Chapter 23

Risk Management:
An introduction to
Financial Engineering

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Understand the risk exposure companies
face and how to hedge these risks
• Understand the difference between
forward contracts and futures contracts
and how they are used for hedging
• Understand how swaps can be used for
hedging
• Understand how options can be used for
hedging

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 Chapter Outline
• Hedging and Price Volatility
• Managing Financial Risk
• Hedging with Forward Contracts
• Hedging with Futures Contracts
• Hedging with Swap Contracts
• Hedging with Option Contracts

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 Example: Disney’s Risk
Management Policy
• Disney provides stated policies and procedures
concerning risk management strategies in its
annual report
– The company tries to manage exposure to interest rates,
foreign currency, and the fair market value of certain
investments
– Interest rate swaps are used to manage interest rate
exposure
– Options and forwards are used to manage foreign
exchange risk in both assets and anticipated revenues
– The company uses a VaR (Value at Risk) model to identify
the maximum 1-day loss in financial instruments
– Derivative securities are used only for hedging, not
speculation

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 Hedging Volatility
• Recall that 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
• Instruments have been developed to hedge the
following types of volatility
– Interest Rate
– Exchange Rate
– Commodity Price
– Quantity Demanded

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 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
• Available tools: forwards, futures, swaps, futures
options, and options

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 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 conduct a better analysis of future projects
• Available tools: forwards, futures, swaps, futures
options

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 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
• Available tools (depend on type of commodity): forwards,
futures, swaps, futures options, options

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 The Risk Management
Process
• Identify the types of price fluctuations that will impact
the firm
• Some risks are obvious; others are not
• Some risks may offset each other, so it is important
to look at the firm as a portfolio of risks and not just
look at each risk separately
• You must also look at the cost of managing the risk
relative to the benefit derived
• Risk profiles are a useful tool for determining the
relative impact of different types of risk

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 Risk Profiles
• Basic tool for identifying and measuring
exposure to risk
• Graph showing the relationship between
changes in price versus changes in firm value
• Similar to graphing the results from a sensitivity
analysis
• The steeper the slope of the risk profile, the
greater the exposure and the greater the need to
manage that risk

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 Reducing Risk Exposure
• The goal of hedging is to lessen the slope of the risk
profile
• Hedging will not normally reduce risk completely
– For most situations, only price risk can be hedged,
not quantity risk
– You may not want to reduce risk completely because
you miss out on the potential upside as well
• Timing
– Short-run exposure (transactions exposure) – can be
managed in a variety of ways
– Long-run exposure (economic exposure) – almost
impossible to hedge - requires the firm to be flexible
and adapt to permanent changes in the business
climate

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 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

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Figure 23.7

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 Hedging with Forwards
• Entering into a forward contract can virtually
eliminate the price risk a firm faces
– It does not completely eliminate risk unless there is no
uncertainty concerning the quantity
• 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
• Forward contracts are primarily used to hedge
exchange rate risk

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 Futures Contracts
• Futures contracts traded on an organized
securities 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
all contracts
• The clearinghouse and margin
requirements virtually eliminate credit risk

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 Futures Quotes
• See Table 23.1
• Commodity, exchange, size, quote units
– The contract size is important when determining the daily
gains and losses for marking-to-market
• Delivery month
– Open price, daily high, daily low, settlement price,
change from previous settlement price, contract lifetime
high and low prices, open interest
– The change in settlement price times the contract size
determines the gain or loss for the day
• Long – an increase in the settlement price leads to a gain
• Short – an increase in the settlement price leads to a loss
– Open interest is how many contracts are currently
outstanding

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 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
• Futures contracts are available on a wide range of
physical assets, debt contracts, currencies, and
equities
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 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 or foreign vs.
domestic interest rates

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 Example: Interest Rate Swap
• Consider the following interest rate swap
– Company A can borrow from a bank at 8% fixed or LIBOR + 1%
floating (borrows fixed)
– Company B can borrow from a bank at 9.5% fixed or LIBOR + .5%
(borrows floating)
– Company A prefers floating and Company B prefers fixed
– By entering into a swap agreement, both A and B are better off than
they would be borrowing from the bank with their preferred type of
loan, and the swap dealer makes .5%

Pay Receive Net

Company A LIBOR + .5% 8.5% -LIBOR
Swap Dealer w/A 8.5% LIBOR + .5%
Company B 9% LIBOR + .5% -9%
Swap Dealer w/B LIBOR + .5% 9%
Swap Dealer Net LIBOR + 9% LIBOR + 9.5% +.5%
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Figure 23.10

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 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

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 Payoff Profiles: Calls
Buy a call with E = $40 Sell a Call E = $40

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

Payoff
40
30 -40

20 -50
10 -60
0 -70
0 20 40 60 80 100 Stock Price
Stock Price

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 Payoff Profiles: Puts
Buy a put with E = $40 Sell a Put E = $40

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

Payoff
25 -20
20 -25
15 -30
10 -35
5 -40
0 -45
0 20 40 60 80 100 Stock Price
Stock Price
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 Hedging Commodity Price
Risk with Options
• “Commodity” options are generally futures options
• Exercising a call
– Owner of the call receives a long position in the futures
contract plus cash equal to the difference between the
exercise price and the futures price
– Seller of the call receives a short position in the futures
contract and pays cash equal to the difference between the
exercise price and the futures price
• Exercising a put
– Owner of the put receives a short position in the futures
contract plus cash equal to the difference between the futures
price and the exercise price
– Seller of the put receives a long position in the futures
contract and pays cash equal to the difference between the
futures price and the exercise price

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 Hedging Exchange Rate
Risk with Options
• May use either futures options on currency or
straight currency options
• Used primarily by corporations that do business
overseas
• U.S. companies want to hedge against a
strengthening dollar (receive fewer dollars when
you convert foreign currency back to dollars)
• Buy puts (sell calls) on foreign currency
– Protected if the value of the foreign currency falls
relative to the dollar
– Still benefit if the value of the foreign currency increases
relative to the dollar
– Buying puts is less risky

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 Hedging Interest Rate
Risk with Options
• Can use futures options
• Large OTC market for interest rate options
• Caps, Floors, and Collars
– Interest rate cap prevents a floating rate from going
above a certain level (buy a call on interest rates)
– Interest rate floor prevents a floating rate from going
below a certain level (sell a put on interest rates)
– Collar – buy a call and sell a put
• The premium received from selling the put will help offset
the cost of buying the call
• If set up properly, the firm will not have either a cash inflow
or outflow associated with this position

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 Quick Quiz
• What are the four major types of
derivatives discussed in the chapter?
• How do forwards and futures differ? How
are they similar?
• How do swaps and forwards differ? How
are they similar?
• How do options and forwards differ? How
are they similar?

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 Comprehensive Problem
• A call option has an exercise price of $50.
– What is the value of the call option at
expiration if the stock price is $35? $75?
• A put option has an exercise price of $30.
– What is the value of the put option at
expiration if the stock price is $25? $40?

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End of Chapter

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