Intro to Risk Management with Derivatives, Risk management allows firms to:

Have greater debt capacity, which has a larger tax shield of interest payments. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. Avoid costs of financial distress. Weakened relationships with suppliers. Loss of potential customers. Distractions to managers.

Utilize comparative advantage in hedging relative to hedging ability of investors Reduce borrowing costs by using interest rate swaps. Minimize negative tax effects due to convexity in tax code

Derivative Securities
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Derivative: Security whose value stems or is derived from the value of other assets.

u Types of Derivatives Forward Futures Options Swaps

Forward Contracts
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An agreement where one party agrees to buy (or sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into.

u Characteristics Flexibility Default risk

Liquidity risk

u Positions in Forwards Long position Short position

FUTURE CONTRACT

A standardized agreement to buy or sell a specified amount of a specific asset at a fixed price in the future.

u Characteristics u Margin Deposits u Initial margin u Maintenance margin u Marking-To-Market u Floor Trading u Clearinghouse

Hedging with Futures

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Hedging: Generally conducted where a price change could negatively affect a firms 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.

Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

Option Contracts
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The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time. Option Terminology
Call option versus put option Holder versus writer or grantor Exercise or strike price Option premium American versus European option

Different Types of Risk

u Speculative risks: Those that offer the chance of a gain as well as a loss. u Pure risks: Those that offer only the prospect of a loss. u Demand risks: Those associated with the demand for a firms products or services. u Input risks: Those associated with a firms input costs. u Financial risks: Those that result from financial transactions. u Property risks: Those associated with loss of a firms productive assets. u Personnel risk: Risks that result from human actions. u Environmental risk: Risk associated with polluting the environment. u Liability risks: Connected with product, service, or employee liability. u Insurable risks: Those which typically can be covered by insurance.

An Approach to Risk Management

u Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm. u Firms often use the following process for managing risks. 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 dealt with. Techniques to Minimize Risk u Transfer risk to an insurance company by paying periodic premiums. u Transfer functions which produce risk to third parties. u Purchase derivatives contracts to reduce input and financial risks. u Take actions to reduce the probability of occurrence of adverse events. u Take actions to reduce the magnitude of the loss associated with adverse events. Avoid the activities that give rise to risk

Nature and Purpose of Trading in Financial Derivatives

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

u Hedging Protect Value of Securities Held Protect the Rate of Return on a Security Investment Reduce Risk of Fluctuations in Borrowed Costs

u Speculating

Using Derivatives to Reduce Risk u Commodity Price Exposure

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

u Security Price Exposure The purchase of a financial futures contract will allow a firm to make a future purchase of the security at todays price, even if the market price on the asset has risen substantially in the interim.

u Foreign Exchange Exposure The purchase of a currency futures or options contract will allow a firm to make a future purchase of the currency at todays price, even if the market price on the currency has risen substantially in the interim.