Derivatives and Risk Management

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Chapter 24

• Derivatives and Risk Management

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Topics in Chapter

• Risk management and stock value maximization.
• Derivative securities.
• Fundamentals of risk management.
• Using derivatives to reduce interest rate risk.

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Do stockholders care about volatile cash flows?

• If volatility in cash flows is not caused by
  systematic risk, then stockholders can eliminate
  the risk of volatile cash flows by diversifying
  their portfolios.
• Stockholders might be able to reduce impact of
  volatile cash flows by using risk management
  techniques in their own portfolios.

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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.
• Implement the optimal capital budget without
  having to raise external equity in years that
  would have had low cash flow due to volatility.

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Risk management allows firms to

• Avoid costs of financial distress.
• Weakened relationships with suppliers.
• Loss of potential customers.
• Distractions to managers.
• Utilize comparative advantage in hedging relative
  to hedging ability of investors.

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Risk management allows firms to (Continued)

• Reduce borrowing costs by using interest rate
  swaps.
• Example Two firms with different credit
  ratings, Hi and Lo
• Hi can borrow fixed at 11 and floating at LIBOR
  1.
• Lo can borrow fixed at 11.4 and floating at
  LIBOR 1.5.

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Hi wants fixed rate, but it will issue floating
and swap with Lo. Lo wants floating rate, but
it will issue fixed and swap with Hi. Lo also
makes side payment of 0.45 to Hi.
Hi Lo
CF to lender -(LIBOR1) -11.40
CF Hi to Lo -11.40 11.40
CF Lo to Hi (LIBOR1) -(LIBOR1)
CF Lo to Hi 0.45 -0.45
Net CF -10.95 -(LIBOR1.45)
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Risk management allows firms to

• Minimize negative tax effects due to convexity in
  tax code.
• Example EBT of 50K in Years 1 and 2, total EBT
  of 100K,
• Tax 7.5K each year, total tax of 15.
• EBT of 0K in Year 1 and 100K in Year 2,
• Tax 0K in Year 1 and 22.5K in Year 2.

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What is corporate risk management?

• Corporate risk management is the management of
  unpredictable events that would have adverse
  consequences for the firm.

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Different Types of Risk

• Speculative risks Those that offer the chance
  of a gain as well as a loss.
• Pure risks Those that offer only the prospect
  of a loss.
• Demand risks Those associated with the demand
  for a firms products or services.
• Input risks Those associated with a firms
  input costs.

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• Financial risks Those that result from
  financial transactions.
• Property risks Those associated with loss of a
  firms productive assets.
• Personnel risk Risks that result from human
  actions.
• Environmental risk Risk associated with
  polluting the environment.
• Liability risks Connected with product,
  service, or employee liability.
• Insurable risks Those which typically can be
  covered by insurance.

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What are the three steps of corporate risk
management?

• 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.

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What are some actions that companies can take to
minimize or reduce risk exposures?

• Transfer risk to an insurance company by paying
  periodic premiums.
• Transfer functions which produce risk to third
  parties.
• Purchase derivatives contracts to reduce input
  and financial risks.

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• 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.

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What is financial risk exposure?

• Financial risk exposure refers to the risk
  inherent in the financial markets due to price
  fluctuations.
• Example A firm holds a portfolio of bonds,
  interest rates rise, and the value of the bonds
  falls.

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Financial Risk Management Concepts

• Derivative Security whose value stems or is
  derived from the value of other assets. Swaps,
  options, and futures are used to manage financial
  risk exposures.

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• Futures Contracts which call for the purchase
  or sale of a financial (or real) asset at some
  future date, but at a price determined today.
  Futures (and other derivatives) can be used
  either as highly leveraged speculations or to
  hedge and thus reduce risk.

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• Hedging Generally conducted where a price
  change could negatively affect a firms profits.
• Long hedge Involves the purchase of a futures
  contract to guard against a price increase.
• Short hedge Involves the sale of a futures
  contract to protect against a price decline in
  commodities or financial securities.

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• Swaps Involve the exchange of cash payment
  obligations between two parties, usually because
  each party prefers the terms of the others debt
  contract. Swaps can reduce each partys
  financial risk.

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How can commodity futures markets be used to
reduce input price risk?

• The purchase of a commodity futures contract will
  allow a firm to make a future purchase of the
  input at todays price, even if the market price
  on the item has risen substantially in the
  interim.

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Chapter 24 Extension Insurance and Bond
Portfolio Risk Management

• Risk identification and measurement
• Property loss, liability loss, and financial loss
  exposures
• Bond portfolio risk management

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How are risk exposures identified and measured?

• Large corporations have risk manage-ment
  personnel which have the responsibility to
  identify and measure risks facing the firm.
• Checklists are used to identify risks.
• Small firms can obtain risk manage-ment services
  from insurance companies or risk management
  consulting firms.

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Describe (1) property loss and(2) liability
loss exposures.

• Property loss exposures Result from various
  perils which threaten a firms real and personal
  properties.
• Physical perils Natural events
• Social perils Related to human actions
• Economic perils Stem from external economic
  events

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• Liability loss exposures Result from penalties
  imposed when responsi-bilities are not met.
• Bailee exposure Risks associated with having
  temporary possession of anothers property while
  some service is being performed. (Cleaners ruin
  your new suit.)
• Ownership exposure Risks inherent in the
  ownership of property. (Customer is injured from
  fall in store.)

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• Business operation exposure Risks arising from
  business practices or operations. (Airline sued
  following crash.)
• Professional liability exposure Stems from the
  risks inherent in professions requiring advanced
  training and licensing. (Doctor sued when
  patient dies, or accounting firm sued for not
  detecting overstated profits.)

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What actions can companies taketo reduce
property and liability exposures?

• Both property and liability exposures can be
  accommodated by either self-insurance or passing
  the risk on to an insurance company.
• The more risk passed on to an insurer, the higher
  the cost of the policy. Insurers like high
  deductibles, both to lower their losses and to
  reduce moral hazard.

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How can diversification reduce business risk?

• By appropriately spreading business risk over
  several activities or operations, the firm can
  significantly reduce the impact of a single
  random event on corporate performance.
• Examples Geographic and product diversification.

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What is financial risk exposure?

• Financial risk exposure refers to the risk
  inherent in the financial markets due to price
  fluctuations.
• Example A firm holds a portfolio of bonds,
  interest rates rise, and the value of the bonds
  falls.

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Financial risk management concepts

• Duration Average time to bondholders' receipt of
  cash flows, including interest and principal
  repayment. Duration is used to help assess
  interest rate and reinvestment rate risks.
• Immunization Process of selecting durations for
  bonds in a portfolio such that gains or losses
  from reinvestment exactly match gains or losses
  from price changes.

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Hedging a bond issue with T-Bond Futures

• It is January, Tennessee Sunshine will issue 5
  million in bonds in June. TS is worried
  interest rates will rise between now and then.
• Current interest rates are 7 for the 20-year
  issue. But TS fears rates might rise by 1 by
  June.
• June T-bond futures are 111-25.

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What are risks of not hedging?

• Interest rates might increase before the bonds
  are issued. At a yield of 8, how much will the
  5 million worth of 20-year 7 semi-annual coupon
  bonds be worth?

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• Pmt 5 million x 7/2 175,000

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• The bonds will be worth only 4,505,181 so TS
  will lose 5,000,000 - 4,505,181 494,819 if
  interest rates decline.
• Actually, TS might just issue 5,000,000 of 8
  bonds if it waits and interest rates increase,
  but the cost of this higher interest rate is the
  494,819 we calculated.

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How can Tennessee Sunshine hedge this risk?

• T-Bond futures represent a contract on a
  hypothetical 20-year 6 bond with semiannual
  payments.
• A futures price of 11125 means 111 plus 25/32
  percent of par, or for a 1,000 par bond, a price
  of 1,117.81.

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T-bond futures contract

• One T-bond futures contract is for 100,000 par
  value of underlying bonds, which is 100 of the
  1,000 par-value bonds. Since each bond is worth
  1,117.81, one contract is for 111,781 worth of
  bonds.
• TS will sell 5,000,000/111,781 44.7 45
  contracts.

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Implied yield on futures contract

• A price of 1,117.81 gives a semi-annual yield of
  2.5284 or an annual yield of about 5.057

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Futures price changes

• T-bond futures prices change every day as
  interest rates change. If interest rates
  increase, bond prices decrease and so does the
  T-bond futures price. If interest rates
  decrease, then bond prices increase, and so does
  the T-bond futures price.

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What happens if interest rates increase 1?

• The yield on the bond underlying the futures
  contract will increase to 5.057 1 6.057.
  This gives a new price of 993.44 (N40,
  I/YR6.057/2, PMT -30, FV -1000 solving
  gives PV 993.44 per underlying bond, or a
  contract price of 99,344.
• This is a decrease of 111,781 - 99,344
  12,437 for each contract.

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Profit or loss from contract

• Since TS sold futures contracts, then it makes
  money when the futures price declines. In this
  case, TS will make 12,437 on each of its 45
  contracts.
• Since TS sold the futures contracts and the price
  went down, it earns a positive profit of 12,437
  x 45 contracts 559,665.

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What is the effectiveness of the hedge?

• TS will lose 494,819 on its own bonds when it
  issues them at the higher coupon rate, but it
  earns 559,665 on its futures contracts.
• Net result 559,665 494,819 64,846 profit
  from the hedge.

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Suppose interest rates fall instead of rise?

• If interest rates fall, then
• TS gains on its bond issue
• TS loses on its futures contracts