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UIUC FIN 321 - Managing Risk

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Managing RiskRisk and Discounted Cash FlowCertainty Equivalent MethodSlide 4ExampleCertainty Equivalent ProblemWhy Manage Diversifiable Risk?Reasons for Managing Diversifiable RisksTypes of RiskHazard RiskManaging Hazard RiskFinancial RiskFinancial Risk Management ToolboxForward ContractsForward Contract ExampleFutures ContractsWhat is the use of a futures contract?Differences between Forwards and FuturesFutures Contract ExampleSwap ContractsCurrency SwapOther SwapsCredit DerivativesOperational RiskStrategic RiskTraditional Approach to Risk ManagementERM ApproachWhat is Driving ERM?Next ClassManaging Risk•Certainty Equivalents•Why Manage Diversifiable Risk?•Types of Risk•Traditional Approach to Risk Management•Enterprise Risk ManagementRisk and Discounted Cash Flow•The risk-adjusted discount rate method discounts for time and risk simultaneously•Cannot handle situations where there is risk, but no time discountExample: Space launch coverage payable at time of launchCertainty Equivalent Method•Discounts separately–risk–time value of moneyPV = =nt=1Ct(1 + r)tCEQt(1 + rf)tnt=1Certainty Equivalent Method•Rather than discounting future cash flows by one risk-adjusted discount rate to account for both time and risk, reduce the future cash flow to account for risk and then discount that value for time at the risk-free rateExample•Risk-free rate is 5%•Investment will pay $1 million in two years•Appropriate risk-adjusted rate is 12%PV = = $797,1941,000,000(1.12)2PV =CEQ2(1.05)2CEQ2 = $878,906•The ratio of CEQ2 to C2 is 87.89%Certainty Equivalent Problem An 18th century ship-owner sends a vessel out on a 2-year voyage. The value of the cargo will not be known until it returns. The expected value of the cargo is $144,000. The present value of the voyage is $100,000. The risk-free rate is 5 percent.Why Manage Diversifiable Risk?•Based on the CAPM, investors are not willing to pay extra for companies that reduce risk that is not correlated with market risk•Based on the APM, investors are not willing to pay extra for companies that reduce risk that is not correlated with one of the priced “factors”•Risks such as fires, lawsuits, computer failures, employee embezzlement, or product failures are not likely tied to market risk or any macroeconomic factors•Why, then, do firms pay to manage these risks?Reasons for Managing Diversifiable Risks•Nonlinear tax structure–Firms with stable earnings pay less in taxes than firms with equal but variable earnings•Avoiding cash shortfalls–Missing positive NPV projects•Reducing the risk of financial distress–Bankruptcy is costly•Managerial self-interest–Manager compensation for potential unemployment–Rewarding managers appropriately•Other economic effects–Suppliers, customers, employeesTypes of RiskCommon risk allocation•Hazard risk•Financial risk•Operational risk•Strategic riskBank view – New Basel Accord•Credit risk –Loan and counterparty risk•Market risk (financial risk)•Operational riskHazard Risk•“Pure” loss situations•Property•Liability•Employee related•Independence of separate risks•Risks can generally be handled by–Insurance, including self insurance–Avoidance–TransferManaging Hazard Risk•Insurance–Policy terms and conditions–Premiums exceed expected losses•Administrative costs•Adverse selection•Moral hazard (and morale hazard)–Deductibles –Policy limits•Self insurance–Captives–Access to reinsurance marketFinancial Risk•Components–Foreign exchange rate–Equity–Interest rate–Commodity price•Correlations among different risks•Use of hedges, not insurance or risk transfer•SecuritizationFinancial Risk Management Toolbox•Forwards•Futures•Swaps•OptionsForward Contracts•A forward contract obligates one party to sell and another party to buy an asset•The exchange takes place in the future•The price is fixed today•No payment is made until maturity•The buyer has a gain if the asset value increases•The contract price is set at origination so that the value is zeroForward Contract Example•Airline agrees to buy a fuel commodity at a fixed price several months in future•When forward contract is established, airline then sets ticket prices for that period•Southwest Airlines hedges fuel prices more than any other airline•One reason – counterparty riskFutures Contracts•A future obligates one party to buy and another to sell a specified asset in the future at a price agreed on today•Futures are standardized contracts traded on organized exchanges•Price changes are settled each day•Margin accounts must maintainedWhat is the use of a futures contract?•Help reduce uncertainty in future spot price•Agricultural futures were one early contract–Farmer can lock in future price of corn before harvest (protect against drop in price)–User of corn can protect against rise in price•Futures are now available on many assets–Agricultural (corn, soybeans, wheat, etc.)–Financial (interest rates, FX, and equities)–Commodities (oil, gasoline, and metals)Differences between Forwards and Futures•Features reducing credit risk–Daily settlement or mark-to-market–Margin account–Clearinghouse•Features promoting liquidity–Contract standardization–Traded on organized exchangesFutures Contract Example•Firm sells (shorts) S&P 500 futures contracts for June 2007 representing a portion of its equity investments•As the S&P 500 index increases, the firm incurs a loss and has to mark its position to market each day, reducing the effect of the equity gain•If the S&P 500 index declines, the firm gains from the futures contract, offsetting some of its investment lossesSwap Contracts•An agreement between two parties to exchange (or swap) periodic cash flows•At each payment date, only the net value of cash flows is exchanged•The cash flows are based on a notional principal or notional amount•The notional amount is only used to determine the cash flowsCurrency Swap•On each settlement date, the US company pays a fixed foreign currency interest rate on a notional amount of another currency and receives a dollar amount of interest on a notional amount in dollars•Since the interest rate is fixed, the only change in value is due to change in FX rate•Using netting, only one party pays the difference between cash flow valuesOther Swaps•Currency-coupon or


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UIUC FIN 321 - Managing Risk

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