Introduction to Derivatives and Risk Management

Corporate Finance
Dr. A. DeMaskey

Learning Objectives

Questions to be answered:

Why should a company manage its risk? What financial techniques can be used to reduce risk? What are derivatives? What are the important characteristics of the various types of derivative securities? How should derivatives be used to manage risk?
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Reasons to Manage Risk

Do stockholders care about volatile cash flows?

If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios.
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Reasons to Manage Risk

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. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility.

Reasons to Manage Risk

Risk management allows firms to: Avoid costs of financial distress.

Weakened relationships with suppliers. Loss of potential customers. Distractions to managers.

Utilize comparative advantage in hedging relative to hedging ability of investors.

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Reasons to Manage Risk

Risk management allows firms to: Reduce borrowing costs by using interest rate swaps. Minimize negative tax effects due to convexity in tax code.

Growth of Derivatives Market

Analytical techniques Technology Globalization

Derivative Securities
Derivative:

Security whose value stems or is derived from the value of other assets. Types of Derivatives

Forward Futures Options Swaps

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Forward Contracts

An agreement where one party agrees to buy (or sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into. Characteristics

Flexibility Default risk Liquidity risk Long position Short position

Positions in Forwards

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Futures Contracts

A standardized agreement to buy or sell a specified amount of a specific asset at a fixed price in the future. Characteristics

Margin Deposits

Initial margin Maintenance margin

Marking-To-Market Floor Trading Clearinghouse

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Hedging with Futures

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. Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.
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Option Contracts

The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time. Option Terminology

Call option versus put option Holder versus writer or grantor Exercise or strike price Option premium American versus European option
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Market Arrangements

Swap Contracts

Financial contracts obligating one party to exchange a set of payments it owns for another set of payments owed by another party.

Currency swaps Interest rate swaps

Usually used because each party prefers the terms of the others debt contract. Reduces interest rate risk or currency risk for both parties involved.
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Different Types of Risk

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

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

Transfer risk to an insurance company by paying periodic premiums. Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial risks. 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.
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Nature and Purpose of Trading in Financial Derivatives

Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Hedging

Protect Value of Securities Held Protect the Rate of Return on a Security Investment Reduce Risk of Fluctuations in Borrowed Costs

Speculating
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Using Derivatives to Reduce Risk

Commodity Price Exposure

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. The purchase of a financial futures contract will allow a firm to make a future purchase of the security at todays price, even if the market price on the asset has risen substantially in the interim.
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Security Price Exposure

Using Derivatives to Reduce Risk

Foreign Exchange Exposure

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

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Risks to Corporations from Financial Derivatives

Increases financial leverage Derivative instruments are too complex Risk of financial distress

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