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BASICS OF FINANCIAL

RISK MANAGEMENT

CAS / ARIA Financial Risk Management


Seminar -- Denver, CO
April, 1999

Rick Gorvett, FCAS, Ph.D.


The College of Insurance
BACKGROUND
AND
MOTIVATION
WHY SHOULD WE STUDY
FINANCIAL RISK MANAGEMENT?

• To better understand the nature and


volatility of financial markets
• To understand the development of new
financial products -- e.g., derivatives and
hybrid securities
• To understand how these products can be
used to change a firm’s risk profile and
protect its financial condition
UNPREDICTABILITY
• Interest rates
– Inflation, cash flows (investing / lending), asset
and liability values
– Late 1970s -- Volcker / FED policy change
• Commodity prices
– Costs, substitute products
– Price shocks -- OPEC, Kuwait
• FX rates
– International cash flows, relative competitiveness
– Early 1970s -- Breakdown of Bretton Woods
FINANCIAL RISKS --
EXAMPLES
• Interest rates
– Savings & Loans
– Inversion of yield curve around 1980
• Commodity prices
– Continental Airlines
– Price of fuel after Iraq invaded Kuwait
• Foreign exchange
– Laker Airlines
– Strengthening of US$ relative to pound in 1981
FINANCIAL RISK MANAGEMENT:
A BROAD FRAMEWORK

• FRM can take several (familiar and


unfamiliar) forms
– Asset hedges
– Liability hedges
– Asset-liability management
– Contingent financing
– Post-loss financing and recapitalization
WHY DO CORPORATIONS USE
FINANCIAL DERIVATIVES?
• Transaction hedges
– FX; debt
– Currency and interest rate risk
• Strategic (economic) hedges
– Protect cash flows or company value from
movements in financial prices
• Reduce funding costs
– FX; synthetic debt
• Trading derivatives for profit
WHY DON’T CORPORATIONS
USE MORE DERIVATIVES?

• Credit risk
• No suitable instrument
• Lack of knowledge
• Accounting / legal issues
• Transaction costs
• Resistance by Board / upper management
VOCABULARY

• Financial derivative: a financial instrument


whose value is a function of another
(“underlying”) financial instrument
• Financial engineering: the creation and
use of financial derivatives to aid in the
management of risk
• Risk profile: describes the effect of changes
in a financial price on the value of a firm
FORWARDS
AND
FUTURES
FORWARD CONTRACTS
• Obligation / agreement to buy/sell in the
future
• Contract price is the “exercise price”; no
payment until maturity
• Physical delivery or cash-settled
• Buyer (holder) is “long”; seller (writer) is
“short
• OTC -- can be tailored
• Two-sided risk
FUTURES CONTRACTS
• Obligation; agree to a future transaction
• Traded on organized exchanges
• Standardized
• Daily settlement (marking to market)
– Reduces default risk: essentially, a series of one-
day contracts
• Margins (performance bonds)
– Initial margin
– Maintenance margin
– Margin call
• Exchange clearinghouse
EXCHANGES VS. OTC
Exchanges OTC Markets
• Advantages • Disadvantages
– Clearinghouse – Credit risk
– Liquidity – Low liquidity
– Standardization – Non-standardization
• Disadvantages • Advantages
– Lack of flexibility – Flexible
– Regulation – Less regulation
– Trading costs – Lower regulatory costs
– Public – Private
TYPES OF CONTRACTS

• Agricultural commodities
– Wheat, corn, soybeans
– Farmer (supplier) can lock in sales price before
harvest (short futures)
– Consumer (user) can lock in purchase price
(long futures)
• Other commodities
– Metals, petroleum
• Financial assets
– FX, stock market indices, interest rates
EXAMPLE
• Ann agrees to buy from Bill one barrel of
oil, five months from now, for $20
– Ann is in the “long” position
– Bill is in the “short” position
• If the price of oil is $25 five months from
now, who pays to whom, and how much?

• If the price of oil is $12 five months from


now, who pays to whom, and how much?
OPTIONS
OPTIONS

• Option to buy or sell the underlying asset


• Right, not obligation
• Call option: right to buy the U/L asset
• Put option: right to sell the U/L asset
• Buyer = holder = long position (option to
exercise)
• Seller = writer = short position
PARAMETERS OF OPTIONS
• Exercise price = strike price = price at
which the holder of the option can exercise
the option (and thus buy or sell the
underlying asset)
• Expiration date
• Premium = amount paid for the option
• American option: can exercise any time up
to and including expiration date
• European option: can exercise only on
expiration date
EXAMPLES OF OPTIONS --
THEY’RE EVERYWHERE
• Traded options
– On stocks, indices, FX, interest rates, futures,
swaps, options,...
• Convertible bonds
• Call provisions on bonds
• On projects
– To expand, abandon, postpone
• Insurance
EXAMPLE
• Amy sells Bob a January European call
option on one share of Compaq stock
• Suppose Compaq stock is trading at 32.5
• Exercise price = 35
• Premium = 3
• In January, suppose:ST=30 ST=40
Total payoff [profit/loss]
Amy: 0 [3] -5 [-2]
Bob: 0 [-3] 5 [2]
OPTION VALUES (cont.)
• Prior to expiration: Call Put
– In-the-money St > X St < X
– At-the-money St = X St = X
– Out-of-the-money St < X St > X
• Intrinsic value - profit that could be made if
the option was immediately exercised
– Call: stock price - exercise price
– Put: exercise price - stock price
• Time value - the difference between the
option price and the intrinsic value
OPTION VALUES:
PAYOFF CHART
Payoff
• Call -- long position
ST
X

• Call -- short position

• Put -- long position

• Put -- short position


PUT-CALL PARITY

• Arbitrage implies a certain relationship


between put, call, and underlying asset
prices
• Two portfolios have, at payoff, identical
values:
– One European call option + cash of PV(X)
– One European put option + one share of stock
• C + PV(X) = P + S
BLACK-SCHOLES FORMULA

VC = S N(d1) - X e-rt N(d2)

d1 = [ln(S/X)+(r+0.5s2)t] / st0.5

d2 = d1 - st0.5
PURPOSES OF DERIVATIVES

• Speculative
– Highly risky
– Highly leveraged
– Very volatile
• Hedging
– Combine with other securities
– Hedge (minimize) risk from other securities
HEDGING

• “Hedge”: Take a position that offsets a


risk
• Risk: Uncertainty regarding the value of
the underlying asset
• By hedging, one changes the risk inherent in
owning the underlying asset
• The return distribution of the underlying asset is
not changed
USING OPTIONS TO HEDGE

• Combine the underlying asset with an


option or options
• Can reduce or eliminate downside risk
while retaining upside potential
• Can protect against falls in held asset
values, or against increases in input prices
OPTION STRATEGIES

• Protective put
– Own stock (long position)
– Own put (long position)
• Covered call
– Own stock (long position)
– Sell call (short position)
• Straddle
• Spread
PROTECTIVE PUT

• Investor owns asset


• Investor also buys (holds) a put on the asset

• Guarantees investment portfolio proceeds at


least equal to the exercise price of the put

+ =
PROTECTIVE PUT EXAMPLE

• Suppose you own a share of stock, and you


purchase a put option with an exercise price of
22.5 on that stock, for a premium of $ 0.75

ST : 30 25 20 15
Premium: -0.75 -0.75 -0.75 -0.75
Put Payoff: 0 0 2.50 7.50
=== === === ===
Overall: 29.25 24.25 21.75 21.75
COVERED CALL
• Investor purchases stock
• Investor also sells (writes) a call option on the
stock

• Option position is “covered” by owning the


underlying stock itself
• (vs. “naked option”)
• Provides additional (premium) income

+ =
COVERED CALL EXAMPLE

• Suppose you own a share of stock, and you write


a call option with an exercise price of 35 on that
stock, for a premium of $ 2.00

ST : 30 35 40 45
Premium: 2 2 2 2
Call Payoff: 0 0 -5 -10
=== === === ===
Overall: 32 37 37 37
STRADDLE
• (Long) Straddle: buy both a call and a put
on a stock
• Each option has the same exercise price and
expiration date
• Believe stock will be relatively volatile
• Worst-case: no movement in stock price
SPREAD
• Combination of options
– Two or more calls, or
– Two or more puts
• Vertical spread: simultaneous sale and purchase
of options with different exercise prices
• Horizontal spread: sale and purchase of options
with different expiration dates
INTEREST RATE OPTIONS

• Cap: a call option on an interest rate


• Floor: a put option on an interest rate
• Collar: simultaneously buying a cap and
selling a floor

• These options can be used to hedge rate-


sensitive debt and assets
INTEREST RATE OPTIONS:
TERMINOLOGY
• Underlying index: interest rate being hedged
or speculated upon; e.g., LIBOR, prime rate
• Strike rate: determines cash flows (similar to
exercise price)
• Settlement frequency: how often the strike
rate and underlying index are compared
• Notional amount: principal to which the
interest rate is applied
• Up-front premium: paid by purchaser to
seller for the option
INTEREST RATE CAPS

• At each settlement date, check whether index


rate is greater than strike rate
• If not, cap purchaser does not receive cash
flows
• If so, purchaser receives from seller:

[ (index rate - strike rate) x


(days in settlement period / 360) x
notional amount ]
INTEREST RATE CAPS:
EXAMPLE
• $20,000,000 two-year quarterly interest rate cap
on 3-month LIBOR with a strike rate of 8%
• Cost: 150 basis points

• Up-front premium = 0.015 x $20M = $300,000


• If 3-month LIBOR = 9%, seller pays
(.09-.08) x 90/360 x $20M
= $50,000 (for that quarter)
INTEREST RATE FLOORS

• At each settlement date, check whether index


rate is greater than strike rate
• If so, floor purchaser does not receive cash
flows
• If not, purchaser receives from seller:

[ (strike rate - index rate) x


(days in settlement period / 360) x
notional amount ]
INTEREST RATE COLLARS

• Purchase a cap to hedge floating-rate


liabilities
• Sell a floor at a lower strike rate
• Sale of floor helps finance purchase of cap

• Net result: Interest expense will be limited


on both ends -- will float between the cap and
floor strike rates
• Can achieve zero-premium collar
SWAPS
SWAPS

• Agreement between two parties


– “Counterparties”
– Exchange sets of future cash flows
• Two major types
– Interest rate swaps
– Currency swaps
• Relatively new FRM tool
SWAPS VS. FUTURES

• Futures
– Standardized
– Exchange-traded
– Short horizons
• Swaps
– Custom tailored between counterparties
– Little regulation; potential for privacy
– Term flexibility
INTEREST RATE SWAPS

• One party pays a fixed interest rate and


receives a floating rate
• The other party pays a floating rate and
receives a fixed rate
• Floating rates involve greater exposure to
interest rate risk
• “Notional principal” is amount on which the
interest payments are determined
INTEREST RATE SWAPS (cont.)

• Principal is not actually exchanged -- only


interest payments
• Generally, only net interest payments are
transacted
– Avoids unnecessary transactions
– Helps credit risk
• At each “settlement date,” a net payment is
made, based on the difference between the
two interest rates (applied to the notional
principal)
CURRENCY SWAPS
• One party holds one currency, and desires a
different currency
• Three sets of cash flows:
– Exchange principal at inception of swap
– Periodic interest payments
– Exchange principal at termination of swap
• Interest rates fixed ==> only change in
value is from FX change
• Generally, only make net payments
LIMITATIONS OF SWAPS

• Counterparties must find each other


– Meet specific needs
– Cost, time; facilitators
• Lack of “liquidity”; difficult to unwrap /
trade / change without consent of other
party
• Credit risk of counterparty
DEVELOPMENT OF SWAP MARKET

• Originally:
– Unique contracts
– Had to search for counterparty
– Investment banks were dominant intermediaries
• More recently:
– More standardized and liquid
– Intermediaries accept contract, then lay off risk
– More highly capitalized firms -- e.g., commercial
banks