Risk Management

Introductory Lecture
Lieven Baele
Tilburg University, CentER, Netspar

This document provides an outline of class presentations. It is

incomplete without the accompanying commentary.

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 Aim of this course
This course is designed to train the participants in
1. Identifying financial risks
2. Measuring them
3. Removing risks that decrease shareholder
value via the use of special financial instruments,
i.e. derivatives.

Focus on application rather than on theory

(learning to fly a plane rather than to build one)

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 Course Material

Exam Material:
Lecture Slides
3 Tutorials
Exercises (some of which in Excel)
Case Studies

Background Material
Book by Ren M. Stulz
Risk Management and Derivatives
Many copies available in the library

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 Examination

Mid-Term Assignment (A)

Practical Exercises (in excel)
Groups of at least 3 and at most 5 students

Case Study (C):

Interview CFO about Risk Management Strategy and procedures.
Written report + 15 min presentation
Groups of at least 3 and at most 5 students

Written Final Exam (F)

3 to 4 exercises
Test whether you understand, not whether you can replicate

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 Examination

Final Grade:
If your grade on the final exam is at least 5:
3 1 3 1 2 1 1
Grade Max F , F A, F C , F C A
4 4 4 4 4 4 4

If your exam grade is < 5, then your Final grade = Exam grade

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 Classroom rules

Classes are not mandatory.

But if you do come, be attentive!

Do come in time for the lectures.

Mobile phones should be off, and hidden.

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 Structure of the Course

Part 1: Risk Management: What and Why?

What is Risk management?
Risk Management and Firm Value
Quantifying Relevant Exposures (Chapter 1-4)

Part 2: Plain-Vanilla Hedging + Pricing Basics

Pricing of/hedging with Forward and Futures Contracts
Pricing of/hedging with Swaps
Pricing of/hedging with Options (Chapter 5-14)

3 Tutorials
- end of September: Value at Risk
- early November: forward/futures
- late November: options
7
 Definition of Risk (Management)
What is Risk?
- A possible future event which if it occurs will lead to an
undesirable outcome.
- Risk is the possibility of suffering loss.
Example: Driving a car -> accident

What is Risk Management?

- Risk Management can be roughly defined as any
set of actions taken by individuals or corporations
in an effort to alter the risk arising from their
primary line(s) of business.
Example: limiting probability of car accident by adapting driving style,
driving sober, avoiding bad weather conditions,
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 Hedging

Risk Management and Hedging.

A hedge is a financial position often a derivative -

put on to reduce the impact of a risk one is exposed
to

Hedging means putting on a hedge

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 Is risk always bad?

There is no such thing as free lunch

Some risks are worth taking because the possible benefit

exceeds the possible costs (ex ante).
- You risk taking a plane to go to your favorite holiday destination
- Making a new beverage is risky: people may not like it!
but: you may invent the new Coca Cola!
One should avoid risk you do not know about.
- Producing and marketing of Coca Cola, instead of speculating on
future price of euro/US$ exchange rate.
- Bridgestone knows a lot about producing tires, but very little about
predicting the future oil price (synthetic rubber is derivative of oil).

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 Risk Management Process

1. Identify relevant risk factors.

2. Understand the distribution of those risk factors
3. Estimate the impact of adverse movements in those risk factors
on the strategic plan.
4. Decide whether to hedge or not.
5. Choose the appropriate financial instrument.
6. Determine how much to hedge.
 Risk Factor Identification: Example

Suppose that the firm ABC builds pre-fabricated housing in

the US. Canada is the major supplier of lumber that is its
most important input. Japan is a major consumer of its
prefabricated housing products. The housing sector is highly
procyclical, while interest rates are also procyclical. Supply
shocks make energy prices counter-cyclical. ABCs big
competitors are Canadian and German companies. ABC has
little debt in its capital structure.
 Risk Factor Identification: Example

What are the major risk factors ABC faces?

A partial list includes changes in:
a) Price of lumber
b) Price of alternatives to pre-fabricated housing
c) Interest rates
d) Oil prices
e) Canadian dollar/US dollar exchange rates
f) Japanese Yen/US dollar exchange rates
g) EUR/US dollar exchange rates
h) Business conditions in US, Canada, Germany, and Japan.
 Risk Management Process

1. Identify relevant risk factors.

2. Understand the distribution of those risk factors
3. Estimate the impact of adverse movements in those risk factors
on the strategic plan.
4. Decide whether to hedge or not.
5. Choose the appropriate financial instrument.
6. Determine how much to hedge.
 ??? per 1 EUR

85% Appreciation

33% Depreciation
in 1 year!

25% Depreciation

15
EUR for 1 ???
??? for 1 USD

17
 Price of Lumber

Lumber (USD)
500

450

400

350

300

250

200

150

100

50

0
70 71 72 74 75 76 77 78 79 81 82 83 84 85 86 88 89 90 91 92 93 95 96 97 98 99 00 02 03 04 05 06 07 09 10 11 12 13 14
Crude Oil Price
3-month US Treasury Bill
10-year US Treasury Bill
Equities - GFC
Equities long term perspective
 Step 2: Understand Distribution of Risk Factors

In most cases, future values of these risk factors are

unpredictable.
Based upon historical data, we can construct though a
probability density function (PDF).
Take example of exchange rate US$/ Euro.
Best prediction for tomorrows rate is its current rate.
(random walk hypothesis)
Annualized long-term volatility: 11%.
Suppose exchange rate returns follow normal distribution
with mean = 0 and volatility = 11%.

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 Uncertainty in Risk Factors

Probability Density Function

Annualized US$/euro Exchange Rate Changes (%)
4,5
4
3,5
3
Probability

2,5
2
1,5
1
0,5
0
-35% -22% -10% 2% 15% 28%
Return

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 Uncertainty in Risk Factors

Probability Density Function

US$ / EUR(V=11%) / Thai Baht (V=15%)

4 ,5
4
EUR vs USD
3 ,5
3
Probability

Thai baht vs USD

2 ,5
2
1 ,5
1
0 ,5
0
-3 5 % -2 2 % -1 0% 2% 15% 28%
R e tu rn

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 Risk Management Process

1. Identify relevant risk factors.

2. Understand the distribution of those risk factors
3. Estimate the impact of adverse movements in those risk factors
on the strategic plan.
4. Decide whether to hedge or not.
5. Choose the appropriate financial instrument.
6. Determine how much to hedge.
 Assessing potential impact+actions

We have identified risk factors and their distribution

Next: Estimate the impact of adverse movements in

those risk factors on the strategic plan.
One risk may strengthen /eliminate other risks
e.g. higher oil price may be compensated by cheaper US$
Various Tools
Value-at-Risk
(Chapter 4)
Cash-Flow at Risk

Next: Decide whether to hedge or not (Chapter 3) , and if so,

how much and how. (Chapter 5 and following)
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 How to reduce risk exposure?

How could a firm solely engaged in copper extraction

reduce its exposure to (large) drops in copper prices?
1. Diversify product line
e.g. extract silver (if silver and copper prices are not perfectly correlated).
2. Manage Expenditure
e.g. increase variable relative to fixed costs.
3. Reduce Leverage
- Reduce debt relative to equity.
4. Use Derivatives
- Often cheapest and most flexible.
- Focus of this course.
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 What is a derivative?

A derivative is a financial instrument with promised

payoffs derived from the value of one or several
contractually specific underlyings.

Underlyings can be anything

- Stock price - Hours of sun in Tilburg

- Exchange rate - Snow in cm in Schiphol
- Interest Rate but also
- Total number of bankruptcies
- Commodity Price - Romney vs Obama
- Number of houses destroyed
in hurricane.
-

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 What is a derivative?

Derivatives come in two flavors:

Plain Vanilla
- Forward Contracts
- Futures Contracts
- Options Contracts

Exotic
Derivative whose payoff cannot be replicated by a
combination of options and futures.
- exotic swap
- binary option

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 Derivative Trading

Derivatives are traded:

(a) on an exchange
e.g. Chicago Mercantile Exchange, Chicago Board Options Exchange
AEX in the Netherlands

(b) over-the-counter (OTC)

Two parties agree on a trade without meeting through an
organized exchange

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 Derivative Trading

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 Derivatives according to underlying

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 Why so much growth?

Strong growth since beginning of 1970s:

Oil crises at beginning / end of 1970s.

Increased volatility of interest rates and exchange rates
Spectacular growth in international trade.
Dramatic increase in international portfolio flows.
Start of exchanges specialized in trading standardized
derivative products.
Derivation of the Black-Scholes Option Pricing Model.

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 Derivatives can be dangerous

If not well understood, trading in derivatives can lead to

large losses that often endanger the financial health of
corporations and other derivative traders.
Famous examples are:
Proctor and Gamble ($137 million)
Orange County (1994, $1.7 billion, bankruptcy)
Barings Bank (1995, $1.3 billion, bankruptcy)
Long Term Capital Management (LTCM).
Enron
Socit Gnrale (2008, euro 5 billion)
Subprime Crisis (2008-2009, ??? Trillion)
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 Derivatives can be dangerous

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 Derivatives can be dangerous

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 Derivatives can be dangerous

Every time something bad happens, derivatives get blamed. You

would think subversives were using them to take over the world.
Anonymous

Based on recent press reports, the current media definition

sometimes seems to be a derivatives transaction is any financial
transaction in which a large amount of money is lost.
Mary Shapiro
Ex-CFTC Chairman

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 unless they are well understood

Derivatives are like finely tuned racing cars. We would not let an
amateur driver enter the Indianapolis 500 at the wheel of a race
car. Neither would the weekend driver at the wheel of a Ford
Escort have any chance of winning.

The same is true with derivatives. Untutored users can crash and
burn. Nonusers cannot win the race.

Rene M. Stulz

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 Main types of Derivatives

1. Options
2. Forward contract
3. Futures contract
4. Swaps

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 Option: Definition

A call option is a security which conveys the right to buy a specified

quantity of an underlying asset at a contractually agreed price at or
before a fixed date.
A put option is a security which conveys the right to sell a specified
quantity of an underlying asset at a contractually agreed price at or
before a fixed date.

Important terms:
- Exercise price
- Option buyer / seller (writer)
- Option premium
- European versus American Options

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 Option: Definition
Net payoff and profit to buying a call (long position) and
selling a call (short position)
Option
Price
Long Call

premium

-premium
ST
Short Call

XX
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 Option: Definition
Net payoff and profit to buying a put (long position) and
selling a put (short position)
Put Option
Price

premium

-premium
ST

X
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 Example 1

Firm: Risky Upside Inc.

Current share Price: $50
Call Option
Underlying: 100 stocks of Risky Upside.
Exercise price: $50.
Time to Maturity : 10 months.
Option Premium: $10 per share.
Investor believes Risky Upside is undervalued

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 Example 1

Strategy 1:
Buy 100 shares of Risky Upside
Cost = 100 * $50 = $5,000
Payoff in 10 months
Stock Price Initial Value at Profit
Investment Maturity
$20 $5,000 $2,000 -$3,000
$110 $5,000 $11,000 $6,000

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 Example 1

Payoff from buying 100 shares of Risky Upside at $50 a share

Gain
+$6,000

Risky Upside Inc. price

-$3,000
20 50 110

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 Example 1

Strategy 2:
Buy a call option on Risky Upside
Cost: 100*$10 = $1,000
Payoff in 10 months:
Stock Price Initial Payoff from Total Payoff
Investment Option
$20 $1,000 0 -$1,000
$110 $1,000 $6,000 $5,000

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 Example 1
Payoff from Call Option on Risky Upside (equivalent
of 100 shares), exercise price of $50
Gain

$5,000

0
Risky Upside Inc. price
-$1,000

20 50 110

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 Example 1

Main differences between 2 strategies:

Buy Shares Call Option

Initial Investment $5,000 $1,000
High
Leverage Low (equivalent to borrowing $4,000
and investing $1,000)

Return on
Investment Low High
Price = $110 120% 500%
Price = $40 -20% -100%

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 Example 2

Firm: Garman Inc.

Producer of Software
Will receive payment of 100m in 6 months.
6 month forward rate: 1 = 1$
Garman Inc. is active in very R&D intensive industry.
A considerable drop in their Cash Flow may mean a
reduction in R&D expenditure, and hence future growth
opportunities.
Management decides to hedge fully.

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 Example 2

Strategy 1
Buy a put option (at cost of $3m).
Underlying: /$ exchange rate
Value of Underlying: 100m
Time to maturity: 6 months.
Exercise Price: 1/$
Payoff in 6 months
Exchange Initial Payoff from Payoff from Total Payoff
Rate Investment Payment Put Option
0.9 $/ $3m $90m $10m $97m
1.1 $/ $3m $110m - $107m

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 Example 2
Strategy 1: Put Option
U nh ed ged
In c o m e to firm in c o m e

G a in w ith
o p tio n
$ 1 0 0 m illio n
L o s s w ith o p tio n

E x c h a n g e rra
a te

E x e rc is e p ric e o f $ 1
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 Forward Contract: Definition

A forward contract is an agreement between 2 parties

to buy (sell) a well-defined asset at a pre-specified price
at a well-defined future point in time.
Positions:
- Long: obligation to buy
- Short: obligation to sell

Forward contracts are not standardized, contrary to futures

contracts, which are traded on organized exchanges.

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 Example 2

Strategy 2
Short forward position (obligation to sell)
Forward Rate: 1$ per .
Value Underlying: 100m.
Time to Maturity: 6 months.

Payoff in 6 months
Exchange Initial Payoff from Payoff from Total Payoff
Rate Investment Payment Forward
0.9 $/ - $90m $10m $100m
1.1 $/ - $110m -$10m $100m

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 Example 2
Strategy 2: Forward Contract Payoff
Gain from contract
to firm

$10 million
Forward
gain Exchange rate

Forward
loss

$0.9 Forward rate $1

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 Example 2
Strategy 2: Firm Income
Unhedged income
Income to firm

Forward
$100 million loss Hedged income
Forward
gain

Exchange rate

Forward rate $1
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 Example 2

Main differences between two strategies:

Put Option Futures Contract

Initial Investment $3m -

Upside potential yes no

yes
Downside risk
(Option premium) no

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 What happened at Socit Generale?

Jrme Kerviel bought 140.000 futures (long position) on

German DAX (main stock index).
We suppose that he bought at futures price around 8.000.
Huge losses when DAX started falling...

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 Swaps: Definition

A SWAP is a contract between two parties who engage

themselves to swap cash flows at pre-specified future
moments according to a pre-specified formula.

Main Swaps:
Interest Rate Swaps.
Currency Swaps.

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 Swaps: Definition

Swaps mainly on interest rates (exchange rates)

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 Swaps: Definition

and typically in the longer term

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 Interest Rate Swap

Interest rate swap:

"At the coupon days, B pays a fixed interest rate on a

notional amount to A. A pays B on the same amount
a floating rate."

The face values are not swapped.

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 Interest Rate Swap

Consider a firm that borrowed $10m to finance a project.

Maturity of loan: 5 years
Interest payment: variable, 6 month US treasury bills.

Firm believes interest rates will increase.

Paying back loans and initiating a new one is costly.

Alternative: enter in an interest swap agreement where

you pay a fixed interest rate (say 5%), whereas the
counterparty pays you the variable rate on 6 month
US treasury bills.

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 Interest Rate Swap

borrowing

6-month
US$ rate

Fixed US$ rate (5%)

Firm ABC Bank

6-month US$ rate

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 Swaps: Definition

Currency swap:

A fixed (variable) rate currency swap involves

counterparty A exchanging fixed (variable) rate
interest in one currency with counterparty B in
return paying fixed (variable) interest in another
currency.

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 Swaps: Definition

Currency swaps are very useful in debt management.

Consider Dutch firm exporting extensively to the US

Ideally, it would like to issue debt in $, and use its $
proceeds to pay back the loan / make interest payments.
The Dutch firm finds it easier to issue debt in the euro area.
(few US investors know the firm, but Europeans do).

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 Swaps: Definition
Solution: enter US$/Euro currency swap agreement.
Initiation day:
Euro principal
Dutch Firm Bank
US $ principal

Coupon day(s)
US $ Interest Rate
Dutch Firm Bank
Euro Interest Rate
Maturity
US $ Principal
Dutch Firm Bank
Euro Principal
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 Conclusion

Definition of Risk, Risk Management, and Hedging.

Outline of Risk Management Process.
Identification of potential Risk Factors.
Introduction to main derivatives:
Options
Forward contracts
Futures Contracts
Swaps

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