Download Financial Risk Management and Derivatives: Understanding Volatility and Risk Mitigation - and more Study notes Financial Management in PDF only on Docsity! 11/2/2007 1 Chapter 23 Financial Derivatives • Firms are exposed to financial risk – Interest rates, commodity prices, equities, FX • Risk management increases value by reducing effects of volatility • Specifically, risk management – Lowers costs of financial distress • Lower cost of debt cost • Increase debt capacity – Lowers (average) tax bill Increased financial volatility? • Foreign Exchange – Breakdown of Bretton Woods (early 1970s) • Interest rates – New Fed policy (late 1970s) • Commodity prices – OPEC shock (1970s) • Stock prices • Risk management protects balance sheet from exposure to financial risks • Avoid C1 risk The Savings & Loans Business - The Good Years • S&L assets mostly long term maturity mortgages • S&L liabilities usually short term savings deposits • Pre-1980s, upward sloping yield curve is formula for success – Earn 6%, Pay 3% The Savings & Loans Business - The Bad Years • Was the S&L position a bomb waiting to detonate? • 1980s - the yield curve inverts – Still earn 6%, but pay 12% 11/2/2007 2 Responses to financial volatility • Better predictions? • Derivative products (rediscovered) – Forwards and futures – Swaps – Options – Hybrid products • Application of risk management concepts to a firm’s balance sheet • Help companies concentrate on core business Risk Management Process • Identification • Evaluation (measurement) – Frequency – Severity • Risk control and risk financing – Evaluate potential for derivatives use • Implementation • Review (monitoring) Identification: Risk Profile Graphical summary of relationship between two variables How is firm value related to financial variables? Example: As interest rates increase, S&L value decreases -20 0 20 -2% -1% 1% 2% Change in interest rate C h a n g e i n v a lu e o f S & L ($ m il li o n s) Spot vs. Forward contracts • Spot contracts are immediate transactions – Contract terms, delivery, and payment all occur (approximately) at the same time – Example: buy a Big Mac at McDonald’s • Forward contracts are an agreement to transact (in fact, an obligation to transact) in the future. The terms of the transaction are determined today. – Terms to agree on: delivery date, forward or contract price (F), type of asset • All terms of forward contracts are completely negotiated between the contracting parties – Over-the-counter 11/2/2007 5 Swap Contract - The Basics • An agreement between two parties to exchange (or swap) periodic cash flows • Most common – interest rate swap – One party pays a fixed interest rate while receiving a floating rate payment – At each payment date, only the net value of cash flows is exchanged – The cash flows are based on a notional principal or notional amount Why use Interest Rate Swaps? • Translates a fixed cash flow into a floating cash flow (or vice versa) • Companies with interest rate exposure can manage the risk • How could S&Ls have used swaps? What is an option contract? • Options give their owners the right, but not the obligation, to buy or sell an asset at a fixed price on or before maturity – Call option is right to buy – Put option is right to sell Example of a call option • Today is December 1, Allison has the right to buy MSFT at $35 per share (called the “exercise” or “strike” price) from Ron on July 31 • Allison wants price to go up • Ron is obligated to sell MSFT to Allison at $35 if she decides to “exercise” the option • Allison must pay Ron a price (called a “premium”) to own this call option 11/2/2007 6 Black-Scholes Equation Tdd T Tr X S d dNXedSNC f Tr f 12 2 1 21 2 ln )()( Hedging vs. Insurance • Forward-based derivatives (forwards, futures and swaps) – No upfront cost – Pay for downside risk by relinquishing upside gain • Option-based derivatives – Premium paid up front – Eliminate downside risk and retain upside gain
