Risk management

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Corporate risk management relates to the management of unpredictable events that would have adverse consequences for the firm.

What is corporate risk management?

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All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.

Why is corporate risk managementimportant to all firms?

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Step 1. Identify the risks faced by the firm.

Step 2. Measure the potential impact of the identified risks.

Step 3. Decide how each relevant risk should be handled.

What are the three steps of corporate risk management?

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Transfer risk to an insurance company by paying periodic premiums.

Transfer functions that produce risk to third parties.

Purchase derivative contracts to reduce input and financial risks.

What are some actions that

companies can take to minimize or reduce risk exposure?

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Take actions to reduce the probability of occurrence of adverse events.

Take actions to reduce the magnitude of the loss associated with adverse events.

Avoid the activities that give rise to risk.

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Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations.

Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

What is a financial risk exposure?

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Derivative: Security whose value stems or is derived from the values of other assets. Swaps, options, and futures are used to manage financial risk exposures.

Futures: Contracts that call for the purchase or sale of a financial (or real) asset at some future date, but at a price determined today. Futures (and other derivatives) can be used either as highly leveraged speculations or to hedge and thus reduce risk.

Financial Risk Management Concepts

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Hedging: Generally conducted where a price change could negatively affect a firm’s profits.

Long hedge: involves the purchase of a futures contract to guard against a price increase.

Short hedge: involves the sale of a futures contract to protect against a price decline in commodities or financial securities.

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Swaps: Involve the exchange of cash payment obligations between two parties, usually because each party prefers the terms of the other’s debt contract. Swaps can reduce each party’s financial risk.

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The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at today’s price, even if the market price on the item has risen substantially in the interim.

How can commodity futures marketsbe used to reduce input price risk?

FUTURE

Contract to buy or sell a stated commodity or financial claim at a specified price at some futures, specified times

• A contract to make or take delivery of a product in the future, at a price set in the present

• In formalized futures and options trading on exchanges, standardized agreements specify price, quantity, and month of delivery

• Started in agriculture, but have expanded to a wide range of products

OPTION

• Sebuah hak untuk membeli atau menjual produk turunan di waktu tertentu dengan harga yang telah disepakati dimuka. Karena sifatnya ini adalah hak, maka pemilik  (pembeli) opsi berhak untuk menggunakannya atau tidak. Sementara bagi penjual opsi terikat kewajiban untuk melaksanakan transaksi dalam hal pemilik opsi ingin menggunakan haknya dimaksud.  Pemilik opsi biasanya hanya akan menggunakan haknya dalam kondisi yang menguntungnya.

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An option is a contract that gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time.

What is an option?

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It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset.

What is the single most importantcharacteristic of an option?

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Call option: An option to buy a specified number of shares of a security within some future period.

Put option: An option to sell a specified number of shares of a security within some future period.

Exercise (or strike) price: The price stated in the option contract at which the security can be bought or sold.

Option Terminology

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Option price: The market price of the option contract.

Expiration date: The date the option matures.

Exercise value: The value of a call option if it were exercised today = Current stock price - Strike price.

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Covered option: A call option written against stock held in an investor’s portfolio.

Naked (uncovered) option: An option sold without the stock to back it up.

In-the-money call: A call option whose exercise price is less than the current price of the under-lying stock.