Principles of Corporate Finance

Ninth Edition

Chapter 27
Managing Risk

Slides by Matthew Will

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 2

Topics Covered
Why Manage Risk? Insurance Forward and Futures Contracts SWAPS How to Set Up A Hedge Is Derivative a Four Letter Word?

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 3

Risk Reduction
Why risk reduction does not add value 1. Hedging is a zero sum game--A corporation that
insures or hedges a risk does not eliminate it. It simply passes the risk to someone else.

2. Investors do-it-yourself alternative

Corporations cannot increase the value of their shares by undertaking transactions that investors can easily do on their own

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 4

Risk Reduction
Risks to a business
Cash shortfalls Financial distress Agency costs Variable costs Currency fluctuations Political instability Weather changes

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 5

Insurance
Most businesses face the possibility of a hazard that can bankrupt the company in an instant. These risks are neither financial or business and can not be diversified. The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 6

Insurance
Example
An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? How can the cost of this hazard be shared

McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 7

Insurance
Example - cont
An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? How can the cost of this hazard be shared

Answer A large number of companies with similar risks can each contribute pay into a fund that is set aside to pay the cost should a member of this risk sharing group experience the 1 in 10,000 loss. The other 9,999 firms may not experience a loss, but also avoided the risk of not being compensated should a loss have occurred.
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 8

Insurance
Example - cont
An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? What would the cost to each group member be for this protection.
Answer

1,000 ,000 ,000 $100 ,000 10 ,000

McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 9

Insurance
Why would an insurance company not offer a policy on this oil platform for $100,000?
Administrative costs Adverse selection Moral hazard

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 10

Insurance
The loss of an oil platform by a storm may be 1 in 10,000. The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one in may damage all in the same area. The result is a much larger risk to the insurer Catastrophe Bonds - (CAT Bonds) Allow insurers to transfer their risk to bond holders by selling bonds whose cash flow payments depend on the level of insurable losses NOT occurring.

(A high-yield debt instrument that is usually insurance linked and meant to raise money in
case of a catastrophe such as a hurricane or earthquake. It has a special condition that states that if the issuer (insurance or reinsurance company) suffers a loss from a particular pre-defined catastrophe, then the issuer's obligation to pay interest and/or repay the principal is either deferred or completely forgiven)

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 11

Hedging with Forwards and Futures

Business has risk Business Risk - variable costs Financial Risk - Interest rate changes

Goal - Eliminate risk

HOW? Hedging & Forward Contracts
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 12

Hedging with Forwards and Futures

Ex - Kellogg produces cereal. A major component and cost factor is sugar. Forecasted income & sales volume is set by using a fixed selling price. Changes in cost can impact these forecasts. To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like todays price, and made your forecasts based on it. But, you can not. You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. This contract is called a Futures Contract. This technique of managing your sugar costs is called Hedging.
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 13

Hedging with Forwards and Futures

1- Spot Contract - A contract for immediate sale & delivery of an asset. 2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. 3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & provides a secondary market for the speculation of Futures.
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 14

Types of Futures
Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -Tbills -Yen -GNMA -Stocks -Eurodollars Index Futures -S&P 500 -Value Line Index -Vanguard Index
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

SUGAR

27- 15

Commodity Futures

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 16

Financial Futures

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 17

Futures Contract Concepts

Not an actual sale Always a winner & a loser (unlike stocks) K are settled every day. (Marked to Market) Hedge - K used to eliminate risk by locking in prices Speculation - K used to gamble Margin - not a sale - post partial amount Hog K = 30,000 lbs Tbill K = $1.0 mil Value line Index K = $index x 500

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 18

Futures and Spot Contracts

The basic relationship between futures prices and spot prices for equity securities.

Ft S0 (1 rf y )t Ft futures price on contractof t length S0 Today's spot price rf Risk free rate y Dividend yield

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 19

Futures and Spot Contracts

Example
The DAX spot price is 5,952.38. The interest rate is 3.6% and the dividend yield on the DAX index is 2.0%. What is the expected price of the 6 month DAX futures contract?

Ft S 0 (1 rf y )t 5,952.38 (1 .018 .01) 6,000

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 20

Futures and Spot Contracts

The basic relationship between futures prices and spot prices for commodities.
CY--The benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivative product.

Ft S0 (1 rf sc cy )t Ft futures price on contractof t length S0 Today's spot price rf Risk free rate cy Convenience yield sc Experss storagecost ncy cy sc Net Convenience yield

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 21

Futures and Spot Contracts

Example
In December the spot price for coffee was $1.234 per pound. The interest rate was 5.36 % per year. The net convenience yield was -5.6%. What was the price of the 9 month futures contract?

Ft S 0 (1 rf sc cy)t or Ft S 0 (1 rf ncy) with timeadjusted r Ft S 0 (1 rf ncy) 1.234(1.0399 .056) 1.3525

McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

Annualized Net Convenience Yield, %

-40.00 10.00 20.00 30.00 40.00 50.00 70.00

-30.00

-20.00

-10.00

60.00

Net Convenience Yield

0.00

01/31/1994 06/30/1994 11/30/1994 04/28/1995 09/29/1995 02/29/1996 07/31/1996 12/31/1996 05/30/1997 10/31/1997 03/31/1998 08/31/1998 01/29/1999 06/30/1999 11/30/1999 04/28/2000 09/29/2000 02/28/2001 07/31/2001 12/31/2001 05/31/2002 10/31/2002 03/31/2003 08/29/2003 01/30/2004 06/30/2004 11/30/2004 04/29/2005 09/30/2005 02/28/2006 07/31/2006 Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 22

27- 23

Homemade Forward Rate Contracts

Borrow for 1 year at 10% Lend for 2 years at 12% Net cash flow Year 0 +90.91 -90.91 0 Year 1 -100 -100 Year 2 -114.04 -114.04

(1 2 year spot rate)2 Forwardinterest rate 1 (1 1 year spot rate) 1.122 1 1.10 .1404 or 14.04%

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 24

Swaps
LIBOR -An interest rate benchmark used to establish the floating interest rate that is paid on the notional principal in an interest-rate swap. LIBOR flat has no spread added to it and represents the best interest rate available in the current market. It is the most common reference on which other interest rates are based.

Year 0 1. Borrow $66.67 at 6% fixed rate 2. Lend $66.67 at LIBOR floating rate Net cash flow 66.67 -66.67 0 1 -4 .5x66.67 -4 .05x66.67 Standard fixed-to-floating swap 0 -4 .5x66.67 2 -4 LIBOR1 x66.67 -4 3 -4 4 -4 5 -70.67

LIBOR4x66.67 LIBOR2x66.67 LIBOR3x66.67 +66.67 -4 -4 -4

LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67 -4 -4 -4 -4

LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 25

SWAPS
birth 1981

Definition - An agreement between two firms, in which each firm agrees to exchange the interest rate characteristics of two different financial instruments of identical principal http://www.investopedia.com/video/play/swaps/#axzz2NQlF qtoB Key points Spread inefficiencies Same notation principal Only interest exchanged

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 26

SWAPS
Plain Vanilla Swap - (generic swap) fixed rate payer floating rate payer counterparties settlement date trade date effective date terms Swap Gain = fixed spread - floating spread

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 27

Swap Curves
SWAP Curves for three currencies during January 2007

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 28

SWAPS
example (vanilla/annually settled) XYZ ABC fixed rate 10% 11.5% floating rate libor + .25 libor + .50 Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1mil face value loans) A: XYZ borrows $1mil @ 10% fixed ABC borrows $1mil @ 7.5% floating XYZ pays floating @ 7.25%
ABC pays fixed @ 10.50%
My interpretation-currently ABC 10.5 rate sa de rha h and ya XYZ ka rate h jo usa pa karna hota.Means XYZ ko benefit. And XYZ floating apna hi pay karaga. Other situation-ABC 11.5 ki jagaha 10.5 de rha h. TO usa benefit of 1%. And lose h usa .25% ka us par jo floating XYZ pay kar rha h.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 29

SWAPS
example - cont Benefit to XYZ floating +7.25 -7.25 fixed +10.50 -10.00 Net gain Benefit ABC floating +7.25 - 7.50 fixed -10.50 + 11.50 net gain Net position 0 +.50 +.50% Net Position -.25 +1.00 +.75%

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 30

SWAPS
example - cont Settlement date ABC pmt 10.50 x 1mil XYZ pmt 7.25 x 1mil net cash pmt by ABC if libor rises to 9% settlement date ABC pmt 10.50 x 1mil XYZ pmt 9.25 x 1mil net cash pmt by ABC = 105,000 = 72,500 = 32,500

= 105,000 = 92,500 = 12,500

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 31

SWAPS
transactions rarely done direct banks = middleman bank profit = part of swap gain

example - same continued XYZ & ABC go to bank separately XYZ term = SWAP floating @ libor + .25 for fixed @ 10.50 ABC terms = swap floating libor + .25 for fixed 10.75

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 32

SWAPS
example - cont settlement date - XYZ Bank pmt 10.50 x 1mil XYZ pmt 7.25 x 1mil net Bank pmt to XYZ

= 105,000 = 72,500 = 32,500

settlement date - ABC Bank pmt 7.25 x 1mil ABC pmt 10.75 x 1mil net ABC pmt to bank

= 72,500 = 107,500 = 35,000

bank swap gain = +35,000 - 32,500 = +2,500

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 33

SWAPS
example - cont benefit to XYZ floating 7.25 - 7.25 = 0 fixed 10.50 - 10.00 = +.50 benefit to ABC floating fixed benefit to bank floating fixed

net gain .50

7.25 - 7.50 = - .25 -10.75 + 11.50 = + .75

net gain .50

+7.25 - 7.25 = 0 10.75 - 10.50 = +.25

net gain +.25

total benefit = 12,500 (same as w/o bank)

McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 34

Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 35

Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?
30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss

50.63 -$510 50.80

cents per lbs

Since you must settle your account every day, you must give your broker $510.00
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 36

Hedging

Hypothetical plot of past changes in the price of the farmers wheat against changes in the price of Kansas City wheat futures. A 1% change in the futures price implies, on average, an .8% change in the price of the farmers wheat.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 37

Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price drops to $2.80.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 38

Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price drops to $2.80. Revenue from Crop: 10,000 x 2.80 June: Short 2K @ 2.94 = 29,400 Sept: Long 2K @ 2.80 = 28,000 Gain on Position------------------------------- 1,400 Total Revenue
McGraw Hill/Irwin

28,000

$ 29,400
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 39

Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price rises to $3.05.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 40

Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price rises to $3.05. Revenue from Crop: 10,000 x 3.05 30,500

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 3.05 = 30,500 Loss on Position------------------------------- ( 1,100 ) Total Revenue
McGraw Hill/Irwin

$ 29,400
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 41

Commodity Speculation
You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (.4400 x 38,000 x 3 ) = Feb: Long 3 May K (.4850 x 38,000 x 3 ) = Loss of 10.23 % =
McGraw Hill/Irwin

+ 50,160 - 55,290 - 5,130

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 42

Margin
The amount (percentage) of a Futures Contract Value that must be on deposit with a broker. Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin. CME margin requirements are 15%
Short position-Thus, you can control $100,000 of assets with only $15,000. 1. The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value. 2. In the context of options, it is the sale (also known as "writing") of an options contract. Long position-. The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value. 2. In the context of options, the buying of an options contract.

McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 43

Commodity Speculation with margin

You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = Feb: Long 3 May K (.4850 x 38,000 x 3 ) =

+ 50,160 - 55,290

Loss =
Loss
-----------=

- 5,130

5130
-------------------=

5130
------------ =

68% loss

Margin
McGraw Hill/Irwin

50160 x.15

7524

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

27- 44

Web Resources
Click to access web sites Internet connection required

www.cbot.com www.cme.com www.nymex.com www.lme.com www.eurexchange.com www.euronext.com

www.bis.org
www.commoditytrader.net www.isda.org
McGraw Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved