INTRODUCTION TO

RISK MANAGEMENT

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BASIC RISK MANAGEMENT

Firms convert inputs into goods and services

Output Input
Commodity
Produc Buye
er r

A firm is profitable if the cost of what it produces exceeds the cost of

its inputs
A firm that actively uses derivatives and other techniques to alter its
risk and protect its profitability is engaging in risk management

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THE PRODUCERS
PERSPECTIVE
A producer selling a risky commodity has an inherent long position in
this commodity

When the price of the commodity decreases, the firms profit decreases
(assuming costs are fixed)

Some strategies to hedge profit

Selling forward
Buying puts
Buying collars

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PRODUCER: HEDGING WITH FORWARD
CONTRACT
A short forward contract allows a producer to lock in a price
for his output
Example: a gold-
mining firm enters
into a short forward
contract, agreeing
to sell gold at a price
of $420/oz. in 1 year

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PRODUCER HEDGING WITH PUT OPTION

Buying a put option allows a producer to have higher

profits at high output prices, while providing a floor on the
price
Example: a gold-
mining firm
purchases a 420-
strike put at the
premium of $8.77/oz

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PRODUCER: INSURING BY SELLING A CALL
A written call reduces losses through a premium, but limits
possible profits by providing a cap on the price
Example: a gold-
mining firm sells
a 420-strike call
and receives an
$8.77 premium

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ADJUSTING THE AMOUNT OF INSURANCE

Insurance is not free!in fact, it is expensive

There are several ways to reduce the cost of insurance
For example, in the case of hedging against a price decline
by purchasing a put option, one can
Reduce the insured amount by lowering the strike price of the put
option. This permits some additional losses
Sell some of the gain. This puts a cap on the potential gain

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THE BUYERS PERSPECTIVE

A buyer that faces price risk on an input has an inherent

short position in this commodity
When the price of the input increases, the firms profit
decreases
Some strategies to hedge profit
Buying forward
Buying calls
Selling collars

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BUYER: HEDGING WITH FORWARD
CONTRACT
A long forward contract allows a buyer to lock in a price
for his input
Example: a firm,
which uses gold as
an input, purchases
a forward contract,
agreeing to buy gold
at a price of $420/oz.
in 1 year

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BUYER: HEDGING WITH A CALL OPTION

Buying a call option allows a buyer to have higher profits

at low input prices, while being protected against high
prices
Example: a firm,
which uses gold as
an input, purchases
a 420-strike call at
the premium of
$8.77/oz

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NON-FINANCIAL RISK MANAGEMENT

Risk management is not a simple matter of hedging or not

hedging using financial derivatives, but rather a series of
decisions that start when the business is first conceived
Some nonfinancial risk-management
decisions are
Entering a particular line of business
Choosing a geographical location for a plant
Deciding between leasing and buying equipment

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REASONS NOT TO HEDGE

Reasons why firms may select not to hedge

Transaction costs of dealing in derivatives (such as commissions
and the bid-ask spread)
The requirement for costly expertise
The need to monitor and control the hedging process
Complications from tax and accounting considerations
Potential collateral requirements

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Collar

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Put vs. Collar

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Zero-cost Collar

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SELECTING THE HEDGE RATIO: Cross
Hedging
Suppose we can produce 1 widget with oz. of gold. If we produce of widgets at a price of :

Profit = - ,

Suppose we hedge long H gold future contracts with each contract covering q oz. Of
gold. If F is the forward price:

Hedged profit = - - F)

Variance:

Variance minimizing hedge position H*:

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SELECTING THE HEDGE RATIO: Quantity
Uncertain

Variance:

H that minimize the variance:

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TUTORIAL

Derivatives Market (THIRD EDITION) Robert L . McDonald

Q4.2,Q4.3, Q4.5,Q4.10,Q4.12, Q4.13, Q4.25

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