Risk Management:

An Introduction to
Financial
Engineering

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

What is Financial Risk Management ?

• Firms deal in various markets:

• Foreign exchange markets
• Interest Rate markets
• Commodity markets
• Stock Markets (Equities)
• They face exposure to unfavourable price movements
(risks) in these markets.
• Volatility in these markets can lead to volatility in cash
flows and returns to firms depending on exposures
• FRM concerns the management of these risks, by
reducing the volatility of cash flows, principally through
the use of derivatives.
 Reducing Risk Exposure
• The goal of hedging is to reduce or eliminate the risk
• Timing
• Short-run exposure (transactions exposure)
• Arising from the need to buy or sell at uncertain prices/rates in the
near future
• Can be managed in a variety of ways
• Long-run exposure (economic exposure)
• Arising from permanent changes in prices or other economic
fundamentals
• Almost impossible to hedge, requires the firm to be flexible and adapt
to permanent changes in the business climate
 What are Derivatives?

Derivatives
• A derivative is a financial instrument whose
return is derived from the return on another
underlying instrument.
• Example of Underlying instruments/assets:
stock, bond, certain commodity…
• Derivatives include futures, forwards, options and
swaps and many others
 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 Forwards
• Entering into a forward contract can virtually
eliminate the price risk a firm faces by “locking-
in” or “fixing” the price to be paid or received
• Because it eliminates the price risk, it prevents
the firm from benefiting if prices move in the
company’s favor
• The firm needs also to evaluate the credit risk of
the counterparty
• Forward contracts are primarily used to hedge
exchange rate risk
 Example – Long Forward
Contract
• A Ltd, an Australian company, will have to
pay £1million for imports from the UK in 90
days time.
• It decides to hedge its currency exchange
rate risk by entering into a long forward
contract today to buy £1,000,000 @ A$2.40 in
90 days time
• In 90 days, the exchange rate is £1 = A$2.46
• A Ltd makes a gain of A$60,000 on the 90 day
forward [(A$2.46 – A$2.40) £1,000,000]
 Futures Contracts
• Definition: a contract between two parties for one
party to buy something from the other at a later date at
a price agreed upon today; subject to a daily
settlement of gains and losses and guaranteed against
the risk that either party might default
• Exclusively traded on a futures exchange
• Require an upfront cash payment called “margin”
• Small relative to the value of the contract
• “Marked-to-market” on a daily basis
• Clearinghouse guarantees performance on contracts -
guarantee is supported by margin requirements (these
are deposits not an expense to the trader).
 Example forward contract VS.
Future contract
• Case 1: In the morning, Sept.15, an investor
buys 125,000 Swiss Francs using a four day
forward contract; delivery is set in Sept. 21. The
price agreed upon is 1.3333 SF/1$.
• Case 2: In Sept 15, the investor goes long one
Sept. CME Swiss Franc futures contract; the
price agreed upon is 1.3333 SF/1$.. Delivery is
on Sept. 21. Margin requirement is $2150.
• (Assume: Day 17, 18, 20 are days off)

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 Mark to the market (for long position)
Time Future price Margin $ settlement Cash flow
SF/$ requirement to buy (marked to
125,000 SF the market)
15/9
SF1.3333/$ $2150 $93,750 -$2150
(morning)
15/9 (close) 1.3245 94,375 +625
16/9 (close) 1.3298 94,000 -375
19/9 (close) 1.3514 92,500 -1500
+2150
21/9 SF125000
-92500
+SF125000
-$93750
6-9
 Future Quotation

Cacao: Size 10 metric tons; $/ton

Open High Low SETTLE CHG OPEN INT

July 3.205 3.230 3.180 3.200 -30 183

September 3.147 3.150 3.085 3.122 -25 93.277

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Future quote

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 Forward Contracts vs
Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Marked to Market daily

Delivery or final cash Contract usually closed out
settlement usually occurs prior to maturity
 A long Hedge (buy futures)
• If an entity is “short” the underlying assest or
knows that it will have to buy a certain asset in
the future (eg. a currency or a commodity) it can
hedge against a price rise by going long (buying)
in future market to “lock in” the price now.
• If the price of asset rises after taking the long
position the hedger will gain on its futures
position but have to pay more than the current
spot price to acquire the underlying asset at the
future time
• The opposite is true if the price falls
 Example: Long Hedge
• In late 2024, an airline company expects the price of oil to increase
during 2025.
• Management decide to hedge 50% of its oil needs by buying oil
futures
• The future (equivalent to say 2,000,000 barrels) were acquired at an
average price of $80 per barrel of oil
• 2025: The price of oil subsequently fell at an average price of $63
per barrel.
• This resulted in a loss of 2,000,000($63-$80) = $34 million
• The company was able to buy its oil needs on spot market as an
average price equivalent to $63 per barrel
• That is, the company lost on the future hedging position but this was
offset by lower prices in the spot market
 Short Hedge (sell futures)

▪ Where a hedger is already owns, will own an asset (e.g.

a commodity producer), that it expects to sell at a future
date it can “lock-in” the price now by going short futures.
▪ The objective of hedging with futures is to take a position
that neutralises risk as far as possible
▪ If the price of the asset rises after taking the short
position the hedger will gain on its underlying asset
position but lose on its futures position and vice-versa if
the asset price falls.
▪ Whichever way the price moves the hedger is locked in at
a price equal to that of the futures contract.
 Swaps
• A long-term agreement between two parties to
exchange cash flows based on specified
relationships
• Generally limited to large creditworthy institutions
or companies
• Type of swaps
• Interest rate swaps – the net cash flow is exchanged
based on interest rates
• Currency swaps – two currencies are swapped based on
specified exchange rates or foreign vs. domestic interest
rates
 Example: Interest Rate Swap
• Assume the following borrowing opportunities are
available to Company A and Company B and that
• Company A wishes to borrow $50m. at fixed rate, and
• Company B wishes to borrow $50m. at floating rate
Fixed Floating
Company A 10% LIBOR + 1%

Company B 9.5% LIBOR + 2%

By each entering into a swap agreement with a swap dealer

both A and B can be better off than they would be by initially
borrowing in their preferred interest rate mode.
 Example: Interest Rate Swap (cont)

Fixed interest of Fixed interest of

9.75% Swap 9.5%
Company Company
Dealer
A earns B
0.75%
LIBOR + 1% LIBOR+1.5%

Borrow in debt Borrow in debt

market at market at 9.5%
LIBOR +1%
 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
• Buyer has the right to exercise the option, the seller is
obligated
• Call – option writer is obligated to sell the asset if the option is
exercised
• Put – option writer is obligated to buy the asset if the option is
exercised
• 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 Profiles: Calls
Sell a Call E = $40
Buy a call with E = $40
0
70 -10 0 20 40 60 80 100
60
-20
50

Payoff
-30
Payoff

40
30 -40
20 -50
10
-60
0
0 20 40 60 80 100 -70

Stock Price Stock Price

 Payoff Profiles: Puts
Sell a Put E = $40
Buy a put with E = $40
0
45 -5 0 20 40 60 80 100
40 -10
35 -15
30

Payoff
-20
Payoff

25
20 -25
15 -30
10 -35
5
0
-40
0 20 40 60 80 100 -45

Stock Price Stock Price

 Future call and put option

Orange: 15.000 lbs; cent/lb

Strike Call Option Put Option

price August Sept. Nov. August Sept. Nov.

80 42.65 45.8 .05 .2

85 37.65 40.8 .05 .35
90 32.65 35.95 .1 .7
95 27.65 27.65 31.6 .05 .2 1.35

140 .4 2.5 8.35 17.75 19.8 22.4

145 1.8 7.15 24.05 26.15

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