Titman - PPT - CH20 Revisi

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 20
Corporate Risk
Management
Copyright © 2018, 2014, 2011 Pearson

Copyright Education, Inc. Education,
© 2018, 2014, 2011 Pearson All Rights
Inc. All Reserved
Rights Reserved
Managing Risk with Insurance Contracts
Insurance is defined as the equitable transfer of the
risk of a loss from one entity to another in exchange
for the payment of premium. Essentially, the insured
exchanges the risk of a large, uncertain, and
possibly devastating loss to an insurance company
in exchange for a guaranteed, small loss (premium).
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Types of Insurance Contracts
Type of Insurance Contract Used
Type of Risk to Hedge
Property damage to company facilities due to fire, storm, or Property insurance

vandalism
Loss of business resulting from a temporary shutdown Business interruption insurance

because of fire or other insured peril
Loss of income resulting from the disability or death of an Key person life insurance
employee in a key position
Losses resulting from claims against the officers and Director and officer insurance
directors for alleged errors in judgment, breaches of duty,
and wrongful acts related to their organizational activities
Losses due to on-the-job injuries suffered by employees Workers’ compensation insurance
Why Purchase Insurance?
• When a firm decides to purchase insurance, it is
typically the result of a cost-benefit type of
analysis involving a comparison of the costs of
purchasing the insurance contract and the
expected cost of retaining the risk that would be
covered by the insurance.
• Self-insurance entails setting aside a calculated
amount of money to compensate for the potential
future loss.
Managing Risk by Hedging with Forward
Contracts (1 of 4)
Hedging refers to a strategy designed to offset the
exposure to price risk. For example, If you are
planning to buy 1 million Euros in 6 months, it will
cost you more if Euro strengthens. Such risk can be
mitigated with forward contracts.
Contracts (2 of 4)
A Forward contract is a contract in which a price is
set today for an asset to be sold in the future. These
contracts are privately negotiated between the
buyer and seller. Since the price is locked-in today,
risk from future adverse price fluctuation is
eliminated.
Contracts (3 of 4)
• If you are planning to buy 1 million Euros in 6
months, you could negotiate a rate today for
Euros (say 1 Euro = $1.35) using a forward
contract.
• In 6-months, regardless of whether Euro has
appreciated or depreciated, your obligation for 1
million Euros will be at $1.35 each or $1.35
million.
Contracts (4 of 4)
The following table shows potential future scenarios
and the cash flows. It is seen that Forward contract
helps to reduce risk if Euro appreciates. However, if
Euro depreciates, Forward contract obligates the
firm to pay a higher amount.
Future Exchange Rate Cost with a Forward Cost without a Forward Effect of Forward
of Euro Contract contract Contract
$1.20 $1.35 million $1.20 million Unfavorable
$1.30 $1.35 million $1.30 million Unfavorable
$1.40 $1.35 million $1.40 million Favorable
$1.50 $1.35 million $1.50 million Favorable
Hedging Commodity Price Risk Using
Forward Contracts (1 of 2)
• Assume jet fuel is currently selling for $100 per barrel. If an
airline company does not want to suffer the risk associated
with future price fluctuations in the cost of fuel, it can enter
into a forward contract today with a delivery price equal to
the current price of fuel of $100. Such a contract will have
a payoff found in Panel A of Figure 20.2.
• The firm that owns this position is said to have taken a
long position. If the actual price of jet fuel rises to $130 in
six months, then the forward contract is worth $30 per
barrel because the cost to airline company remains $100
per barrel.
Hedging Commodity Price Risk Using
Forward Contracts (2 of 2)
Assume a refining company anticipates that it will
have jet fuel refined and ready for sale in six
months. To eliminate the risk of drop in market price
in six months, the company can sell a forward
contract (i.e. take a short position) for the delivery
of fuel in six months at a price of $100. The payoff
for this contract is found in panel B. If the price of jet
fuel rises to $130 on the delivery date, the refining
company suffers a loss of $30 on the forward
contract, as the price received per barrel is $100.
Figure 20.2 Delivery Date Profits or Losses (Payoffs) from a
Forward Contract
(Panel A) Long Position in Forward Contract
Figure 20.2 Delivery Date Profits or Losses (Payoffs) from a
Forward Contract
(Panel B) Short Position in Forward Contract
The Problem
Consider the profits that Progressive might earn if it
chooses to hedge only 80% of its anticipated 1
million barrels of crude oil under the conditions just
described.
Step 1: Picture the Problem
• The figure shows that the future price of crude oil
could have a dramatic impact on the total cost of 1
million barrels of crude oil.
• If the price is not managed, it will significantly
affect the future profits of the firm.
Step 2: Decide on a Solution Strategy
The firm can hedge its risk by purchasing a forward
contract. This will lock-in the future price of oil at the
forward rate of $130 per barrel.
Step 3: Solve (1 of 2)
The table on the next slide contains the calculation
of firm profits for the case where the price of crude
oil is not hedged (column E), the payoff on the
forward contract (column F) and firm profits where
the price of crude is 80% hedged (column G).
Profit/Loss on 80% Hedged
Price of Total Cost Total Total Refining Unhedged Forward Annual
Oil/bbl of Oil Revenues Costs Annual Profits Contract Profits
=(A-
A B=A×1m C D=$30×1m E=C+B+D $130)×1mx%He G=E+F
dge
$110 $(110,000,000) $165,000,000 $(30,000,000) $25,000,000 $(16,000,000) $9,000,000
115 (115,000,000) $165,000,000 (30,000,000) $20,000,000 $(12,000,000) $8,000,000
120 (120,000,000) $165,000,000 (30,000,000) $15,000,000 $(8,000,000) $7,000,000
125 (125,000,000) $165,000,000 (30,000,000) $10,000,000 $(4,000,000) $6,000,000
130 (130,000,000) $165,000,000 (30,000,000) $5,000,000 $— $5,000,000
135 (135,000,000) $165,000,000 (30,000,000) $0 $4,000,000 $4,000,000
140 (140,000,000) $165,000,000 (30,000,000) $(5,000,000) $8,000,000 $3,000,000
Step 4: Analyze
• The total cost of crude oil increases as the price of
crude oil increases. The unhedged annual profits
range from a loss of $5 million to a gain of $25
million.
• With 80% hedging, losses are avoided and the
firm ends with profits ranging from $3 million to
$5million. The forward contract obviously benefits
the firm when the price of oil is higher than $130.
Hedging Currency Risk Using Forward
Contracts (1 of 2)
• Currency risk can be hedged using forward
contracts.
• For example, If Disney expects to receive ¥500
million from its Tokyo operations in 3 months.
Disney can lock-in the exchange rate and thereby
eliminate any risk of an unfavorable move in
exchange rates.
Hedging Currency Risk Using Forward
Contracts (2 of 2)
Disney will follow a 2-step procedure to hedge its
currency risk:
1. (Today): Enter into a forward contract which
requires Disney to sell ¥500 million three
months from now at the forward rate of say
$0.009123/ ¥.
2. (In three months): Disney will convert its ¥500
million cash flow at the contracted forward
rate, yielding $4,561,500 (¥500 m ×
$0.009123).
Limitations of Forward Contract
1. Credit risk exposure: Both parties are exposed to
the credit risk or default risk that the other party may
default on his or her obligation.
2. Sharing of strategic information: The parties know
what specific risk is being hedged. In case of
exchange-traded contracts, the parties to the
agreement are anonymous so no such sharing of
information would occur.
3. It is hard to determine the market values of
negotiated contracts as these contracts are not
traded.
20.4 MANAGING RISK WITH
EXCHANGE—TRADED FINANCIAL
DERIVATIVES
Managing Risk with Exchange—Traded
Financial Derivatives
• A derivative contract is a security whose value is
derived from the value of the another asset or
security (which is referred to as the underlying
asset).
• Exchange traded financial derivatives cannot be
customized (like forward contracts) and are
available only for specific assets and for limited
set of maturities.
Futures Contract
• A futures contract is a contract to buy or sell a
stated commodity (such as soybean or corn) or a
financial claim (such as U.S. Treasury bonds) at a
specified price at some specified future time.
These contracts, like forward contracts, can be
used by the financial manager to lock in future
prices of raw materials, interest rates, or
exchange rates.
• Two categories: Commodity futures and financial
futures.
Managing Default Risk in Futures Market
Futures exchanges use two mechanisms to control
credit or default risk.
1. Futures Margin – Futures exchanges require
participants to post collateral called futures
margin or just margins. Collateral is used to
guarantee that he or she will fulfill the obligations
in that contract.
2. Marking to Market – This means that daily gains
or losses from a firm’s futures contract are
transferred to or from its margin account.
Figure 20.4 Marking to Market on Futures Contracts
Margin Account Change in Value Change in Value

Balance on 10 Value of 1 Futures of 1 Futures of 10 Futures
Date Futures Contracts Contract Contract Contracts
1-Oct-17 $4,000 $2,578 Blank Blank
2-Oct-17 $3,180 $2,496 ($82) ($820)
3-Oct-17 $3,250 $2,503 $7 $70
4-Oct-17 $3,880 $2,566 $63 $630
Hedging with Futures Contract (1 of 4)
Futures contract can be used to build financial
hedges like forward contracts.
– If the firm is planning to buy, it can enter into a long
hedge by purchasing the appropriate futures contract.
– If the firm is planning to sell, it can enter into a short
hedge by selling (or going short) a futures contract.
Futures contracts are only available for a subset of
all assets and for a limited set of maturities. As a
result, it is often not possible to form a perfect
hedge.
• Restrictions on available futures contracts and
maturities give rise to the following practical
problems:
1. Inability to find a futures contract on the exact
asset that is the source of risk
2. The hedging firm may not know the exact date
when the hedged asset will be bought or sold
3. The maturity of the futures contract may not
match the period for which the underlying
asset is to be held or until it must be acquired
• The three reasons listed (on previous slide) lead to
basis risk. Basis risk arises any time the asset
underlying the futures contract is not identical to the
asset underlying the firm’s risk exposure. As a
consequence, if the basis risk is nonzero, the firm
does not have a perfect hedge.
• If a specific asset is not available, the best alternative
is to use an asset whose price changes are highly
correlated with the asset. In general, whenever the
correlation is higher, the hedge will be better.
Option Contracts (1 of 2)
• There are many situations in which firms would like to
guarantee a minimum revenue but do not need to
absolutely fix their revenues. The firm can accomplish
this if it hedges with options rather than with futures
contracts.
• Options are rights (not an obligation) to buy or sell a
given number of shares or an asset at a specific price
over a given period.
• The option owner’s right to buy is known as a call
option while the right to sell is known as a put
option.
Option Contracts (2 of 2)
For example, if you buy a call option on 100 shares
of XYZ stock at a premium of $4.50 and exercise
price of $40 maturing in 90 days means:
– You can buy the XYZ stock at $40, even though the
market price of the stock maybe above $40.
– If the stock price is below $40, you will choose not to
use your option contract and will lose the premium paid
• A key difference between an options contract and a futures
contract is that the option owner does not have to exercise
the option.
A Graphical Look at Option Pricing
Relationships
Figures 20.5 to Figures 20.8 graphically illustrate the
expiration date profit or loss from the following option
positions:
– Buying a call option (figure 20.5)
– Selling (Writing) a call option (figure 20.6)
– Buying a put option (figure 20.7)
– Selling (Writing) a put option (figure 20.8)
Figure 20.5 Expiration Date Profit or Loss from Purchasing a
Call Option
Figure 20.6 Expiration Date Profit or Loss from Selling
(Writing) a Call Option
Figure 20.7 Expiration Date Profit or Loss on Holding a Put
Option
Figure 20.8 Expiration Date Profit or Loss from Selling
(Writing) a Put Option
Option Pricing Relationship Summary
Blank Buy Call Write Call Buy Put Write Put
Maximum Profit Unlimited Premium Exercise Price − Premium

Premium
Maximum Loss Premium Unlimited Premium Exercise Price −

Premium
Future Market Bullish Bearish Bearish Bullish

Expectation
Break-even Point Exercise Price + Exercise Price + Exercise Price − Exercise Price −
Premium Premium Premium Premium
Figure 20.9 Option Price Quotes for Apple Computers on
February 24, 2016
AAPL (APPLE INC) Price as of 2/24/2016: $93.99
Last Last
Calls Vol Open Int Puts Vol Open Int
Sale Sale
16 Apr 90
16 Apr 90 Call $7.15 30 4,050 $3.04 220 11,897
Put
16 Apr 95
16 Apr 95 Call $4.26 361 10,394 $5.15 272 15,221
Put
16 Apr 100
16 Apr 100 Call $2.18 508 117,700 $8.35 22 125,674
Put
16 Jul 90
16 Jul 90 Call $9.40 0 1,147 $5.35 0 4,546
Put
16 Jul 95
16 Jul 95 Call $7.15 116 2,966 $8.30 234 4,487
Put
16 Jul 100
16 Jul 100 Call $4.86 7 9,639 $11.20 216 15,109
Put
Sources: www.cboe.com, www.quote.com, wsj.com, www.fidelity.com, and www.optionshouse.com.
The Problem
If you paid $5 for a call option with an exercise price
of $25, and the stock is selling for $35 at expiration,
what are your profits and losses? What is the break-
even point on this call option?
Step 1: Picture the Problem (1 of 2)
Stock Price Call Exercise Exercised Profit or

Premium Price or Not Loss Maximum
A B C D E Loss=
Premium
Blank Blank Blank Blank = Max(O,
A−C)−B
Break
$20 ($5) $25 No ($5) Even
$25 ($5) $25 No ($5) Point
$30 ($5) $25 Yes $0
$35 ($5) $25 Yes $5
$40 ($5) $25 Yes $10
• Break-even Point = Exercise price + Premium
• Profit = (Stock price − Exercise price) − Premium
– If (stock price – exercise price) is negative, the profit or
losses is equal to $0 – Premium.
Step 3: Solve
• Break-even Point = Exercise price + Premium
= $25 + $5
= $30
• Profit (at stock price of $35)
= (Stock Price – Exercise Price) – Premium
= ($35 − $25) − $5
= $5
Step 4: Analyze
• The graph in Step 1 shows that the option buyer
will start exercising the option once it crosses $25.
• The option buyer will earn $1 (before considering
option premium) for every $1 that the stock price
rises above $25. Since the option premium is $5,
at a stock price of $30, the option position earns
$5 that covers the premium and leads to a no
profit/no loss situation.
20.5 VALUING OPTIONS AND SWAPS
Valuing Options and Swaps
• The value of option is determined by the present
value of the expected payout when the option
expires.
• The most popular option pricing model is the
Black-Scholes Option Pricing Model (BS-OPM).
Black—Scholes Option Pricing Model (1 of 3)
There are six variables that influence an option’s
price:
1. The price of the underlying stock
2. The option’s exercise or strike price
3. The length of time left until expiration
4. The expected stock price volatility over life of
the option
5. The risk-free rate of interest
6. The underlying stock’s dividend yield
What IF Value of Call option Value of Put Option
Price of underlying stock increases Increases Decreases
Exercise price is higher Decreases Increases
Time to expiration is longer Increases Increases
Stock price volatility is higher over the life of Increases Increases

the option
Risk-free rate of interest is higher Increases Decreases
The stock pays dividend Decreases Increases
Black-Scholes option pricing model for call options
is stated as follows:
Call Option  Stock Price   Strike    Risk-free   Time to  
  N ( d1 )    e      N (d 2 )
Value (Call )  Today (P0 )   Price ( X )   rate   expiration 
 Stock Price   Variance in 

   Risk-free  Time to
Today Stock Returns
ln    
 Stock   Rate 2  Expiration
   
d1   Price   
Variance in Time to

Stock Returns Expiration
Variance in Time to
d 2  d1  
The Problem
What will happen if the firm decides to issue a large
dividend?
Given:
– Current price of stock = $32
– Exercise price = $30
– Maturity = 0.25 years
– Annualized variance in stock returns = .16
– Risk-free rate =4%
If the firm declares a dividend, the stock price is
expected to fall. Assume the firm declares a
dividend of $1 and the price drops from $32 to $31.
Equation 20-1 can be used to determine the value
of call option using Black-Scholes option pricing
model to examine the impact of dividend payment
and consequent decline in stock price.
 Stock Price   Variance in 
   Risk-free  Time to
Today Stock Returns
ln    
 Stock   Rate 2  Expiration
   
d1   Price   
Variance in Time to

Line d−1 (steps) Computation Blank
1 In(S/E) Blank 0.03278
2 R=.5(Variance) .5*.16 0.08
3 (Rf+.5Var)*time (.04+line2)*.25 0.03
4 Numerator line 1+line3 0.06278
5 tXvariance .16*.25 0.04
6 Sqrt(T*Variance) sqrt(line5) 0.2
7 d−1 line 4/line 6 0.31395
Variance in Time to
d 2  d1  
Line d−2 (steps) Computation Blank
8 tXvariance .16*.25 0.04
9 sqrt(T*Variance) sqrt (line 8) 0.2
10 d−2 line (7−9) .1139
11 N(d1) Normsdist (line7) 0.6232
12 N(d2) Normsdist (line10) 0.545
Call Option  Stock Price   Strike    Risk-free   Time to  

  N (d1 )    e      N (d 2 )
Value (Call )  Today (P0 )   Price ( X )   rate   expiration 
Line Call value (steps) Computation Blank
13 S*N(d−1) $31*line 11 19.3198
14 −R*t −0.12*0.25 −0.0100
15 exp^(−R*T) exp (line 14) 0.99

$25*line
16 E*e^RT*N(d−2) 15*line 12 16.198
Blank Call Value Line 13−Line 16 3.122
Step 4: Analyze
• The value of this option is $3.12 using BS-OPM.
• The current stock price of $31 represents a $1
decline due to distribution of $1 dividend. As
expected, a decline in the stock price leads to fall
in the value of call option from $3.77 to $3.12.
Therefore, the larger the stock’s dividend yield,
the lower the value of call option on that stock.
Swap Contract
• A swap contract involves the swapping or trading
of one set of payments for another.
• An interest rate swap may involve trading fixed
interest payments for floating-rate interest
payments.
• A currency swap involves an exchange of debt
obligations in different currencies.
Figure 20.10 Fixed—Interest—Rate for Floating—Interest—
Rate Swap
9.75% 8.5%
 $250 million  $250 million
2 2
Six-Month LIBOR Fixed-Rate Floating-Rate

Year Rate Coupon Coupon Net Swap Cash Flow
A B C D E
0.00 8.5% Blank Blank Blank

0.50 7.2% $12,187,500 $10,625,000 ($1,562,500)
1.00 10.0% $12,187,500 $ 9,000,000 ($3,187,500)
1.50 9.3% $12,187,500 $12,500,000 $312,500
2.00 9.8% $12,187,500 $11,625,000 ($562,500)
2.50 10.8% $12,187,500 $12,250,000 $62,500
3.00 11.3% $12,187,500 $13,500,000 $1,312,500
3.50 11.5% $12,187,500 $14,125,000 $1,937,500
4.00 10.5% $12,187,500 $14,375,000 $2,187,500
4.50 9.5% $12,187,500 $13,125,000 $937,500
5.00 Blank $12,187,500 $11,875,000 ($312,500)

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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

Property damage to company facilities due to fire, storm, or Property insurance

Loss of business resulting from a temporary shutdown Business interruption insurance

Losses due to on-the-job injuries suffered by employees Workers’ compensation insurance

$1.20 $1.35 million $1.20 million Unfavorable

$1.30 $1.35 million $1.30 million Unfavorable

$1.40 $1.35 million $1.40 million Favorable

$1.50 $1.35 million $1.50 million Favorable

$110 $(110,000,000) $165,000,000 $(30,000,000) $25,000,000 $(16,000,000) $9,000,000

115 (115,000,000) $165,000,000 (30,000,000) $20,000,000 $(12,000,000) $8,000,000

120 (120,000,000) $165,000,000 (30,000,000) $15,000,000 $(8,000,000) $7,000,000

125 (125,000,000) $165,000,000 (30,000,000) $10,000,000 $(4,000,000) $6,000,000

130 (130,000,000) $165,000,000 (30,000,000) $5,000,000 $— $5,000,000

135 (135,000,000) $165,000,000 (30,000,000) $0 $4,000,000 $4,000,000

140 (140,000,000) $165,000,000 (30,000,000) $(5,000,000) $8,000,000 $3,000,000

Margin Account Change in Value Change in Value

1-Oct-17 $4,000 $2,578 Blank Blank

2-Oct-17 $3,180 $2,496 ($82) ($820)

3-Oct-17 $3,250 $2,503 $7 $70

4-Oct-17 $3,880 $2,566 $63 $630

Blank Buy Call Write Call Buy Put Write Put

Maximum Profit Unlimited Premium Exercise Price − Premium

Maximum Loss Premium Unlimited Premium Exercise Price −

Future Market Bullish Bearish Bearish Bullish

Stock Price Call Exercise Exercised Profit or

$30 ($5) $25 Yes $0

$35 ($5) $25 Yes $5

$40 ($5) $25 Yes $10

What IF Value of Call option Value of Put Option

Price of underlying stock increases Increases Decreases

Exercise price is higher Decreases Increases

Time to expiration is longer Increases Increases

Stock price volatility is higher over the life of Increases Increases

Risk-free rate of interest is higher Increases Decreases

The stock pays dividend Decreases Increases

 Stock Price   Variance in 

Line d−2 (steps) Computation Blank

8 tXvariance .16*.25 0.04

9 sqrt(T*Variance) sqrt (line 8) 0.2

10 d−2 line (7−9) .1139

11 N(d1) Normsdist (line7) 0.6232

12 N(d2) Normsdist (line10) 0.545

Call Option  Stock Price   Strike    Risk-free   Time to  

Line Call value (steps) Computation Blank

13 S*N(d−1) $31*line 11 19.3198

14 −R*t −0.12*0.25 −0.0100

15 exp^(−R*T) exp (line 14) 0.99

Blank Call Value Line 13−Line 16 3.122

Six-Month LIBOR Fixed-Rate Floating-Rate

0.00 8.5% Blank Blank Blank

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13 SN(d−1) $31line 11 19.3198

14 −Rt −0.120.25 −0.0100