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# Lecture Finance Advanced Corporate Finance Futures Contract

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```									               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
rate
n                 n
PV =   
t=1
Ct
(1 + r)t =   
t=1
CEQt
(1 + rf)t
Example
• Risk-free rate is 5%
• Investment will pay \$1 million in two years
• Appropriate risk-adjusted rate is 12%
1,000,000
PV =              = \$797,194
(1.12)2
CEQ2
PV =
(1.05)2

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
• Moral hazard (and morale hazard)
– Deductibles
– Policy limits
• Self insurance
– Captives
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
Toolbox
•   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
contract?
• 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
Futures
• Features reducing credit       • Features promoting
risk                             liquidity
– Daily settlement or mark-     – Contract standardization
– 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
currency
– 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
– Similar to insurance, but risk could be highly correlated
Operational Risk
Causes of operational risk
• Internal processes
• People
• Systems
Examples
• Product recall
• Customer satisfaction
• Information technology
• Labor dispute
• Management fraud
Strategic Risk
Examples
• Competition
• Regulation
• Technological innovation
• Political impediments
• Risks are handled separately (silos)
– Corporate risk manager handles hazard risks
– CFO or investment department handles financial
risks
– 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
Fraud
- Injuries      - Interest Rates                 - Competition
- Recalls
What is Driving ERM?
• Board of Directors concern about what can go
wrong
• Need for one person or group to be responsible
for risk oversight
– Chief Risk Officer