j. k. dietrich - fbe 532 – spring, 2006 module iii: techniques for risk management week 6 –...

J. K. Dietrich - FBE 532 – Spring, 2006

Module III: Techniques for Risk Management

Week 6 – February 16, 2006


Asset-Liability Risk

Assets Liabilities and EquityCash Short-Term Notes

Inventories Trade PayablesAccounts Receivable Other Current Liabilities

Current Assets Current Liabilities

Fixed Assets Long-Term DebtIntangible Assets Equity

Total Assets Liabilities and EquityCas

h I

nfl

ows

Cash

Ou

tflows


Cash-Flow Risks

Period 1 2 3 4 5 6Cash Revenues 100 120 90 80 140 160Cash ExpensesCosts of Goods 60 72 54 48 84 96

Interest 10 10 10 10 10 10Net Cash Flow 30 38 26 22 46 54

Variation in Cash Flows Due to Relation Between

Inflows and Outflows


Risk Management

PeriodCash RevenuesCash ExpensesCosts of Goods

InterestNet Cash Flow

Product Prices

Substitute PricesExchange Rates

Commodity Input PricesFixed Asset Values

Labor Costs

Short-Term BorrowingLong-Term Borrowing


Asset-Liability Management

Focus on variability of cash flows– Main concern is to be able to make all

contractual payment to avoid defaults– Secondary concern is to minimize risk

(variability)– Third concern is to increase net cash flows by

taking advantage of predictability in variations Objective is to measure and manage

variability in cash flows


Exposure to Risk

A general term to describe a firm’s exposure to a particular risk (e.g. a commodity price) is to classify the exposure as long or short

Long exposure means that the firm will benefit from increases in prices or values

Short exposure means that the firm will benefit from decreases in prices or values


Long Exposure

A firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples– The firm owns assets, as in inventories of raw

materials or finished goods– The firm produces a commodity or product, as

in an agribusiness raising wheat or livestock– The firm will take possession in the future or a

commodity or an asset– The firm has bought a commodity or asset


Short Exposure A firm (or individual) is short if at the time

of the risk assessment if it needs or will need an asset or commodity. As examples– The firm is planning or has promised to deliver

raw materials or finished goods – The firm uses a commodity or product in

production as inputs, like steel or lumber– The firm will have possession in the future or a

commodity or an asset it does not need or needs to sell

– The firm has sold a commodity or asset and must deliver


Price Exposure in a Diagram

P0 P0

Long

Short

Profit

Loss

0 0

Profit

Loss


Exposure to Risks

Time/ Situation

Present or inPresent Plan

Future TimePeriod

Have,Will Have, orWill Receive

LONG LONG

Need,Will Need, orWill Deliver

SHORT SHORT


Examples of Exposure

Farmer with wheat is long wheat Honey Baked Ham is short pork before

Easter selling season Treasurer with excess cash in three months

is short investments Company needing cash in nine months is

long financial assets (its liabilities are others’ assets) to sell


Types of Derivative Contracts Three basic types of contracts

– Futures or forwards– Options– Swaps (we discuss next week)

Many basic underlying assets– Commodities– Currencies– Fixed incomes or residual claims


Futures Contracts

Wall Street Journal tables Standardized contracts

– Quantity and quality– Delivery date– Last trading date– Deliverables

Clearing house is counterparty Margin requirements, mark to market


Forward vs. Futures Contracts

Bilateral contract (usually with a financial firm as counterparty)

Terms are tailor made to needs of corporate, not standardized

No exchange of cash until maturity of contract

Over-the-counter market not as liquid as organized exchange


Managing Risk with Futures

Offset price or interest rate risk with contract which moves in opposite direction

“Cross diagonally in the box” Identify contract with price or interest rate which

moves as close as possible with the price or interest rate exposure

Imperfect correlation is basis risk Not using futures or forwards can be speculation


Hedging

Time/Situation

Present orPresent Plan

Future TimePeriod

Have,Will Have, orWill Receive

LONG LONG

Need,Will Need, orWill Deliver

SHORT SHORT

Insurance Companywith Premiums

Insurance CompanyHedge

Bank Planning to Borrow

Borrowing Hedge


Forward Contracts

Example 1: GE is awarded a contract to supply turbine blades to British Air. On August 1, GE will receive ₤10 million.

How should GE hedge its risk?


Forward Market Hedge

Current spot price for ₤ 1 = $ 1.74 Six month forward rate is ₤ DM 1 = $1.75 Hedge future income by selling ₤ 10 million

for delivery in one year (short in futures or forward market)

This transaction assures future revenue of $17.5 million without any cash flows today.


Possibilities

Say the spot price on December 1 is $1.70 per ₤ .

GE sells its ₤ 10 million for $1.75 per ₤ , yielding $17.5 million

If it had not hedged, its ₤ 10 million, at a rate of $1.70 would yield $17 million.

The forward is worth $0.5 million.


Possible Outcomes

Spot Rate Value of Deal

Value of Forward

Total Cash Flow

$1.70 $17m $0.5m $17.5m

$1.75 $17.5m 0 $17.5m

$1.80 $18m -$0.5m $17.5m


Key Points

Revenues are guaranteed irrespective of exchange rate movements– The cost of hedging varies depending on

exchange rate movements Futures hedging is effective when the

magnitude and timing of future currency cash flows is known

Pricing in dollars simply shifts risk


Options (Definition)

An option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date– call is right to buy, put is right to sell

– strike or exercise price is a fixed price which determines conversion value

– expiration date

Options on stocks, commodities, real estate, and future contracts


Call Options Profits at Maturity

0Strike Price

Profit

Asset Value

Payoffto Buyer


Call Writer’s (Seller’s) Profits

0Strike Price

Profit

Loss

Asset Value

Possible Cost to Writer


Option Value Sensitivityto Price Changes in Assets

Write Put Write Call

Buy Put Buy Call

S S


Managing Risk with Options Similar to hedging risk with futures or forwards except

that you only hedge again bad or adverse outcomes Partially offset price or interest rate risk with contract

which moves in opposite direction Identify options with price or interest rate which

moves as close as possible with the price or interest rate exposure but again imperfect correlation results in basis risk

Options only hedge against adverse outcome so they are similar to insurance and cost money


Foreign Currency Options

Useful if the timing of foreign currency cash flows is uncertain

Example 2: GE submits a bid to supply turbine blades to Lufthansa for ₤ 10 million

The funds will be received on August 1 only if GE wins

How does GE hedge this risk?


Using Options

Selling ₤ forward is not the answer: GE may lose the bid and the ₤ may rise

Options solve the problem; GE buys put options to sell ₤ 10m on August 1 at a rate of, say, 1 ₤ = $1.70

GE pays a bank $100,000 for the puts


Suppose GE Loses the Bid

If the rate is below $1.70, GE can buy ₤ DM in the market at a lower price and sell them for a profit by exercising the put.

If the rate is above $1.70, GE lets the option expire– Hedging costs in either event are $100,000– If the puts are fairly priced GE will not suffer

an expected loss even net of hedging costs


Suppose GE Wins the Bid

If the rate is below $1.70, GE exercises the put for $17m, using the ₤ 10 million paid by Lufthansa.

If the rate is above $1.70, GE lets the option expire, and converts the ₤ 10 million at the market rate

GE makes at least $17 million if it wins the bid, less the $100,000 cost of the option


Other Uses of Options

Use call options to hedge the risk of foreign tender offers

Hedge risk when quantity of cash flows is uncertain

Currency options can be used to protect profit margins and prevent frequent revisions of product prices abroad


Interest-Rate Derivatives Interest rates and asset values move in opposite

directions Long cash means short assets Short cash means long (someone else’s) asset Basis risk comes from spreads between

exposure and hedge instrument, e.g. default risk premiums

Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown


Caps, floors, and collars

If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note

If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call

A collar is a cap and a floor


Collars: Cap 6%, floor 4%

Profit

0

Loss

9400 9500 9600


Other option developments

Credit risk options Casualty risk options Requirements for developing an option

– Interest

– Calculable payoffs

– Enforceable


Replication Futures with Options

P0 P0

LongProfit

Loss

0 0

Profit

Loss

Buy Call

Write Put


Next Week – February 23, 2006

Review this week’s discussion to identify areas needing clarification

Read and prepare case Union Carbide Corporation Interest Rate Risk Management and identify issues in the case you have questions about

Review weekly Objectives and prepare for midterm examination due March 9, 2006

j. k. dietrich - fbe 532 – spring, 2006 module iii: techniques for risk management week 6 –...

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