Risk management allows firms to have greater debt capacity due to reduced risk, avoid costs of financial distress, and reduce borrowing costs through techniques like interest rate swaps. This increases a firm's value by lowering its cost of capital and avoiding expensive downturns that destroy shareholder value.
Risk management allows firms to have greater debt capacity due to reduced risk, avoid costs of financial distress, and reduce borrowing costs through techniques like interest rate swaps. This increases a firm's value by lowering its cost of capital and avoiding expensive downturns that destroy shareholder value.
Risk management allows firms to have greater debt capacity due to reduced risk, avoid costs of financial distress, and reduce borrowing costs through techniques like interest rate swaps. This increases a firm's value by lowering its cost of capital and avoiding expensive downturns that destroy shareholder value.
Risk management allows firms to have greater debt capacity due to reduced risk, avoid costs of financial distress, and reduce borrowing costs through techniques like interest rate swaps. This increases a firm's value by lowering its cost of capital and avoiding expensive downturns that destroy shareholder value.
Different Types of Risk Demand risks: Those associated with the demand for a firm’s products or services. Financial risks: Those that result from financial transactions. Property risks: Those associated with loss of a firm’s productive assets. Personnel risk: Risks that result from human actions. Liability risks: Connected with product, service, or employee liability. An Approach to Risk Management Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm. Firms often use the following process for managing risks. 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. Techniques to Minimize Risk Transfer risk to an insurance company by paying periodic premiums. Transfer functions which produce risk to third parties. Hedging (offsetting) the likely gain with likely loss 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. Financial risk exposures 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 volatility – Interest Rate – Exchange Rate – Commodity Price Interest Rate Volatility • Debt is a key component of a firm’s capital structure • Interest rates can fluctuate dramatically in short periods of time • Companies that hedge against changes in interest rates can stabilize borrowing costs • This can reduce the overall risk of the firm Exchange Rate Volatility • Companies that do business internationally are exposed to exchange rate risk • The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency • If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and do a better analysis of future projects Commodity Price Volatility • Most firms face volatility in the costs of materials and in the price that will be received when products are sold • Depending on the commodity, the company may be able to hedge price risk using a variety of tools • This allows companies to make better production decisions and reduce the volatility in cash flows Reducing Financial Risk Exposure • Financial risks exposures can be managed through hedging. • A hedge is a strategy to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security. • There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Derivatives Derivative: Security whose value stems is derived from the value of other assets. Types of Derivatives – Forward – Futures – Options – Swaps • Derivatives are not the only way to hedge. Strategically diversifying a portfolio to reduce certain risks can also be considered as hedge. 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 position payoff = $1,050 – $1,020 = $30 • Short position payoff = $1,020 – $1,050 = – $30 Case 2: Spot price = $1,000 • Long position payoff = $1,000 – $1,020 = – $20 • Short 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 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:
Have greater debt capacity, which has a larger tax
shield of interest payments. Avoid costs of financial distress. Reduce borrowing costs by using interest rate swaps.