisation is responsible for the determination and documentation of all risk management objectives. Once the board has determined the objectives (which risks must be managed), it will determine related risk management policies; that is, how the risk management objectives will be implemented. The chief executive officer and executive management will establish risk management procedures, strategies and reporting structures. The procedures and strategies are developed within the constraints of the risk management objectives and policies set by the board.

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(d) It is often argued in risk management literature that risk must be identified, measured and managed. Discuss the logic and reasons behind the contention that risk must be identified, measured and managed. Before an organisation can begin to manage risk exposures it needs to know what those exposures are; therefore it is necessary to identify all potential risk exposures relating to all financial and operational components of a business. The number, extent and scope of risk exposures will vary depending on the business operation; for example, a mining company will be exposed to a different range of risks than would a financial institution or a hotel chain. Once a risk exposure is identified it is necessary to measure the potential operational and financial impacts of the exposure, given a range of scenarios. Based on this quantitative analysis, an organisation will decide how, or if, the risk is to be managed. Given a decision to manage a risk, the organisation will determine alternative strategies that may be appropriate to manage the risk determine the most suitable strategy and put procedures in place to implement the strategy.

5. The primary purpose of a derivative product is the management of a risk exposure. Explain how a derivative contract achieves this risk management function. The basic principal behind using a derivative product to manage an identified risk exposure is that the derivative strategy will lock-in a price today that will apply at a specified future date. The price of a derivative contract is based on a specified underlying commodity or financial instrument traded in the physical markets. For example, a derivative product such as a futures contract which may be used to lock-in the price of a commodity such as gold today for delivery at a future date is based on the actual price of gold in the spot or physical market. Similarly, the price of an interest rate futures contract may be based on a financial instrument such as the 90-day bank-accepted bill, or the 3-year or 10-year Australian treasury bonds. If commodity prices, interest rates, exchange rates or share market prices move then the value of related derivative contracts will also move; thus locking in the underlying price. Page 2 of 6

Generic derivative products are futures, forwards, options and swap. Each type of contracts has different characteristics that enable risk managers to make choices as to which type of contract best meets a particular risk management need.

6. A large fund manager has forecast that it will need to purchase at least $100 million worth of shares at the end of the next quarter. The fund manager has a policy that requires it to hedge the risk that the share price may rise over that period using a share index futures contracts. (a) Define a futures contract. A futures contract is an agreement between two parties to buy, or sell, a specified commodity or financial instrument at a specified date in the future at a price determined today. Futures contracts are standardised contracts traded through a formal exchange that enable the management of risk exposures associated with commodities and financial assets.

(b) Given the above scenario, what futures market transactions will the funds manager make today, and in three-month's time? A future contract risk management strategy requires the risk manager to carry out a transaction in the futures market today that corresponds with the physical market transaction risk that will occur at a future date. In this scenario the risk manager is planning to buy shares in the future so he/she will buy share index futures contracts today. In three months, the risk manager will close-out the futures market position be selling identical share index futures contracts.

(c) What are the cash flow implications for the funds manager of the futures contract risk management strategy? At the commencement of the strategy the funds manager will be required to make an initial margin payment. This will be a specified percentage of the notional contract value. The futures contracts will be marked-to-market daily by the futures exchange clearing house. If contract prices have moved against the funds manager, the manager will be required to top up the margin account with a maintenance margin call. Page 3 of 6

When the futures market position is closed out, the manager will have made either a profit or a loss, being the net difference between the initial buy contract price and the final sell contract price. The profit or loss from the futures market transactions will be used to offset changes in the share prices in the share market.

(d) Explain how making a loss with the futures market strategy can result in the risk manager successfully hedging an identified risk exposure. Assume a company that has to roll-over a short-term debt facility in three months time. The risk manager may use a futures market strategy to hedge the interest rate risk by selling a 90-day bank accepted bills futures contract. If interest rates subsequently fall over the futures contract period, then the manager would make a loss on the futures transactions. However the manager would be able to borrow in the debt market at the new lower interest rate. The loss made in the futures market is offset by the lower cost of borrowing in the debt market. The manager is satisfied because he/she had locked-in an interest rate; therefore, the risk that interest rates may rise had been hedged or covered.

8. An importer has entered into a USD contract that will require payment of USD1 million in one month. The importer wishes to lock-in an exchange rate today in order to protect its future profit margins. An investment bank gives the following quote: AUD/USD0.7420-25 17:12. Calculate the bank's one-month forward exchange rate. As the forward are points are falling, they are subtracted from the spot rate: = = = AUD/USD0.7420 17 AUD/USD0.7403 AUD/USD0.7403-13 0.7425 12 0.7413

Spot rate Minus forward points Forward rate

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9. An investor enters into a call option on Santos Limited shares with an exercise price of $19.25 per share in two months, and pays a premium of $0.60 per share. (a) Define an option and explain the premium and the exercise price. An option contract gives the option-buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified price on or before a specified date. The price established in the option contract is known as the exercise price, or the strike price. The exercise price is the price determined today at which the buyer of the option is able to buy or sell the specified commodity or financial instrument at the exercise date. The option has value, therefore the writer (or seller) of an option contract will receive a premium from the buyer of the option contract. The premium is paid up-front whether or not the option is exercised at a later date.

(b) What is a call option? A call option gives the option-buyer the right to buy the commodity or financial instrument specified in the option contract at the exercise price either on a specified date, or alternatively at any time up to a specified date.

(c) Using the above example, draw a fully labelled diagram of the call option showing the profit and loss profile of the option buyer and the writer of the option (including the break-even price).

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(a) Buyer of option Profit Break-even

(b) Seller of option Profit Break-even

+$0.60 Premium 0 $19.25 $19.85 Premium -$0.60 Market price $19.85 $19.25

Loss

Exercise price

Loss

Exercise price

(d) At what minimum share price will the option buyer exercise the option on the expiration date? The buyer of the option will exercise the contract if the share price is above $19.25. If the share price is between $19.25 and the break-even price of $19.85 the buyer will recover part of the premium paid. If the share price moves above the break-even price of $19.85 then the buyer is in-the-money. The option writer has lost the entire premium.

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