Chapter Five

Financial Risk Management

 Different Types of Risk
 Demand risks: Those associated with the demand for
a firm’s products or services.
 Financial risks: Those that result from financial
transactions.
 Property risks: Those associated with loss of a firm’s
productive assets.
 Personnel risk: Risks that result from human actions.
 Liability risks: Connected with product, service, or
employee liability.
An Approach to Risk Management
 Corporate risk management is the management of
unpredictable events that would have adverse
consequences for the firm.
 Firms often use the following process for managing
risks.
Step 1. Identify the risks faced by the firm.
Step 2. Measure the potential impact of
the identified risks.
Step 3. Decide how each relevant risk
should be dealt with.
 Techniques to Minimize Risk
 Transfer risk to an insurance company by paying
periodic premiums.
 Transfer functions which produce risk to third parties.
 Hedging (offsetting) the likely gain with likely loss
 Take actions to reduce the probability of occurrence
of adverse events.
 Take actions to reduce the magnitude of the loss
associated with adverse events.
 Avoid the activities that give rise to risk.
 Financial risk exposures
 Financial risk exposure refers to the risk inherent in
the financial transactions due to price fluctuations.
• volatility in returns is a classic measure of risk
• Volatility in day-to-day business factors often leads to
volatility in cash flows and returns
• If a firm can reduce that volatility, it can reduce its
business risk
• Types of financial volatility
– Interest Rate
– Exchange Rate
– Commodity Price
 Interest Rate Volatility
• Debt is a key component of a firm’s capital structure
• Interest rates can fluctuate dramatically in short
periods of time
• Companies that hedge against changes in interest
rates can stabilize borrowing costs
• This can reduce the overall risk of the firm
 Exchange Rate Volatility
• Companies that do business internationally
are exposed to exchange rate risk
• The more volatile the exchange rates, the
more difficult it is to predict the firm’s cash
flows in its domestic currency
• If a firm can manage its exchange rate risk, it
can reduce the volatility of its foreign earnings
and do a better analysis of future projects
 Commodity Price Volatility
• Most firms face volatility in the costs of
materials and in the price that will be received
when products are sold
• Depending on the commodity, the company
may be able to hedge price risk using a variety
of tools
• This allows companies to make better
production decisions and reduce the volatility
in cash flows
 Reducing Financial Risk Exposure
• Financial risks exposures can be managed through
hedging.
• A hedge is a strategy to reduce the risk of adverse
price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related
security.
• There is a risk-reward tradeoff inherent in hedging;
while it reduces potential risk, it also chips away at
potential gains.
 Derivatives
 Derivative: Security whose value stems is
derived from the value of other assets.
 Types of Derivatives
– Forward
– Futures
– Options
– Swaps
• Derivatives are not the only way to hedge.
Strategically diversifying a portfolio to reduce
certain risks can also be considered as hedge.
 Use of derivatives
 Hedge
 use derivatives to reduce risk on an existing
position
 Speculate
 use derivatives to take on risk in the hope of
making a profit
 Arbitrage
 Use the difference between spot and
futures/forward prices to generate risk-free
profit
 Hedging with Forward Contracts
• A contract where two parties agree on the price of
an asset today to be delivered and paid for at some
future date
• Forward contracts are legally binding on both parties
• They can be tailored to meet the needs of both
parties and can be quite large in size
• Positions
– Long – agrees to buy the asset at the future date
– Short – agrees to sell the asset at the future date
• Because they are negotiated contracts and there is
no exchange of cash initially, they are usually limited
to large, creditworthy corporations
 Hedging with Forward Contracts
• Pros
1. Flexible
• Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default risk—requires information
to screen good from bad risk
 Hedging with Forwards
• Entering into a forward contract can virtually
eliminate the price risk a firm faces
• Because it eliminates the price risk, it
prevents the firm from benefiting if prices
move in the company’s favor
• The firm also has to spend some time and/or
money evaluating the credit risk of the
counterparty
 Payoff profile
Example: assume company XX wish to hedge fluctuation in
commodity price using forward contract. The following
information are supplemented regarding prices.
Today: Spot price = $1,000
6-month forward price = $1,020
In six months at contract expiration:
Case 1: Spot price = $1,050
• Long position payoff = $1,050 – $1,020 = $30
• Short position payoff = $1,020 – $1,050 = – $30
Case 2: Spot price = $1,000
• Long position payoff = $1,000 – $1,020 = – $20
• Short position payoff = $1,020 – $1,000 = $20
 Futures Contracts
Futures contracts are highly standardized forward
contracts traded on organized exchanges subject
to specific rules.
Require an upfront cash payment called margin
– Small relative to the value of the contract
– “Marked-to-market” on a daily basis
• Clearinghouse guarantees performance on all
contracts
• The clearinghouse and margin requirements virtually
eliminate credit risk
 Hedging with Futures
• The risk reduction capabilities of futures are
similar to those of forwards
• The margin requirements and marking-to-
market require an upfront cash outflow and
liquidity to meet any margin calls that may
occur
• Futures contracts are standardized, so the firm
may not be able to hedge the exact quantity it
desires
• Credit risk is virtually nonexistent
 Swaps
• A long-term agreement between two parties to
exchange cash flows based on specified
relationships
• Can be viewed as a series of forward contracts
• Generally limited to large creditworthy institutions
or companies
• Interest rate swaps – the net cash flow is exchanged
based on interest rates
• Currency swaps – two currencies are swapped
based on specified exchange rates
 Example
• Consider a UK Company wishing to raise 150 million dollar for
10 years at a floating rate of interest for investment in united
states and other US company that wishes to raise 100 million
pound for 10 years at a fixed rate of interest for investment in
united kingdom.
• The UK company can borrow $150 million at a floating rate of
interest LIBOR + 0.75 percent. The US company could borrow
£100 million at a fixed rate of interest of 8.5 %. A swap dealer
that has both these clients may spot swap opportunities,
knowing that market condition could permit the UK company
to borrow at fixed rate of 8% and the US company can borrow
at floating rate of LIBOR+ 0.25 %.
• Assume that the spot exchange rate is $1.5/ £1.
• Is there an opportunity to swap?
 Option Contracts
• The right, but not the obligation, to buy (sell) an
asset for a set price on or before a specified date
– Call – right to buy the asset
– Put – right to sell the asset
– Exercise or strike price –specified price
– Expiration date – specified date
• Unlike forwards and futures, options allow a firm to
hedge downside risk, but still participate in upside
potential
• Pay a premium for this benefit
 Payoff profile
Example: Assume company XX wish to hedge
fluctuation in commodity price using option. The
following information are supplemented regarding
prices.
Today: Spot price = $1,000
6-month option price = $1,020 (strike price)
option premium= $10
 Call option
In six months at contract expiration:
Case 1: Spot price = $1,050
• Long position payoff = $1,050 – ($1,020 +10) = $20
• Short position payoff = ($1,020 +10) – $1,050 = –
$20
Case 2: Spot price = $1,000
Since buying at spot market is cheaper than the
contract option holder will not exercise its right.
• Long position payoff = – $10 (premium paid)
• Short position payoff = $10 (premium received)
 Put option
In six months at contract expiration:
Case 1: Spot price = $1,050
Since selling at spot market is higher than the
contract option holder will not exercise its right.
• Long position payoff = $10 (premium received)
• Short position payoff = - $10 (premium paid)
Case 2: Spot price = $1,000
• Long position payoff = 1000 +10 – $1,020 = -$10
• Short position payoff = $1,020 – (1000+10)= $10
 Put option
• What will be the payoff profile under
put option if the six months option
price is $1015?
 Put Option
In six months at contract expiration:
Case 1: Spot price = $1,015
• Long position payoff = 1015 +10 – $1,020 = +$10
• Short position payoff = $1,020 – (1015+10)= -$10
 How can risk management increase the
value of a corporation?
Risk management allows firms to:

 Have greater debt capacity, which has a larger tax

shield of interest payments.
 Avoid costs of financial distress.
 Reduce borrowing costs by using interest rate
swaps.