CORPORATE RISK

MANAGEMENT
GROUP 1
Classification of Risk
Measurement of risk in non financial firms
Principle of hedging
Hedging with Forward, Futures, Swap, Options
Contracts, Insurance, Risk management products
Financial Engineering and Corporate Strategy
Risk management practices
CONTENTS:
The wide array of risks that a management firms exposed can be classified into
5 categories:
1. Technological Risk: arise mostly in the R&D and Operations stage of the
value chain.
2. Economic Risks: arise from fluctuations in the revenues(output price and
demand) and production cost ( Raw material cost, energy cost and labor
cost)
3. Financial Risks: arise from volatility of Interest rates, currency rates,
commodity prices and stock prices.
4. Performance risks: arise when contracting counterparties do not fulfill
their obligations.
5. Legal and Regulatory risks: change in laws and regulations

CLASSIFICATION OF
RISK
To assess the Financial price risk we may:
a) Examine the financial statements to get an idea of
the risk exposure
b) Assess the sensitivity of the firms value or cash flow
to changes in the financial prices and
c) Conduct monte carlo simulation.
MEASUREMENT OF RISK IN
NON FINANCIAL FIRMS
Examining the Balance sheet and Profit & loss account throw light on a
number of questions like:
Does the firm have a strong liquidity position as per high Current
ratio and Quick ratio? A strong liquidity position cushions against
the volatility of cash flows caused by changes in Financial prices.
Does the firm have a low gearing ratio (leverage)? A low gearing
ration provides greater financial flexibility to cope with volatility in
financial prices.
What is the Foreign exchange transaction exposure? If the balances
of receivables and payables are high, their values would change in
response to shifts in the exchange rates.
Is the firm exposed to interest rate risk? If the firm relies mainly on
free floating debt it has a high interest rate exposure.
EXAMINE THE
FINANCIAL STATEMENTS
Determine the sensitivity of Firms Value or Cash Flow by:

Analyzing the Historical data on firm value, cash flows and
financial prices
e.g. The sensitivity of a firms value to exchange rate may be estimated as
Firm Value = a + b Exchange rate

ASSESS THE SENSITIVITY
Monte carlo methods are used in finance to value and analyze
(complex) instruments, portfolios and investments by simulating
the various sources of uncertainty affecting their value, and then
determining their average value over the range of resultant
outcomes.
The advantage of monte carlo methods over other techniques
increases as the dimensions (sources of uncertainty) of the
problem increase.


MONTE CARLO SIMULATION
One way to manage these risks and uncertainties is to enter into
transactions that expose the entity to risk and uncertainty that fully or
partially offsets one or more of the entitys other risks and uncertainties,
transactions known as hedges.
The instrument acquired to offset risk or uncertainty is known as hedging
instrument and the risk or uncertainty hedged is known as hedged item.
There are predominantly two motivations for a company to hedge:
To lock-in a future price which is attractive, relative to an organisations costs.
To secure a commodity price fixed against an external contract


PRINCIPLE OF HEDGING
Forward contract is an OTC agreement between two parties, to buy or
sell an asset at a certain time in the future for a certain price.
The price of the underlying instrument, in whatever form, is paid before
control of the instrument changes.
This is one of the many forms of buy/sell orders where the time of trade
is not the time where the securities themselves are exchanged.
The forward price is commonly contrasted with the spot price, which is the
price at which the asset changes hands on the spot date.
The difference between the spot and the forward price is the forward
premium or forward discount, generally considered in the form of a profit
or loss, by the purchasing party.
HEDGING WITH
FORWARD CONTRACTS
What Does Futures Contract Mean?

A contractual agreement, generally made on the trading floor of
a futures exchange, to buy or sell a particular commodity or
financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the
underlying asset; they are standardized to facilitate trading on a
futures exchange.
Some futures contracts may call for physical delivery of the
asset, while others are settled in cash.

HEDGING WITH FUTURE
CONTRACTS
There are many different kinds of futures contracts, reflecting the many
different kinds of "tradable" assets about which the contract may be based
such as commodities, securities (such as single-stock futures), currencies or
intangibles such as interest rates and indexes.
1. Foreign exchange market
2. Money market
3. Bond market
4. Equity market
5. Soft Commodities market

TYPES OF FUTURE
CONTRACTS
FUTURES HEDGING
What Does Swap Mean?

If firms in separate countries have comparative advantages on interest rates,
then a swap could benefit both firms.

For example, one firm may have a lower fixed interest rate, while another has
access to a lower floating interest rate. These firms could swap to take
advantage of the lower rates.

HEDGING WITH
SWAPS
Interest rate swaps
Currency swaps
Commodity swaps
Equity swap
Credit default swaps
Other variations

TYPES OF SWAPS
Spread compression
Market segmentation
Market saturation
Difference in financial norms
REASON FOR SWAPS
An option contract is an agreement under which the seller of the option grants
the buyer the right, but not the obligation, to buy or sell(depending on whether
it is a call option or a put option) some asset at a predetermined price during
the specified period. The buyer of the option has to pay a premium to enjoy the
right.

Forward vs options:
In forwards contract both parties agree to act in the future whereas in an
option transaction occurs only if the buyer of the option chooses to exercise
it.
In forward contract no money exchanges hands whereas in options the buyer
of the contract pays option premium.

Hedging with options:diagrams

HEDGING WITH OPTION
CONTRACTS
Imagine a firm going for a long term floating rate loan
The risks involved are the interest rates rising sharply
increasing the debt service burden

OPTIONS IN DEBT
CONTRACTS
Main advantages offered by Insurance companies:
They can price the risks reasonably accurately
Provides low cost administration service due to specialisation and
economies of scale.
Provides advice on measures to reduce risks
Pools risks by holding large diversified pool of assets

Disadvantages of Insurance:
It incurs administrative costs
Problem of adverse selection- cant differentiate between good and bad
risks
Exposed to problem of moral hazard
Loading fee- diff between insurance premium and expected payoff.
HEDGING WITH
INSURANCE
Option contract on debt instruments- options on treasury bill
Option contract on foreign currencies options with British
pounds
Option contract on stock market indices-option on S&P 500
index
Option contract on stock index futures.
TYPES OF OPTION
CONTRACTS
Real options-
Diversify product line and services to reduce risks
Invest in preventive maintenance
Emphasise quality control to reduce product liability
Build flexible production systems
Shorten time to introduce product to market
Delay investment until uncertainty is resolved
Carry extra liquidity on the balance sheet to tide over
difficult periods
Maintain reserve borrowing power to meet contingencies.
HEDGING WITH REAL
TOOLS AND OPTIONS
Real options cost a great deal.
In some cases real options may be the only viable
means to handle risks
Real options are far less liquid
Firm with real options may profit from assuming
more risk a firm with flexible production
facilities can benefit more by manufacturing
products subject to high price volatility.

REAL VS. FINANCIAL
OPTIONS
The financial and operating environment today is more
riskier than in the past
Substantial increase in the average rate as well as
volatility of inflation
Greater volatility in interest rates , exchange rates,
and commodity prices
Increased global competition.

EVOLUTION OF RISK
MANAGEMENT TOOLS
Exchange rate volatility- currency futures,
currency swaps, currency options
Interest rate volatility- floating rate loans, T-Bill
futures, T-Bond futures, options on T-Bonds, caps
floors and collars.
Petroleum prices- futures in heating oil, futures in
WTI, hybrids, option in WTI
Metal price volatility- fwds, futures,
options,hybrids.

VOLATILITY AND RISK
MANAGEMENT TOOLS:

Corporate strategy bricks and mortar
TVA

RISK MANAGEMENT PRACTICES
Align risk management with corporate strategy
Proactively manage uncertainties
Employ mix of real and financial methods
Know the limits of risk management tools
Dont put undue pressure on corporate treasury
to generate profits
Learn when it is worth reducing risk
GUIDELINES FOR RISK
MANAGEMNET