2. 2
Part 8 Risk Management
Chapter26:Managing Risk
Chapter27: Managing International Risks
3. 3
Chapter26 Managing Risk
26-1 Why Manage Risk?
26-2 Insurance
26-3 Reducing Risk with Options
26-4 Forward and Futures Contracts
26-5 Swaps
26-6 How to Set Up a Hedge
26-7 Is "Derivative" A Four-letter Word?
4. 4
26-1 Why Manage Risk?
・Financial transactions undertaken solely to reduce risk
do not add value in perfect markets.
Reason1:Hedging is a zero-sum game
Reason2:Investors' do-it-yourself alternative
If risk management affects the value of firm,it must be because
"other things" not because risk shifting is inherently
valuable.
5. 5
The reason risk-reducing transactions
can make sense in practice
• Reducing the risk of cash shortfalls or financial distress
– covenants
• Agency costs may be mitigated by risk management
– hedging can make it easier to monitor and
motivate managers.
6. 6
CRO needs to come up with answers to
the following questions
1. What are the major risks that the company is facing and what
are the possible consequences?
2. Is the company being paid for taking these risks?
3. How should risk be controlled?
7. 7
26-2 Insurance
• some advantages in bearing risk
– considerable experience in insuring similar risks
– skilled at providing advice
– pool risks by holdding a large,diversified portfolio of policies
• some disadvantages in bearing risk
– administrative cost
– adverse selection
– moral hazard
8. 8
26-3 Reducing Risk with Options
・The goverment's bought put options that gave it the right to sell
oil at an excercise price of $70 per barrel.
・The profile (c) should be familiar to you as the protective put
strategy that we encountered in section 20-2.
9. 9
26-4 Forward and Futures Contracts
Forward Contract
Futures Contract
Structure:
Customized to customers need. Usually no
initial payment required.
Standardized. Initial margin payment
required.
Method of pre-
termination:
Opposite contract with same or different
counterparty. Counterparty risk remains while
terminating with different counterparty.
Opposite contract on the exchange.
Risk: High counterparty risk Low counterparty risk
Market regulation: Not regulated Government regulated market
Meaning:
A forward contract is an agreement between
two parties to buy or sell an asset (which can
be of any kind) at a pre-agreed future point in
time.
A futures contract is a standardized
contract, traded on a futures
exchange, to buy or sell a certain
underlying instrument at a certain
date in the future, at a specified price.
Institutional
guarantee:
The contracting parties Clearing House
Contract size:
Depending on the transaction and the
requirements of the contracting parties.
Standardized
Expiry date: Depending on the transaction Standardized
Transaction
method:
Negotiated directly by the buyer and seller Quoted and traded on the Exchange
Guarantees:
No guranantee of settlement until the date of
maturity only the forward price, based on the
spot price of the underlying asset is paid
Both parties must deposit an initial
guarantee (margin). The value of the
operation is marked to market rates
with daily settlement of profits and
losses.
10. 10
Trading and pricing financial contract
t
ft yrSF )1(0 −+=
Ft=the future price for a contract lasting t periods
S0=today's spot price
rf=risk free interest
y=dividend yield or interest rate
000,4)0.010.151(980,3 =−+×=tF
11. 11
26-5 Swaps
• interest rate swap
• currency swap
• total return swap
Year 0
Years1-4
Years5
Dollars
Euros
Dollars
Euros
Dollars
Euros
1Issue dollar loan
+10
-0.6
-10.6
2Swap dollars for euros
-10
+8
+0.6
-0.4
+10.6
-8.4
3Net cash flow
0
+8
0
-0.4
0
-8.4
dollar rate 5%
euro rate 6%
12. 12
26-6 How to set up a hedge
Expected change in value of A=a+δ(change in value of B)
・Delta(δ)：the sensitivity of A to changes in the value of B
・hedge ratio:the number of B that should be sold to hedge the purchase of B
[ ] [ ] [ ]{ }+×+×+×= 3)(2)(1)(
1
321 CPVCPVCPV
V
Duration
13. 13
26-7 Is "derivative"A four-letter word?
• Precoution1:Don't be takes as surprise
• Precoution2:Place bets when you have some comparative
advantage that ensure the odds are in your favor.
※Is derivative dangerous?
Suppose that a bank enters into a $10 million interest rate
swap and the other party goes bankrupt the next day.
How much has the bank lost??
14. 14
27 Managing International Risks
27-1 The Foreign Exchange Market
27-2 Some Basic Relationships
27-3 Hedging Currency Risk
27-4 Exchange Risk and International Investment Decisions
27-5 Political Risk
16. 16
27-2 Some Basic Relationships
• Problem1:Why is the dollar rate of interest rate different
from,say, the yen rate?
• Problem2:Why is the forward rate of exchange different from
the spot rate?
• Problem3:What determines next year's expected spot rate
of exchange between dollars and yens?
• Problem4:What is the relationship between the inflation rate
in the United States and the inflation rate in Japan?
17. 17
Basic Relationships
Difference in
interest rates
1+ryen/1+r$
Expected change
in spot rate
E(syen/$)/syen/$
Expected difference
in inflation rates
E(1+iyen)/E(1+i$)
Difference between
forward and spot rates
fyen/$/syen/$
equals
equals
equals
equals
Suppose that individuals were not worried about risk and that
there were no barriers or costs to international trade on capital flows.
18. 18
Interest rates and exchange rates
• Interest rate parity theory says that the difference in
interest rates must equal the difference between the
forward and spot exchange rates.
Difference in
interest rates
1+ryen/1+r$
Difference between
forward and spot rates
fyen/$/syen/$
equals
19. 19
The forward premium
and changes in spot rate
• The expectations theory of exchange rate tells us that the
percentage difference between the forward rate today's
spot rate is equal to the expected change in the spot rate.
Expected change
in spot rate
E(syen/$)/syen/$
equals
Difference between
forward and spot rates
fyen/$/syen/$
20. 20
Changes in the exchange rate
and inflation rate
• Purchasing power parity implies that any differences in the
rates of inflation will be offset by a chan in the exchange
rate.
Expected change
in spot rate
E(syen/$)/syen/$
Expected difference
in inflation rates
E(1+iyen)/E(1+i$)
equals
21. 21
Interest rates and inflation rate
• If the expected real interest rates are equal, then the
difference in money rates must be equal to the difference
in the expected inflation rates.
Difference in
interest rates
1+ryen/1+r$
Expected difference
in inflation rates
E(1+iyen)/E(1+i$)
equals
22. 22
27-3 Hedging Currency Risk
• Operational hedging:
Balancing production closely with sales
• Financial hedges:
Borrowing in foreing currencies,selling currency forward,
or using foreign currency derivatives such as swaps and
options
23. 23
27-4 Exchange Risk and
International Investment Decisions
0
1
2
3
4
5
capital
cost
NPV
CF($)
-1300
400
450
510
575
650
12%
513
CF
(Swiss francs)
-1560
471
520
578
639
709
9.90%
513
・When deciding whether to invest overseas,separate out the investment
decision from the decision to take on currency risk.
・Your view about future exchange rates should not enter into the
investment decision.
24. 24
27-5 Political Risk
• Business in every country are exposed to the risks of unanticipated
actions by governments or the courts.
• Calculating NPVs for investment projects becomes exceptionally difficult
when political risks are significant.
