Download Week 6 Slides

Module III: Techniques for Risk
Management
Week 6 – February 16, 2006
J. K. Dietrich - FBE 532 – Spring, 2006
Asset-Liability Risk
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
J. K. Dietrich - FBE 532 – Spring, 2006
Cash Outflows
Cash Inflows
Assets
Cash-Flow Risks
Period
Cash Revenues
Cash Expenses
Costs of Goods
Interest
Net Cash Flow
1
100
2
120
60
10
30
72
10
38
3
4
90
80
5
140
54
10
26
48
10
22
84
10
46
Variation in Cash Flows
Due to Relation Between
Inflows and Outflows
J. K. Dietrich - FBE 532 – Spring, 2006
6
160
96
10
54
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 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
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
Profit
Long
0
Loss
P0
0
Loss
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
J. K. Dietrich - FBE 532 – Spring, 2006
Present or in
Present Plan
Future Time
Period
LONG
LONG
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
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
Time/
Situation
Have,
Will Have, or
Will Receive
Need,
Will Need, or
Will Deliver
Present or
Present Plan
Future Time
Period
LONG
LONG
SHORT
SHORT
Insurance Company
with Premiums
J. K. Dietrich - FBE 532 – Spring, 2006
Insurance Company
Hedge
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
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
0
Strike Price
J. K. Dietrich - FBE 532 – Spring, 2006
Asset Value
Call Writer’s (Seller’s) Profits
Profit
Strike Price
0
Possible Cost
to Writer
Loss
J. K. Dietrich - FBE 532 – Spring, 2006
Asset Value
Option Value Sensitivity
to Price Changes in Assets
Buy Put
S
Write Put
J. K. Dietrich - FBE 532 – Spring, 2006
Buy Call
S
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 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
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
0
Loss
J. K. Dietrich - FBE 532 – Spring, 2006
9400
9500
9600
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
Profit
Long
0
Loss
J. K. Dietrich - FBE 532 – Spring, 2006
P0
0
Loss
Buy Call
P0
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