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Chapter 27Principlesof

CorporateFinance

Ninth Edition

Managing Risk

Slides by

Matthew Will

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw Hill/Irwin

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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Topics Covered

Why Manage Risk?Insurance

Forward and Futures Contracts

SWAPS

How to Set Up A Hedge

Is Derivative a Four Letter Word?

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Risk Reduction

Why risk reduction does not add value

1. Hedging is a zero sum game--A corporation thatinsures or hedges a risk does not eliminate it. It simply passes the risk to someone

else.

2. Investors do-it-yourself alternativeCorporations cannot increase the value of their shares by undertaking transactions that

investors can easily do on their own.

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Risk Reduction

Risks to a business Cash shortfalls

Financial distress

Agency costs

Variable costs

Currency fluctuations

Political instability

Weather changes

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Insurance

Most businesses face the possibility of ahazard that can bankrupt the company in an

instant.

These risks are neither financial or businessand can not be diversified.

The cost and risk of a loss due to a hazard,

however, can be shared by others who sharethe same risk.

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Insurance

ExampleAn offshore oil platform is valuedat $1 billion. Expert meteorologistreports indicate that a 1 in 10,000

chance exists that the platform maybe destroyed by a storm over thecourse of the next year.

? How can the cost of this hazardbe shared

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Insurance

Example - contAn offshore oil platform is valued at $1 billion. Expertmeteorologist reports indicate that a 1 in 10,000 chance exists thatthe platform may be destroyed by a storm over the course of thenext year.

? How can the cost of this hazard be shared

Answer

A large number of companies with similar risks can eachcontribute pay into a fund that is set aside to pay the

cost should a member of this risk sharing groupexperience the 1 in 10,000 loss. The other 9,999 firmsmay not experience a loss, but also avoided the risk ofnot being compensated should a loss have occurred.

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Insurance

Example - contAn offshore oil platform is valued at $1 billion. Expertmeteorologist reports indicate that a 1 in 10,000 chance exists that

the platform may be destroyed by a storm over the course of the

next year.

? What would the cost to each group member befor this protection.

Answer

000,100$000,10

000,000,000,1

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Insurance

Why would an insurance company not offera policy on this oil platform for $100,000?

Administrative costsAdverse selection

Moral hazard

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Insurance

The loss of an oil platform by a storm may be 1 in 10,000.The risk, however, is larger for an insurance companysince all the platforms in the same area may be insured,thus if a storm damages one in may damage all in the samearea. The result is a much larger risk to the insurer

Catastrophe Bonds - (CAT Bonds) Allow insurers totransfer their risk to bond holders by selling bonds whosecash flow payments depend on the level of insurable losses

NOT occurring.

(A high-yield debt instrument that is usually insurance linked and meant to raise money incase of a catastrophe such as a hurricane or earthquake. It has a special condition thatstates that if the issuer (insurance or reinsurance company) suffers a loss from aparticular pre-defined catastrophe, then the issuer's obligation to pay interest and/orrepay the principal is either deferred or completely forgiven)

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Hedging with Forwards and Futures

Business has riskBusiness Risk - variable costs

Financial Risk - Interest rate changes

Goal - Eliminate risk

HOW?

Hedging & Forward Contracts

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Ex - Kellogg produces cereal. A major component and costfactor is sugar.

Forecasted income & sales volume is set by using a fixedselling price.

Changes in cost can impact these forecasts.

To fix your sugar costs, you would ideally like to purchase allyour sugar today, since you like todays price, and made yourforecasts based on it. But, you can not.

You can, however, sign a contract to purchase sugar at

various points in the future for a price negotiated today. This contract is called a Futures Contract.

This technique of managing your sugar costs is calledHedging.

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1- Spot Contract - A contract for immediate sale & delivery of

an asset.

2- Forward Contract - A contract between two people for the

delivery of an asset at a negotiated price on a set date in the

future.

3- Futures Contract - A contract similar to a forward contract,

except there is an intermediary that creates a standardized

contract. Thus, the two parties do not have to negotiate the

terms of the contract.

The intermediary is the Commodity Clearing Corp (CCC). The

CCC guarantees all trades & provides a secondary market

for the speculation of Futures.

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Types of Futures

Commodity Futures

-Sugar -Corn -OJ

-Wheat -Soy beans -Pork bellies

Financial Futures

-Tbills -Yen -GNMA

-Stocks -Eurodollars

Index Futures

-S&P 500 -Value Line Index

-Vanguard Index

SUGAR

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Commodity Futures

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Financial Futures

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Futures Contract Concepts

Not an actual sale

Always a winner & a loser (unlike stocks)

K are settled every day. (Marked to Market)

Hedge - K used to eliminate risk by locking in prices

Speculation - K used to gambleMargin - not a sale - post partial amount

Hog K = 30,000 lbs

Tbill K = $1.0 mil

Value line Index K = $index x 500

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Futures and Spot Contracts

yieldDividend

ratefreeRisk

pricespotsToday'

lengthtofcontractonpricefutures

)1(

0

0

y

r

S

F

yrSF

f

t

tft

The basic relationship between futures prices and spotprices for equity securities.

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Example

The DAX spot price is 5,952.38. The interest rate is 3.6% and the dividend

yield on the DAX index is 2.0%. What is the expected price of the 6 month

DAX futures contract?

000,6

)01.018.1(38.952,5

)1(0

t

ft yrSF

2 20

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yieldeConveniencNet

coststorageExpersssc

yieldeConvenienc

ratefreeRisk

pricespotsToday'

lengthtofcontractonpricefutures

)1(

0

0

sccyncy

cy

r

S

F

cyscrSF

f

t

t

ft

The basic relationship between futures prices and spotprices for commodities.CY--The benefit or premium associated with holding an underlying product

or physical good, rather than the contract or derivative product.

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Example

In December the spot price for coffee was $1.234 per pound. The interest

rate was 5.36 % per year. The net convenience yield was -5.6%. What was

the price of the 9 month futures contract?

3525.1

)056.0399.1(234.1

)1(

radjustedwith time)1(

)1(

0

0

0

ncyrSF

ncyrSF

orcyscrSF

ft

ft

t

ft

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Net Convenience Yield

-40.00

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

01/31/1994

06/30/1994

11/30/1994

04/28/1995

09/29/1995

02/29/1996

07/31/1996

12/31/1996

05/30/1997

10/31/1997

03/31/1998

08/31/1998

01/29/1999

06/30/1999

11/30/1999

04/28/2000

09/29/2000

02/28/2001

07/31/2001

12/31/2001

05/31/2002

10/31/2002

03/31/2003

08/29/2003

01/30/2004

06/30/2004

11/30/2004

04/29/2005

09/30/2005

02/28/2006

07/31/2006

Annua

lizedNetConvenie

nceYield,%

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Homemade Forward Rate Contracts

Year 0 Year 1 Year 2

Borrow for 1 year at 10% +90.91 -100

Lend for 2 years at 12% -90.91 -114.04

Net cash flow 0 -100 -114.04

%04.14or1404.

110.1

12.1

1rate)spotyear11(

rate)spotyear21(rateinterestForward

2

2

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Swaps

0 1 2 3 4 5

1. Borrow $66.67 at 6%

fixed rate 66.67 -4 -4 -4 -4 -70.67

2. Lend $66.67 at LIBOR

floating rate -66.67 .5x66.67

LIBOR1

x66.67 LIBOR2x66.67 LIBOR3x66.67

LIBOR4x66.67

+66.67

Net cash flow 0 -4 -4 -4 -4 -4

.05x66.67 LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67

Standard fixed-to-floating

swap 0 -4 -4 -4 -4 -4

.5x66.67 LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67

Year

LIBOR -An interest rate benchmark used to establish the floating interest rate that is paid on the notional principal in an

interest-rate swap. LIBOR flat has no spread added to it and represents the best interest rate availablein the current market. It is the most common reference on which other interest rates are based.

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SWAPS

birth 1981

Definition - An agreement between two firms, in which each

firm agrees to exchange the interest rate characteristics of

two different financial instruments of identical principal

http://www.investopedia.com/video/play/swaps/#axzz2NQlF

qtoB

Key points

Spread inefficienciesSame notation principal

Only interest exchanged

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http://www.investopedia.com/video/play/swaps/http://www.investopedia.com/video/play/swaps/http://www.investopedia.com/video/play/swaps/http://www.investopedia.com/video/play/swaps/

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SWAPS

Plain Vanilla Swap - (generic swap)

fixed rate payer

floating rate payer

counterparties

settlement date trade date

effective date

terms

Swap Gain = fixed spread - floating spread

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Swap Curves

SWAP Curves for three currencies during January 2007

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SWAPS

example (vanilla/annually settled)

XYZ ABC

fixed rate 10% 11.5%

floating rate libor + .25 libor + .50

Q: if libor = 7%, what swap can be made 7 what is the profit (assume$1mil face value loans)

A:

XYZ borrows $1mil @ 10% fixed

ABC borrows $1mil @ 7.5% floating

XYZ pays floating @ 7.25%

ABC pays fixed @ 10.50%My interpretation-currently ABC 10.5 rate sa de rha h and ya XYZ ka rate h jo usa pa karna hota.Means XYZ ko benefit.

And XYZ floating apna hi pay karaga.

Other situation-ABC 11.5 ki jagaha 10.5 de rha h. TO usa benefit of 1%. And lose h usa .25% ka us par jo floating XYZ pay kar rha h.

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SWAPS

example - cont

Benefit to XYZ Net position

floating +7.25 -7.25 0

fixed +10.50 -10.00 +.50

Net gain +.50%

Benefit ABC Net Position

floating +7.25 - 7.50 -.25

fixed -10.50 + 11.50 +1.00

net gain +.75%

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SWAPS

example - cont

Settlement date

ABC pmt 10.50 x 1mil = 105,000

XYZ pmt 7.25 x 1mil = 72,500

net cash pmt by ABC = 32,500

if libor rises to 9%

settlement date

ABC pmt 10.50 x 1mil = 105,000XYZ pmt 9.25 x 1mil = 92,500

net cash pmt by ABC = 12,500

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SWAPS

transactions

rarely done direct

banks = middleman

bank profit = part of swap gain

example - same continued

XYZ & ABC go to bank separately

XYZ term = SWAP floating @ libor + .25 for fixed @ 10.50

ABC terms = swap floating libor + .25 for fixed 10.75

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SWAPS

example - cont

settlement date - XYZ

Bank pmt 10.50 x 1mil = 105,000

XYZ pmt 7.25 x 1mil = 72,500

net Bank pmt to XYZ = 32,500

settlement date - ABC

Bank pmt 7.25 x 1mil = 72,500

ABC pmt 10.75 x 1mil = 107,500

net ABC pmt to bank = 35,000

bank swap gain = +35,000 - 32,500 = +2,500

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SWAPS

example - contbenefit to XYZ

floating 7.25 - 7.25 = 0

fixed 10.50 - 10.00 = +.50 net gain .50

benefit to ABCfloating 7.25 - 7.50 = - .25

fixed -10.75 + 11.50 = + .75 net gain .50

benefit to bank

floating +7.25 - 7.25 = 0fixed 10.75 - 10.50 = +.25 net gain +.25

total benefit = 12,500 (same as w/o bank)

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Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the

Spot Price of hogs will rise in the future. Thus, you go Long on

10 Hog Futures. If the price drops .17 cents per pound ($.0017)

what is total change in your position?

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Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the

Spot Price of hogs will rise in the future. Thus, you go Long on

10 Hog Futures. If the price drops .17 cents per pound ($.0017)

what is total change in your position?

30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss

Since you must settle your account every day, you must giveyour broker $510.00

50.63

50.80

-$510

centsper lbs

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Hedging

Hypothetical plot of past changes

in the price of the farmers wheat

against changes in the price of

Kansas City wheat futures. A 1%change in the futures price implies,

on average, an .8% change in the

price of the farmers wheat.

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Commodity Hedge

In June, farmer John Smith expects to harvest 10,000

bushels of corn during the month of August. In June,

the September corn futures are selling for $2.94 per

bushel (1K = 5,000 bushels). Farmer Smith wishes

to lock in this price.Show the transactions if the Sept spot price drops to

$2.80.

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Commodity Hedge

In June, farmer John Smith expects to harvest 10,000 bushels of

corn during the month of August. In June, the September cornfutures are selling for $2.94 per bushel (1K = 5,000 bushels).

Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price drops to $2.80.

Revenue from Crop: 10,000 x 2.80 28,000

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 2.80 = 28,000 .

Gain on Position------------------------------- 1,400

Total Revenue $ 29,400

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Commodity Hedge

In June, farmer John Smith expects to harvest 10,000

bushels of corn during the month of August. In June,

the September corn futures are selling for $2.94 per

bushel (1K = 5,000 bushels). Farmer Smith wishes

to lock in this price.Show the transactions if the Sept spot price rises to

$3.05.

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Commodity Hedge

In June, farmer John Smith expects to harvest 10,000 bushels of

corn during the month of August. In June, the September cornfutures are selling for $2.94 per bushel (1K = 5,000 bushels).

Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price rises to $3.05.

Revenue from Crop: 10,000 x 3.05 30,500

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 3.05 = 30,500 .

Loss on Position------------------------------- ( 1,100 )

Total Revenue $ 29,400

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Commodity Speculation

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290

Loss of 10.23 % = - 5,130

You have lived in NYC your whole life and areindependently wealthy. You think you know everythingthere is to know about pork bellies (uncurred bacon)because your butler fixes it for you every morning.Because you have decided to go on a diet, you think

the price will drop over the next few months. On theCME, each PB K is 38,000 lbs. Today, you decide toshort three May Ks @ 44.00 cents per lbs. In Feb, theprice rises to 48.5 cents and you decide to close yourposition. What is your gain/loss?

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Margin

The amount (percentage) of a Futures Contract Value that

must be on deposit with a broker.

Since a Futures Contract is not an actual sale, you need

only pay a fraction of the asset value to open a position =

margin.

CME margin requirements are 15% Short position-Thus, you can control $100,000 of assets with only $15,000. 1. The sale

of a borrowed security, commodity or currency with the expectation that the asset will

fall in value.

2. In the context of options, it is the sale (also known as "writing") of an options

contract.

Long position-. The buying of a security such as a stock, commodity or currency, with

the expectation that the asset will rise in value.

2. In the context of options, the buying of an options contract.

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di l i

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Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290

Loss = - 5,130

Loss 5130 5130

Margin 50160 x.15 7524------------ = -------------------- = ------------ = 68% loss

You have lived in NYC your whole life and are independently wealthy.

You think you know everything there is to know about pork bellies(uncurred bacon) because your butler fixes it for you every morning.Because you have decided to go on a diet, you think the price will dropover the next few months. On the CME, each PB K is 38,000 lbs.Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb,the price rises to 48.5 cents and you decide to close your position.

What is your gain/loss?

Commodity Speculation with margin

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Web Resources

www.cbot.com

www.cme.com

www.nymex.com

www.lme.com

www.eurexchange.com

www.euronext.comwww.bis.org

www.commoditytrader.net

www.isda.org

Click to access web sitesInternet connection required
http://www.cbot.com/http://www.cme.com/http://www.nymex.com/http://www.lme.com/http://www.eurexchange.com/http://www.euronext.com/http://www.bis.org/http://www.commoditytrader.net/http://www.isda.org/http://www.isda.org/http://www.commoditytrader.net/http://www.bis.org/http://www.euronext.com/http://www.eurexchange.com/http://www.lme.com/http://www.nymex.com/http://www.cme.com/http://www.cbot.com/

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