AC4331 Topic 8 & 9

Corporate Financial Policy Semester A 2012-13 City University of Hong Kong

Topic 8&9

Introduction to Financial Management Free Cash Flow Financial Planning and Forecasting Financial Assets and Time Value of Money Risk and Return Bond and Stock Valuation Cost of Capital Cash Flow Estimation and Risk Analysis Capital Structure and Leverage Treasury and Valuation Enterprise Risk Management Dividends and Share Repurchase Merger and Acquisitions Working Capital Management

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Topic 8 & 9: Treasury and Valuation Enterprise Risk Management

Extra Ref:
Smart,Chapter 20 (pg. 670-675) Managing Financial, Economic and Politic Risk
Eugene and Brigham 12E, Chapter 23, (pg. 834-837) - Corporate Risk Management

Chapter 18

Motives for Risk Management Fundamentals of Risk Management Derivative Securities Using Derivatives
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Motives for risk management

Diversified shareholders may already be hedged against various types of risk. Reducing volatility increases firm value only if it leads to higher expected cash flows and/or a reduced WACC.

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Reduced volatility reduces bankruptcy risk, which enables the firm to increase its debt capacity.

By reducing the need for external equity, firms can maintain their optimal capital budget.
Reduced volatility helps avoid financial distress costs. Managers have a comparative advantage in hedging certain types of risk. Reduced volatility reduces the costs of borrowing. Reduced volatility reduces the higher taxes that result from fluctuating earnings.
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Fundamentals for risk management

Corporate risk management relates to the management of unpredictable events that would have adverse consequences for the firm. All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.

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Speculative risks: offer the chance of a gain as well as a loss. Pure risks: offer only the prospect of a loss. Demand risks: risks associated with the demand for a firms products or services. Input risks: risks associated with a firms input costs. Financial risks: result from financial transactions.

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Property risks: risks associated with loss of a firms productive assets. Personnel risk: result from human actions. Environmental risk: risk associated with polluting the environment. Liability risks: connected with product, service, or employee liability. Insurable risks: risks that typically can be covered by insurance.

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What is a financial risk exposure?*

Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

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Financial market movement Interest Rates Rise

Effect on Business
Working capital costs increases Interest costs of floating rate borrowing increase Yields on floating rate investments increases

Interest Rates Fall

Working capital costs decreases Interest costs of floating rate borrowing decrease Existing fixed rate borrowing relatively more expensive than variable rate borrowing until renegotiated Yields on floating rate investments fall

Value of domestic currency falls

Exposure to foreign currencies has greater impact Cost of imported goods increases

Value of domestic currency rises

Products become less competitive on world market

Value of foreign earnings fall

Value of overseas investments and property falls
QP Manual Module B Section 14 2008 page 4 13

Financial market movement

Commodity Prices Rise

Effect on Business
Working capital costs increases

Commodity Prices Fall

Working capital costs decreases

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Managing Financial Risk*

Step 1. Step 2. Step 3.

Identify the risks faced by the firm. Measure the potential impact of the identified risks. Decide how each relevant risk should be dealt with.

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Step 1: The Risk Profile A plot showing the relationship between changes in the price of some goods, services, or rate and changes in the value of the firm. Step: Measure the Risk and Reducing Risk Exposure Reduce the risk to bearer level and thereby flatten out the risk profile

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Risk

Size of cost of the risk event

Low High Transfer Avoidance

Low High

Retention Loss Control

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Approaches that companies can take to minimize or reduce risk exposures**

Insurance Transfer - Transfer risk to an insurance company by paying periodic premiums. Non-insurance Transfer - Transfer functions which produce risk to third parties. It includes hedging price risk (eg. Interest rate, foreign exchange and commodity prices) purchase derivatives contracts to reduce input and financial risks.
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Retention - Take actions to reduce the probability of occurrence of adverse events (active vs passive) Loss Control - Take actions to reduce the magnitude of the loss associated with adverse events. Avoidance - avoid the activities that give rise to risk.

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Prior to undertaking interest rate risk management, the treasurer must: 1) identify and measure the interest exposure 2) seek Board approval for the policy Types: 100% hedging, selective hedging, no hedging 3) Authority and parameters must be given

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(a) Forward rate agreements (b) Financial futures (c) Options (interest rate caps, interest rate collars) (d) Swaps

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A forward agreement is an obligation to buy or sell a given asset on a specified date at a price specified at the transaction date of the contract

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Expect increase in interest rate Buy the forward rate at agreed rate to lock in the current interest rate Profit = Market interest rate at the settlement date - Agreed rate

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A future contract is an obligation to make (seller) or take (buyer) delivery of a specified quantity and quality of an underlying asset at a specified future date and at a price agreed when the contract originates Tool: Hang Seng Index Futures

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Contract size: HK$50* index Minimum price fluctuation: One index point ($50) Last trading day: The bus day preceeding the last business day of the month Delivery method: Cash settlement Initial margin (Variable): $50,000

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Bet on the market will become bearish Take a short position in HS futures contract Close out the position by buying HS futures contract Profit = no. of contracts* $50 * ( the index at the date you short - the index at maturity)

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Bet on the market will become bearish (fall) (yesterday closing: 17,097)

Expects market to fall may on 1 Sept sell, say three, Oct. H S futures at 17,097; (deposit: 3*50,000=150,000)

Take a short position in HS futures contract Close out the position by buying HSI futures contract on Oct 30 at 16,900 (if index is 16,900 on Oct 30) Profit = 3* $50 * (17,097-16,900)[ the index at the date you short - the index at maturity] = $29,550 less commission and also receives deposit of 150,000
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Bet on the market will become bullish (rise) (yesterday closing: 17,097)

Expects market to rise may on 1 Sept___, say three, Oct. H S I futures at 17,097; (deposit: 3*50,000=150,000)

Take a position in HS futures contract On Oct 30, forced to close out the position by ______ HS futures contract on Oct 30 at 16,900 (if index is 16,900 on Oct 30) Loss = 3* $50 * (17097-16900)[ the index at the date you short - the index at maturity] = _____ less commission May need to pay variation margin if wishes to avoid being closed out 28

Bet on the market will become bullish (rise) (yesterday closing: 17,097)

Expects market to rise may on 1 Sept buy, say three, Oct. H S I futures at 17,097; (deposit: 3*50,000=150,000)

Take a long position in HS futures contract On Oct 30, forced to close out the position by selling HS futures contract on Oct 30 at 16,900 (if index is 16,900 on Oct 30) Loss = 3* $50 * (17097-16900)[ the index at the date you short - the index at maturity] = 29,550 less commission May need to pay variation margin if wishes to avoid being closed out
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It allows for speculation on interest rate movements or for hedging by borrowers and investors with actual or intended physical positions in HIBOR based (or similar) products.

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Bet the interest rate will rise Sell the 3-month HIBOR future contract Close out the position by selling the contract If HIBOR increase then the borrower loses on the physical market but wins on the futures market

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Form of contract Trading market

Futures Forward contract contract Standardised Customized Over the counter Settlement date No

Have active secondary market Settlement Market to market daily Margin Yes

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An option is a right but not an obligation to buy (call) or sell (put) a specified asset at the exercise price on or before the expiry date
To reduce or minimize interest rate risk Tools: Interest rate caps, interest rate collars

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For floating-rate borrowers, they can hedge against interest rate risk by buying an interest rate put option from the lender This guarantees that the interest rate will not exceed the cap rate (exercise price) for the life of the option. Buyer is buying insurance against an unfavourable interest rate movement

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A borrower can buy a put and simultaneously sell a call option, at a lower rate of interest A collar provides the same protection as a cap but the potential benefit of a fall in rates is limited by the call option

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A swap is an obligation between two counter-parties to exchange future specified cash flows on specified dates Rationale: it derives from arbitrage opportunities that arise as a result of different perceptions of risk and credit standing held by different markets.

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You want to borrow fixed rate loan but you have comparative advantage in borrowing floating rate loan. Through financial intermediaries, another counterparty is introduced. Every period, you give a fixed interest to and received floating interest from your counterparty.

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interest rate swap does not involve an exchange of the principal amount and is not a form of borrowing It is a means of reducing perceived interest rate risk by switching from fixed to floating rate or vice-versa It reduces the cost of borrowed funds

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Hedging: Generally conducted where a price change could negatively affect a firms profits. Long hedge: Involves the purchase of a futures contract to guard against a price increase. Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities.
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Types of exposure: i) transaction - fluctuation arise out of the need to buy or sell at uncertain prices in near future (short run) Ii) translation fluctuations due to currency translation Iii) economic permanent changes in prices or other economic fundamentals (long term)

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Types of foreign exchange risk

(a) Transaction Risk - where there is a possibility for a movement in the rate of exchange between the initiation and completion of a transaction. - (importers and exporters) (b) Translation Risk - arises from the translation into domestic currency of a companys foreign subsidiary or branch operations in order to prepare group accounts in the domestic currency. There is no immediate cash effect and FX gains and losses may never be realised. Foreign currency translation gain or loss is dependent upon the translation method used. (c) Economic Risk - arises from the structure of the business, the structure and operating currencies of competitors and the manner in which costs, prices and profits respond to exchange rate movements.
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Who are subject to foreign exchange risk? Businesses which have net assets or net liabilities denominated in foreign currencies, which are subject to exchange rate movements against domestic currency, have foreign exchange risk

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Important issues to address:

How foreign exchange markets operate Why exchange rates fluctuate How to protect against exchange risk

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Hedging
i) internal/external ii) natural/transactional

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I. Natural Hedging
Methods that a company can adopt within its own company to reduce its exposure to foreign exchange risk

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b) Foreign Exchange Risk

Examples: An exporter with cash inflows and/or assets denominated in a foreign currency may hedge, by borrowing in that currency. Early settlement on foreign currency trade receivables or payables may be feasible especially if a discount can be negotiated. Hedge intra-group receivables and payables through settlement procedures .

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Methods of natural hedging: 1. pricing sales in the local currency 2. offsetting payment of imports and exports in same foreign currency 3. bilateral netting of accounts between affiliate companies 4. intercompany forward contracts where a holding company or central treasury acts as a banker to subsidiaries.

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II. Transactional hedging techniques Generally use a financial product to transfer the risk to a financial intermediary

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Forward Contracts To buy or sell foreign currencies for future settlement at a price determined today. Foreign Currency futures A currency futures contract represents an obligation to make or take delivery of a specified quantity of a foreign currency at a specified future date at a price agreed/when the contract originates. Foreign currency futures perform the same function as forward contracts in that they allow hedgers to lock into an exchange rate today, by buying or selling a futures contract, for settlement at some future point in time.

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Foreign Exchange Risk Hedging Techniques

Foreign Currency Options The buyer of a currency call (put) option has the right to buy (sell) a predetermined amount of one currency in exchange for a predetermined amount of another currency on (or before) a predetermined date. Currency options on an Over the Counter basis can be tailored to the option buyers specific needs with respect to amount, exercise price and expiration date.

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Other Methods:
Foreign exchange swaps Short term investment and borrowing combinations Foreign currency accounts

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1. A firm that needs to borrow long-term in the future has a long position in bonds. Wealth would decrease in response to a decrease in bond price (or increase in interest rates). Interest rate exposure can be hedged with interest rate futures and swaps. 2. A firm is long in the goods it sells, and short in the goods it buys. These exposures can be managed with futures and forward contracts. 3. A domestic firm which sells in foreign currencies has a long position in them. The risk of devaluation can be offset by forward contracts, or by acquiring liabilities in the foreign currency.
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Uses of Derivatives
Derivatives: Security whose value stems

or is derived from the value of other assets. Options, futures, forward contracts and swaps can be used to manage financial risk exposures.

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Options: Options can be used to hedge various financial exposure such as exchange risk and interest rate risk.

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Futures: Contracts which call for the purchase or sale of a financial (or real) asset at some future date, but at a price determined today. Futures (and other derivatives) can be used either as highly leveraged speculations or to hedge and thus reduce risk. A futures contract is a legally binding commitment to make or take delivery of a given quantity of a given asset at a given time in the future.

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Hedging: Generally conducted where a price change could negatively affect a firms profits. Long hedge: Involves the purchase of a futures contract to guard against a price increase. Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities.
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Forward contract: one party agrees to buy a commodity at a specific price on a future date and the counterparty agrees to make the sale. There is physical delivery of the commodity. Futures contract: standardized, exchangetraded contracts in which physical delivery of the underlying asset does not actually occur.
Commodity futures Financial futures

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How can commodity futures markets be used to reduce input price risk?
The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at todays price, even if the market price on the item has risen substantially in the interim.

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A forward contract is a contract made today for the delivery of an asset in the future. The buyer of the future contract agrees to pay a specified amount at a specified date in the future in order to receive a given asset at the exercise price. If at maturity: Actual price > Exercise priceProfit Actual price < Exercise priceLoss

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1. Futures are marked to market daily. The daily gain or loss from holding a futures contract is transferred between traders each day. 2. Margins must be posted on futures contracts. 3. Forward contracts tend to be customized, where futures contracts are standardized so that they can be widely traded on exchanges. 4. Futures contracts often have active secondary markets, forward contracts do not.

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A producer or user of commodity can lock in the transaction price through a forward or futures contract. This reduces uncertainty about future revenues or expenses. A producer (farmer) is long in the crop to be sold at a future date. A user (a food processing firm) is short in the commodity used in future production. The basic idea is to balance a natural long (or short) position with an offsetting short (or long) position, in order to reduce risk and have profitability determined by operating activities.

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Hedging is usually used when a price change could negatively affect a firms profits.
Long hedge: involves the purchase of a futures contract to guard against a price increase. Short hedge: involves the sale of a futures contract to protect against a price decline.

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The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at todays price, even if the market price on the item has risen substantially in the interim.

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Example: In Jan, a manufacturer of silver products plans to buy 20,000 ounces of silver in Jun to fill a contract based on a silver price of $2.5/oz. In Jan., cash silver price is $2.5/oz and July silver futures are trading at $2.9/oz. He establishes a hedge. On 15 Jun, the manufacturer purchases silver in the cash market at $3.1/oz and sells his future position at $3.2/oz.

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Hedging example:Manufacturer
1. He originally has a short position in silver so he buys futures and takes a long hedge position.

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Hedging example

2. Net purchase price of silver:

Per oz Total

Cash price in June $3.1 Less: Gain in futures ($3.2-$2.9) Net purchase price $2.8

$0.3

$62,000 $ 6,000 $56,000

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The exchange of cash payment obligations between two parties, usually because each party prefers the terms of the others debt contract.
Fixed-for-floating Floating-for-fixed

Swaps can reduce each partys financial risk.

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1. A firm that needs to borrow long-term in the future has a long position in bonds. Wealth would decrease in response to a decrease in bond price (or increase in interest rates). Interest rate exposure can be hedged with interest rate futures and swaps. 2. A firm is long in the goods it sells, and short in the goods it buys. These exposures can be managed with futures and forward contracts. 3. A domestic firm which sells in foreign currencies has a long position in them. The risk of devaluation can be offset by forward contracts, or by acquiring liabilities in the foreign currency.
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1.Identify

the risks faced by the firm. 2.Measure the potential impact of the identified risks. 3.Decide how each relevant risk should be handled.

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Derivative Securities more on options

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A contract that gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time. Its important to remember:
It does not obligate its owner to take action. It merely gives the owner the right to buy or sell an asset.

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Call option: an option to buy a specified number of shares of a security within some future period. Put option: an option to sell a specified number of shares of a security within some future period. Exercise (or strike) price: the price stated in the option contract at which the security can be bought or sold. Option price: option contracts market price.
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Expiration date: the date the option matures. Exercise value: the value of an option if it were exercised today (Current stock price Strike price). Covered option: an option written against stock held in an investors portfolio. Naked (uncovered) option: an option written without the stock to back it up.

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In-the-money call: a call option whose exercise price is less than the current price of the underlying stock. Out-of-the-money call: a call option whose exercise price exceeds the current stock price. Long-term Equity AnticiPation Securities (LEAPS): similar to normal options, but they are longer-term options with maturities of up to 2 years.
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A call option with an exercise price of $25, has the following values at these prices:
Stock Price $25 30 35 40 45 50 Call Option Price $ 3.00 7.50 12.00 16.50 21.00 25.50
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Stock Price $25.00 30.00 35.00 40.00 45.00 50.00

Strike Price $25.00 25.00 25.00 25.00 25.00 25.00

Exercise Value $0.00 5.00 10.00 15.00 20.00 25.00

Option Price 3.00 7.50 12.00 16.50 21.00 25.50

Option Premium 3.00 2.50 2.00 1.50 1.00 0.50

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The premium of the option price over the exercise value declines as the stock price increases. This is due to the declining degree of leverage provided by options as the underlying stock price increases, and the greater loss potential of options at higher option prices.

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Option Value
30 25 20 15 10 5 5 50 10 15 20 25 30 Exercise value 35 40 45 Market price

Stock Price

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Data: P = $15; X = $15; t = 0.5; rRF = 6%

Ending Stock Price $10 Range $20 $10 Call Option Value $0 $5 $5

Strike Price $15 $15

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Step 1: Calculate the value of the portfolio at the end of 6 months. (If the option is in-the-money, it will be sold.)
Ending Ending Stock Stock Price 0.5 Value $10 0.5 $5 $20 0.5 $10 Ending Value Option of Value = Portfolio $0 = $5 -$5 = $5

+ +

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Step 2: Calculate the PV of the riskless portfolio today.

Future portfolio value PV (1 rRF ) t $5 PV 1.0296 PV $4.86

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Step 3: Calculate the cost of the stock in the portfolio.

Cost of stock in portfolio % of stock in portfolio Stock price 0.5 $15

Step 4: Calculate the market value of the option.

Price of option Cost of stock PV of portfolio $7.50 $4.86 $2.64
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$7.50

As Factor Increases Current stock price Exercise price Time to expiration Risk-free rate Stock return volatility

Option Value Increases Decreases Increases Increases Increases

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As Factor Increases Current stock price Exercise price Time to expiration Risk-free rate Stock return volatility

Option Value Decreases Increases Increases Decreases Increases

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1. Self-study: Read Pg 588-589. Find out how firms manage risk in practice. 2. Reading: Find out how to use derivates to reduce risk. Read Eugene pg 587 and find out the use and misuse of derivatives 3. Do the following assignment at home: Self-test problems listed on Eugene textbook page 587 Challenge problem: Try Eugene Textbook P18-8 * Note: Black and Scholes Model is not included in the course syllabus.

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