5200_13 - Derivatives and Enterprise Risk Management

FINE 5200 XIII. Derivatives and Enterprise Risk Management

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XIII. DERIVATIVES AND ENTERPRISE RISK MANAGEMENT

• Uncertainty, Risk and Hedging

o Sources of risk

o Risk profile and analysis

o Cash flow hedging

• Derivatives and Enterprise Risk Management

o Hedging using forward contracts

o Hedging using futures contracts

o Hedging using swaps

o Hedging using options

• Options and Corporate Financial Management

o Warrants

o Bonds with embedded options

o Real options


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1. Sources of Risk

• What are risks? o The known knowns o The known unknowns o The unknown unknowns

“Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

Donald Rumsfeld (U.S. Secretary of Defense, 2001-2006), at the Department of Defense news briefing, February 12, 2002.

• Examples of “known unknowns” and “unknown unknowns” in the corporate world?


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• Corporate risks fall into four broad categories:

o Hazard risks � Damage/harm due to external forces (e.g., natural disasters)

o Financial risks � Exposure to currency exchange rate or commodity prices

o Operational risks � Disruptions to business operations (human resources, supply chain,

production, distribution, etc) o Strategic risks

� Failure to respond to changing customer demand/needs, social and demographic trends, regulatory or environmental changes, or changes in competition or technology, etc.

• We will only discuss the first two types of risks.


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2. Hazard Risk and Insurance

• Hazard risk has a unique profile:

o Typically beyond the company’s control

o Rare

o Unpredictable

o Potential for large losses or damage

• Hazard risk is typically managed by buying the appropriate type of insurance:

o Commercial liability insurance

o Business interruption insurance

o Key personnel insurance

o Workers’ compensation and employer’s liability insurance


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3. Managing Financial Risk

• Financial risk is typically linked to the adverse movement of a key market indicator

or variable:

o Commodity prices

o Interest rates

o Currency exchange rates

o Stock market index

o Inflation

o etc

• How do we measure financial risk?

o Volatility

� Standard deviation

� Variance

o VaR (Value at Risk)

� e.g., A stock portfolio has a 1-day, 5% VaR of $1 million.

o Risk profile/distribution (see next page)


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3.1. Hedging and financial risk management

a) To hedge or not to hedge?

• Risk-return tradeoff

• Acceptable level of risk

• Control/reduce risk exposure

b) Long-run vs. short-run exposure

• Long-run exposure (i.e., economic exposure)

o Business cycle/market-wide financial crisis

o Permanent shift in demand/supply

o Changes in regulations and trade barriers, etc.

• Short-run exposure (i.e., transitional exposure)

o Exposure to temporary changes in prices

o Size or quantity is not affected.


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c) Natural hedge

• Hedging by changing business practices, without any use of derivatives:

o Vertical integration (managing exposure to prices)

o Localize both revenues and expenses (managing currency exposure)

d) Benefit of hedging with derivatives

• Both long-run and short-turn exposure

• Cost effective

• Flexible

e) Choice of derivatives:

• Forward contracts

• Futures contracts

• Swaps

• Options

• Others


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3.2. Hedging using forward contracts

• What are they?

o A contract where two parties (known as counterparties) agree on the price of an

asset today to be delivered and paid for at some future date (long vs. short).

o Forward contracts are legally binding on both parties.

o They can be customized/tailored to meet the needs of both parties.

o The contracts are negotiated between the two counterparties and there is no

upfront cost to enter.

o Due to credit risk concerns, only large, creditworthy financial and non-financial

institutions are normally accepted as counterparties.

• Examples of forward contracts:

o Interest rate forwards (a.k.a., forward rate agreements)

o Currency forwards

o Commodity forwards

• What are forward contracts used for?

o Locking in the price for a future transaction (purchase or sale).


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• Payoff profiles for forward contracts:


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Example 1

• Consider a three-month forward contract on 100 ounces of gold.

• The investor takes a long position in the forward contract.

• The delivery/forward price is $1,200 per ounce.

• Determine the investor’s payoff in three months if the gold price ends up in a range between $1,150 and $1,250.

• What if the investor had a short position in the forward contract instead?


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• Hedging with forward contracts:

o Taking an opposite position in the forward contract

• Any potential problems with this type of hedging?

o Air Canada hedging disaster (Globe & Mail, Dec. 03, 2008: Air Canada fuel

hedges backfire as oil drops):

http://investdb4.theglobeandmail.com/servlet/ArticleNews/story/GAM/20

081203/RAIRCANADA03


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3.3. Hedging using futures contracts

• Similar to forward contracts except for:

o Trading on organized securities exchange (standardized contracts)

o Margin requirement and daily marking to market

o Little or no credit risk problems

o No or rare deliveries (closing out position prior to maturity)

• Examples of futures contracts:

o Commodity futures

� Industrial: gold, silver, crude oil, natural gas, lumber, etc.

� Agricultural: corn, soy bean, orange juice, beef, etc.

o Stock index futures

o Interest rate futures

o Currency futures


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3.4. Hedging using swaps

• What are they?

o A long-term agreement between two parties to exchange (or swap) cash flows

at specified times based on specified relationships

o Equivalent to a portfolio of forward contracts

o Generally limited to large creditworthy financial or non-financial institutions

• Types of swaps:

o Interest rate swaps – the net cash flow is exchanged based on interest rates

o Currency swaps – two currencies are swapped based on specified exchange

rates or foreign vs. domestic interest rates

o Commodity swaps – fixed quantities of a specified commodity are exchanged

at fixed times in the future

o Credit default swaps – corporate bonds are exchanged for face value based on a

reference entity’s default


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• Example: An interest rate swap


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3.5. Hedging using options

• What are they?

o The buyer of the option has the right, but not the obligation, to buy (or sell) an

asset at a fixed price on or before a specified date

o Must pay an upfront fee to purchase the option

o Call – right to buy the asset

o Put – right to sell the asset

o Fixed price: exercise price or strike price

o Specified date: expiration date or maturity

o American vs. European options

• Option asymmetries:

o Asymmetric, nonlinear payoffs

o Buyer-seller asymmetry:

� Buyer may lose at most the purchase price, but may make much more than

the initial purchase price.

� Seller (writer) may make at most the selling price, but may lose much

more than the initial selling price.


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• Call option payoff profiles:


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• Put option payoff profiles:


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Example 2

• Suppose an investor just bought a three-month call option on 100 shares of Stock XYZ.

• The strike price of the option is $50 (per share).

• Determine the investor’s payoff in three months if stock price ends up in a range between $25 and $75.

• What if the investor bought a put option instead?


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• Hedging with put options:


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4. Options and Corporate Financial Management

• Options are used extensively in corporate financial management:

o Warrants

o Convertible bonds

o Corporate incentives (employee stock options)

o Others


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4.1. Warrants

• Warrants are similar to call options:

o Exercise price

o Maturity

o Number of shares per each warrant

• Warrants are also different from exchange traded call options:

o They are sold by the company, not other investors.

o They are usually sold as sweeteners in a package of loans, bonds, common

stock or preferred stock.

o Most warrants are detachable so that they can be sold or exercised irrespective

of the original package they are bundled together.

o When warrants are exercised, investors pay the strike price to the company and

the company gives investors new shares (dilution of ownership).


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4.2. Convertible bonds

• A convertible bond is a bond with an embedded call option.

o Embedded means that the call option is not detachable from the bond.

• The call option gives the investor the right to exchange the bond for a fixed number

of the company’s common shares:

o e.g., 25 shares for a $1,000 par bond

• Key features of a convertible bond:

o Conversion ratio: the number of shares received per $1,000 par (e.g., 25)

o Conversion price: the par value given up for each common share (e.g.,

$1000/25 = $40)

• Value of a convertible bond (see figure on next page):

Straight bond value + Call value


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Example: Convertible bonds


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4.3. Corporate incentives (employee stock options)

• Why do firms use ESOs?

• What are unique features of ESOs?

o Vesting period o Forfeiture o Reload o Performance vesting o Repricing o Purchased or prepaid o Indexing

Figure 25.4: Canadian Examples


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4.4. Equity as a call option on the firm’s assets

Firm Value = Equity + Debt

• Debt obligation is the strike price of the call option:


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Example 3

(Example 25.8 / p.743)

• Buckeye Industries has a zero-coupon bond issue with a face value of $100, due in

one year.

• The value of Buckeye’s assets is currently worth $109.

• Jim Tressell, the CEO, believes that the assets in the firm will be worth either $92 or

$138 in one year.

• The risk-free rate is 6% (EAR).

• What is the value of Buckeye’s equity? The value of the debt?

• Suppose that Buckeye can reconfigure its existing assets in such a way that the value

in a year will be $80 or $160. If the current value of the assets is unchanged, will the

stockholders favour such a move? Why or why not?


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4.5. Insurance and loan guarantees

• Insurance and loan guarantees are essentially put options:

o It gives you the right to sell/recover a fixed dollar amount from the insurance

company when the defined event (e.g., earthquake, hurricane or default) occurs

that either destroy or damage the underlying asset.

� What is the strike price of the option?

o Unlike a regular put option though, insurance is unique in a number of ways:

� The exercise of the option is exogenous, i.e. triggered by the defined event

(e.g., earthquake).

� Option price (or insurance premium) is not paid upfront. It is usually paid

in monthly installments.

� The option is renewable (by the payment of each installment).


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4.6. Managerial options (real options)

• Real options are choices that allow managers the flexibility to either undertake or

terminate a business initiative such as:

o Expanding a business operation

o Downsizing a business operation

o Abandoning a business operation

o Launching a new product

o Deferring an investment

o Etc.

Documents

5200_13 - Derivatives and Enterprise Risk Management