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XIII. DERIVATIVES AND ENTERPRISE RISK MANAGEMENT

Uncertainty, Risk and Hedging
o Sources of risk
o Risk profile and analysis
o Cash flow hedging
Derivatives and Enterprise Risk Management
o Hedging using forward contracts
o Hedging using futures contracts
o Hedging using swaps
o Hedging using options
Options and Corporate Financial Management
o Warrants
o Bonds with embedded options
o Real options

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1. Sources of Risk
What are risks?
o The known knowns
o The known unknowns
o The unknown unknowns
Reports that say that something hasn't happened are always interesting to me,
because as we know, there are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some
things we do not know. But there are also unknown unknowns -- the ones we don't
know we don't know. And if one looks throughout the history of our country and
other free countries, it is the latter category that tend to be the difficult ones.
Donald Rumsfeld (U.S. Secretary of Defense, 2001-2006), at the Department
of Defense news briefing, February 12, 2002.
Examples of known unknowns and unknown unknowns in the corporate
world?

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Corporate risks fall into four broad categories:

o Hazard risks

Damage/harm due to external forces (e.g., natural disasters)
o Financial risks

Exposure to currency exchange rate or commodity prices
o Operational risks

Disruptions to business operations (human resources, supply chain,
production, distribution, etc)
o Strategic risks

Failure to respond to changing customer demand/needs, social and
demographic trends, regulatory or environmental changes, or changes in
competition or technology, etc.
We will only discuss the first two types of risks.

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2. Hazard Risk and Insurance

Hazard risk has a unique profile:
o Typically beyond the companys control
o Rare
o Unpredictable
o Potential for large losses or damage
Hazard risk is typically managed by buying the appropriate type of insurance:
o Commercial liability insurance
o Business interruption insurance
o Key personnel insurance
o Workers compensation and employers liability insurance

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3. Managing Financial Risk

Financial risk is typically linked to the adverse movement of a key market indicator
or variable:
o Commodity prices
o Interest rates
o Currency exchange rates
o Stock market index
o Inflation
o etc
How do we measure financial risk?
o Volatility

Standard deviation

Variance
o VaR (Value at Risk)

e.g., A stock portfolio has a 1-day, 5% VaR of $1 million.
o Risk profile/distribution (see next page)
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3.1. Hedging and financial risk management

a) To hedge or not to hedge?
Risk-return tradeoff
Acceptable level of risk
Control/reduce risk exposure
b) Long-run vs. short-run exposure
Long-run exposure (i.e., economic exposure)
o Business cycle/market-wide financial crisis
o Permanent shift in demand/supply
o Changes in regulations and trade barriers, etc.
Short-run exposure (i.e., transitional exposure)
o Exposure to temporary changes in prices
o Size or quantity is not affected.

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c) Natural hedge
Hedging by changing business practices, without any use of derivatives:
o Vertical integration (managing exposure to prices)
o Localize both revenues and expenses (managing currency exposure)
d) Benefit of hedging with derivatives
Both long-run and short-turn exposure
Cost effective
Flexible
e) Choice of derivatives:
Forward contracts
Futures contracts
Swaps
Options
Others

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3.2. Hedging using forward contracts

What are they?
o A contract where two parties (known as counterparties) agree on the price of an
asset today to be delivered and paid for at some future date (long vs. short).
o Forward contracts are legally binding on both parties.
o They can be customized/tailored to meet the needs of both parties.
o The contracts are negotiated between the two counterparties and there is no
upfront cost to enter.
o Due to credit risk concerns, only large, creditworthy financial and non-financial
institutions are normally accepted as counterparties.
Examples of forward contracts:
o Interest rate forwards (a.k.a., forward rate agreements)
o Currency forwards
o Commodity forwards
What are forward contracts used for?
o Locking in the price for a future transaction (purchase or sale).
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Payoff profiles for forward contracts:

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Example 1
Consider a three-month forward contract on 100 ounces of gold.
The investor takes a long position in the forward contract.
The delivery/forward price is $1,200 per ounce.
Determine the investors payoff in three months if the gold price ends up in a range
between $1,150 and $1,250.
What if the investor had a short position in the forward contract instead?

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Hedging with forward contracts:

o Taking an opposite position in the forward contract

Any potential problems with this type of hedging?

o Air Canada hedging disaster (Globe & Mail, Dec. 03, 2008: Air Canada fuel
hedges backfire as oil drops):
http://investdb4.theglobeandmail.com/servlet/ArticleNews/story/GAM/20
081203/RAIRCANADA03
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3.3. Hedging using futures contracts

Similar to forward contracts except for:
o Trading on organized securities exchange (standardized contracts)
o Margin requirement and daily marking to market
o Little or no credit risk problems
o No or rare deliveries (closing out position prior to maturity)
Examples of futures contracts:
o Commodity futures

Industrial: gold, silver, crude oil, natural gas, lumber, etc.

Agricultural: corn, soy bean, orange juice, beef, etc.
o Stock index futures
o Interest rate futures
o Currency futures

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3.4. Hedging using swaps

What are they?
o A long-term agreement between two parties to exchange (or swap) cash flows
at specified times based on specified relationships
o Equivalent to a portfolio of forward contracts
o Generally limited to large creditworthy financial or non-financial institutions
Types of swaps:
o Interest rate swaps the net cash flow is exchanged based on interest rates
o Currency swaps two currencies are swapped based on specified exchange
rates or foreign vs. domestic interest rates
o Commodity swaps fixed quantities of a specified commodity are exchanged
at fixed times in the future
o Credit default swaps corporate bonds are exchanged for face value based on a
reference entitys default

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Example: An interest rate swap

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3.5. Hedging using options

What are they?
o The buyer of the option has the right, but not the obligation, to buy (or sell) an
asset at a fixed price on or before a specified date
o Must pay an upfront fee to purchase the option
o Call right to buy the asset
o Put right to sell the asset
o Fixed price: exercise price or strike price
o Specified date: expiration date or maturity
o American vs. European options
Option asymmetries:
o Asymmetric, nonlinear payoffs
o Buyer-seller asymmetry:

Buyer may lose at most the purchase price, but may make much more than
the initial purchase price.

Seller (writer) may make at most the selling price, but may lose much
more than the initial selling price.
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Call option payoff profiles:

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Put option payoff profiles:

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Example 2
Suppose an investor just bought a three-month call option on 100 shares of Stock
XYZ.
The strike price of the option is $50 (per share).
Determine the investors payoff in three months if stock price ends up in a range
between $25 and $75.
What if the investor bought a put option instead?

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Hedging with put options:

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4. Options and Corporate Financial Management

Options are used extensively in corporate financial management:
o
o
o
o

Warrants
Convertible bonds
Corporate incentives (employee stock options)
Others

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4.1. Warrants
Warrants are similar to call options:
o Exercise price
o Maturity
o Number of shares per each warrant
Warrants are also different from exchange traded call options:
o They are sold by the company, not other investors.
o They are usually sold as sweeteners in a package of loans, bonds, common
stock or preferred stock.
o Most warrants are detachable so that they can be sold or exercised irrespective
of the original package they are bundled together.
o When warrants are exercised, investors pay the strike price to the company and
the company gives investors new shares (dilution of ownership).

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4.2. Convertible bonds

A convertible bond is a bond with an embedded call option.
o Embedded means that the call option is not detachable from the bond.
The call option gives the investor the right to exchange the bond for a fixed number
of the companys common shares:
o e.g., 25 shares for a $1,000 par bond
Key features of a convertible bond:
o Conversion ratio: the number of shares received per $1,000 par (e.g., 25)
o Conversion price: the par value given up for each common share (e.g.,
$1000/25 = $40)
Value of a convertible bond (see figure on next page):
Straight bond value + Call value

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Example: Convertible bonds

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4.3. Corporate incentives (employee stock options)

Why do firms use ESOs?
What are unique features of ESOs?
o Vesting period
o Forfeiture
o Reload
o Performance vesting
o Repricing
o Purchased or prepaid
o Indexing
Figure 25.4: Canadian Examples

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4.4. Equity as a call option on the firms assets

Firm Value = Equity + Debt
Debt obligation is the strike price of the call option:

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Example 3
(Example 25.8 / p.743)
Buckeye Industries has a zero-coupon bond issue with a face value of $100, due in
one year.
The value of Buckeyes assets is currently worth $109.
Jim Tressell, the CEO, believes that the assets in the firm will be worth either $92 or
$138 in one year.
The risk-free rate is 6% (EAR).

What is the value of Buckeyes equity? The value of the debt?

Suppose that Buckeye can reconfigure its existing assets in such a way that the value
in a year will be $80 or $160. If the current value of the assets is unchanged, will the
stockholders favour such a move? Why or why not?

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4.5. Insurance and loan guarantees

Insurance and loan guarantees are essentially put options:
o It gives you the right to sell/recover a fixed dollar amount from the insurance
company when the defined event (e.g., earthquake, hurricane or default) occurs
that either destroy or damage the underlying asset.

What is the strike price of the option?
o Unlike a regular put option though, insurance is unique in a number of ways:

The exercise of the option is exogenous, i.e. triggered by the defined event
(e.g., earthquake).

Option price (or insurance premium) is not paid upfront. It is usually paid
in monthly installments.

The option is renewable (by the payment of each installment).

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4.6. Managerial options (real options)

Real options are choices that allow managers the flexibility to either undertake or
terminate a business initiative such as:
o
o
o
o
o
o

Expanding a business operation

Downsizing a business operation
Abandoning a business operation
Launching a new product
Deferring an investment
Etc.

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