Risk Management
S ANA TAUSEEF
Outline
Reasons for risk management
Types of risks and risk responses
Role of Derivative instruments in risk hedging
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Why firms manage their risks?
Decreases Reduces Increases Reduces
volatility of financial debt borrowing
cash flows risk capacity rate
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Risk Responses
01 02 03 04 05
Totally avoid Reduce Reduce Transfer risk Accept the
activity that probability of magnitude of to a third risk
gives rise to occurrence of loss party
risk an adverse associated
event with an
adverse event
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Types of Risks
Commodity price risk
Foreign exchange risk
Interest rate risk
Project selection risk
Credit risk
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Derivatives and Risk Hedging
◦ Financial instruments that derive their values from the performance
of underlying assets.
◦ Underlying assets are basic assets trading in cash markets like equity,
fixed-income, currency, and commodity.
Four basic derivatives are:
Forwards (forward commitment)
Futures (forward commitment)
Options (contingent claim)
Swaps (forward commitment)
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Forward Contracts
◦ Over-the-counter contract to buy/sell an underlying asset at a
future date at a pre-specified price.
◦ A forward commitment, each party agrees that it will fulfill its
responsibility at the designated future date.
A party with a short position in the forward contract has an obligation to sell
the underlying asset at the pre-specified price in the future.
A party with a long position in the forward contract has an obligation to buy
the underlying asset at the pre-specified price in the future.
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Forward Contract
These are customized contracts; hence each contract is unique
in terms of contract size, expiration date, asset quality and type.
There is no middle party or intermediary, hence these bilateral
contracts are exposed to counterparty risk.
Settlement (physical or in cash) takes place at the end of the
contract period only.
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Future Contracts
They are same as forwards but:
Traded on exchange and daily settlement of gains and losses
Parties entering into the contract do not need to know each other
Liquidity provided by market makers
The contract terms are standardized
Quantity and quality of underlying asset
Month of delivery
Delivery and settlement conditions
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Example 1: Risk Hedging using futures
In January 2023, Company A- must pay £1 million in September for imports from Britain and
Company B- will receive £3 million in September from exports to Britain
Current exchange rate 1.2234
September futures price 1.2269
Size of futures contract £62,500
Company A’s hedging strategy-Long position in 16 future contracts.
Company B’s hedging strategy-Short position in 48 futures contracts.
What if exchange rate increases to 1.2285 in September? Falls to 1.2240?
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Daily Settlement and Margins
Exchange ensures that neither party has an incentive to default on their contract.
This is done through:
◦ Initial margin requirement: Both the long and the short parties must deposit
money in their brokerage accounts.
◦ Marking to market: At the end of each trading day, gain is added or loss is
subtracted from the parties’ brokerage accounts so as to offset the change in the
futures price.
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Daily Settlement and Margins
Maintenance margin requirement: Investors are required to have a minimum
balance in their margin accounts at the end of each day.
Margin Call: If the margin account balance falls below the maintenance margin
requirement, then a margin call is triggered and the investor is required to bring
the account balance back to the initial margin amount.
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Example 2
On March 1, 2022, Mr. X buys a December gold future contract at a future price of $1,910 per
ounce. The contract size is 100 ounces of gold, the initial margin is $10,000 per contract and the
maintenance margin is $7,500 per contract. On the same day Mr. Y sells a December gold
contract at price of $1,910 per ounce. Calculate the margin account balance for each trader at
the end of each of the five trading days (include the margin call if required).
Date Closing Price
March 1 1,915
March 2 1,918
March 3 1,930
March 4 1,938
March 5 1,927
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Swaps: Main Features
A forward commitment-two parties agree to exchange cash flows at
periodic intervals
One party pays a variable series that is determined by an underlying asset
or rate and other party pays either: (a) variable series determined by a
different underlying asset or rate or (b) fixed series
Better suited for risks that involve multiple payments-can be considered
as a series of forward contracts
OTC contract-privately negotiated and subject to default
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Example 3
Assume that a Savings and Loan Association has just loaned $1 million for 5 years at 12% with annual
payments and that it pays a deposit rate that equals LIBOR plus 1%. To avoid the interest rate risk, it enters
a swap with a swap dealer for 5 years where it pays 12% fix on the notional principal of $1 million and
receives floating rate of LIBOR plus 3%. Determine the net cash flow from year 1 through 5 for the Savings
and Loan Association if the one year LIBOR rates at respective time periods are:
YEAR 1-YEAR LIBOR
0 10
1 10
2 8
3 10
4 8
5 11
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Example 4
Assume that the dealer in the Example 3 knew of a potential party in the swap
market, Party A, which is willing to pay a floating rate of LIBOR plus 3.1% in
exchange for a fix rate of 12% on the notional principal of $1 million. However,
Party A is willing to accept the terms of only 3 years not 5 years that the dealer
desires. Determine the net cash flow for the dealer from year 1 through 5
assuming the LIBOR rates previously given.
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Options: Main Features
It is the right, not an obligation, to buy or sell an underlying asset at a future
date at a specified price; hence a contingent claim
Two option types:
Call Option: An option/right to buy an underlying asset a future date at a specified price
Put Option: An option/right to sell an underlying asset a future date at a specified price
Two option positions:
Long position: Buying an option/right
Short position: Selling an option/right means taking an obligation
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Options
Can be exercised by physical delivery or cash settlement
Option buyer (long party) pays a price (option premium) to the
option seller and gets the right
Option buyer will exercise the option/right when the price
movement is favorable for him, hence profits for buyer are
unlimited
If the price move is not favorable, buyer will not exercise the right
and it will expire worthless, hence incurs a loss (limited) equal to
the option price
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Options
Option seller or writer sells the right and receives the price or
option premium
Through selling the right, writer gets an obligation to fulfill the
contract if long party exercises it, hence the loss is unlimited
Only the short can default-if long exercises and the short fails to
do what it is supposed to do
In case the long party does not exercise the right, seller gets the
limited profit (equal to the option premium).
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Options: Four Strategies
1. Long call: Buying a right to buy
2. Short call: Selling a right to buy (taking an obligation to sell)
3. Long put: Buying a right to sell
4. Short put: Selling a right to sell (taking an obligation to buy)
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References
Brigham, E. F. & Ehrhardt, M. C. (2020). Financial Management.
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2012). Fundamentals of Corporate Finance. India:
McGraw Hill.
Fundamentals of Corporate Finance, Brealey Myers Marcus, 4th edition.
Corporate Finance. CFA-II Program Curriculum.
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