; Lecture Finance Advanced Corporate Finance Futures Contract
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Lecture Finance Advanced Corporate Finance Futures Contract


  • pg 1
									               Managing Risk
•   Certainty Equivalents
•   Why Manage Diversifiable Risk?
•   Types of Risk
•   Traditional Approach to Risk Management
•   Enterprise Risk Management
 Risk and Discounted Cash Flow
• The risk-adjusted discount rate method
  discounts for time and risk simultaneously
• Cannot handle situations where there is risk,
  but no time discount

Example: Space launch coverage payable at
         time of launch
    Certainty Equivalent Method
• Discounts separately
  – risk
  – time value of money
   Certainty Equivalent Method
• Rather than discounting future cash flows
  by one risk-adjusted discount rate to
  account for both time and risk, reduce the
  future cash flow to account for risk and then
  discount that value for time at the risk-free
                n                 n
        PV =   
                     (1 + r)t =   
                                        (1 + rf)t
• Risk-free rate is 5%
• Investment will pay $1 million in two years
• Appropriate risk-adjusted rate is 12%
          PV =              = $797,194
          PV =

          CEQ2 = $878,906
• The ratio of CEQ2 to C2 is 87.89%
    Certainty Equivalent Problem
An 18th century ship-owner sends a vessel out on a 2-
year voyage. The value of the cargo will not be known
until it returns. The expected value of the cargo is
$144,000. The present value of the voyage is $100,000.
The risk-free rate is 5 percent.
   Why Manage Diversifiable Risk?
• Based on the CAPM, investors are not willing to
  pay extra for companies that reduce risk that is
  not correlated with market risk
• Based on the APM, investors are not willing to
  pay extra for companies that reduce risk that is
  not correlated with one of the priced “factors”
• Risks such as fires, lawsuits, computer failures,
  employee embezzlement, or product failures are
  not likely tied to market risk or any
  macroeconomic factors
• Why, then, do firms pay to manage these risks?
Reasons for Managing Diversifiable Risks
 • Nonlinear tax structure
   – Firms with stable earnings pay less in taxes than
     firms with equal but variable earnings
 • Avoiding cash shortfalls
   – Missing positive NPV projects
 • Reducing the risk of financial distress
   – Bankruptcy is costly
 • Managerial self-interest
   – Manager compensation for potential unemployment
   – Rewarding managers appropriately
 • Other economic effects
   – Suppliers, customers, employees
               Types of Risk
Common risk allocation
• Hazard risk
• Financial risk
• Operational risk
• Strategic risk
Bank view – New Basel Accord
• Credit risk
  – Loan and counterparty risk
• Market risk (financial risk)
• Operational risk
                 Hazard Risk
•   “Pure” loss situations
•   Property
•   Liability
•   Employee related
•   Independence of separate risks
•   Risks can generally be handled by
    – Insurance, including self insurance
    – Avoidance
    – Transfer
         Managing Hazard Risk
• Insurance
  – Policy terms and conditions
  – Premiums exceed expected losses
     • Administrative costs
     • Adverse selection
     • Moral hazard (and morale hazard)
  – Deductibles
  – Policy limits
• Self insurance
  – Captives
  – Access to reinsurance market
                 Financial Risk
• Components
  –   Foreign exchange rate
  –   Equity
  –   Interest rate
  –   Commodity price
• Correlations among different risks
• Use of hedges, not insurance or risk transfer
• Securitization
      Financial Risk Management
•   Forwards
•   Futures
•   Swaps
•   Options
            Forward Contracts
• A forward contract obligates one party to sell
  and another party to buy an asset
• The exchange takes place in the future
• The price is fixed today
• No payment is made until maturity
• The buyer has a gain if the asset value increases
• The contract price is set at origination so that
  the value is zero
      Forward Contract Example
• Airline agrees to buy a fuel commodity at a
  fixed price several months in future
• When forward contract is established, airline
  then sets ticket prices for that period
• Southwest Airlines hedges fuel prices more
  than any other airline
• One reason – counterparty risk
             Futures Contracts
• A future obligates one party to buy and another
  to sell a specified asset in the future at a price
  agreed on today
• Futures are standardized contracts traded on
  organized exchanges
• Price changes are settled each day
• Margin accounts must maintained
     What is the use of a futures
• Help reduce uncertainty in future spot price
• Agricultural futures were one early contract
  – Farmer can lock in future price of corn before
    harvest (protect against drop in price)
  – User of corn can protect against rise in price
• Futures are now available on many assets
  – Agricultural (corn, soybeans, wheat, etc.)
  – Financial (interest rates, FX, and equities)
  – Commodities (oil, gasoline, and metals)
 Differences between Forwards and
• Features reducing credit       • Features promoting
  risk                             liquidity
   – Daily settlement or mark-     – Contract standardization
     to-market                     – Traded on organized
   – Margin account                  exchanges
   – Clearinghouse
      Futures Contract Example
• Firm sells (shorts) S&P 500 futures contracts
  for June 2007 representing a portion of its
  equity investments
• As the S&P 500 index increases, the firm
  incurs a loss and has to mark its position to
  market each day, reducing the effect of the
  equity gain
• If the S&P 500 index declines, the firm gains
  from the futures contract, offsetting some of its
  investment losses
             Swap Contracts
• An agreement between two parties to exchange
  (or swap) periodic cash flows
• At each payment date, only the net value of
  cash flows is exchanged
• The cash flows are based on a notional
  principal or notional amount
• The notional amount is only used to determine
  the cash flows
             Currency Swap
• On each settlement date, the US company
  pays a fixed foreign currency interest rate
  on a notional amount of another currency
  and receives a dollar amount of interest on a
  notional amount in dollars
• Since the interest rate is fixed, the only
  change in value is due to change in FX rate
• Using netting, only one party pays the
  difference between cash flow values
                      Other Swaps
• Currency-coupon or cross-currency interest rate swap
   – Still two different currencies
   – One interest rate is a fixed rate, one rate is floating
• Interest rate swap
   – Special case of currency-coupon swap: there is only one
   – Two interest rates: one fixed and one floating
   – Very useful to insurers
• Equity swap
   – One party pays the return on an equity index (such as the
     S&P 500) while receiving a floating interest rate
             Credit Derivatives
• Total return swap
   – One party pays interest and capital gains/losses
   – Other party pays floating (or fixed) interest rate
• Credit default swap
   – Fastest growing derivative
   – Insurers and reinsurers heavily involved
   – One party pays a periodic fee
   – Other party pays any losses incurred in default or from
     credit downgrade
   – Similar to insurance, but risk could be highly correlated
             Operational Risk
Causes of operational risk
• Internal processes
• People
• Systems
• Product recall
• Customer satisfaction
• Information technology
• Labor dispute
• Management fraud
              Strategic Risk
• Competition
• Regulation
• Technological innovation
• Political impediments
Traditional Approach to Risk Management
 • Risks are handled separately (silos)
   – Corporate risk manager handles hazard risks
   – CFO or investment department handles financial
   – Managers handle operating risk
   – CEO (or C-suite) handles strategic risk
 • Each area has its own approach
   – Terminology
   – Risk tolerance
   – Reports
 • No overall coordination or aggregation
                   ERM Approach

             Aggregate Risk Management

Hazard Risk     Financial Risk     Operational   Strategic Risk
                                   Risk          - Regulation
- Hurricanes    - Credit Risk
                                   - Internal    - Reputation
- Lawsuits      - Market Risk
- Injuries      - Interest Rates                 - Competition
                                   - Recalls
        What is Driving ERM?
• Board of Directors concern about what can go
• Need for one person or group to be responsible
  for risk oversight
  – Chief Risk Officer
• Technological advances
  – Computing power
  – Analytical techniques
• ERM is moving from risk control to risk
               Next Class
• Beyond NPV – Simulation, Options and Trees
• Read Chapters 10 and 11

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