17/2/2016

RISK MANAGEMENT AND TYPES OF RISK

The scientist who developed the Saturn 5

rocket that launched the first Apollo mission
to the moon put it this way:

You want a valve that does not leak and you

try everything possible to develop one. But
the real world provides you with a leaky valve.
You have to determine how much leaking you
can tolerate

The word risk derives from the Italian

word risicare, which means to dare.

In this sense, risk is a choice.

Credit risk/default risk:

Demand risks:

Enterprise risk management:

Environmental risk:

Event risks:

Financial risks:

Input risks:

(obituary of Arthur Rudolph, New York Times, January 3, 1996).

Risk associated with the ability of customers and vendors to pay

or deliver.
Those associated with the demand for a firms products or
services.
This deals with managing all of the various risks across the firm
from an enterprise-wide view.2
Risk associated with polluting the environment.
Risk associated with particular types of events, such as fire, flood,
or theft.
Those that result from financial transactions.
Those associated with a firms input costs.

17/2/2016

Legal or liability risks:

Liquidity risk:

Market or Price risk:

Operational risk:

Personnel risk:

Political risk:

Property risks:

Reputation risk:

Speculative risks:

Hedging is a form of risk management.

Risk connected with product, service, or employee liability.

Risk associated with the inability to buy or sell commodities at quoted
prices.
Risk associated with unexpected changes in the market price of
commodities.
Risk associated with the performance or availability of physical or
managerial systems.
Risks that result from human actions.

Step 1. Set the hedging objective.

Step 2. Establish the hedging level.
Step 3. Execute the hedging strategy.
Step 4. Constantly monitor and reassess exposure.
Step 5. Quantify the final outcome.

Risk due to new regulations, expropriation, etc.

Those associated with loss of a firms productive assets.
Risk associated with the firms business reputation.
Those that offer the chance of a gain as well as a loss. This is not a
hedge

In energy finance,
Refineries want to hedge themselves against
increases in the price of oil, and
Oil producers want to hedge themselves
against decreases in the price of oil.

17/2/2016

Firms hedge for two reasons,

1. The first is that management is risk averse,

meaning that management wants to reduce the

likelihood the oil price changes unfavorably.

2.

The second is that hedging can reduce the

likelihood that a company will incur
financial distress and therefore increase the
ability to fund profitable capital projects

derivative markets help companies reduce

risks
. . . allowing them to concentrate more on
their core business.
So, if they can reduce or eliminate price risk,
then shareholders are happy
By transferring the risk of business processes
that firms do not have any insight into or
control over, they are able to concentrate on
competencies that they are best at

increasing the overall effectiveness and efficiency of the

firm.

Its a contract that derives its value based on

the value of something else e.g. oil, gas,
gold, silver
3 types of derivative products traded:
1. Futures
2. Options
3. Swaps

You dont actually have to purchase the

derivative!
Uses

For integrated companies, many of the risks

are considered to be hedged naturally and
offset each other.
However, this is not necessarily true because
with global operations, many outputs will not
be available in the same location where the
input is needed.

1. Speculate
2. Hedge

17/2/2016

Consumers of energy such as airlines and

utilities may need to hedge against increases
in energy prices because these are inputs into
their business.
Hedging can increase firm value
(see Carter, Rogers, and Simkins 2006; Smithson and Simkins 2005).

Risk management allows firms to:

Have greater debt capacity, which has a
larger tax shield of interest payments.
2. Lower cost of capital.
3. Prevent underinvestment
4. Avoid costs of financial distress.
5. Utilize comparative advantage in hedging
relative to hedging ability of investors.
6. Minimize negative tax effects.

1.

Volatility is usually defined as the annualized

standard deviation of commodity price
returns.
Over the four-year period 20072010, it is
clear that crude oil has the greatest price
volatility, followed by equities, interest rates,
and currencies.

17/2/2016

A forward contract is an agreement to buy or

sell a commodity at a fixed price in the
future.
These contracts require physical delivery and
are traded over the counter (OTC).

A future contract is an agreement to buy or

sell acommodity for a certain price (futures
price) at a certain time (expiration date).
These contracts are standardized, may not
require physical delivery, and are traded on
organized exchanges.

For example, assume that in December 2012,

Party A agrees to buy and Counterpart B
agrees to sell 50,000 barrels of crude oil at
Chicago in January 2014 for a price of $80
per barrel.
The contract quantity is 50,000 barrels, the
delivery date is January 2014, the delivery
place is Chicago, and the forward price is $80
per barrel.

The party that has agreed to buy has what is

termed a long position.
The party that has agreed to sell has a short
position.

17/2/2016

A forward contract is an agreement to buy or

sell a commodity at a fixed price in the
future.
These contracts require physical delivery and
are traded over the counter (OTC).

A future contract is an agreement to buy or

sell acommodity for a certain price (futures
price) at a certain time (expiration date).
These contracts are standardized, may not
require physical delivery, and are traded on
organized exchanges.

For example, assume that in December 2012,

Party A agrees to buy and Counterpart B
agrees to sell 50,000 barrels of crude oil at
Chicago in January 2014 for a price of $80
per barrel.
The contract quantity is 50,000 barrels, the
delivery date is January 2014, the delivery
place is Chicago, and the forward price is $80
per barrel.

Spot Price, Forward Price, Futures Price,

Prompt Month, Open Interest, and Volume

The spot price is the price established today for

delivery of the asset today (or within 24 hours).
The forward price of an asset is the price
established today for delivery of the asset on a
designated future date.
If this is the price on a futures contract, it is
referred to as the futures price.
In other words, the spot price is the price for
immediate delivery, while the forward/futures
price is the price for future delivery.

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The prompt month futures contract refers to

the nearest month of delivery for which
NYMEX futures prices are published during
the trading month.
Open interest is the total number of contracts
outstanding, and
volume of trading is the number of trades in
one day.

Futures contracts are settled daily which

means that at the end of every trading day,
the last traded price (settlement) is used to
value the investors position.
Futures exchanges require each customer to
post an initial margin in their account in the
form of cash or other collateral when the
contract is originated.

South Africa

South African Futures Exchange (SAFEX)

Asia
Bangladesh

Chittagong Stock Exchange (CSE)

Dhaka Stock Exchange (DSE)
China

China Financial Futures Exchange (CFFEX)

Dalian Commodity Exchange (DCE)
Shanghai Futures Exchange (SHFE)

Zhengzhou Commodity Exchange (ZCE)

Hong Kong
Hong Kong Exchanges and Clearing (HKEx)

Hong Kong Futures Exchange (HKFE) [merged]

Hong Kong Stock Exchange (HKSE) [merged]

Africa

Hong Kong Mercantile Exchange (HKMEx, defunct)

India
Bharat Diamond Bourse

Bombay Stock Exchange (BSE)

Indian Energy Exchange (IEX)

MCX Stock Exchange (MCX-SX)

Multi Commodity Exchange (MCX)

National Commodity and Derivatives Exchange (NCDEX)

National Spot Exchange
National Stock Exchange of India (NSE)
Iran
Iran Mercantile Exchange

Iranian Energy Exchange (IRENEX)

Iranian oil bourse
Tehran Stock Exchange
Japan

Central Japan Commodity Exchange (C-COM, defunct)

Kansai Commodities Exchange (KEX)
Osaka Securities Exchange (OSE)

Tokyo Commodity Exchange (TOCOM)

Tokyo Financial Exchange (TFX)
Tokyo Stock Exchange (TSE)

Yokohama Commodity Exchange (Y-COM) (merged, 2006)

Korea
Korea Exchange (KRX), formed from merger of KOSDAQ
Malaysia

Philippines

Manila Commodity Exchange (MCX)

Singapore
Singapore Commodity Exchange (SICOM)
Singapore Exchange (SGX)

Singapore Mercantile Exchange (SMX)

Taiwan
Taiwan Futures Exchange (TAIFEX)
Thailand

Thailand Futures Exchange (TFEX)

Bond Electronic Exchange (BEX)

United Arab Emirates

Dubai Gold & Commodities Exchange

Dubai Mercantile Exchange (DME)

NASDAQ Dubai
Europe
Pan-European
BlueNext

Eurex Exchange
Euronext

European Energy Exchange

NASDAQ OMX Commodities Europe

Austria
Energy Exchange Austria

BELFOX (Belgian Futures & Options Exchange)

Czech Republic

European Climate Exchange

OMX

Belgium

OTE, CO2 emission market, Prague

France

Euronext Paris
Germany

Risk Management Exchange (RMX), previously called

Warenterminbrse Hannover (Commodity Exchange
Hannover, WTB)
Hungary

Budapest Stock Exchange (BSE)

Pakistan Mercantile Exchange (PMEX), formerly National Commodity Exchange

Limited (NCEL)

Turkey

Turkish Derivatives Exchange (TURDEX, in Turkish: Vadeli

lem ve Opsiyon Borsas or VOB)

Mercantile Exchange Nepal Limited (MEX)

Pakistan

Derivative and Commodity Exchange Nepal Ltd. (DCX)

Agricultural Futures Exchange of Thailand (AFET)

Bursa Malaysia
Nepal

Karachi Stock Exchange (KSE)

Norway
Imarex

Poland
GPW (Warsaw Stock Exchange)
Romania

Bursa de Valori Bucureti (BVB) (Bucharest Stock

Exchange)
Russia
Moscow Exchange

Moscow Interbank Currency Exchange (MICEX) (merged,

2012)
RTS Stock Exchange (RTS) (merged, 2012)
Serbia
Belgrade Stock Exchange (BELEX)
Slovakia

Commodity Exchange Bratislava (CEB)

Spain

Mercado Espaol de Futuros Financieros (MEFF)

Ukraine

Ukrainian Exchange (UX)

United Kingdom
Baltic Exchange

ICE Futures Europe, formerly London International

Financial Futures and Options Exchange (LIFFE)
London Metal Exchange (LME)
North America
Canada

Montreal Exchange (MX) (owned by the TMX Group)

Mexico

Mexican Derivatives Exchange (MexDer)

United States

Chicago Board of Trade (CBOT) (Since 2007 a Designated

Contract Market owned by the CME Group)
Chicago Climate Exchange (CCE)
Chicago Mercantile Exchange (CME) (Since 2007 a
Designated Contract Market owned by the CME Group)
CME Group
Intercontinental Exchange (ICE)

International Monetary Market (IMM)

Kansas City Board of Trade (KCBT) (Since 2012, a

Designated Contract Market owned by the CME Group)
Minneapolis Grain Exchange (MGEX)

Nadex (formerly HedgeStreet)

New York Mercantile Exchange (NYMEX) and (COMEX)
(Since 2008 Designated Contract Markets owned by the
CME Group)

OneChicago (Single-stock futures (SSF's) and Futures on

ETFs)
Oceania

Australia
Australian Securities Exchange

Finance and Energy Exchange

AQUA Markets

The margin account is marked to market at

the end of each trading day according to that
days price movements.
All outstanding contract positions are
adjusted to the settlement price set by the
exchange after trading ends.
Forward contracts may not require either
counterparty to post collateral.

17/2/2016

Over 99 percent of futures contracts are

closed out before maturity by entering into
an offsetting trade

if the investor is long one contract, he must sell

one contract to close the long position.

If a futures contract is not closed out before

maturity, it is usually settled by delivering the
assets underlying the contract.
This is known as physical settlement.

This is known as financial settlement.

When there are alternatives about what is

delivered, where it is delivered, and when it is
delivered, the party with the short position
chooses.

On July 24, 2012, a crude oil purchasing

director wants to hedge his crude oil
purchase planned for January 2015.

Futures contracts on crude oil, natural gas,

and heating oil traded on the NYMEX or ICE.

17/2/2016

Cash Price
Futures Price
(i.e., Spot Price)
July 24, 2012, cash price
$88.41 per Bbl
$88.81 per Bbl
January 2, 2015, cash price
$95.50 per Bbl
of $96.10
$7.09 per Bbl

Basis (Cash price minus

futures price)

$0.40 per Bbl

$0.60 per Bbl

$0.20 basis loss

Result:
Cash purchase price of
$96.10 per Bbl
crude oil
Minus crude oil
$7.09 per Bbl
futures gain
Net purchase price of
$89.01 per Bbl
crude oil

In essence, the hedger bought a futures

contract (a long hedge) in July 2012 and then
sold back the futures contract in January 2,
2015, to offset the position.
The spot price of crude oil on January 2 is
$96.10 per barrel.

He buys a January 2015 futures contract on

the NYMEX at $88.41 per barrel (contract size
is for 1,000 barrels).
On the same day, the crude oil spot price is
$88.81 per barrel (Bbl).
The director closes out this futures contract
on January 2, 2015, at $95.50 per barrel. As
shown, the director has made a profit of
$7.09 per barrel (95.50 minus 88.41) on the
futures contract.

Without the futures hedge, the director would

have paid $7.09 per barrel more for the fuel
(cash price net purchase price of crude oil
with futures = $96.10 $89.01).
However, by using the futures contract and
purchasing crude oil in the spot market, the
gain of $7.09 on the futures offsets the $7.29
per barrel increase in the crude oil spot price.
As a result, the directors net cost of crude oil
is $89.01 per barrel (i.e., $96.10 spot price in
January 2015 minus the futures hedging gain
of $7.09 per barrel).

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In summary, many participants in the futures

markets are hedgers.
They want to reduce a particular risk they face.
They can take either long or short positions on
futures contracts depending on their exposure.
A long futures hedge is appropriate when you
know you will purchase an asset in the future and
want to lock in the price.
A short futures hedge is appropriate when you
know you will sell an asset in the future and want
to lock in the price.

Basic risk: used to describe the risk that the

value of the commodity being hedged may

not change in tandem with the value of the
derivative contract used to hedge the price
risk.
In an ideal hedge, the hedge would match the
underlying position in every respect.
However, in actuality, basic risk is a high
concern, even if the derivatives contract is for
the exact same commodity being hedged.

The NYMEX has a futures contract on high

density polyethylene (HDPE), and one contract
covers 47,000 pounds.
Chemical companies use HDPE to make various
plastics such as bottles and crates.
On July 27, 2012, a chemical company could
purchase (go long one futures contract) that
matures in December 12, 2012, and lock in a
price of $0.58 per pound.
This contract would be marked to market each
day, but effectively the company has locked in
this price for the volume hedged.

Basic risk often takes three different forms:

1. product basis risk (such as when the
derivatives contract is not for the same
commodity, known as a cross-hedge),
2. time basis risk (timing difference), and
3. locational basis risk (the futures contract is
for a different delivery point from the
hedgers exposure).

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