CHAPTER 23: RISK MANAGEMENT

Enterprise Risk Management

What is a risk?
A risk is the possibility/likelihood of incurring a loss.
Risks faced by individual investors and companies and ways in which these risks can be mitigated
Individual Investor
Type of Risk Method to mitigate risk
Systematic Risk

Systematic risks are To help mitigate this risk one can

caused by factors that use insurance, however this risk is
are external to the difficult to manage is not always
organization insurable
Unsystematic Risk
To overcome this risk,
This is the risk that is diversification is key. This simply
inherent in a specific means to invest in more than on
company or industry uncorrelated asset
*both systematic and unsystematic risks affect returns

Company
Type of risk: Faces
fluctuations/volatilit
y in key variables: Method to mitigate risk
Interest rates, To mitigate these risks,
exchange rates, hedging is recommended.
prices (received or Hedging is simply taking
paid), quantity offsetting positions in the
demanded. same or correlated asset.
*affects cashflows (business and financial risks)
When partaking in hedging; two options are available:
1- Long position agrees to buy the asset at the future date
2- Short position agrees to sell the asset at the future date
Hedging often utilizes derivative securities. Derivative securities are those whose value depends on another
underlying asset.
For example:
- Options contracts
- Forward contracts
- Futures contracts
- Swaps

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HEDGING

Hedging is more concerned about the preservation of shareholders value. In order to create an artificial
hedge, you need to invest in derivative instruments. These instruments do not create additional value, they
only preserve the company’s existing value.

Types of Hedging

Natural Hedge

Artificial Hedge

Natural hedge: a natural hedge is the reduction in risk that can arise from an institution’s normal operating
procedures. i.e. when a hedge does not happen naturally, derivative instruments can help.

Derivative securities: Hedging instruments is a financial instrument that represents a claim to another
financial asset.

Hedging creates an Agency problem because:

- Hedging reduces risk of loss
- Hedging prevents upside gain (potential for an increase in value)
- Hedging may not add value
- Hedging focuses on value protection rather than value enhancement
- Hedging consumes resources
Therefore, it is often a source of agency problem because shareholders are interested in wealth
maximization, not the preservation of value.

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REWARD, RISK AND EXPOSURE

 Reward- a compensation for taking risk
 Exposure- vulnerability to a risk factor
 Risk- probability of incurring a loss

Risk Profiles
 Basic tool for identifying and measuring exposure to risk.
 Graph showing the relationship between changes in a risk factor vis-à-vis changes in firm value.
NB. The steeper the slope of the risk profile, the greater the exposure and the more a firm needs to
manage that risk.

Reducing Risk Exposure:

- The goal of hedging is to lessen the slope of the risk profile.
- Hedging will not normally reduce risk completely. For most situations only price risk can be hedged
not quantity risk.
- You may not want to reduce risk completely because you miss out on the potential upside as well

Timing:

Short-run exposure (transactions exposure) – can be managed in a variety of ways.

Long-run exposure (economic exposure)- almost impossible to hedge, requires the firm to be flexible
and adapt to permanent changes in the business climate.

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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
1- Long – agrees to buy the asset at the future date
2- 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.
What keeps either party from defaulting on the contract?
Unfortunately, in spite of being legally binding, a Forward contract is quite prone to default. So, we
need to put in place a mechanism to deal with this. Futures can solve this issue.
Forward Contract Payoffs (gain/loss) at Maturity
 Long position payoff: Spot price – Forward price = S – F
 Short Position payoff: Forward price – Spot price = F - S
Hedging with Forwards
Entering into a forward contract can virtually eliminate the price risk a firm face. It does not completely
eliminate risk unless there is no uncertainty concerning the quantity 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. Forward contracts are primarily
used to hedge exchange rate risk.
Hedging with Forwards
A Cereal producing Company hopes to have its next batch of ready-to-sell inventory of cereal in the
next three months. The operations unit informs the management that 10,000,000 boxes of cereal will be
ready for dispatch to the wholesalers. The marketing department, however, forecasts a drop in consumer
demand for the next quarter and estimates that only 8,000,000 boxes might be able to be sold. The
company ends up selling 9,000,000 boxes in the quarter through some aggressive selling. As a result of
falling demand, the price per box is likely to drop from US$5 to US$4 per box. A Forward Contract for a
price of $5 per box is available.
- What type of risks the company is exposed to?
The Company faces exposure to both price and demand risk.
- Draw the price risk profile for the company

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The company enters a forward contract for 8,000,000 cereal boxes at a forward price of US$5 per
box of cereal.
- What position would it have taken in the contract?
Short position, i.e.; sell the cereal boxes forward at US$5 per box
- Will the company be able to completely hedge its exposure? Why? Why not? Support your answers
with calculations.
It will not be able to hedge the total risk exposure completely because a part of demand risk will remain
unhedged.
 Estimated revenue for unhedged position = 9,000,000 x 4 =US$36,000,000
 If all 9,000,000 boxes were hedged, revenue = 9,000,000 x 5 =US$45,000,000
 If 8,000,000 boxes are hedged, revenue = 8,000,000 x 5 =US$40,000,000
 Revenue on unhedged boxes = 1,000,000 x 4 =US$4,000,000
 Total revenue on partial hedge = US$44,000,000
 Net unhedged exposure = US$1,000,000
Problems with Forward Contracts:
 Prevent upside potential of risk
 On settlement date, the party on the losing side of the contract has motivation to default
 Performance risk / Counterparty risk / Credit risk
 Quantity risk cannot be hedged
 Contracts are tailor-made to suit the needs of contracting parties. Therefore, they become largely
non-tradeable.
Forward Price vs Forward Value
 The forward price is always associated with the product in question (the price of the product that
is supposed to be delivered.)
 The forward value is the price of the forward contract (the price paid for the piece of paper)
For example:
Price of product= $150k
Price of the contract = $150 dollars

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Futures Contracts
Futures contracts are essentially (conceptually) the same as Forward Contracts. However, unlike
Forwards, Futures are traded on an organized securities exchange.
- This contract reduces credit risk and motivation for default.
Mechanisms put in place to reduce credit risk:
 Funds are to be deposited in a brokerage account when it is opened (this is called an initial
margin)
 Additionally, you will also have to maintain a minimum balance in your account which will
allow you to trade. This is referred to as the maintenance margin.
NB. Short position  one would take the short position when you are concerned that the selling price
will decrease.
NB. Long position  one would take the long position when you are concerned that the purchase price
will increase.
Broad Classification of Futures

Commodity futures have commodities as underlying

assets. Examples include but are not limited to corn,
wheat, soybean, oil and metals.

Financial futures have financial assets as the underlying.

Examples include stock, bonds, currencies, treasury
notes, options and indices

Buying and Selling Futures

You trade through a broker by opening a margin account. A margin account is like a bank
account, but it can contain cash as well as securities. To initiate a trade, you make a starting
deposit in your margin account. This is called initial margin. As you go on trading, the balance
in your margin account keeps fluctuating. If the balance goes below a certain threshold, the
broker informs you through a margin call. The threshold is called the maintenance margin. You
need to then top up your account to continue trading. As you can see, this reduces credit risk.
You cannot default without losing some of your own money in the account. All payments

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between buyers and sellers are handled (cleared) by a “clearinghouse”, which is usually operated
by the exchange.
DEMONSTRATION EXAMPLE:
So = $40.00
R= 2%

40 (1+.20)1 = 40.80 the amount you will charge next year.

Therefore,
So (1+ R )=Fo  Forward Price
NB.

Long Position Short Position

Gain/Loss/Payoff/Profi
t S-F F-S

Forward Value
ƒo= forward value
Key: Fo- future value; So-present value
Fo
ƒo= So− Value of forward contract
(1+ R)
Note: The value of a forward contract at initiation is always equal to zero dollars:
Proof:
So (1 + R) = Fo forward price
Therefore:
F
So =
1+ R
Fo
ƒo= So−
(1+ R)
Fo Fo
ƒo= − =0
(1+ R) (1+ R)

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NB. IN THE WORLD OF DERIVATIVRE CONTRACTS, TIME IS ONLY MEASURED IN

YEARS. SO, IF YOU ARE GIVEN DATA IN MONTHS, CONVERT IT TO YEARS.

So= $40 So.25 = 42

Fo= F = 42 (1 + 0.2) ^1-.25
40(1.02)
= 42.63
= 40.80

0.25 YEARS
0 YEARS 1 YEAR
f0.25 = 42 - 40.80 / (1.02) ^1-0.25
Value of contract S1= 45
= 1.80
f= 40 - 40.8/1.02 F1 = 45 (1.02)^0
Nb. value of the paper contract
=0 = 45
after three (3) months

Ft= St (1 + R) ^T-t On the date of expiry, the

Where T- total amount of
time and t- time which has
elapsed.
Ft = St – Fo / (1 + R) ^T-t
spot and forward price must
be equal. Otherwise they
will be made to be equal
through the arbitrage
process.

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END OF CHAPTER QUESTIONS

Question 2.
Suppose you sell five (5) May 2011 silver futures contracts at the last price of the day, which is $36.987
per oz. the standard contract size is 5000 trey oz.
Selling the futures contract means that when the time comes you will be selling silver.
 Short position
What will your profit or loss be if the silver prices turn out to be $37.05 per oz. at maturity?
 There will be a loss in this situation
Payoff/Gain or Loss on Short Position:
=F–S
= 36.987 – 37.05
= $-0.063 per oz
= 5(5000) (-0.063)
=-1,575

PROBLEM 7
Hedging – taking an opposite position
Acquire a long position in corn futures.
- In order to hedge your position you need to go long in 26 corn futures contracts at Fo = 6.0025
To get the 26 contracts= 130000/5000
- Buy 26 corn futures contracts that will mature in December

Part 2
Long payoff:
=S–F
= 5.83 – 6.0025
= $-0.1725 PER BUSHEL
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= $-0.1725 (130000)
= $-22425 – TOTAL LOSS (EXCESS AMOUNT PAID)
SUMMARY

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SWAPS AND INTEREST RATES

- A long-term agreement between two parties to exchange cash flows based on specified relationships.
- An interest rate swap is simply a series of forward contracts based on interest rates.
- There are two types of interest rates:
1. Fixed rates
2. Variable or floating rates
An example of a floating interest rate is LIBOR (London Inter Bank Offer Rate.)
EXAMPLE:

Fixed Floating
Bank A 10% L + 0.5
Company B 11.75% L
Relative difference  -1.75% 0.5% 

Quality spread differential -1.75 - 0.5 = -2.25 = |2.25|

Swap Dealer (0.25)
Remaining Quality Spread Differential 2.00
Step 1. Examine if a gainful situation exists.
Total potential gain = 2.25%
How they are going to distribute this gain is up to the both parties.
Recommendations:
1) Bank A has a comparative advantage in the fixed rate market. Therefore, it should borrow at a
fixed rate and swap for floating
2) Company B has a comparative advantage in the floating rate market. Therefore, borrow at a
floating rate and then swap for the fixed rate.
Remaining QSD = 2

A= 1%
L + 0.5 – 1
L – 0.5
B = 1%

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11.75 – 1 = 10.75
After swapping, company B cannot end up with more than 10.75% interest rate.

Swap Dealer: Receipts - Payments

Receipts= L – 0.5 + 10.75 ; Payments= 10 + L
Receipts – Payments
= L – 0.5 + 10.75 – (10 + L)
= L – 0.5 + 10.75 – 10 – L
= L -L – 0.5 + 10.75 – 10 – L
= 0.25%

EXAMPLE 2
ABC can borrow at either a fixed rate of 11% or a floating rate of LIBOR + 1%. XYZ can borrow
at either a fixed rate of 10% or a floating rate of LIBOR + 3%. The swap dealer can help them
meet and negotiate for a fee of 2% of the deal.
Construct a mutually beneficial swapping arrangement if ABC and XYZ decide to share the
available QSD equally.
 ABC can borrow at either a fixed rate of 11% or a floating rate of LIBOR + 1%.
 XYZ can borrow at either a fixed rate of 10% or a floating rate of LIBOR + 3%
 ABC has a comparative advantage in the floating rate market.
 XYZ has a comparative advantage in the fixed rate market.
Recommendation:

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- To ABC: Borrow floating and swap for fixed.

- To XYZ: Borrow fixed and swap for floating.

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Interest Rate Swap without a Swap Dealer

If the parties interested in an interest rate swap get lucky and meet each other without a swap
dealer, they save the dealer fee.
Let us take an example:
Company A can borrow at a fixed rate of 6% or a floating rate of LIBOR + 1%.
Company B can borrow at a fixed rate of 8% or a floating rate of LIBOR + 1.5%.
Their managements meet and agree to distribute any QSD equally amongst them. Construct a
mutually beneficial swap.
Absolute Cost Advantage
Company A can borrow at a fixed rate of 6% or a floating rate of LIBOR + 1%
Company B can borrow at a fixed rate of 8% or a floating rate of LIBOR + 1.5%
Notice that;
Company A has an advantage in both fixed and floating rate markets (2% and 0.5% respectively)
This means that Company A has an absolute cost advantage over Company B.

 In which market does it have more advantage?

- Fixed rate market
Notice that Company B has an absolute disadvantage in both markets.
 Where does it have lesser disadvantage?
- Floating rate market
Recommendation:
 To A: Borrow fixed and swap for floating
 To B: Borrow floating and swap for fixed

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Let us analyze as follows:

 Net payment after all receipts for A = L + 0.25%
 6% (debt market) + L + 0.25% (to B) – Receipt from B = L + 0.25%
 6 + L + 0.25 – RB = L + 0.25
 RB = L + 0.25 – 6 – L – 0.25 = - 6%
 RB = 6%
 A receiving 6% from B is the same thing as B paying 6% to A

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What about B?
 B’s Receipt = L + 0.25%
 B’s Payments = 6% + L + 1.5%
 Net position = Receipts – Payments
 Net position = L + 0.25% - (6% + L + 1.5%)
 Net position = L + 0.25% - 6% - L - 1.5%
 Net position = -7.25%
 The minus sign signifies a net payment of 7.25%.
 This is exactly what B wanted.

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