Risk Management: Dr. Keith M. Howe Summer 2008

Risk Management
Dr. Keith M. Howe

Summer 2008
Definition
Risk and uncertainty
Risk management
Risk aversion
The process of formulating the benefit-cost

trade-offs of risk reduction and deciding on the
course of action to take (including the decision
to take no action at all).
Two more definitions
• Derivatives
• financial assets (e.g., stock option, futures, forwards, etc)
whose values depend upon the value of the underlying
assets.
• Hedge
• the use of financial instruments or of other tools to reduce
exposure to a risk factor.
Figure 1.2. Gains and losses from buying shares and a call option on Risky
Upside Inc.
Gain
+$6,000
Risky Upside Inc. price
-$3,000
20 50 110
Panel A. Gain frombuyingshares of Risky

Upside Inc. at $50 per share.
G ain
$5,00 0
0
R isky U pside Inc. price
-$1,000
20 50 110
Panel B. Gainfrombuying acall option on

shares of RiskyUpside Inc. withexercise price
of $50 fora premiumof $10pershare.
Figure 1.3. Hedging with forward contract. Garman ’s
income is in dollars and the exchange rate is the dollar price
of one euro.
Unhedged income
Income to firm
$100 million
$90 million
Exchange rate
$0.90 $1
Panel A. Income to Garman if it does not hedge.

Gain from contract
to firm
$10 million
Forward
gain Exchange rate
Forward
loss
$0.9 Forward rate $1
Panel B. Forward contract payoff.

U nhedged incom e
Incom e to firm
Forw ard
$100 m illion loss H edged incom e
Forw ard
gain
E xchange rate
Forw ard rate $1
Panel C. Hedged firm income.

Unhedged
Income to firm income
Gain with
option
$100 million
Loss with option
Exchange rate
Exercise price of $1
Panel D. Comparison of income with put contract and income with forward contract.
Risk management irrelevance
proposition
• Bottom line: hedging a risk does not increase firm value when
the cost of bearing the risk is the same whether the risk is borne
within the firm or outside the firm by the capital markets.
• This proposition holds when financial markets are perfect.

Risk management irrelevance
proposition
• Allows us to find out when homemade risk management is not equivalent to

risk management by the firm.
• This is the case whenever risk management by a firm affects firm value in a
way that investors cannot mimic.
• For risk management to increase firm value, it must be more expensive to

take a risk within the firm than to pay the capital markets to take it.
Role of risk management
Risk management can add value to the firm by:
• Decreasing taxes
• Decreasing transaction costs (including
bankruptcy costs)
• Avoiding investment decision errors
Bankruptcy costs and
costs of financial distress
• Costs incurred as a result of a bankruptcy filing are
called bankruptcy costs.
• The extent to which bankruptcy costs affect firm
value depends on their extent and on the probability
that the firm will have to file for bankruptcy.
• The probability that a firm will be bankrupt is the
probability that it will not have enough cash flow to
repay the debt.
• Direct bankruptcy costs
• Average ratio of direct bankruptcy costs to total assets: 2.8%
• Indirect bankruptcy costs

• Many of these indirect costs start accruing as soon as a firm’s
financial situation becomes unhealthy, called costs of financial
distress
• Managers of a firm in bankruptcy lose control of some
decisions. They might not allowed to undertake costly new
projects, for example.
Figure 3.1. Cash flow to shareholders and operating cash flow.
C ash flow to shareholders

U nhedged cash flow
$450M
Expected cash
flow $350M
$250M
C ash flow to the

Expected cash firm
$250M flow $350M $450M
Figure 3.2. Creating the unhedged firm out of the hedged firm.
Unhedged cash flow

Cashflow to
shareholders
Forward
loss Hedged firm cash
$350M
(hedged) flow
Forward
gain
$350M (gold sold at forward)

Figure 3.3. Cash flow to claimholders and bankruptcy costs.
Cash flow to claimholders

Unhedged cash flow
$450M
Expected cash
flow hedged
$350M
Unhedged
$340M
Bankruptcy
cost
$230M
Cash flow to the

Expected cash firm
$250M flow $350M $450M
Analysis of decreasing
transaction cost by hedging
Value of firm unhedged = PV (C – Bankruptcy costs)
= PV (C) – PV (Bankruptcy costs)
= value of firm without bankruptcy costs – PV (bankruptcy costs)
Gain from risk management

= value of firm hedged – value of firm unhedged
= PV( bankruptcy costs)
Value of firm unhedged + gain from risk management
= value of firm hedged

= value of firm without bankruptcy costs
Taxes and risk
management
Tax rationale for risk management: If it moves a dollar away from a possible
outcome in which the taxpayer is subject to a high tax rate and shifts it to a
possible outcome where the taxpayer incurs a low tax rate, a firm or an
investor reduces the present value of taxes to be paid. It applies whenever
income is taxed differently at different levels.
- Carrybacks and carryforwards

- Tax shields
- Personal taxes
Example
The firm pays taxes at the rate of 50 percent on cash flow in excess of
$300 per ounce. For simplicity, the price of fold is either $250 or $450 with
Equal probability. The forward price is $350.
Optimal capital
structure and risk
management
• In general, firms cannot eliminate all risk, debt is
risky.
• By having more debt, firms increase their tax shield from debt but
increase the present value of costs of financial distress.
• The optimal capital structure of a firm:

• Balances the tax benefits of debt against the costs of financial
distress.
• Through risk management:

• A firm can reduce the present value of the costs of financial
distress by making financial distress less likely.
• As a result, it can take on more debt.
Should the firm hedge to reduce the risk of
large undiversified shareholders?
• Large undiversified shareholders can increase firm value

• Risk and the incentives of managers
• Large shareholders, managerial incentives, and homestake
Figure 3.6. Firm after-tax cash flow and debt issue.
After tax cash flow of hedged

firm
330
325
320
315
310
305
Principal amount of debt
100 200 300 400
Optimal amount of
debt, $317.073M
Risk management process
Risk identification
Risk assessment
Review
Selection of risk-mgt
techniques
Implementation
The rules of risk management
Risk Management
• There is no return without risk
• Be transparent
• Seek experience
• Know what you don’t know
• Communicate
• Diversify
• Show discipline
• Use common sense
• Get a RiskGrade
Source: Riskmetrics Group (www.riskmetrics.com)

Types of risks firms face
Market risk Hazard risk

- interest rate - physical damage
- foreign exchange - liabilities
- commodity price - business interruption
Operational risk Strategic risk

- industry sectors - competition
- geographical regions - reputation
- investor support
Assignment of risk responsibilities
CEO
Strategic risk
management
CRO
Market risk Hazard risk Operational risk

management management management
Hedgeable Insurable Diversifiable

Three dimensions of risk transfer
•Hedging
•Insuring
•Diversifying
A new concept of risk management
(VAR)
• Value-at-risk (VAR) is a category of risk measures that describe
probabilistically the market risk of mostly a trading portfolio.
• It summarizes the predicted maximum loss (or worst loss) over a

target horizon within a given confidence interval.
• If the portfolio return is normally distributed, has zero mean, and

has volatility σ over the measurement period, the 5 percent VAR
of the portfolio is:
VAR = 1.65 X s X Portfolio value

Example of VAR
• The US bank J.P. Morgan states in its 2000
annual report that its aggregate VAR is about
$22m.
• The bank, one of the pioneers in risk management,

may say that for 95 percent of the time it does not
expect to lose more than $22m on a given day.
More on VAR
• The main appeal of VAR was to describe risk in dollars - or
whatever base currency is used - making it far more transparent
and easier to grasp than previous measures.
• VAR also represents the amount of economic capital necessary to

support a business, which is an essential component of “economic
value added” measures.
• VAR has become the standard benchmark” for measuring financial

risk.
Instruments used in risk
management
• Forward contracts
• Futures contracts
• Hedging
• Interest rate futures contracts
• Duration hedging
• Swap contracts
• Options
Forward Contracts
• A forward contract specifies that a certain commodity will be
exchanged for another at a specified time in the future at
prices specified today.
• Its not an option: both parties are expected to hold up their end of the deal.
• If you have ever ordered a textbook that was not in stock, you have entered
into a forward contract.
Example
Suppose S&P index price is $1050 in 6 months. A

holder who entered a long position at a forward price of
$1020 is obligated to pay $1020 to acquire the index,
and hence earns $1050 - $1020 = $30 per unit of the
index. The short is likewise obligated to sell for $1020,
and thus loses $30.
Payoff after 6 months
If the index price in 6 months = $1020, both the long and short have a 0 payoff.
If the index price > $1020, the long makes money and the short loses money.
If the index price < $1020, the long loses money and the short makes money.
S&R Index S&R Forward

in 6 months long short
900 -$120 $120
950 -70 70
1000 -20 20
1020 0 0
1050 30 -30
1100 80 -80
Problem: The current S&P index is $1000. You have just
purchased a 6- month forward with a price of $1100. If
the index in 6 months has appreciated by 7%, what is
the payoff of this position?
Solution: F0=1100
S1=1000*1.07=1070
Payoff: 1070-1100= - $30.
Example: Valuing a Forward
Contract on a Share of Stock
Consider the obligation to buy a share of Microsoft stock one

year from now for $100. Assume that the stock currently sells
for $97 per share and that Microsoft will pay no dividends
over the coming year. One-year zero-coupon bonds that pay
$100 one year from now currently sell for $92. At what price
are you willing to buy or sell this obligation?
Valuing a forward contract
Strategy 1---- the forward contract
Today One year from now
Buy a forward contract Buy stock at a price of $100.

Sell the share for cash at market
Strategy 2 ---- the portfolio strategy

Today One year from now
Buy stock today Sell the stock

Sell short $100 in face value Buyback the zero-coupon
of 1-year zero-coupon bonds bonds of $100
Cost Cash flow one

Today year from now
Strategy 1 ? S1- $100

Strategy 2 $97-$92 S1- $100
Since strategies 1 and 2 have identical cash flows in the future,

they should have the same cost today to prevent arbitrage.
? = $97 - $92 = $5
In strategy 1, the obligation to buy the stock for $100 one year
from now, should cost $5.
The no-arbitrage value of a forward contract on a share of stock (the
obligation to buy a share of stock at a price of K, T years in the future),
assuming the stock pays no dividends prior to T, is
K
S0 −
where (1 + rf )T
S0 = current price of the stock
K
(1 + rf )T = the current market price of a default-free zero-coupon bond
paying K, T years in the future
At no arbitrage: S 0 − K
=0
(1 + rf ) T
F0 = K = S 0 (1 + rf ) T
Currency Forward Rates
• Currency forward rates are a variation on forward price of stock.
• In the absence of arbitrage, the forward currency rate F0 (for example,

Euros/dollar) is related to the current exchange rate (or spot rate) S0, by the
equation
F0 1 + rforeign
=
S 0 1 + rdomestic
• where r = the return (unannualized) on a domestic or foreign risk-free security
over the life of the forward agreement, as measured in the respective country's
currency
Forward Currency Rates
Example: The Relation Between Forward Currency Rates

and Interest Rates
Assume that six-month LIBOR on Canadian funds is 4 percent

and the US$ Eurodollar rate (six-month LIBOR on U.S. funds)
is 10 percent and that both rates are default free. What is the six-
month forward Can$/US$ exchange rate if the current spot rate
is Can$1.25/US$? Assume that six months from now is 182
days.
Currency Forward Rates
Answer: (LIBOR is a zero-coupon rate based on an
actual/360 day count.) So
Canada United States
Six-month interest 2.02% =

182
× 4% 5.06% =
182
×10%
Rate (unannualized): 360 360
The forward rate is Can$1.21 1.0202

= × 1.25.
US $ 1.0506
Futures Contracts: Preliminaries
• A futures contract is like a forward contract:

• It specifies that a certain commodity will be exchanged for another at
a specified time in the future at prices specified today.
• A futures contract is different from a forward:

• Futures are standardized contracts trading on organized exchanges
with daily resettlement (“marking to market”) through a
clearinghouse.
Futures Contracts: Preliminaries
• Standardizing Features:
• Contract Size
• Delivery Month
• Daily resettlement
• Minimizes the chance of default
• Initial Margin
• About 4% of contract value, cash or T-bills held in a
street name at your brokerage.
Daily Resettlement: An Example
Suppose you want to speculate on a rise in the $/¥ exchange
rate (specifically you think that the dollar will appreciate).
Currency per
U.S. $ equivalent U.S. $
W ed Tue W ed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159
Currently $1 = ¥140.
The 3-month forward price is $1=¥150.
• Currently $1 = ¥140 and it appears that the dollar is
strengthening.
• If you enter into a 3-month futures contract to sell ¥ at the
rate of $1 = ¥150 you will make money if the yen
depreciates. The contract size is ¥12,500,000
• Your initial margin is 4% of the contract value:
$1
$3,333.33 = .04 × ¥12,500,00 0 ×
¥150
If tomorrow, the futures rate closes at $1 = ¥149, then
your position’s value drops.
Your original agreement was to sell ¥12,500,000 and
receive $83,333.33:
$1
$83,333.33 = ¥12,500,00 0 ×
¥150
But ¥12,500,000 is now worth $83,892.62:
$1
$83,892.62 = ¥12,500,000 ×
¥149
You have lost $559.28 overnight.
• The $559.28 comes out of your $3,333.33 margin account,
leaving $2,774.05
• This is short of the $3,355.70 required for a new position.
$1
$3,355.70 = .04 × ¥12,500,00 0 ×
¥149
Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds or your position will be closed out.
This is usually done with a reversing trade.
Selected Futures Contracts
Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels Chicago BOT
Wheat 5,000 bushels Chicago & KC
Cocoa 10 metric tons CSCE
OJ 15,000 lbs. CTN
Metals & Petroleum
Copper 25,000 lbs. CMX
Gold 100 troy oz. CMX
Unleaded gasoline 42,000 gal. NYM
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Eurodollar $1 million LIFFE
Futures Markets
• The Chicago Mercantile Exchange (CME) is by far

the largest.
• Others include:
• The Philadelphia Board of Trade (PBOT)
• The MidAmerica Commodities Exchange
• The Tokyo International Financial Futures Exchange
• The London International Financial Futures Exchange
The Chicago Mercantile Exchange
• Expiry cycle: March, June, September, December.
• Delivery date 3rd Wednesday of delivery month.
• Last trading day is the second business day preceding
the delivery day.
• CME hours 7:20 a.m. to 2:00 p.m. CST.
CME After Hours
• Extended-hours trading on GLOBEX runs from 2:30 p.m. to

4:00 p.m dinner break and then back at it from 6:00 p.m. to
6:00 a.m. CST.
• Singapore International Monetary Exchange (SIMEX) offer
interchangeable contracts.
• There’s other markets, but none are close to CME and
SIMEX trading volume.
Wall Street Journal Futures Price Quotes
Highest price that day Lifetime Open
Open High Low Settle Change High Low Interest
Highest and lowest prices over the lifetime of the contract.
Corn (CBT) 5,000 bu.; cents per bu.
July 179 180 178¼ 178½ -1½ 312 177 2,837
Sept 186 186½ 184 186 -¾ 280 184 104,900
Dec 196 197 194 196½ -¼ 291¼ 194 175,187
TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

Sept 117-05 117-21 116-27 117-05 +5 131-06 111-15 647,560
Dec 116-19 117-05 116-12 116-21 +5 128-28 111-06 13,857
Opening price Closing price Daily Change
DJ INDUSTRIAL AVERAGE (CBOT) - $10 times average
Sept 11200 11285 11145 11241 -17 11324 7875 18,530
Dec 11287 11385 11255 11349 -17 11430 7987 1,599
Lowest price that day
Number of open contracts
Expiry month
Basic Currency Futures Relationships
• Open Interest refers to the number of contracts outstanding

for a particular delivery month.
• Open interest is a good proxy for demand for a contract.
• Some refer to open interest as the depth of the market. The
breadth of the market would be how many different contracts
(expiry month, currency) are outstanding.
Hedging
• Two counterparties with offsetting risks can eliminate
risk.
• For example, if a wheat farmer and a flour mill enter into a forward
contract, they can eliminate the risk each other faces regarding the future
price of wheat.
• Hedgers can also transfer price risk to speculators and

speculators absorb price risk from hedgers.
• Speculating: Long vs. Short
Hedging and Speculating Example
You speculate that copper will go up in price, so you go long 10 copper
contracts for delivery in 3 months. A contract is 25,000 pounds in cents
per pound and is at $0.70 per pound or $17,500 per contract.
If futures prices rise by 5 cents, you will gain:

Gain = 25,000 × .05 × 10 = $12,500
If prices decrease by 5 cents, your loss is:

Loss = 25,000 × -.05 × 10 = -$12,500
Hedging: How many contacts?
You are a farmer and you will harvest 50,000 bushels of corn in
3 months. You want to hedge against a price decrease. Corn
is quoted in cents per bushel at 5,000 bushels per contract. It
is currently at $2.30 cents for a contract 3 months out and the
spot price is $2.05.
To hedge you will sell 10 corn futures contracts:

50,000 bushels
= 10 contracts
5,000 bushels per contract
Now you can quit worrying about the price of corn

and get back to worrying about the weather.
Interest Rate Futures
Contracts
Pricing of Treasury Bonds
Consider a Treasury bond that pays a semiannual coupon of $C
for the next T years:
• The yield to maturity is r
C C C C+F
…
0 1 2 3
2T
Value of the T-bond under a flat term structure
= PV of face value + PV of coupon payments
F C 1 
PV = + 1 −
(1 + r ) T
r  (1 + r )T 
Pricing of Treasury Bonds
If the term structure of interest rates is not flat, then
we need to discount the payments at different rates
depending upon maturity
C C C C+F
…
0 1 2 3
2T
= PV of face value + PV of coupon payments
C C C C+F
PV = + + ++
(1 + r1 ) (1 + r2 ) (1 + r3 )
2 3
(1 + r2T ) T
Pricing of Forward Contracts
An N-period forward contract on that T-Bond
− Pforward C C C C+F
…
0 N N+1 N+2 N+3 N+2T
Can be valued as the present value of the forward price.
Pforward
PV =
(1 + rN ) N
C C C C+F
+ + ++
(1 + rN +1 ) (1 + rN + 2 ) (1 + rN +3 )
2 3
(1 + rN + 2T )T
PV =
(1 + rN ) N
Futures Contracts
• The pricing equation given above will be
a good approximation.
• The only real difference is the daily
resettlement.
Hedging in Interest Rate Futures
• A mortgage lender who has agreed to loan money in the

future at prices set today can hedge by selling those
mortgages forward.
• It may be difficult to find a counterparty in the forward who
wants the precise mix of risk, maturity, and size.
• It’s likely to be easier and cheaper to use interest rate futures
contracts however.
Duration Hedging
• As an alternative to hedging with futures or forwards,

one can hedge by matching the interest rate risk of
assets with the interest rate risk of liabilities.
• Duration is the key to measuring interest rate risk.
Duration Hedging
• Duration measures the combined effect of maturity,
coupon rate, and YTM on bond’s price sensitivity
• Measure of the bond’s effective maturity
• Measure of the average life of the security
• Weighted average maturity of the bond’s cash flows
Duration Formula
PV (C1 ) ×1 + PV (C2 ) × 2 +  + PV (CT ) × T
D=
PV
N
Ct × t
∑ (1 + r ) t
D = tN=1
Ct
∑
t =1 (1 + r )
t
Calculating Duration
Calculate the duration of a three-year bond that
pays a semi-annual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually?
Calculating Duration
Discount Present Years x PV
Years Cash flow factor value / Bond price
0.5 $40.00 0.96154 $38.46 0.0192

1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Duration is expressed in units of time; usually years.
Duration
The key to bond portfolio management

• Properties:
• Longer maturity, longer duration
• Duration increases at a decreasing rate
• Higher coupon, shorter duration
• Higher yield, shorter duration
• Zero coupon bond: duration = maturity
Swaps Contracts: Definitions
• In a swap, two counterparties agree to a contractual

arrangement wherein they agree to exchange cash flows at
periodic intervals.
• There are two types of interest rate swaps:
• Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
• Cross-Currency interest rate swap
• This is often called a currency swap; fixed for fixed rate debt service in two (or
more) currencies.
The Swap Bank
• A swap bank is a generic term to describe a financial
institution that facilitates swaps between counterparties.
• The swap bank can serve as either a broker or a dealer.
• As a broker, the swap bank matches counterparties but does not assume any of the
risks of the swap.
• As a dealer, the swap bank stands ready to accept either side of a currency swap,
and then later lay off their risk, or match it with a counterparty.
An Example of an Interest Rate Swap
• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank located in the U.K.
and wishes to raise $10,000,000 to finance floating-rate
Eurodollar loans.
• Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent.
• It would make more sense to for the bank to issue floating-rate notes at LIBOR
to finance floating-rate Eurodollar loans.
• Firm B is a BBB-rated U.S. company. It needs

$10,000,000 to finance an investment with a five-year
economic life.
• Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at
11.75 percent.
• Alternatively, firm B can raise the money by issuing 5-year floating-rate
notes at LIBOR + ½ percent.
• Firm B would prefer to borrow at a fixed rate.
The borrowing opportunities of the two firms are:

COMPANY B BANK A
Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR
Swap The swap bank makes

this offer to Bank A:
Bank You pay LIBOR – 1/8 %
10 3/8%
per year on $10 million
LIBOR – 1/8% for 5 years and we will
Bank pay you 10 3/8% on $10
million for 5 years
A
COMPANY B BANK A
½% of $10,000,000 =
$50,000. That’s quite
Swap Here’s what’s in it for Bank A:
a cost savings per
They can borrow externally at
year for 5 years.
Bank 10% fixed and have a net
10 3/8% borrowing position of
LIBOR – 1/8% -10 3/8 + 10 + (LIBOR – 1/8) =

Bank LIBOR – ½ % which is ½ %
10% better than they can borrow
A floating without a swap.
COMPANY B BANK A
The swap bank
makes this offer to
Swap
company B: You
pay us 10½% per Bank
year on $10 million 10 ½%
for 5 years and we LIBOR – ¼%
will pay you Company
LIBOR – ¼ % per
year on $10 million B
for 5 years.
COMPANY B BANK A
Here’s what’s in it for B:
½ % of $10,000,000 =
Swap $50,000 that’s quite a
cost savings per year for
Bank
5 years.
They can borrow externally at 10 ½%
LIBOR + ½ % and have a net LIBOR – ¼%
borrowing position of Company LIBOR

+ ½%
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% B
which is ½% better than they can borrow floating.
COMPANY B BANK A
The swap bank makes money too. ¼% of $10 million
Swap = $25,000 per year
for 5 years.
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
A 10 ½ - 10 3/8 = 1/8 B
¼
COMPANY B BANK A
The swap bank makes ¼%
Swap
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
A B
A saves ½% B saves ½%
COMPANY B BANK A
An Example of a Currency Swap
• Suppose a U.S. MNC wants to finance a £10,000,000
expansion of a British plant.
• They could borrow dollars in the U.S. where they are well
known and exchange for dollars for pounds.
• This will give them exchange rate risk: financing a sterling project with
dollars.
• They could borrow pounds in the international bond market,
but pay a premium since they are not as well known abroad.
• If they can find a British MNC with a mirror-
image financing need they may both benefit
from a swap.
• If the spot exchange rate is S0($/£) = $1.60/£,
the U.S. firm needs to find a British firm
wanting to finance dollar borrowing in the
amount of $16,000,000.
Consider two firms A and B: firm A is a U.S.–based

multinational and firm B is a U.K.–based multinational.
Both firms wish to finance a project in each other’s country of
the same size. Their borrowing opportunities are given in the
table below. $ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
$ £
Company B 10.0% 12.0%
A’s net position is to borrow at £11%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
A saves £.6%
$ £
Company B 10.0% 12.0%
B’s net position is to borrow at $9.4%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
$ £ B saves $.6%
Company B 10.0% 12.0%
The swap bank makes money too: 1.4% of $16 million
Swap financed with 1% of
£10 million per year
Bank
$8% $9.4%
for 5 years.
£11% £12%
$8% Firm At S0($/£) = $1.60/£, that Firm £12%
A is a gain of $124,000 per B
year for 5 years. The swap bank
$ £ faces exchange rate
Company A 8.0% 11.6% risk, but maybe
Company B 10.0% 12.0% they can lay it off
(in another swap).
Variations of Basic Swaps
• Currency Swaps
• fixed for fixed
• fixed for floating
• floating for floating
• amortizing
• Interest Rate Swaps

• zero-for floating
• floating for floating
• Exotica
• For a swap to be possible, two humans must like the idea. Beyond that,
creativity is the only limit.
Risks of Interest Rate and
Currency Swaps
• Interest Rate Risk
• Interest rates might move against the swap bank after it has only gotten half of
a swap on the books, or if it has an unhedged position.
• Basis Risk
• If the floating rates of the two counterparties are not pegged to the same index.
• Exchange Rate Risk

• In the example of a currency swap given earlier, the swap bank would be
worse off if the pound appreciated.
Risks of Interest Rate and
Currency Swaps
• Credit Risk
• This is the major risk faced by a swap dealer—the risk that a counter party will
default on its end of the swap.
• Mismatch Risk
• It’s hard to find a counterparty that wants to borrow the right amount of money for
the right amount of time.
• Sovereign Risk
• The risk that a country will impose exchange rate restrictions that will interfere with
performance on the swap.
Pricing a Swap
• A swap is a derivative security so it can be priced in
terms of the underlying assets:
• How to:
• Plain vanilla fixed for floating swap gets valued just like a bond.
• Currency swap gets valued just like a nest of currency futures.

Options
• Many corporate securities are similar to the stock options
that are traded on organized exchanges.
• Almost every issue of corporate stocks and bonds has
option features.
• In addition, capital structure and capital budgeting
decisions can be viewed in terms of options.
Options Contracts: Preliminaries
• An option gives the holder the right, but not the obligation, to
buy or sell a given quantity of an asset on (or perhaps before) a
given date, at prices agreed upon today.
• Calls versus Puts
• Call options gives the holder the right, but not the obligation, to buy a
given quantity of some asset at some time in the future, at prices agreed
upon today. When exercising a call option, you “call in” the asset.
• Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you “put” the asset to someone.
• Exercising the Option
• The act of buying or selling the underlying asset through the option contract.
• Strike Price or Exercise Price

• Refers to the fixed price in the option contract at which the holder can buy or
sell the underlying asset.
• Expiry
• The maturity date of the option is referred to as the expiration date, or the
expiry.
• European versus American options
• European options can be exercised only at expiry.
• American options can be exercised at any time up to expiry.
• In-the-Money
• The exercise price is less than the spot price of the underlying asset.
• At-the-Money
• The exercise price is equal to the spot price of the underlying asset.
• Out-of-the-Money
• The exercise price is more than the spot price of the underlying asset.
• Intrinsic Value
• The difference between the exercise price of the option and the spot price of
the underlying asset.
• Speculative Value
• The difference between the option premium and the intrinsic value of the
option.
Option Intrinsic + Speculative

=
Premium Value Value
Call Options
• Call options gives the holder the right, but not the obligation,
to buy a given quantity of some asset on or before some time
in the future, at prices agreed upon today.
• When exercising a call option, you “call in” the asset.
Basic Call Option Pricing
Relationships at Expiry
• At expiry, an American call option is worth the same as a
European option with the same characteristics.
• If the call is in-the-money, it is worth ST - E.
• If the call is out-of-the-money, it is worthless.
CaT = CeT = Max[ST - E, 0]
• Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
CaT is the value of an American call at expiry
CeT is the value of a European call at expiry
Call Option Payoffs
60
40 Buy a call
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)
-40
-60
Exercise price = $50

Call Option Payoffs
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)

Write a call
-40
-60

Call Option Profits
60
40
Buy a call
Option profits ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)

Write a call
-40
-60
Exercise price = $50; option premium = $10

Put Options
• Put options gives the holder the right, but
not the obligation, to sell a given quantity of
an asset on or before some time in the
future, at prices agreed upon today.
• When exercising a put, you “put” the asset
to someone.
Basic Put Option Pricing
Relationships at Expiry
• At expiry, an American put option is worth
the same as a European option with the
same characteristics.
• If the put is in-the-money, it is worth E - ST.
• If the put is out-of-the-money, it is
worthless.
PaT = PeT = Max[E - ST, 0]
Put Option Payoffs
60
40 Buy a put
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-40
-60

Put Option Payoffs
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-40 write a put
-60

Put Option Profits
Option profits ($)
60
40
20 Write a put
10
0
0 10 20 30 40 50 60 70 80 90 100
-10
Buy a put
-20 Stock price ($)
-40
-60
Exercise price = $50; option premium = $10

Selling Options
• The seller (or writer) of an • The purchaser of an option
option has an obligation. has an option.
profits ($)
60
40
Buy a call
Option profitsOption
($)
20 Write a put
10
0
0 10 20 30 40 50 60 70 80 90 100
-10
Buy a put
-20 Stock price ($)
Write a call
-40
-60
Reading The Wall Street Journal
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
This option has a strike price of $135;
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
a recent price for the stock is $138.25
July is the expiration month
This makes a call option with this exercise price in-the-
money by $3.25 = $138¼ – $135.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Puts with this exercise price are out-of-the-money.

--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,365 call options with this exercise price were
traded.
The CALL option with a strike price of $135 is trading for
$4.75.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,431 put options with this exercise price were
traded.
The PUT option with a strike price of $135 is trading for
$.8125.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions.
Combinations of Options
• Puts and calls can serve as the building
blocks for more complex option contracts.
• If you understand this, you can become a
financial engineer, tailoring the risk-return
profile to meet your client’s needs.
Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Value at
Protective Put strategy has
expiry
downside protection and
upside potential
$50
Buy the Buy a put with an exercise

stock price of $50
$0
Value of
$50
stock at
expiry
Protective Put Strategy Profits
Value at
expiry
$40 Buy the stock at $40
Protective Put
strategy has
downside protection
and upside potential
$0
Buy a put with

$40 $50 exercise price of
$50 for $10
-$40
Value of
stock at
expiry
Covered Call Strategy
Value at
expiry
$40 Buy the stock at $40
Covered call
$10
$0
Value of stock at expiry
$30 $40 $50
-$30 Sell a call with
-$40 exercise price of
$50 for $10
Long Straddle: Buy a Call and a Put
Value at
expiry
Buy a call with an
$40
exercise price of
$30 $50 for $10
$0
-$10
Buy a put with an
-$20
$30 $40 $50 $60 $70 exercise price of
$50 for $10
Value of
stock at
A Long Straddle only makes money if the
expiry
stock price moves $20 away from $50.
Short Straddle: Sell a Call and a Put
Value at
expiry
A Short Straddle only loses money if the stock

price moves $20 away from $50.
$20
Sell a put with exercise price of
$10 $50 for $10
$0
Value of stock at
expiry
$30 $40 $50 $60 $70
-$30
Sell a call with an
-$40 exercise price of $50 for $10
Long Call Spread
Value at
expiry Buy a call with an
exercise price of
$50 for $10
$5 long call spread

$0
-$5
-$10 Value of
stock at
$50 $60 expiry
$55
Sell a call with exercise
price of $55 for $5
Put-Call Parity
In market equilibrium, it mast be the case that option prices
− rT
are set such that: C0 + Xe = P0 + S0
Otherwise, riskless portfolios with positive payoffs exist.
Buy the
Value at Buy the stock at $40 stock at $40
expiry financed with some
Buy a call option with debt: FV = $X
an exercise price of $40
P0
Sell a put with an
$0 exercise price of $40
− C0
-[$40-P0] $40 $40 + C0 Value of
− rT
$40-P0 stock at
− ($40 − Xe )
-$40 $40 − Xe − rT expiry
Valuing Options
• The last section • This section considers
concerned itself with the the value of an option
value of an option at prior to the expiration
expiry. date.
• A much more
interesting question.
Option Value Determinants
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate + –
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option C0 must fall within

max (S0 – E, 0) < C0 < S0.
The precise position will depend on these factors.
Market Value, Time Value and Intrinsic Value for
an American Call
The value of a call option C0 must fall within
Profit max (S0 – E, 0) < C0 < S0.
ST
-E
ST
CaT > Max[ST - E, 0]
Market Value
Time value
Intrinsic value
E ST
loss Out-of-the-money In-the-money
An Option‑Pricing Formula
• We will start with a • Then we will graduate

binomial option pricing to the normal
approximation to the
formula to build our
binomial for some real-
intuition. world option valuation.
Binomial Option Pricing Model
Suppose a stock is worth $25 today and in one period will either be worth 15% more
or 15% less. S0= $25 today and in one year S1is either $28.75 or $21.25. The risk-free
rate is 5%. What is the value of an at-the-money call option?
S0 S1
$28.75
$25
$21.25
1. A call option on this stock with exercise price of $25 will have the
following payoffs.
2. We can replicate the payoffs of the call option. With a levered position in
the stock.
S0 S1 C1
$28.75 $3.75
$25
$21.25 $0
Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either $7.50
or $0.
The levered equity portfolio has twice the option’s payoff so the portfolio is
worth twice the call option value.
S0 ( S1 - debt ) = portfolio C1
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
The levered equity portfolio value today is
today’s value of one share less the present
value of a $21.25 debt: $21.25
$25 −
(1 + rf )
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
We can value the option today as half of the 1  $21.25 
C0 = $25 −
value of the levered equity portfolio:
2  (1 + rf ) 
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
The Binomial Option Pricing Model
If the interest rate is 5%, the call is worth:
1 $21.25  1
C0 =  $25 −  = ( $25 − 20.24 ) = $2.38
2 (1.05)  2
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
The Binomial Option Pricing Model
If the interest rate is 5%, the call is worth:
1 $21.25  1
C0 =  $25 −  = ( $25 − 20.24 ) = $2.38
2 (1.05)  2
S0 C0 ( S1 - debt ) = portfolio C1
$28.75 - $21.25 = $7.50 $3.75
$25 $2.38
$21.25- $21.25 = $0 $0
The most important lesson (so far) from the binomial
option pricing model is:
the replicating portfolio intuition.

Many derivative securities can be valued by
valuing portfolios of primitive securities
when those portfolios have the same
payoffs as the derivative securities.
The Risk-Neutral Approach to Valuation
S(U), V(U)
q
S(0), V(0)
1- q
S(D), V(D)
We could value V(0) as the value of the replicating portfolio.
An equivalent method is risk-neutral valuation
q × V (U ) + (1 − q ) × V ( D)
V ( 0) =
(1 + rf )
The Risk-Neutral Approach to Valuation
S(U), V(U)
q
q is the risk-neutral
probability of an “up”
S(0), V(0)
move.
1- q
S(0) is the value of the S(D), V(D)
underlying asset today.
S(U) and S(D) are the values of the asset in the next
period following an up move and a down move,
respectively.
V(U) and V(D) are the values of the asset in the next period following an
up move and a down move, respectively.
The Risk-Neutral Approach to
Valuation S(U), V(U)
q
q × V (U ) + (1 − q ) × V ( D)
S(0), V(0)
V ( 0) =
(1 + rf )
1- q
S(D), V(D)
• The key to finding q is to note that it is already impounded into

an observable security price: the value of S(0):
q × S (U ) + (1 − q ) × S ( D)
S ( 0) =
(1 + rf )
(1 + rf ) × S (0) − S ( D )
A minor bit of algebra yields: q =
S (U ) − S ( D)
Example of the Risk-Neutral Valuation of a Call:
Suppose a stock is worth $25 today and in one period will either
be worth 15% more or 15% less. The risk-free rate is 5%. What
is the value of an at-the-money call option?
The binomial tree would look like this:
$28.75 = $25 × (1.15)
q $28.75,C(D)
$25,C(0) $21.25 = $25 × (1 − .15)
1- q
$21.25,C(D)
The next step would be to compute the risk neutral

probabilities
(1 + r f ) × S (0) − S ( D)
q=
S (U ) − S ( D)
(1.05) × $25 − $21.25 $5

q= = =2 3
$28.75 − $21.25 $7.50
2/3 $28.75,C(D)
$25,C(0)
1/3
$21.25,C(D)
After that, find the value of the call in the up state and down state.
C (U ) = $28.75 − $25
2/3 $28.75, $3.75
$25,C(0) C ( D) = max[$25 − $28.75,0]
1/3
$21.25, $0
Finally, find the value of the call at time 0:

q × C (U ) + (1 − q ) × C ( D )
C ( 0) =
(1 + rf )
2 3 × $3.75 + (1 3) × $0
C ( 0) =
(1.05)
C ( 0) =
$2.50
= $2.38 2/3 $28.75,$3.75
(1.05)
$25,$2.38
$25,C(0)
1/3
$21.25, $0
Risk-Neutral Valuation and the Replicating Portfolio
This risk-neutral result is consistent with valuing the

call using a replicating portfolio.
2 3 × $3.75 + (1 3) × $0 $2.50
C0 = = = $2.38
(1.05) 1.05
1 $21.25  1
C0 =  $25 −  = ( $25 − 20.24 ) = $2.38
2 (1.05)  2
The Black-Scholes Model
The Black-Scholes Model is
C0 = S × N(d1 ) − Ee − rT × N(d 2 )
Where
C0 = the value of a European option at time t = 0
r = the risk-free interest rate.
σ2 N(d) = Probability that a
ln(S / E ) + (r + )T
2 standardized, normally
d1 =
σ T distributed, random
variable will be less than
d 2 = d1 − σ T or equal to d.
The Black-Scholes Model allows us to value options in the
real world just as we have done in the 2-state world.
Find the value of a six-month call option on the Microsoft with an
exercise price of $150
The current value of a share of Microsoft is $160
The interest rate available in the U.S. is r = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the option is $10—
our answer must be at least that amount.
Let’s try our hand at using the model. If you have a calculator handy,
follow along.
First calculate d1 and d2
ln( S / E ) + (r + .5σ 2 )T
d1 =
σ T
ln(160 / 150) + (.05 + .5(0.30) 2 ).5
d1 = = 0.5282
0.30 .5
Then,
d 2 = d1 − σ T = 0.52815 − 0.30 .5 = 0.31602
C0 = S × N(d1 ) − Ee − rT × N(d 2 )
d1 = 0.5282 N(d1) = N(0.52815) = 0.7013

d 2 = 0.31602 N(d2) = N(0.31602) = 0.62401
C0 = $160 × 0.7013 − 150e −.05×.5 × 0.62401

C0 = $20.92
Another Black-Scholes Example
Assume S = $50, X = $45, T = 6 months, r = 10%,
and σ = 28%, calculate the value of a call and a put.
( )
 
2
50 0.28
ln +  0.10 − 0 +  0.50
45  2 
d1 = = 0.884
0.28 0.50
d 2 = 0.884 − 0.28 0.50 = 0.686

From a standard normal probability table, look up N(d1) =
0.812 and N(d2) = 0.754 (or use Excel’s “normsdist” function)
C = 50 e −0 ( 0.5) (0.812) − 45 e −0.10( 0.50) (0.754) = $8.32
P = $8.32 − $50 + $45e −0.10( 0.50 ) = $1.125

Stocks and Bonds as Options
• Levered Equity is a Call Option.
• The underlying asset comprise the assets of the firm.
• The strike price is the payoff of the bond.
• If at the maturity of their debt, the assets of the firm are greater
in value than the debt, the shareholders have an in-the-money
call, they will pay the bondholders and “call in” the assets of the
firm.
• If at the maturity of the debt the shareholders have an out-of-the-
money call, they will not pay the bondholders (i.e. the
shareholders will declare bankruptcy) and let the call expire.
• Levered Equity is a Put Option.
• The underlying asset comprise the assets of the firm.
• The strike price is the payoff of the bond.
• If at the maturity of their debt, the assets of the firm are less in
value than the debt, shareholders have an in-the-money put.
• They will put the firm to the bondholders.
• If at the maturity of the debt the shareholders have an out-of-
the-money put, they will not exercise the option (i.e. NOT
declare bankruptcy) and let the put expire.
• It all comes down to put-call parity.
−rT
C0 = S + P0 − X e
Value of a Value of a Value of a
call on the
Value of risk-free
= the firm + put on the –
firm firm bond
Stockholder’s Stockholder’s
position in terms position in terms
of call options of put options
Capital-Structure Policy and Options
• Recall some of the agency costs of debt:

they can all be seen in terms of options.
• For example, recall the incentive
shareholders in a levered firm have to take
large risks.
Balance Sheet for a Company in Distress
Assets BVMVLiabilities BVMV

Cash $200$200LT bonds $300?
Fixed Asset $400$0Equity $300 ?
Total $600$200Total $600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.

Selfish Strategy 1: Take Large Risks
(Think of a Call Option)
The Gamble Probability Payoff

Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)

Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
$100
NPV = −$200 +
1.50
NPV = −$133
Selfish Stockholders Accept Negative NPV Project with
Large Risks
• Expected cash flow from the Gamble

• To Bondholders = $300 × 0.10 + $0 = $30
• To Stockholders = ($1000 - $300) × 0.10 + $0 = $70
• PV of Bonds Without the Gamble = $200
• PV of Stocks Without the Gamble = $0
• PV of Bonds With the Gamble = $30 / 1.5 = $20
• PV of Stocks With the Gamble = $70 / 1.5 = $47
The stocks are worth more with the high risk project because
the call option that the shareholders of the levered firm hold
is worth more when the volatility is increased.
Mergers and Options
• This is an area rich with optionality, both
in the structuring of the deals and in their
execution.
Investment in Real Projects & Options
• Classic NPV calculations typically ignore

the flexibility that real-world firms typically
have.
• The next chapter will take up this point.
Summary and Conclusions
• The most familiar options are puts and calls.
• Put options give the holder the right to sell stock at a set
price for a given amount of time.
• Call options give the holder the right to buy stock at a set
price for a given amount of time.
• Put-Call parity −rT
C0 + X e = S + P0
Summary and Conclusions
• The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
• Much of corporate financial theory can be presented in
terms of options.
1. Common stock in a levered firm can be viewed as a call option on the assets
of the firm.
2. Real projects often have hidden option that enhance value.

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Risk Management

Dr. Keith M. Howe

Risk and uncertainty

The process of formulating the benefit-cost

Risky Upside Inc. price

Panel A. Gain frombuyingshares of Risky

Panel B. Gainfrombuying acall option on

Panel A. Income to Garman if it does not hedge.

$0.9 Forward rate $1

Panel B. Forward contract payoff.

Forw ard rate $1

Panel C. Hedged firm income.

• This proposition holds when financial markets are perfect.

• Allows us to find out when homemade risk management is not equivalent to

• For risk management to increase firm value, it must be more expensive to

• Indirect bankruptcy costs

C ash flow to shareholders

C ash flow to the

Unhedged cash flow

$350M (gold sold at forward)

Cash flow to claimholders

Cash flow to the

Gain from risk management

Value of firm unhedged + gain from risk management

= value of firm hedged

- Carrybacks and carryforwards

• The optimal capital structure of a firm:

• Through risk management:

• Large undiversified shareholders can increase firm value

After tax cash flow of hedged

Source: Riskmetrics Group (www.riskmetrics.com)

Market risk Hazard risk

Operational risk Strategic risk

Market risk Hazard risk Operational risk

Hedgeable Insurable Diversifiable

• It summarizes the predicted maximum loss (or worst loss) over a

• If the portfolio return is normally distributed, has zero mean, and

VAR = 1.65 X s X Portfolio value

• The bank, one of the pioneers in risk management,

• VAR also represents the amount of economic capital necessary to

• VAR has become the standard benchmark” for measuring financial

Suppose S&P index price is $1050 in 6 months. A

S&R Index S&R Forward

Consider the obligation to buy a share of Microsoft stock one

Buy a forward contract Buy stock at a price of $100.

Strategy 2 ---- the portfolio strategy

Buy stock today Sell the stock

Cost Cash flow one

Strategy 1 ? S1- $100

Since strategies 1 and 2 have identical cash flows in the future,

• In the absence of arbitrage, the forward currency rate F0 (for example,

Example: The Relation Between Forward Currency Rates

Assume that six-month LIBOR on Canadian funds is 4 percent

Canada United States

Six-month interest 2.02% =

The forward rate is Can$1.21 1.0202

• A futures contract is like a forward contract:

• A futures contract is different from a forward:

• The Chicago Mercantile Exchange (CME) is by far

• Extended-hours trading on GLOBEX runs from 2:30 p.m. to

TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

• Open Interest refers to the number of contracts outstanding