Chapter Six

Financial Risk Management

 What is Financial Risk?
 Financial risk exposure refers to the risk
inherent in the financial transactions due to
price fluctuations.
• Volatility in returns is a classic measure of risk
• Volatility in day-to-day business factors often
leads to volatility in cash flows and returns. If
a firm can reduce that volatility, it can reduce
its business risk
 Types of Financial Risks
• Credit risk: possibility that a loss may occur from the
failure of another party to perform according to the
terms of a contract
• Currency risk: risk that the value of a financial
instrument will fluctuate due to changes in foreign
exchange rates
• Interest rate risk: risk that interest rate changes will
affect the financial well-being of an entity
• Liquidity risk: risk that an entity will encounter
difficulty in realizing assets or otherwise raising funds
to meet commitments associated with financial
instruments.
 Categories of Risk
. Firm-specific risk: also known as diversifiable or
unsystematic risk. These risks are specific to the
particular activities of the company and the company
can manage many sources of these risks with
adequate internal controls and other risk
management techniques.
. Market-wide or systematic risk: risk that cannot be
diversified. Market risk is associated with the
economic environment in which all companies
operates. These risks can be managed using
derivative contracts and other financial risk
management tools.
 Manage the risk using internal operating
techniques
• Smoothing – used for interest rate risk
management, this involves maintaining a
balance between fixed and floating rate debt.
• Leading and lagging – used to hedge against
foreign currency fluctuations, this involves
changing the timing payments or receivables
depending on changes in foreign currencies.
 Manage the risk using internal operating
techniques
• Matching – matching assets and liabilities of the
same nature.
– For example, to hedge against foreign currency
movements you would match assets and liabilities
denominated in the same currency.
– Conversely, to protect against movements in interest
rates, you would match assets and liabilities having a
common interest rate.
• Netting – assets and liabilities are netted to
determine the overall exposure which then can
be hedged using external techniques.
Manage the risk using external (derivative)

 Derivative: Security whose value stems is

derived from the value of other assets.
 Types of Derivatives
– Forward
– Futures
– Options
– Swaps
 Use of derivatives
 Hedge
 use derivatives to reduce risk on an existing
position
 Speculate
 use derivatives to take on risk in the hope of
making a profit
 Arbitrage
 Use the difference between spot and
futures/forward prices to generate risk-free profit
 Hedging with Forward Contracts
• A contract where two parties agree on the price of
an asset today to be delivered and paid for at some
future date
• Forward contracts are legally binding on both parties
• They can be tailored to meet the needs of both
parties and can be quite large in size
• Positions
– Long – agrees to buy the asset at the future date
– Short – agrees to sell the asset at the future date
• Because they are negotiated contracts and there is
no exchange of cash initially, they are usually limited
to large, creditworthy corporations
 Hedging with Forward Contracts
• Pros
1. Flexible
• Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default risk—requires information
to screen good from bad risk
 Hedging with Forwards
• Entering into a forward contract can virtually
eliminate the price risk a firm faces
• Because it eliminates the price risk, it
prevents the firm from benefiting if prices
move in the company’s favor
• The firm also has to spend some time and/or
money evaluating the credit risk of the
counterparty
 Payoff profile
Example: assume company XX wish to hedge
fluctuation in commodity price using forward
contract. The following information are supplemented
regarding prices.
Today: Spot price = $1,000
6-month forward price = $1,020
In six months at contract expiration:
Case 1: Spot price = $1,050
• Long (Buy) position payoff = $1,050 – $1,020 = $30
• Short (Sell) position payoff = $1,020 – $1,050 = – $30
Case 2: Spot price = $1,000
• Long (Buy) position payoff = $1,000 – $1,020 = – $20
• Short (Sell) position payoff = $1,020 – $1,000 = $20
 Futures Contracts
• Futures contracts are highly standardized
forward contracts traded on organized
exchanges subject to specific rules.
• Require an upfront cash payment called margin
– Small relative to the value of the forward contract
– “Marked-to-market” on a daily basis
• Clearinghouse guarantees performance on all
contracts
• The clearinghouse and margin requirements virtually
eliminate credit risk
 Hedging with Futures
• The risk reduction capabilities of futures are
similar to those of forwards
• The margin requirements and marking-to-
market require an upfront cash outflow and
liquidity to meet any margin calls that may
occur
• Futures contracts are standardized, so the firm
may not be able to hedge the exact quantity it
desires
• Credit risk is virtually nonexistent
 Swaps
• A long-term agreement between two parties to
exchange cash flows based on specified
relationships
• Can be viewed as a series of forward contracts
• Generally limited to large creditworthy institutions
or companies
• Interest rate swaps – the net cash flow is exchanged
based on interest rates
• Currency swaps – two currencies are swapped
based on specified exchange rates
 Example
• Consider a UK Company wishing to raise 150 million dollar for
10 years at a floating rate of interest for investment in united
states and other US company that wishes to raise 100 million
pound for 10 years at a fixed rate of interest for investment in
united kingdom.
• The UK company can borrow $150 million at a floating rate of
interest LIBOR + 0.75 percent. The US company could borrow
£100 million at a fixed rate of interest of 8.5 %. A swap dealer
that has both these clients may spot swap opportunities,
knowing that market condition could permit the UK company
to borrow at fixed rate of 8% and the US company can borrow
at floating rate of LIBOR+ 0.25 %.
• Assume that the spot exchange rate is $1.5/ £1.
• Is there an opportunity to swap?
 Option Contracts
• The right, but not the obligation, to buy (sell) an
asset for a set price on or before a specified date
– Call – right to buy the asset
– Put – right to sell the asset
– Exercise or strike price –specified price
– Expiration date – specified date
• Unlike forwards and futures, options allow a firm to
hedge downside risk, but still participate in upside
potential
• Pay a premium for this benefit
 Payoff profile
Example: Assume company XX wish to hedge
fluctuation in commodity price using option.
The following information are supplemented
regarding prices.
Today: Spot price = $1,000
6-month option price = $1,020 (strike
price)
option premium= $10
 Call option
In six months at contract expiration:
Case 1: Spot price = $1,050
• Long position payoff = $1,050 – ($1,020 +10) =
$20
• Short position payoff = ($1,020 +10) – $1,050 = –
$20
Case 2: Spot price = $1,000
Since buying at spot market is cheaper than the
contract option holder will not exercise its right.
• Long position payoff = – $10 (premium paid)
• Short position payoff = $10 (premium received)
 Put Option
In six months at contract expiration:
Case 1: Spot price = $1,050
Since selling at spot market is higher than the
contract option holder will not exercise its right.
• Long position payoff = $10 (premium received)
• Short position payoff = - $10 (premium paid)
Case 2: Spot price = $1,000
• Long position payoff = (1000 +10 )– $1,020 = -
$10
• Short position payoff = $1,020 – (1000+10)= $10
 Put option
• What will be the payoff profile under
put option if the six months option
price is $1015?
 Put Option
In six months at contract expiration:
Case 1: Spot price = $1,015
• Long position payoff = 1015 +10 – $1,020 = +
$10
• Short position payoff = $1,020 – (1015+10)=
-$10
 How can risk management increase the
value of a corporation?
Risk management allows firms to:
 Reducing cash flow and earnings volatility.
 Increasing the value of a company’s shares. By
reducing financial volatility, it can lower
shareholders’ rate of return and thus the cost of
capital which can increase profits and value of
a company.