CORPORATE RISK

MANAGEMENT

GROUP 1
 Contents:
•Classification of Risk
•Measurement of risk in non financial firms
•Principle of hedging
•Hedging with Forward, Futures, Swap, Options
Contracts, Insurance, Risk management products
•Financial Engineering and Corporate Strategy
•Risk management practices
 Classification of risk
The wide array of risks that a management firms exposed
•

can be classified into 5 categories:

1.Technological Risk: arise mostly in the R&D and Operations
stage of the value chain.
2.Economic Risks: arise from fluctuations in the
revenues(output price and demand) and production cost (
Raw material cost, energy cost and labor cost)
3.Financial Risks: arise from volatility of Interest rates,
currency rates, commodity prices and stock prices.
4.Performance risks: arise when contracting counterparties
do not fulfill their obligations.
5.Legal and Regulatory risks: change in laws and regulations
6.
 Measurement of risk in non
financial firms

To assess the Financial price risk we may:

•

a)Examine the financial statements to get

an idea of the risk exposure
b)Assess the sensitivity of the firms value
or cash flow to changes in the financial
prices and
c)Conduct monte carlo simulation.
 Examine the financial
statements
Examining the Balance sheet and Profit & loss account
•

throw light on a number of questions like:

•Does the firm have a strong liquidity position as per
high Current ratio and Quick ratio? A strong liquidity
position cushions against the volatility of cash flows
caused by changes in Financial prices.
•Does the firm have a low gearing ratio (leverage)? A
low gearing ration provides greater financial
flexibility to cope with volatility in financial prices.
•What is the Foreign exchange transaction exposure? If
the balances of receivables and payables are high,
their values would change in response to shifts in the
exchange rates.
•Is the firm exposed to interest rate risk? If the firm
 Assess the sensitivity

Determine the sensitivity of Firm’s Value or Cash

•

Flow by:
•

•Analyzing the Historical data on firm value, cash

flows and financial prices
• e.g. – The sensitivity of a firm’s value to exchange
rate may be estimated as
• Firm Value = a + b
Exchange rate
•
 monte carlo simulation

•Monte carlo methods are used in finance to value and analyze

(complex) instruments, portfolios and investments by simulating
the various sources of uncertainty affecting their value, and then
determining their average value over the range of resultant
outcomes.
•The advantage of monte carlo methods over other techniques
increases as the dimensions (sources of uncertainty) of the
problem increase.
•
•
 Principle of hedging

•One way to manage these risks and uncertainties is to enter

into transactions that expose the entity to risk and
uncertainty that fully or partially offsets one or more of
the entity’s other risks and uncertainties, transactions
known as ‘hedges’.
•The instrument acquired to offset risk or uncertainty is
known as ‘hedging instrument’ and the risk or uncertainty
hedged is known as ‘hedged item’.
•There are predominantly two motivations for a company to
hedge:
• To lock-in a future price which is attractive, relative to
an organisation’s costs.
• To secure a commodity price fixed against an external
contract
•
 HEDGING WITH Forward
CONTRACTS

•Forward contract is an OTC agreement between two

parties, to buy or sell an asset at a certain time in the
future for a certain price.
•The price of the underlying instrument, in whatever form, is
paid before control of the instrument changes.
•This is one of the many forms of buy/sell orders where the
time of trade is not the time where the securities
themselves are exchanged.
•The forward price is commonly contrasted with the spot
price, which is the price at which the asset changes hands
on the spot date.
•The difference between the spot and the forward price is
the forward premium or forward discount, generally
considered in the form of a profit or loss, by the
purchasing party.
 HEDGING WITH FUTURE
CONTRACTS

• What Does Futures Contract Mean?

•

A contractual agreement, generally made on the trading floor of

a futures exchange, to buy or sell a particular commodity or
financial instrument at a pre-determined price in the future.
•Futures contracts detail the quality and quantity of the
underlying asset; they are standardized to facilitate trading on a
futures exchange.
•Some futures contracts may call for physical delivery of the

asset, while others are settled in cash.

•
 TYPES OF FUTURE
CONTRACTS
There are many different kinds of futures contracts,
•

reflecting the many different kinds of "tradable" assets

about which the contract may be based such as
commodities, securities (such as single-stock futures),
currencies or intangibles such as interest rates and indexes.
1.Foreign exchange market
2.Money market
3.Bond market
4.Equity market
5.Soft Commodities market
•
FUTURES HEDGING
 HEDGING WITH
SWAPS
• What Does Swap Mean?
•

If firms in separate countries have comparative advantages

on interest rates, then a swap could benefit both firms.
•

•For example, one firm may have a lower fixed interest rate,
while another has access to a lower floating interest rate.
These firms could swap to take advantage of the lower rates.
•
 TYPES OF SWAPS
•Interest rate swaps
•Currency swaps
•Commodity swaps
•Equity swap
•Credit default swaps
•Other variations
•
 REASON FOR SWAPS
•Spread compression
•Market segmentation
•Market saturation
•Difference in financial norms
 HEDGING WITH OPTION
CONTRACTS
qAn option contract is an agreement under which the seller of the option
grants the buyer the right, but not the obligation, to buy or sell(depending on
whether it is a call option or a put option) some asset at a predetermined price
during the specified period. The buyer of the option has to pay a premium to
enjoy the right.
q
qForward vs options:
•In forwards contract both parties agree to act in the future whereas in an
option transaction occurs only if the buyer of the option chooses to exercise
it.
•In forward contract no money exchanges hands whereas in options the buyer of
the contract pays option premium.
•

qHedging with options:diagrams

•
 Options in debt
contracts
•Imagine a firm going for a long term
floating rate loan
•The risks involved are the interest rates

rising sharply increasing the debt service

burden
•
 HEDGING WITH
INSURANCE
Main advantages offered by Insurance companies:
•

•They can price the risks reasonably accurately

•Provides low cost administration service due to specialisationand
economies of scale.
•Provides advice on measures to reduce risks
•Pools risks by holding large diversified pool of assets
•

Disadvantages of Insurance:
•

•It incurs administrative costs

•Problem of adverse selection- cant differentiate between good and bad
risks
•Exposed to problem of moral hazard
•Loading fee- diff between insurance premium and expected payoff.
 Types of option contracts

•Option contract on debt instruments- options on

treasury bill
•Option contract on foreign currencies– options
with British pounds
•Option contract on stock market indices-option on
S&P 500 index
•Option contract on stock index futures.
 Hedging with real tools
and options
Real options-
•

•Diversify product line and services to reduce risks

•Invest in preventive maintenance
•Emphasise quality control to reduce product liability
•Build flexible production systems
•Shorten time to introduce product to market
•Delay investment until uncertainty is resolved
•Carry extra liquidity on the balance sheet to tide over difficult
periods
•Maintain reserve borrowing power to meet contingencies.
 REAL VS. FINANCIAL
OPTIONS
•Real options cost a great deal.
•In some cases real options may be the only viable
means to handle risks
•Real options are far less liquid
•Firm with real options may profit from assuming
more risk – a firm with flexible production
facilities can benefit more by manufacturing
products subject to high price volatility.
•
 EVOLUTION OF RISK
MANAGEMENT TOOLS

The financial and operating environment

•

today is more riskier than in the past –

•Substantial increase in the average rate as
well as volatility of inflation
•Greater volatility in interest rates ,
exchange rates, and commodity prices
•Increased global competition.
•
 Volatility and Risk
Management Tools:
•Exchange rate volatility- currency futures, currency
swaps, currency options
•Interest rate volatility- floating rate loans, T-Bill
futures, T-Bond futures, options on T-Bonds, caps
floors and collars.
•Petroleum prices- futures in heating oil, futures in
WTI, hybrids, option in WTI
•Metal price volatility- fwds, futures,
options,hybrids.
 Risk management practices

•Corporate strategy – bricks and mortar

•TVA

•
 Guidelines for risk
managemnet

•Align risk management with

corporate strategy
•Proactively manage uncertainties
•Employ mix of real and financial
methods
•Know the limits of risk management
tools
•Don’t put undue pressure on
corporate treasury to generate