T21.1 Chapter Outline

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Chapter 24Risk Management An Introductionto
Financial Engineering

• Homework 1,4,5 6

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Lecture Organization

• Hedging and Price Volatility
• Hedging with Forward Contracts
• Hedging with Futures Contracts
• Hedging with Swap Contracts

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Example Statement of Risk Management Policy at
Walt Disney Company

• The companys foreign currency revenues continue
  to grow and thus, Disneys management believes it
  is prudent to reduce the risk associated with
  fluctuations in the value of the US dollar in the
  foreign exchange markets. The Company uses
  foreign currency forward and option contracts to
  reduce the impact of changes in the value of its
  existing foreign currency assets and liabilities,
  commitments and anticipated foreign currency
  revenues denominated in Japanese yen, French
  francs, German marks, British pounds, and other
  currencies. The primary focus of the companys
  foreign exchange risk management program is to
  reduce earnings volatility. By policy, the
  company maintains hedge coverages between minimum
  and maximum percentages of its anticipated
  foreign exchange exposures for each of the next
  five years. (Emphasis added)
• Excerpt from the Walt Disney Company 1995 Annual
  Report

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1997-1999 Currency crises
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Nortel Networks stock price (logarithmic scale)
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The Risk Management Process

• Step 1 Identify the source of the risk exposure.
• Is the nature of the risk financial, currency,
  commodity, energy?
• Step 2 Quantify the risk exposure.
• What is the extent of the potential loss?
• Step 3 Assess the impact of the exposure(s) on
  the firms business and financial
  strategies.
• Is hedging always beneficial? To whom, and
  under what conditions?
• Step 4 Assess honestly your firms ability to
  design and implement a risk management
  program.
• Does enough expertise exist within the firm to
  operate the program (or to hire someone to do
  so)?
• Step 5 Select the appropriate risk management
  products.

Adapted from Financial Risk Management by Tim
Campbell and William Kracaw, HarperCollins
Publishing, 1993
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1) Forward Contract Example Let's say you are
a corn farmer. Your crop is planted in April,
but will not be harvested until September. You
don't know what the price of corn will be in
September. To hedge your risk you can enter into
a forward contract to sell your corn in September
at 4.00/bushel. A forward contract is a
contract made today for delivery of an asset in
the future at a price agreed upon today. The
buyer of a forward contract agrees to take
delivery of the underlying asset at a future time
T, at a price agreed upon today. No money
changes hands until time T. Buying a forward
contract is also called taking a
position in the forward contract. The seller of
a forward contract agrees to deliver the
underlying asset at a future time T, at a price
agreed upon today. Again, no money changes hands
until time T. Selling a forward contract is also
called taking a position in the
forward.
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How can the farmer use the forward contract to
hedge his risk? The spot price is the price at
which you could purchase or sell the asset for
today. The delivery price is the price at which
you agree to purchase or sell the asset for in
the future. The payoff from a long position in
a forwards contract is
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Risk Profile for a Wheat Grower (Figure 24.6)
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Risk Profile for a Wheat Buyer (Figure 24.7)
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Payoff Profiles for a Forward Contract (Figure
24.8)
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2) Futures Contract In practice, people trade
futures contracts, not forwards contracts. A
futures contract is exactly like a forwards
contract except that intermediate gains or losses
are posted each day during the futures contract
life. This is what is called
. Typically brokers require that you put up
cash when you enter a futures contract. The cash
you put up is called . Example
Lets say you buy 2 gold futures contracts, each
for 100 oz. of gold (so you are long gold
futures). The broker requires that you put up
2000 in margin for each contract, or a total of
4000 in margin. The day you enter the futures
contract the futures price of gold is 400/oz.
The next day the futures price drops to 397.00.
What is the balance in your margin account?
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Note that there is something called a maintenance
margin. In this case it is 1500 per contract or
a total of 3000. When your margin balance drops
below 3000, your broker will give you a
. You have to put in enough money so
that your balance is back up to the initial
margin of 4000. On June 9, your balance dropped
to 2,660, which is under the maintenance margin
of 3,000. You have to post
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Sample National Post Futures Price Quotations
(Figure 24.11)

• FUTURE PRICES
• Thursday, June 1, 2000

Source The National Post, June 3, 2000. Used
with permission.
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Convergence of Futures and Spot
prices Difference between spot and futures
prices. The spot price of an asset is what I
could buy or sell it for today. For example, the
spot price of gold may be 390/oz. The futures
price of gold is what I could buy/sell it for in
the future. For example, the February 1995
futures price of gold was 394.50 on October 26,
1994. As the delivery date is approached, the
futures and spot prices must be the same, or else
there is an arbitrage opportunity
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Using futures to speculate Futures contracts can
be used to speculate on the future prices of
commodities. You can control a large asset
position with relatively little cash. For
example you can speculate on inflation going up.
If inflation increases, then the price of gold
(an inflation hedge) increases. Example Each
gold futures contract is for 100 oz. of gold.
What you could do today is go long 10 Feb 95
futures contract for a total of 1000 oz of gold
at 394.50/oz. Say you are right and inflation
goes up. The price of gold in Feb 95 rises to
400/oz. How much did you make? If gold drops
to 390/oz
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Using futures to hedge Futures are also very
useful in hedging. Example In May a farmer
thinks he is going to have to sell 50,000 bushels
of corn sometime in July. He wants to hedge
against the price per bushel going down by using
a July futures contract. Each futures contract
is for 5,000 bushels. The farmer wants to hedge
against a price decrease, so he/she needs to
______ 10 futures contracts. We see that the
futures price for July corn futures is
2.41/bushel. Say that there is a huge surplus
of corn in July and the spot price of corn in
July is 2.00/bushel. What is is total
gain/loss in futures?
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To recap If a firm needs to buy an asset in the
future, it can go _____ futures contracts to
hedge. If a firm needs to sell an asset in the
future (a corn farmer), the firm can go _____
futures contracts to hedge. Long
Position Short Position Asset increases in
price Make Money Lose Money Asset decreases in
price Lose Money Make Money Moral to the
story derivatives can be used to reduce risk (if
you ________ ) as well as increase risk (if you
________ )
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Illustration of an Interest Rate Swap (Figure
24.12)
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Chapter 24 Quick Quiz

• 1. Why is risk management more important now than
  it was in the 1960s?
• 2. How does a forward contract differ from a
  futures contract?

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Solution to Problem 24.1

• Refer to Figure 24.11 in the text to answer this
  question. Suppose you purchase a September 2000
  cocoa futures contract on June 1, 2000. What will
  your profit or loss be if cocoa prices turn out
  to be 1,500 per metric ton at expiration?
• The initial contract value is equal to
• (price per ton)(number of tons specified in the
  contract)
• Initial contract value (871 per ton)(10
  tons per contract) 8,710
• Final contract value (1,500 per ton)(10
  tons per contract) 15,000
• So our gain on the futures contract is
  15,000 - 8,710 6,290.