‡Classification of Risk ‡Measurement of risk in non financial firms ‡Principle of hedging ‡Hedging with Forward, Futures, Swap, Options Contracts, Insurance, Risk management products ‡Financial Engineering and Corporate Strategy ‡Risk management practices

CLASSIFICATION OF RISK The wide array of risks that a management firms exposed can be classified into 5 categories: 1. Financial Risks: arise from volatility of Interest rates. Legal and Regulatory risks: change in laws and regulations . currency rates. 4. Economic Risks: arise from fluctuations in the revenues(output price and demand) and production cost ( Raw material cost. 5. commodity prices and stock prices. Technological Risk: arise mostly in the R&D and Operations stage of the value chain. Performance risks: arise when contracting counterparties do not fulfill their obligations. energy cost and labor cost) 3. 2.

MEASUREMENT OF RISK IN NON FINANCIAL FIRMS To assess the Financial price risk we may: a) Examine the financial statements to get an idea of the risk exposure b) Assess the sensitivity of the firms value or cash flow to changes in the financial prices and c) Conduct monte carlo simulation. .

‡ What is the Foreign exchange transaction exposure? If the balances of receivables and payables are high. their values would change in response to shifts in the exchange rates. ‡ Does the firm have a low gearing ratio (leverage)? A low gearing ration provides greater financial flexibility to cope with volatility in financial prices. .EXAMINE THE FINANCIAL STATEMENTS Examining the Balance sheet and Profit & loss account throw light on a number of questions like: ‡ Does the firm have a strong liquidity position as per high Current ratio and Quick ratio? A strong liquidity position cushions against the volatility of cash flows caused by changes in Financial prices. ‡ Is the firm exposed to interest rate risk? If the firm relies mainly on free floating debt it has a high interest rate exposure.

ASSESS THE SENSITIVITY Determine the sensitivity of Firm·s Value or Cash Flow by: ‡ Analyzing the Historical data on firm value. ² The sensitivity of a firm·s value to exchange rate may be estimated as Firm Value = a + b Exchange rate . cash flows and financial prices e.g.

‡ The advantage of monte carlo methods over other techniques increases as the dimensions (sources of uncertainty) of the problem increase. . portfolios and investments by simulating the various sources of uncertainty affecting their value. and then determining their average value over the range of resultant outcomes.MONTE CARLO SIMULATION ‡ Monte carlo methods are used in finance to value and analyze (complex) instruments.

transactions known as ¶hedges·.PRINCIPLE OF HEDGING ‡ One way to manage these risks and uncertainties is to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity·s other risks and uncertainties. To secure a commodity price fixed against an external contract . relative to an organisation·s costs. ‡ There are predominantly two motivations for a company to hedge: To lock-in a future price which is attractive. ‡ The instrument acquired to offset risk or uncertainty is known as ¶hedging instrument· and the risk or uncertainty hedged is known as ¶hedged item·.

is paid before control of the instrument changes. in whatever form. ‡ The price of the underlying instrument.HEDGING WITH FORWARD CONTRACTS ‡ Forward contract is an OTC agreement between two parties. ‡ The forward price is commonly contrasted with the spot price. ‡ This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. generally considered in the form of a profit or loss. which is the price at which the asset changes hands on the spot date. to buy or sell an asset at a certain time in the future for a certain price. . ‡ The difference between the spot and the forward price is the forward premium or forward discount. by the purchasing party.

Futures contracts detail the quality and quantity of the underlying asset.HEDGING WITH FUTURE CONTRACTS What Does Futures Contract Mean? A contractual agreement. . generally made on the trading floor of a futures exchange. to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Some futures contracts may call for physical delivery of the asset. they are standardized to facilitate trading on a futures exchange. while others are settled in cash.

Bond market 4.TYPES OF FUTURE CONTRACTS There are many different kinds of futures contracts. Soft Commodities market . Equity market 5. securities (such as single-stock futures). reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities. Money market 3. 1. Foreign exchange market 2. currencies or intangibles such as interest rates and indexes.




These firms could swap to take advantage of the lower rates. one firm may have a lower fixed interest rate. while another has access to a lower floating interest rate. then a swap could benefit both firms.HEDGING WITH SWAPS What Does Swap Mean? If firms in separate countries have comparative advantages on interest rates. . For example.

TYPES OF SWAPS ‡ ‡ ‡ ‡ ‡ ‡ Interest rate swaps Currency swaps Commodity swaps Equity swap Credit default swaps Other variations .



REASON FOR SWAPS ‡ ‡ ‡ ‡ Spread compression Market segmentation Market saturation Difference in financial norms .

‡ In forward contract no money exchanges hands whereas in options the buyer of the contract pays option premium. Hedging with options:diagrams . but not the obligation.HEDGING WITH OPTION CONTRACTS An option contract is an agreement under which the seller of the option grants the buyer the right. to buy or sell(depending on whether it is a call option or a put option) some asset at a predetermined price during the specified period. The buyer of the option has to pay a premium to enjoy the right. Forward vs options: ‡ In forwards contract both parties agree to act in the future whereas in an option transaction occurs only if the buyer of the option chooses to exercise it.

OPTIONS IN DEBT CONTRACTS Imagine a firm going for a long term floating rate loan The risks involved are the interest rates rising sharply increasing the debt service burden .

HEDGING WITH INSURANCE Main advantages offered by Insurance companies: ‡ They can price the risks reasonably accurately ‡ Provides low cost administration service due to specialisation and economies of scale. ‡ Provides advice on measures to reduce risks ‡ Pools risks by holding large diversified pool of assets Disadvantages of Insurance: ‡ It incurs administrative costs ‡ Problem of adverse selection.diff between insurance premium and expected payoff. .cant differentiate between good and bad risks ‡ Exposed to problem of moral hazard ‡ Loading fee.

.TYPES OF OPTION CONTRACTS ‡ Option contract on debt instruments.options on treasury bill ‡ Option contract on foreign currencies² options with British pounds ‡ Option contract on stock market indices-option on S&P 500 index ‡ Option contract on stock index futures.

Real options‡ Diversify product line and services to reduce risks ‡ Invest in preventive maintenance ‡ Emphasise quality control to reduce product liability ‡ Build flexible production systems ‡ Shorten time to introduce product to market ‡ Delay investment until uncertainty is resolved ‡ Carry extra liquidity on the balance sheet to tide over difficult periods ‡ Maintain reserve borrowing power to meet contingencies. HEDGING WITH REAL TOOLS AND OPTIONS .

.REAL VS. FINANCIAL OPTIONS ‡ Real options cost a great deal. ‡ In some cases real options may be the only viable means to handle risks ‡ Real options are far less liquid ‡ Firm with real options may profit from assuming more risk ± a firm with flexible production facilities can benefit more by manufacturing products subject to high price volatility.

and commodity prices ‡ Increased global competition. exchange rates.EVOLUTION OF RISK MANAGEMENT TOOLS The financial and operating environment today is more riskier than in the past ² ‡ Substantial increase in the average rate as well as volatility of inflation ‡ Greater volatility in interest rates . .

currency options ‡ Interest rate volatility. futures.currency futures.futures in heating oil. options. T-Bond futures. option in WTI ‡ Metal price volatility. futures in WTI. ‡ Petroleum prices.fwds. hybrids. currency swaps.floating rate loans. caps floors and collars. T-Bill futures.hybrids. options on T-Bonds. .VOLATILITY AND RISK MANAGEMENT TOOLS: ‡ Exchange rate volatility.

RISK MANAGEMENT PRACTICES Corporate strategy ² bricks and mortar TVA .

GUIDELINES FOR RISK MANAGEMNET ‡ ‡ ‡ ‡ ‡ Align risk management with corporate strategy Proactively manage uncertainties Employ mix of real and financial methods Know the limits of risk management tools Don·t put undue pressure on corporate treasury to generate profits ‡ Learn when it is worth reducing risk .

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