Risk Management

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Risk Management

• Chapter 23

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What is Risk?

• Exposure to loss or injury
• Lost opportunity
• Risk Aversion
• All else equal a risk averse investor, when
  evaluating two investments of equal risk, will
  choose the investment with the higher return.
• All else equal a risk averse investor, when
  evaluating two investments of equal returns, will
  choose the investment with the least risk.

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Risk Management

• The Goal of corporate risk management is not to
  eliminate or avoid all risks.
• Successful risk management must balance the
  potential returns from taking risks with the
  potential costs of eliminating or reducing risk
  exposure
• Three Categories of Risk Management
• Taking action to eliminate risk exposure
• Taking action to reduce risk exposure
• Taking no action at all

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Risk Exposure

• The riskiness of an asset or a transaction cannot
  be assessed in isolation.
• If I purchase a life insurance policy on my life
  it is risk reducing to my family.
• If you buy a life insurance policy on my life
  you are betting on my death!
• In one context the purchase or sale of an asset
  is risk reducing in another it adds to risk
  exposure.

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Another Example Hedging

• Suppose a farmer has 100,000 bushels of wheat
  ready to harvest in one month. The current price
  of wheat is 3 a bushel.
• The farmer faces price risk if the price of wheat
  falls before she gets to market.
• The farmer could enter into a forward contract to
  sell the 100,000 bushels of wheat in one month at
  3 per bushel. This contract eliminates price
  risk to the farmer.
• In this case we say that the farmer has hedged
  her position. If wheat prices fall she has
  locked in a 3 price but if prices rise she
  still only receives 3 per bushel

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Another Example Speculating

• Suppose that you are not a farmer and you enter
  into a forward contract to sell 100,000 bushels
  of wheat at 3 per bushel in one year.
• If the price of wheat in 1 month is 2.50 you
  win. You could buy wheat for 2.50 and sell it
  for 3.00 (your forward contract). Your profit
  50,000
• If the price of wheat rises to 3.50 you loss.
  You must pay 3.50 per bushel and you must sell
  it at 3.00 per bushel. Your loss 50,000
• Your position is a speculative position. The
  same contract that reduced risk for the farmer
  exposes you to risk. However, with risk comes
  the potential for gain!

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Risks Facing Firms

• Operation (Production) Risk
• The risk that machines will breakdown.
• The risk that raw material deliveries will not
  arrive on time.
• The risk that workers will not show up for work.
• This would include theft and fraud costs.
• Business Risk (Price and Volume risk)
• The risk that demand will change because of
  personal preference or need.
• The risk that output price will fall. (farmer)

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• Market Risks (Input Price Risks)
• The risk that the price of key raw materials may
  rise.
• For firms that borrow money the risk that
  interest rates and interest expense increase.
• Credit Risk
• The risk associated with selling on credit.
• The risk associated with entering into contracts
  in which one party may default.

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Firm Enterprise Risk Management
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Risk Management Gone Bad

• Procter and Gamble
• Barings and Sumitomo
• Nick Leeson
• Long Term Capital Management
• Orange County, California

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The Risk Management Process

• Risk Identification
• Risk Assessment
• Selection of Risk Management Techniques
• Implementation
• Review

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Risk Identification

• Bringing hidden risks to light and making them
  transparent is fundamental to risk management.
• Enron 2001
• What are the most important risk exposures?
• Must be aware of all the risks we face
• When evaluating risks we must look at the whole
  entity not just pieces.
• To help in identifying risk exposures, it is a
  good idea to maintain a checklist that enumerates
  all of the entities risks!

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Example Farmer John

• Before a farmer plants his wheat crop he faces
  both price and quantity risk.
• Suppose that the farmer enters into a futures
  contract to protect against price risk. The
  forward contract calls for the farmer to sell all
  his output at 3 per bushel.
• This clearly only addresses one side of the risk
  equation.

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• Suppose that bumper crops always cause prices to
  fall.
• While crop failures always cause prices to rise.
• A hypothetical revenue stream might look like

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• What happens to the hedged position?

• By locking in a price of 3.00 per bushel the
  farmer has eliminated price risk but is now
  exposed to quantity risk.
• Before the forward contract was purchased there
  was no revenue risk now there is a great deal
  of revenue risk.

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Risk Assessment

• What are the costs associated with the identified
  risks?
• Where possible quantify by examining variability
  in revenues, profits stock value.
• What qualitative costs are there?
• Statistical modeling and simulations are often
  used to quantify risks
• VAR (Value at Risk)

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Selection of Risk-Management Techniques

• Risk Avoidance
• Loss Prevention and Control
• Risk Retention
• Risk Transfer

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Risk Avoidance

• A conscious decision not to be exposed to a
  particular risk.
• Avoidance of certain risky businesses or
  projects
• Remember complete risk avoidance is typically not
  a profitable strategy

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Loss Prevention and Control

• Actions taken to reduce the likelihood or the
  severity of a loss
• Proper Monitoring and oversight

Loss Retention

• Absorbing Risks and covering costs out of ones
  own resources
• Happens by default when risks havent been
  properly identified.
• Sometimes it is more profitable to bear risk than
  to pay to reduce or eliminate it.

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Risk Transfer

• Transferring the risk to others
• Selling a risky asset
• Buying Insurance
• Methods of Risk Transfer
• Hedging
• Insuring
• Diversifying

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Implementation

• Once a risk management decision has been made we
  must implement it.
• Minimize costs

Review

• Risk Management a is Dynamic process.
• Are we addressing all risks?
• Have risk exposures changed?
• Are better risk management techniques available.

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The Three Dimensions of Risk Management

• Hedging
• Insuring
• Diversifying

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Hedging

• One is said to hedge risk when the action taken
  to reduce ones risk exposure also causes one to
  give up possible gain.
• For example
• A farmer that contracts to sell his crop for 3 a
  bushel eliminates the risk that prices may fall
• However the farmer also gives up the chance to
  profit if crop prices rise.

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Insuring

• When we insure we pay a premium to avoid losses.
• By buying insurance you substitute a sure loss
  (the premium) for the possibility of larger
  losses if you do not insure.
• The fundamental difference between hedging and
  insuring is that in hedging you give up the
  potential for gain. With insurance you preserve
  the possibility of a gain.
• But at what price (the premium)

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Diversification

• Diversifying means holding many different risky
  assets instead of concentrating all of your
  investment in one or a few risky assets
• Limits your exposure to the risk of any single
  asset.
• Diversification can be carried out by individual
  investors directly in the market, by the firm or
  by a financial intermediary.
• Many argue that diversification is better left to
  financial institutions and investors!

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Hedging With Futures

• Nature of Futures Contracts
• Futures Contract Standardized agreement to buy
  or sell a specific quantity of an asset at a
  future date for a predetermined price.
• The buyer of the contract takes a long position
  and agrees to take delivery.
• The seller of a contract takes a short position
  and agrees to deliver the asset.
• The clearinghouse and the exchanges.
• Futures contracts are traded on numerous
  exchanges
• Chicago Board of Trade (CBT)
• Chicago Board Options Exchange (CBOE)
• Chicago Mercantile Exchange (CME)
• along with numerous growing international markets

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• The exchange clearinghouse
• Options are a zero sum gain
• For every buyer there is a seller
• A sellers gains are a buyers losses (and vice
  versa)
• To help assure that participants perform all
  transactions are made with the clearinghouse as a
  middleman.

Clearinghouse
Buyer Long Position
Seller Short Position
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• The buyer and seller never have to transact
  together
• To further leverage the transaction the
  participants only need put up a small portion of
  the contract.
• Margin Sales
• A typical wheat contract is for 5000 bushels
• Participants can buy or sell with a much smaller
  upfront investment.
• Wheat contracts require a margin of 230 per
  contract for speculative investments
• Only 170 for hedged positions
• Margin is not an investment or price

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• To help assure that participants do not default
  accounts are marked-to-market daily
• gains are credited to appropriate accounts
• losses are debited to appropriate accounts
• if an account falls below the minimum margin
  requirement a margin call is placed.
• To reduce potential losses an investor can
  immunize their position by taking an opposite
  position.
• Typically futures arent exercised

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• Types of Futures
• Asset/Commodity
• Corn
• Wheat
• Pork Bellies
• Financial
• T-bills
• SP 500

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Techniques for using Financial Futures

• Holders of a long position (buyers) benefit from
  rising prices.
• A long position in a futures contract assures
  that you can buy an asset at a fixed price.
• If prices for an asset rise you benefit because
  you can buy the asset at a cheap price.

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• Assume you bought a futures contract to buy
  1,000,000 bushels of wheat (200 contracts) for
  2.50 a bushel in August of 2001.
• What would happen if the price of a bushel rose
  to 3.00 in august at expiration (Spot price)?
• Profit 0.50 1,000,000 500,000
• Initial Investment (margin) was just 200230
  46,000
• Highly levered transactions
• ii. What if the price was 2.00?
• Loss - 0.50 1,000,000 - 500,000

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The Payoff Long Futures

If the futures price rises you profit
F0
Spot Price At Maturity
If the futures price falls you lose
-F0
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• Holders of a short position (sellers) benefit
  from falling prices.
• A short position in a futures contract assures
  that you can sell an asset at a fixed price.
• If prices for an asset fall you benefit because
  you can sell the asset at a high price.

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• Assume you sold a futures contract to for
  1,000,000 bushels of wheat at 2.50 a bushel
  delivered in August of 2001.
• What would happen if the price of a bushel rose
  to 3.00 in august at expiration (Spot price)?
• Loss -0.50 1,000,000 -500,000
• ii. What if the price was 2.00?
• Profit 0.50 1,000,000 500,000

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The Payoff Short Futures

F0
If the futures price falls you win
F0
Spot Price At Maturity
If the futures price rises you lose
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Notes on Hedging using Futures

• The payoff diagrams clearly show that futures
  payoffs are two sided.
• You protect against downside risk but you also
  lose upside potential.
• However, Futures are a relatively cheap way of
  reducing risk!

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Hedging With Swaps

• Started in 1981 in Eurobond market
• Long-term hedge
• Historically Swaps were privately negotiated
  between two parties. Today many swaps are
  standardized and can be initiated with a bank.
• Costly to close out early
• Default by opposite party causes loss of swap

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Using Swaps to reduce interest rate risk

• Suppose that your company issue 100 million in
  new bonds.
• At the time the best rates available were on
  variable rate bonds.
• Your cost is Prime 2
• You face the risk of rising interest rates
• If rates rise interest expense will increase and
  income will fall.
• Your bank offers a swap
• Notional value 100 million
• You pay bank 9 percent fixed rate
• Bank pays you Prime 2

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The Swap diagram
Bank
9
Your Company
Prime 2
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The Payoff Swap

If rates rise the cash flow from the swap will
offset the cost of your variable rate bonds
7
Prime Rate
If rates fall the cost of the swap will offset
the gains associated with your variable rate bonds
-9 million
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• Why not just issue fixed rate debt to start with?
• After all swaps cost money
• Interest rate swaps, quality spreads and the cost
  of funds
• Suppose that company A and B want to issue debt
  and they face the following debt choices

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• Company A wishes to issue floating rate debt
  (Prime 1)
• Company B wishes to issue fixed rate debt (10.5)
• But A has a competitive advantage issuing fixed
  rate debt and B has an advantage issuing floating
  rate debt??????
• Company A issues Fixed Rate debt at 8 percent
• Company B issues floating rate debt at Prime
  2.

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• Now we will create a Swap that allows both firms
  to achieve their borrowing needs and reduce
  borrowing costs.
• The Swap
• Company A pays B the prime rate
• Company B pays A 8

Company B
Prime
Company A
8
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• The Payoff

• The net cost to both firms is less than the
  borrowing options they faced before the swap.
• A borrows at Prime instead of Prime 1
• B borrows at 10 instead of 10.5

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Notes on Hedging with Swaps

• Swaps can be used to reduce interest rate risk
  and to reduce net borrowing costs.
• Swaps are hedges since the user gives up upside
  potential in the transaction.
• Swaps can provide a long hedge.
• Because the transactions are made between two
  parties Users of swaps should be aware of
  potential credit risk

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Insuring With Options

• Characteristics of Options
• Definition Right but not an obligation to buy
  or sell an asset at a specified price (striking
  price) on or before a specified date
  (expiration date).
• Call option Right to buy -- pay premium to
  seller for this right.
• Put Option Right to sell -- pay premium to
  seller for this right.
• Note Seller of option must buy or sell as
  arranged in the option, so the seller gets a
  premium for this risk. The premium is the price
  of the option. The Black-Scholes option pricing
  model can be used to figure out the premium (or
  price) of an option.

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• Long position The buyer of the option, who
  gains if the price of the option increases.
• Short position The seller of the option, who
  earns the premium if the option is not exercised
  (because it is not valuable to the buyer of the
  option).

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Payoff call option

• Suppose that we have a call option with the
  following characteristics
• Exercise price 100
• Premium 4.00
• What does the payoff look like for the buyer and
  the writer of this option?

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The Payoff Buying a Call

Gross Payoff
Net Payoff
In the Money
100
-4
Asset Price
Premium 4
Out of the Money
Note The writer (seller) of the option receives
the payoff if the option is not exercised.
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• How can a call option be used to reduce risk?
• Suppose you run a large bakery
• If wheat prices rise so do your costs.
• Buy a call option on wheat
• If wheat prices rise
• The cost of flour will increase your costs
• The option will be in the money and generate
  profits
• The profits from the option can be used to offset
  the higher cost of flour!

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• If Wheat prices fall
• Flour costs will decrease
• The option is out of the money and you will not
  exercise (you lose the premium)
• But you protect the upside potential of falling
  input prices!
• You have created a cost cap or ceiling
• Variable rate loans with an interest rate ceiling
  have certain characteristics of a call option!

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The Payoff Writing a Call

Premium 4
You Win
Net Payoff
4
100
Asset Price
You Lose
Gross Payoff
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• The writer of a call benefits if asset prices do
  not rise
• Keep the call premium
• Lose if asset price rises more than the call
  premium
• The benefit of writing a call is that it
  generates cash (the premium)
• If prices are flat or decrease you benefit.
• Who faces the risk of falling prices?
• The Farmer?
• PNW?

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Payoff Put option

• Suppose that we have a put option with the
  following characteristics
• Exercise price 40
• Premium 5.00
• What does the payoff look like for the buyer and
  the writer of this option?

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The Payoff Buying a Put

Gross Payoff
40
Premium 5
35
Out of the Money
40
Asset Price
In the Money
Net Payoff
Note The writer (seller) of the option receives
the payoff if the option is not exercised.
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• How can a put option be used to reduce risk?
• Suppose you are a wheat farmer
• If wheat prices fall so do your revenues.
• Buy a put option on wheat
• If wheat prices fall
• The revenues from selling your wheat will
  decrease
• But the option will be in the money and generate
  profits
• The profits from the option can be used to offset
  lower revenues!

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• If Wheat prices rise
• Revenues will increase
• The option is out of the money and you will not
  exercise (you lose the premium)
• But you protect the upside potential of rising
  output prices!
• This is an example of a floor
• By using a put option we have created a lower
  bound to protect us from downside risk while
  preserving upside potential!
• Hmmm this sounds vaguely familiar ?

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The Payoff Writing a Put

Premium 5
You Win
Net Payoff
4
Asset Price
40
You Lose
Gross Payoff
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• The writer of a put benefits if asset prices do
  not rise
• Keep the put premium
• Lose if asset price fall more than the put
  premium
• The benefit of writing a put is that it generates
  cash (the premium)
• If prices are flat or increase you benefit.
• Who faces the risk of rising prices?
• The Baker?

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Summary

• Risk is defined as uncertainty that matters to
  people. Risk management is the process of
  formulating the benefit-cost trade-offs of risk
  reduction and deciding on a course of action to
  take.
• All risks are ultimately borne by people in their
  capacity as consumers, stakeholders of firms and
  other economic organizations, or taxpayers.

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• The riskiness of an asset or a transaction cannot
  be assessed in isolation or in the abstract it
  depends on the specific frame of reference. In
  one context, the purchase or sale of a particular
  asset may add to ones risk exposure in another,
  the same transaction may be risk reducing.
• Speculators are investors who take positions that
  increase their exposure to certain risks in the
  hope of increasing their wealth. In contrast,
  hedgers take positions to reduce their exposures.
  The same person can be a speculator on some
  exposures and a hedger on others.

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• An effective risk management process involves
• Risk identification
• Risk assessment
• Selection of risk-management techniques
• Implementation
• Review

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• Risk management techniques include all of the
  following
• Risk avoidance
• Loss prevention and control
• Risk retention
• Risk transfer
• There are three dimensions of risk transfer
  hedging, insuring, and diversifying.

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• To Hedge Risks we use
• Futures
• Swaps
• To Insure we employ
• Insurance contracts
• Options (writing and buying)

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The End