Slide 1: CORPORATE RISK MANAGEMENT GROUP 1 Contents: : Classification of Risk
Measurement of risk in non financial firms
Principle of hedging
Hedging with Forward, Futures, Swap, Options Contracts, Insurance, Risk management products
Financial Engineering and Corporate Strategy
Risk management practices Contents: Classification of risk : The wide array of risks that a management firms exposed can be classified into 5 categories:
Technological Risk: arise mostly in the R&D and Operations stage of the value chain.
Economic Risks: arise from fluctuations in the revenues(output price and demand) and production cost ( Raw material cost, energy cost and labor cost)
Financial Risks: arise from volatility of Interest rates, currency rates, commodity prices and stock prices.
Performance risks: arise when contracting counterparties do not fulfill their obligations.
Legal and Regulatory risks: change in laws and regulations Classification of risk Measurement of risk in non financial firms : To assess the Financial price risk we may:
Examine the financial statements to get an idea of the risk exposure
Assess the sensitivity of the firms value or cash flow to changes in the financial prices and
Conduct monte carlo simulation. Measurement of risk in non financial firms Examine the financial statements : Examining the Balance sheet and Profit & loss account throw light on a number of questions like:
Does the firm have a strong liquidity position as per high Current ratio and Quick ratio? A strong liquidity position cushions against the volatility of cash flows caused by changes in Financial prices.
Does the firm have a low gearing ratio (leverage)? A low gearing ration provides greater financial flexibility to cope with volatility in financial prices.
What is the Foreign exchange transaction exposure? If the balances of receivables and payables are high, their values would change in response to shifts in the exchange rates.
Is the firm exposed to interest rate risk? If the firm relies mainly on free floating debt it has a high interest rate exposure. Examine the financial statements Assess the sensitivity : Determine the sensitivity of Firm’s Value or Cash Flow by:
Analyzing the Historical data on firm value, cash flows and financial prices
e.g. – The sensitivity of a firm’s value to exchange rate may be estimated as
Firm Value = a + b Exchange rate Assess the sensitivity monte carlo simulation : Monte carlo methods are used in finance to value and analyze (complex) instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes.
The advantage of monte carlo methods over other techniques increases as the dimensions (sources of uncertainty) of the problem increase. monte carlo simulation Principle of hedging : One way to manage these risks and uncertainties is to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity’s other risks and uncertainties, transactions known as ‘hedges’.
The instrument acquired to offset risk or uncertainty is known as ‘hedging instrument’ and the risk or uncertainty hedged is known as ‘hedged item’.
There are predominantly two motivations for a company to hedge:
To lock-in a future price which is attractive, relative to an organisation’s costs.
To secure a commodity price fixed against an external contract Principle of hedging HEDGING WITH Forward CONTRACTS : Forward contract is an OTC agreement between two parties, to buy or sell an asset at a certain time in the future for a certain price.
The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.
The forward price is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date.
The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit or loss, by the purchasing party. HEDGING WITH Forward CONTRACTS HEDGING WITH FUTURE CONTRACTS : What Does Futures Contract Mean?
A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.
Some futures contracts may call for physical delivery of the asset, while others are settled in cash. HEDGING WITH FUTURE CONTRACTS TYPES OF FUTURE CONTRACTS : There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes.
Foreign exchange market
Soft Commodities market TYPES OF FUTURE CONTRACTS FUTURES HEDGING : FUTURES HEDGING HEDGING WITH SWAPS : What Does Swap Mean?
If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms.
For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates. HEDGING WITH SWAPS TYPES OF SWAPS : Interest rate swaps
Credit default swaps
Other variations TYPES OF SWAPS REASON FOR SWAPS : Spread compression
Difference in financial norms REASON FOR SWAPS HEDGING WITH OPTION CONTRACTS : An option contract is an agreement under which the seller of the option grants the buyer the right, but not the obligation, to buy or sell(depending on whether it is a call option or a put option) some asset at a predetermined price during the specified period. The buyer of the option has to pay a premium to enjoy the right.
Forward vs options:
In forwards contract both parties agree to act in the future whereas in an option transaction occurs only if the buyer of the option chooses to exercise it.
In forward contract no money exchanges hands whereas in options the buyer of the contract pays option premium.
Hedging with options:diagrams HEDGING WITH OPTION CONTRACTS Options in debt contracts : Imagine a firm going for a long term floating rate loan
The risks involved are the interest rates rising sharply increasing the debt service burden Options in debt contracts HEDGING WITH INSURANCE : Main advantages offered by Insurance companies:
They can price the risks reasonably accurately
Provides low cost administration service due to specialisation and economies of scale.
Provides advice on measures to reduce risks
Pools risks by holding large diversified pool of assets
Disadvantages of Insurance:
It incurs administrative costs
Problem of adverse selection- cant differentiate between good and bad risks
Exposed to problem of moral hazard
Loading fee- diff between insurance premium and expected payoff. HEDGING WITH INSURANCE Types of option contracts : Option contract on debt instruments- options on treasury bill
Option contract on foreign currencies– options with British pounds
Option contract on stock market indices-option on S&P 500 index
Option contract on stock index futures. Types of option contracts Hedging with real tools and options : Real options-
Diversify product line and services to reduce risks
Invest in preventive maintenance
Emphasise quality control to reduce product liability
Build flexible production systems
Shorten time to introduce product to market
Delay investment until uncertainty is resolved
Carry extra liquidity on the balance sheet to tide over difficult periods
Maintain reserve borrowing power to meet contingencies. Hedging with real tools and options REAL VS. FINANCIAL OPTIONS : Real options cost a great deal.
In some cases real options may be the only viable means to handle risks
Real options are far less liquid
Firm with real options may profit from assuming more risk – a firm with flexible production facilities can benefit more by manufacturing products subject to high price volatility. REAL VS. FINANCIAL OPTIONS EVOLUTION OF RISK MANAGEMENT TOOLS : The financial and operating environment today is more riskier than in the past –
Substantial increase in the average rate as well as volatility of inflation
Greater volatility in interest rates , exchange rates, and commodity prices
Increased global competition. EVOLUTION OF RISK MANAGEMENT TOOLS Volatility and Risk Management Tools: : Exchange rate volatility- currency futures, currency swaps, currency options
Interest rate volatility- floating rate loans, T-Bill futures, T-Bond futures, options on T-Bonds, caps floors and collars.
Petroleum prices- futures in heating oil, futures in WTI, hybrids, option in WTI
Metal price volatility- fwds, futures, options,hybrids. Volatility and Risk Management Tools: Risk management practices : Corporate strategy – bricks and mortar
TVA Risk management practices Guidelines for risk managemnet : Align risk management with corporate strategy
Proactively manage uncertainties
Employ mix of real and financial methods
Know the limits of risk management tools
Don’t put undue pressure on corporate treasury to generate profits
Learn when it is worth reducing risk Guidelines for risk managemnet