Chapter 23

Derivatives and Risk

Management

Topics in Chapter

Risk management and stock value

maximization.
Derivative securities.
Fundamentals of risk management.
Using derivatives to reduce
interest rate risk.

Intrinsic Value: Risk Management

Foreign exchange rates
Foreign exchange rates
Product prices
Product prices
and demand
and demand

Net operating
profit after taxes

Input costs
Input costs

Required investments
in operating capital

Free cash flow

=
(FCF)

FCF1

Value =
(1 + WACC)1
Market risk aversion
Firms debt/equity mix

FCF2

+
(1 + WACC)2

Weighted average
cost of capital
(WACC)

FCF
+ +
(1 +
WACC)
Firms business risk
Firms business risk
Market interest rates
Market interest rates
3

Do stockholders care about

volatile cash flows?

If volatility in cash flows is not caused

by systematic risk, then stockholders
can eliminate the risk of volatile cash
flows by diversifying their portfolios.
Stockholders might be able to reduce
impact of volatile cash flows by using
risk management techniques in their
own portfolios.
4

How can risk management

increase the value of a
corporation?

Risk management allows firms to:

Have greater debt capacity, which
has a larger tax shield of interest
payments.
Implement the optimal capital budget
without having to raise external
equity in years that would have had
low cash flow due to volatility.
(More...
)

Risk management allows

firms to:

Avoid costs of financial distress.

Weakened relationships with suppliers.

Loss of potential customers.
Distractions to managers.

Utilize comparative advantage in

hedging relative to hedging ability
of investors.
(More...
)

Risk management allows

firms to (Continued):

Reduce borrowing costs by using

interest rate swaps.

Example: Two firms with different

credit ratings, Hi and Lo:
Hi can borrow fixed at 11% and
floating at LIBOR + 1%.
Lo can borrow fixed at 11.4% and
floating at LIBOR + 1.5%.
(More...

Hi wants fixed rate, but it will issue floating and

swap with Lo. Lo wants floating rate, but it will
issue fixed and swap with Hi. Lo also makes
side payment of 0.45% to Hi.
Hi
CF to
lender

Lo

-(LIBOR+1%)

-11.40%

CF Hi to Lo

-11.40%

+11.40%

CF Lo to Hi

+(LIBOR+1%)

-(LIBOR+1%)

CF Lo to Hi

+0.45%

-0.45%

Net CF

-10.95% -(LIBOR+1.45%)

(More)

Risk management allows

firms to:

Minimize negative tax effects due to

convexity in tax code.
Example: EBT of $50K in Years 1 and
2, total EBT of $100K,

Tax = $7.5K each year, total tax of $15.

EBT of $0K in Year 1 and $100K in

Year 2,

Tax = $0K in Year 1 and $22.5K in Year 2.

9

What is corporate risk

management?

Corporate risk management is the

management of unpredictable
events that would have adverse
consequences for the firm.

10

Different Types of Risk

Speculative risks: Those that offer

the chance of a gain as well as a loss.
Pure risks: Those that offer only the
prospect of a loss.
Demand risks: Those associated with
the demand for a firms products or
services.
Input risks: Those associated with a
firms input costs.
(More...
11
)

Financial risks: Those that result from financial

transactions.
Property risks: Those associated with loss of a
firms productive assets.
Personnel risk: Risks that result from human
actions.
Environmental risk: Risk associated with polluting
the environment.
Liability risks: Connected with product, service, or
employee liability.
Insurable risks: Those which typically can be
covered by insurance.
12

What are the three steps of

corporate risk management?

Step 1. Identify the risks faced by

the firm.
Step 2. Measure the potential
impact of the identified risks.
Step 3. Decide how each relevant
risk should be dealt with.

13

What are some actions that

companies can take to minimize or
reduce risk exposures?

Transfer risk to an insurance

company by paying periodic
premiums.
Transfer functions which produce
risk to third parties.
Purchase derivatives contracts to
reduce input and financial risks.
(More...
14
)

Take actions to reduce the

probability of occurrence of adverse
events.
Take actions to reduce the
magnitude of the loss associated
with adverse events.
Avoid the activities that give rise to
risk.
15

What is financial risk

exposure?

Financial risk exposure refers to

the risk inherent in the financial
markets due to price fluctuations.
Example: A firm holds a portfolio
of bonds, interest rates rise, and
the value of the bonds falls.

16

Financial Risk
Management Concepts

Derivative: Security whose value

stems or is derived from the value
of other assets. Swaps, options,
and futures are used to manage
financial risk exposures.

(More...17

Futures: Contracts which call for

the purchase or sale of a financial
(or real) asset at some future date,
but at a price determined today.
Futures (and other derivatives) can
be used either as highly leveraged
speculations or to hedge and thus
reduce risk.
18

Hedging: Generally conducted where a

price change could negatively affect a
firms profits.

Long hedge: Involves the purchase of a

futures contract to guard against a price
increase.
Short hedge: Involves the sale of a futures
contract to protect against a price decline
in commodities or financial securities.
(More...
19
)

Swaps: Involve the exchange of

cash payment obligations between
two parties, usually because each
party prefers the terms of the
others debt contract. Swaps can
reduce each partys financial risk.

20

How can commodity futures

markets be used to reduce input
price risk?

The purchase of a commodity

futures contract will allow a firm to
make a future purchase of the
input at todays price, even if the
market price on the item has risen
substantially in the interim.

21

Hedging a bond issue with

T-Bond Futures

It is January, Tennessee Sunshine

will issue $5 million in bonds in
June. TS is worried interest rates
will rise between now and then.
Current interest rates are 7% for
the 20-year issue. But TS fears
rates might rise by 1% by June.
June T-bond futures are 11125.
22

What are risks of not

hedging?

Interest rates might increase before

the bonds are issued. At a yield of
8%, how much will the $5 million
worth of 20-year 7% semi-annual
coupon bonds be worth?

23

PMT = $5 million x 7%/2 =

$175,000

INPUTS

OUTPUT

40
N

4
I/YR

175000 5000000
PV
PMT
FV
-4,505,181

24

The bonds will be worth only

$4,505,181 so TS will lose $5,000,000 $4,505,181 = $494,819 if interest rates
decline.
Actually, TS might just issue $5,000,000
of 8% bonds if it waits and interest rates
increase, but the cost of this higher
interest rate is the $494,819 we
calculated.
25

How can Tennessee

Sunshine hedge this risk?

T-Bond futures represent a contract

on a hypothetical 20-year 6% bond
with semiannual payments.
A futures price of 11125 means
111% plus 25/32 percent of par, or
for a $1,000 par bond, a price of
$1,117.81.
26

T-bond futures contract

One T-bond futures contract is for

$100,000 par value of underlying
bonds, which is 100 of the $1,000
par-value bonds. Since each bond
is worth $1,117.81, one contract is
for $111,781 worth of bonds.
TS will sell $5,000,000/$111,781 =
44.7 = 45 contracts.
27

Implied yield on futures

contract

A price of $1,117.81 gives a semiannual yield of 2.5284% or an

annual yield of about 5.057%:

INPUTS
OUTPUT

40
N

-1117.81 30
I/YR
PV
PMT
2.5284

1000
FV

28

Futures price changes

T-bond futures prices change every

day as interest rates change. If
interest rates increase, bond prices
decrease and so does the T-bond
futures price. If interest rates
decrease, then bond prices
increase, and so does the T-bond
futures price.
29

What happens if interest

rates increase 1%?

The yield on the bond underlying the

futures contract will increase to 5.057%
+ 1% = 6.057%. This gives a new price
of $993.44 (N=40, I/YR=6.057/2, PMT =
-30, FV = -1000; solving gives PV =
993.44 per underlying bond, or a
contract price of $99,344.
This is a decrease of $111,781 $99,344 = $12,437 for each contract.
30

Profit or loss from contract

Since TS sold futures contracts, then it

makes money when the futures price
declines. In this case, TS will make
$12,437 on each of its 45 contracts.
Since TS sold the futures contracts
and the price went down, it earns a
positive profit of $12,437 x 45
contracts = $559,665.
31

What is the effectiveness

of the hedge?

TS will lose $494,819 on its own

bonds when it issues them at the
higher coupon rate, but it earns
$559,665 on its futures contracts.
Net result = 559,665 494,819 =
$64,846 profit from the hedge.

32

Suppose interest rates fall

instead of rise?

If interest rates fall, then:

TS gains on its bond issue

TS loses on its futures contracts

33