Module III: Techniques for Risk Management

Week 6 February 16, 2006

J. K. Dietrich - FBE 532 Spring, 2006

Asset-Liability Risk
Cash Inflows
Liabilities and Equity Cash Short-Term Notes Inventories Trade Payables Accounts Receivable Other Current Liabilities Current Assets Current Liabilities Fixed Assets Long-Term Debt Intangible Assets Equity Total Assets Liabilities and Equity Assets

Cash Outflows

J. K. Dietrich - FBE 532 Spring, 2006

Cash-Flow Risks
Period Cash Revenues Cash Expenses Costs of Goods Interest Net Cash Flow 1 100 60 10 30 2 120 72 10 38 3 90 54 10 26 4 80 48 10 22 5 140 84 10 46 6 160 96 10 54

Variation in Cash Flows Due to Relation Between Inflows and Outflows

J. K. Dietrich - FBE 532 Spring, 2006

Risk Management
Product Prices Substitute Prices Exchange Rates

Commodity Input Prices Fixed Asset Values Labor Costs

Period Cash Revenues Cash Expenses Costs of Goods Interest Net Cash Flow

Short-Term Borrowing Long-Term Borrowing

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Exposure to Risk
A

general term to describe a firms 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
J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Price Exposure in a Diagram

Profit Long 0 Loss 0 Loss Profit

P0

P0

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

Exposure to Risks
Time/ Situation Have, Will Have, or Will Receive Need, Will Need, or Will Deliver Present or in Present Plan LONG Future Time Period LONG

SHORT

SHORT

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

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
J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Hedging

Bank Planning to Borrow

Insurance Company Hedge

Time/ Situation Have, Will Have, or Will Receive Need, Will Need, or Will Deliver

Present or Present Plan LONG

Future Time Period LONG

SHORT

SHORT

Insurance Company with Premiums

J. K. Dietrich - FBE 532 Spring, 2006

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?

J. K. Dietrich - FBE 532 Spring, 2006

Forward Market Hedge

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.
Current

J. K. Dietrich - FBE 532 Spring, 2006

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.

J. K. Dietrich - FBE 532 Spring, 2006

Possible Outcomes
Spot Rate Value of Deal $1.70 $1.75 $1.80
J. K. Dietrich - FBE 532 Spring, 2006

Value of Forward $0.5m 0 -$0.5m

Total Cash Flow $17.5m $17.5m $17.5m

$17m $17.5m $18m

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

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Call Options Profits at Maturity

Profit

Payoff to Buyer

Strike Price

Asset Value

J. K. Dietrich - FBE 532 Spring, 2006

Call Writers (Sellers) Profits

Profit

Strike Price
0
Possible Cost to Writer

Asset Value

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

Option Value Sensitivity to Price Changes in Assets

Buy Put
Buy Call

Write Put
J. K. Dietrich - FBE 532 Spring, 2006

Write Call

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
J. K. Dietrich - FBE 532 Spring, 2006

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?

J. K. Dietrich - FBE 532 Spring, 2006

Using Options
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
Selling

J. K. Dietrich - FBE 532 Spring, 2006

Suppose GE Loses the Bid

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
If

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
J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Interest-Rate Derivatives
Interest

rates and asset values move in opposite directions Long cash means short assets Short cash means long (someone elses) 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
J. K. Dietrich - FBE 532 Spring, 2006

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

J. K. Dietrich - FBE 532 Spring, 2006

Collars: Cap 6%, floor 4%

Profit

9400

9500

9600

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

Other option developments

Credit

risk options Casualty risk options Requirements for developing an option Interest Calculable payoffs Enforceable
J. K. Dietrich - FBE 532 Spring, 2006

Replication Futures with Options

Profit
Long 0 Loss Profit Buy Call

P0

0 Loss

P0 Write Put

J. K. Dietrich - FBE 532 Spring, 2006

Next Week February 23, 2006

Review

this weeks 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