Chapter 23 – Enterprise Risk Management
Chapter 23
Enterprise Risk Management
CHAPTER WEB SITES
Section Web Address
Introduction www.numa.com
23.4 www.cbot.com
www.cme.com
www.theice.com
www.biz.uiowa.edu/iem
www.cftc.gov
23.5 www.isda.org
23.6 www.cboe.com
www.optionseducation.com
www.margrabe.com
www.treasurers.org
CHAPTER ORGANIZATION
23.1 Insurance
23.2 Managing Financial Risk
The Risk Profile
Reducing Risk Exposure
Hedging Short-Run Exposure
Cash Flow Hedging: A Cautionary Note
Hedging Long-Term Exposure
Conclusion
23.3 Hedging With Forward Contracts
Forward Contracts: The Basics
The Payoff Profile
Hedging with Forwards
23.4 Hedging With Futures Contracts
Trading in Futures
Futures Exchanges
Hedging with Futures
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23.5 Hedging With Swap Contracts
Currency Swaps
Interest Rate Swaps
Commodity Swaps
The Swap Dealer
Interest Rate Swaps: An Example
23.6 Hedging with Option Contracts
Option Terminology
Options versus Forwards
Option Payoff Profiles
Option Hedging
Hedging Commodity Price Risk with Options
Hedging Exchange Rate Risk with Options
Hedging Interest Rate Risk with Options
Actual Use of Derivatives
23.7 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
23.1 Insurance
Insurance is the most widely used risk management tool. It protects against hazard
risks.
A firm will consider insurance if the cost of eliminating a risk is greater than the
present value of the expected loss from not purchasing insurance.
Common insurance types include property, liability, and worker’s compensation.
23.2 Managing Financial Risk
Real-World Tip: The use of derivative securities is a major component of our
economy. Interest rate contracts are the largest category of derivatives used. In
June of 2006, there was almost $262 trillion notional value of interest rate
contracts. Of that, 79 percent was swap agreements, 14 percent was option
contracts, and the remainder was forward agreements. The notional amount for
all derivatives contracts was about $197 trillion dollars at the end of 2003.
Compare this to the U.S. 2006 GDP of $13 trillion. Of course, the notional
amount is not the true value at risk, especially for interest rate contracts, but it is
still a very large number. For updated information, see the derivatives statistics at
the Bank for International Settlements web site (www.bis.org).
A. The Risk Profile
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A plot showing how firm value is affected by changes in prices or
rates.
B. Reducing Risk Exposure
Although perfect hedging may be impossible, the normal goal is to
reduce financial risk to bearable levels and thereby flatten out the
risk profile.
Lecture Tip: To illustrate the concept of the risk profile, have the
students consider the concept of a reduction in risk exposure by
introducing a friendly wager they could make on a baseball game
– say, the St. Louis Cardinals versus the Chicago Cubs. The wager
could be as follows: for every run the Cardinals win by, the student
would win $10 (a score of St. Louis 7, Chicago 2 would result in a
profit of $50), but should the Cardinals lose, the student would
lose $10 per run differential. The payoff could easily be plotted on
a risk profile.
Now ask how they might reduce the risk of the bet, should they
become nervous about the amount of the bet prior to the game.
Point out that there are many Cardinals and Cubs fans who would
also like a similar wager. The students could hedge the wager by
placing a similar wager on the Cubs of, say, $6 per run. The
combined wager could be plotted on the risk profile resulting in a
net profit or loss of $4 per run differential, depending on the
game’s outcome.
Finally, mention that had the students placed a $10 per run bet on
the Cubs to exactly offset the $10 per run bet on the Cardinals,
they would have created a perfect hedge. Of course, this perfect
hedge would have resulted in zero profit.
C. Hedging Short-Run Exposure
Often called transactions exposure – caused by the need to enter
into transactions in the near future at uncertain prices or rates.
D. Cash Flow Hedging: A Cautionary Note
Hedging the risk of commodity or other “real asset” price
fluctuations is a hedge for the firm’s near-term cash flows.
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E. Hedging Long-Term Exposure
Often called economic exposure – rooted in long-term economic
fundamentals and more difficult to hedge on a permanent basis.
Real-World Tip: Metallgesellschaft AG, the 14th largest company
in Germany, shocked investors when it announced around $1
billion in losses from trading energy derivatives on the NYMEX
and OTC, according to The Wall Street Journal on March 7, 1994.
Apparently, a senior executive at Metallgesellschaft AG committed
the firm to deliver petroleum products “for up to 10 years into the
future.” He then attempted to hedge this short position using
various derivative instruments. His strategy was inadequate,
however, to avoid the losses due to the price drop that occurred
when OPEC failed to reach an agreement in November, 1993. As a
result, the firm lost approximately $1 billion and fired the
executive in charge of hedging the firm’s position. The executive
filed suit against the company for defamation and civil conspiracy.
Research into the hedging strategies employed by the company
seems to indicate that the problem lay in the size of the position
and the lack of resources to meet margin calls. If the positions had
been maintained, then the company would probably have come out
ahead. The moral here is this: make sure your boss understands
what you are doing when you hedge and is willing to provide the
necessary liquidity to meet any margin requirements.
F. Conclusion
Hedging enables a firm to (1) insulate itself from transitory price
fluctuations and (2) adapt to fundamental changes in market
conditions.
23.3 Hedging with Forward Contracts
A. Forward Contracts: The Basics
Forward contract – agreement between a buyer (long) and a seller
(short) for future delivery of an asset at a price specified today
Forward price – price agreed upon today to be paid at a future date
when delivery occurs
Settlement date – date when delivery occurs and the forward price
is paid
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Lecture Tip: In a forward contract, both parties are legally bound
to execute the transaction in the future at the agreed-upon price,
but no money changes hands at the inception of the contract. Here
is an example to help explain this concept to students.
Suppose you want to buy a new Ford Mustang convertible as soon
as it becomes available. You contract with the dealer to pay a
specified price on a specified future date (the delivery date). In
essence, a private-market forward contract has been created. You
have a long position (buyer) in the underlying asset (Mustang) and
the Ford dealer has a short position (seller).
Now suppose that after the contract is signed, demand for the car
rises so that the market value of the car increases above the
agreed-upon price. You have a document that gives you the right to
buy the asset at below market prices and the dealer is obligated to
sell at that price. The “long” position wins because prices have
increased.
Suppose on the other hand, the economy worsens and the demand
for cars decreases. This drives the market value of the car lower.
The dealer, however, has a contract that forces you to pay the
above market price. In this case, the “short” position wins
because prices have decreased.
What keeps either party from defaulting on the contract? This
question is a good lead-in to the discussion of futures, margin and
marking-to-market.
B. The Payoff Profile
Plot of gains and losses on a contract as a result of unexpected
price changes.
C. Hedging with Forwards
The basic concept in managing financial risk is that once we
establish the firm’s exposure to financial risk, we try to find a
financial arrangement, such as a forward contract, with an
offsetting payoff profile.
Note that forwards reduce variability on both sides – you stand to
lose less, but you also won’t earn as high a return if things go well.
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23.4 Hedging with Futures Contracts
Futures contract – forward contract traded only on an exchange
with gains and losses recognized on a daily basis
Mark-to-market – process for recognizing gains and losses
A. Trading in Futures
Typically, futures contracts are divided into two broad categories
– commodity contracts such as oil, gold, or wheat
– financial contracts such as T-bond or S&P 500
Lecture Tip: So, what are the major differences between an OTC
forward contract and an exchange traded futures contract?
Forward Futures
Customized Standard features (delivery date, size of
contract, quality of asset, etc.)
Search cost – use dealers No search cost – contact broker
Low liquidity High liquidity
Higher default risk – limited to large,
creditworthy institutions
Virtually no default risk
No up-front or intermediate cash flows Initial margin requirements, daily marking-
to-market, margin calls
No Clearinghouse Clearinghouse that guarantees
performance
Delivery normally occurs Majority of contracts offset, not delivered
Lecture Tip: Reconsider the Mustang example presented earlier.
How do we ensure that both parties fulfill their end of the contract,
particularly if there is a large price movement one way or the
other? The answer provides the main distinguishing characteristic
between straight forward contracts and futures contracts. The only
guarantees with a forward contract are the fear of litigation if one
party defaults and a desire to maintain a good reputation.
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Suppose instead of entering into a forward contract with the
dealer, you enter into a futures contract with the Mustang as the
underlying asset. In this instance, both parties would deposit
margin (or a good-faith deposit) with an independent third party.
Funds would then be transferred back and forth between your
account and the dealer’s account on a regular basis as the price of
the Mustang fluctuated. When it came time to buy the car, any gain
or loss would already be accounted for, thereby reducing the
likelihood of default.
B. Futures Exchanges
Settlement price – price at which contracts are marked-to-market.
Determined by the settlement committee at each exchange; may or
may not equal the price at the last trade
Open interest – number of outstanding contracts
C. Hedging with Futures
Lecture Tip: It may be beneficial to demonstrate a futures hedge
and the potential payoffs for a soybean farmer who anticipates a
harvest of 100,000 bushels in September. Costs to produce the
soybeans are incurred long before the harvest, but the farmer is at
risk that the price of soybeans will fall before harvest time. To
reduce this risk, the farmer takes a short position (because he
wants to sell the soybeans) in the futures contract. This short
position offsets the long position that he already has in soybeans.
Futures contract terms are for 5,000 bushels, and suppose the
current futures price is $2.50 per bushel. The farmer can lock in
the delivery price of soybeans at $2.50 for his harvest by shorting
(selling) 20 soybean futures contracts on June 1st. No cash changes
hands today, although margin is held in the farmer’s account. The
20 contracts represent delivery of 100,000 bushels. The cash flow
at delivery is $2.50(100,000) = $250,000
Scenario:
Date Closing Farmer Net
06/01 no money changes hands
06/10 2.60 pay 10,000 (-.1*100,000) -10,000
06/15 2.40 receive 20,000 (.2*100,000) +10,000
06/30 2.20 receive 20,000 +30,000
07/20 2.30 pay 10,000 +20,000
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08/05 2.40 pay 10,000 +10,000
08/16 2.20 receive 20,000 +30,000
09/01 2.20
The farmer will deliver the soybeans and receive $2.20 per bushel
for 220,000 + 30,000 profit from the futures for a total cash inflow
of 250,000. If a bumper crop occurs and the farmer harvests
120,000 bushels, the farmer will receive 250,000 for the first
100,000 and then an additional 20,000*2.20 = 44,000 for the
extra.
Suppose instead there is a poor harvest and the farmer only has
70,000 bushels. But because of the short supply, the price is $2.75
per bushel. The farmer would realize a loss of 25,000
(.25*100,000) on the futures contracts and would receive
70,000(2.75) = 192,500 for the sale of the soybeans. His net profit
would be $167,500. As this illustrates, the farmer can only hedge
price risk, not quantity risk.
23.5 Hedging with Swap Contracts
Swap contract – an agreement by two parties to exchange or swap
specified cash flows at specified intervals in the future
A. Currency Swaps
Two firms agree to exchange a specific amount of one currency for
a specific amount of another currency at specific future dates.
Lecture Tip: The following example illustrates that a currency
swap is essentially a “parallel loan.”
Example: Two multinational companies with foreign projects need
to obtain financing. Company A is based in England and has a
U.S. project. Company B is based in the U.S. and has a British
project.
1. Both firms want to avoid exchange rate fluctuations.
2. Both firms receive currency for investment at time zero and
repay loans as funds are generated by the foreign project.
3. Both firms could avoid exchange rate fluctuations if they
arrange loans in the country of the project. Funds generated in
England for the U.S. company (B) would be in pounds and
repayment would be in pounds. The opposite would be true for the
British company.
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4. Both firms can borrow cheaper in their home countries than
they can in the country where the project originates.
The firms arrange loans for the initial investment in their home
currency and then use the proceeds from the project, converted to
the home currency through a swap agreement, to repay the loan.
Cash flows for the swap: Assume a fixed exchange rate of $2 per
£1, a fixed interest rate of 10% for both firms, and a four-year
loan.
Year 0 1 2 3 4
Company
A
-£100,000
+
$200,000
-$20,000
+
£10,000
-$20,000
+
£10,000
-$20,000
+
£10,000
-$20,000
+
£10,000
Company
B
-$200,000
+
£100,000
-£10,000
+
$20,000
-£10,000
+
$20,000
-£10,000
+
$20,000
-£10,000
+
$20,000
These cash flows are the same as those for a parallel loan. The
firms have effectively fixed the exchange rate for the $200,000
(£100,000) loan.
B. Interest Rate Swaps
Just as two companies can agree to exchange currencies at specific
future dates, they can also agree to exchange the cash flows
associated with respective loan agreements.
Interest rate swaps are generally used to convert a fixed rate
obligation to a floating rate obligation, or vice versa, depending on
the needs of the company.
Only the net interest payment is exchanged since we are dealing
with one currency.
C. Commodity Swaps
Commodity swaps involve the exchange of a fixed quantity of a
commodity at specified future dates. Price volatility is reduced.
D. The Swap Dealer
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Dealer that takes the opposite position in a swap agreement for a
company. S/he then looks for other swap arrangements to offset the
risk. Dealers try to have as flat a risk profile as possible.
E. Interest Rate Swaps: An Example
The goal of the dealer is to create offsetting swap trades that create
a flat risk profile that still generates a profit.
23.6 Hedging With Option Contracts
Option contract – an agreement that gives the owner the right, but
not the obligation, to buy or sell an asset at a specified price on or
before a specified date
A. Option Terminology
Call option – a contract that gives the owner the right to buy the
underlying asset at a specified price for a specified period of time
Put option – a contract that gives the owner the right to sell the
underlying asset at a specified price for a specified period of time
Strike or exercise price – the price specified in the option contract
Expiration date – the last date of the option contract
B. Options versus Forwards
Forwards – both parties have obligations
Options – the option owner has rights, the option writer (seller) has
the obligation if the option is exercised
C. Option Payoff Profiles
Option payoff profiles are typically flat on one side of the exercise
price and linearly increasing or decreasing on the other.
D. Option Hedging
Put options are often used to hedge long positions because they can
limit your downside risk, while still providing you with the
opportunity to make money on the up-side.
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Call options can be used to hedge short positions because they lock
in a purchase price regardless of how much the asset price
increases.
E. Hedging Commodity Price Risk with Options
Futures options – options on futures contracts
Lecture Tip: Here’s an example of a farmer hedging with a futures
option on wheat. A farmer, who wishes to avoid risk of falling
prices, may buy a put option on a wheat futures contract. If prices
fall, the farmer exercises his option and receives a short position
in a futures contract on wheat plus the cash difference between the
strike price and the futures price. If the commodity price rises, the
farmer will not exercise the option and sells the crop in the market.
F. Hedging Exchange Rate Risk with Options
Operate like commodities futures options.
G. Hedging Interest Rate Risk with Options
Interest rate cap – a call option on an interest rate (locks in the
highest rate you would have to pay)
Floor – a put option on an interest rate (locks in the lowest rate you
will be able to pay)
Collar – purchasing a cap and selling a floor (often you will have
to sell the floor if you want to be able to purchase the cap)
H. Actual Use of Derivatives
The use of derivatives by large corporations varies widely. Some
make extensive use, while others employ none, assuming that over
time the risks will cancel out.
For those that do use derivatives, the most common are currency
and interest rate contracts.
23.7 Summary and Conclusions
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