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Risk Management

©2006 Thomson/South-Western

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Introduction

This chapter describes the various motives that companies have to manage firm-specific risks

It also explains basic non-hedging and hedging strategies used to reduce risk

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What is Risk?

Risk is the possibility that the actual cash flows from an investment or any other business transaction will be different from expected cash flows

Risk management occurs when a firm takes deliberate steps to minimize that difference

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Why Manage Risk?

True, investors can eliminate firm-specific (unsystematic) risk by holding a well-diverse portfolio

But investor diversification can’t produce the important benefits that risk management within a firm creates- namely, the preservation of valuable investment opportunities

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Risk Management Benefits Management of risk at the firm level reduces the

probability of financial distress and the loss of value

from forced liquidation

Risk management enables firms to maintain capital

expenditures by stabilizing internally generated funds

Risk management allows managerial performance to

be evaluated on the basis of factors under manager’s

control

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Non-Hedging Strategies

Acquisition of additional information: Test marketing, consumer surveys, and market research can reduce the risk of making poor decisions

Diversification of customer and supplier base reduces threat to firm viability

Insurance provides cash payments designed to offset losses due to natural disasters, the death of key employees, product liability, and unforeseen business interruptions

Control measures such as patents, copyright protection, use agreements, and legal action can reduce business risks

Flexibility in use of assets

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Hedging strategies for risk management A hedge is a transaction that limits the

risk associated with fluctuations in the price of a commodity, currency or financial instrument

Hedging results from the creation of a position in a forward contract, a futures contract, or an option

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Forward Contracts

A forward contract is an agreement to buy or sell an asset At a specified price At a specified time

The party agreeing to buy the asset holds a “long” position

The party agreeing to sell the assets holds a “short” position

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More About Forward Contracts Forward contracts are not traded on an

exchange – meaning there is no organized market for their purchase and sale

Forward contracts are subject to performance risk, which is the risk that the party with losses on the contract will fail to make the required payments

Forward contracts are very common in the foreign exchange market

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Futures Contracts

A futures contract is a standardized contract, traded on an organized exchange, to buy or sell an asset At a specified price At a specified time

The party agreeing to buy the asset holds a “long” position

The party agreeing to sell the asset holds a “short” position

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More on Futures Contracts Futures contracts require:

Daily settlement between buyers and sellers (marking to market)

Maintenance of a margin account to cover potential losses

Futures exchanges provide: Standardized contracts A clearinghouse to handle all payments

between buyers and sellers

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Long Hedge

Wait until July and buy the oil

Buy the oil today at $45 / barrel and store it

until needed

Execute a long hedge by purchasing crude

oil in the futures market for delivery in July

Masco Industries anticipates the need for 100,000 barrels of crude oil in July 2005. To meet this supply requirement, the company could:

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How the Long Hedge Works

If the price of oil rises to $50 by July, the company will pay $500,000 more for the oil than if purchased earlier

But the long futures position generates a profit of $500,000, offsetting the impact of the price increase

Masco Industries decides to execute a long hedge by taking a long futures position in 100,000 barrels of crude oil at an agreed upon price of $45 / barrel.

Bottom Line: The long hedge locks in a $45 / barrel purchase price

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Short Hedge

Earthgrains has agreed to sell 50,000 bushels of wheat to another bakery in November, at the prevailing market price

Fearful that the price of wheat will decline by November, Earthgrains constructs a short hedge by taking a short position in November wheat futures

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How a Short Hedge Works

If the price of wheat falls by November, Earthgrains will receive less money from the other bakery

But the short futures position will produce an offsetting gain, because it allows Earthgrains to sell wheat at a higher price

Net result: short futures position enables Earthgrains to “lock-in” a selling price for the wheat

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Hedging with futures options Futures call option

A call option on futures gives the holder the right, but not the obligation, to take a long position in a futures contract

Futures put option A put option on futures gives the holder the right, but

not the obligation, to take a short position in a futures contract

An important difference Futures options (unlike futures) require the payment of

an option premium