Corporate Risk Management2

Chapter 20
Corporate Risk
Management
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives
1. Reasons to manage risk

2. Define risk management in the context of
the five-step risk management process.
3. Understand how insurance contracts can
be used to manage risk.
4. Use forward contracts to hedge
commodity price risk.

20-2
Learning Objectives (cont.)
5. Understand the advantages and

disadvantages of using exchange traded
futures and option contracts to hedge
price risk.
6. Understand how to value option and how
swaps work.

20-3
Principles Used in This Chapter
• Principle 2: There is a Risk-Return

Tradeoff.
– Business is inherently risky but a lot of risk
that a firm is exposed to are at least partially
controllable through the use of financial
contracts. Corporations are devoting increasing
amounts of time and resources to the active
management of their risk exposure.

20-4
Reasons to Manage Risk
1. Debt capacity
– Risk management can reduce the volatility of
cash flows, and this decrease the probability of
bankruptcy.
– Firms with lower operating risks can use more
debt, which can lead to higher stock prices due
to the interest tax savings from the
deductibility of interest expense.

20-5
2. Maintaining the optimal capital budget

over time.
– By smoothing out the cash flows, risk
management can alleviate the problem of
incurring high costs associated with external
equity to achieve the optimal capital budget.

20-6
3. Financial distress
– Risk management can reduce the likelihood of
low cash flows and financial distress.

20-7
4. Comparative advantage in hedging

– Firms generally have lower transactions costs
due to a larger volume of hedging activities.
– Effective risk management requires specialized
skills and knowledge that firms are more likely
to have.

20-8
5. Borrowing costs
– Firms can sometimes reduce input costs,
especially the interest rate on debt, through
the use of derivative instruments called
“swaps”.
– Any cost reduction adds value to the firm.

20-9
6. Tax effects
– Tax system encourages risk management to
stabilize company earnings.
7. Compensation system
– Many compensation systems establish “floors” and
ceilings” on bonuses or they reward managers for
meeting targets.
– The manager’s bonus is higher when earnings are
stable.
– So even if hedging does not add much value for
stockholders, it still may be beneficial to managers.

20-10
20.1 Five Step
Corporate Risk
Management
Process

Five Step Corporate Risk
Management Process
1. Identify and understand the firm’s major

risks.
2. Decide which type of risks to keep and
which to transfer.
3. Decide how much risk to assume.
4. Incorporate risk into all the firm’s decisions
and processes.
5. Monitor and manage the risk that the firm
assumes.
20-12
Step1: Identify and Understand the
Firm’s Major Risks
• Identifying risks relates to understanding the
factors that drive the firm’s cash flow volatility.
For example:
– Demand risk - fluctuations in demand
– Commodity risk – fluctuations in prices of raw
materials
– Country risk – unfavorable government policies
– Operational risk – cost overruns in firm’s
operations
– Exchange rate risk – changes in exchange rates

20-13
Step1: Identify and Understand the
Firm’s Major Risks (cont.)
• All the listed sources of risk (except

operational risk) are external to the firm.
• Risk management generally focuses on

managing external factors that cause
volatility in firm’s cash flows.

20-14
Step 2: Decide Which Type of Risk to
Keep and Which to Transfer
• This is perhaps the most critical step.
• For example, oil and gas exploration and

production firms have historically chosen
to assume the risk of fluctuations in the
price of oil and gas. However, some firms
have chosen to actively manage the risk.

20-15
Step 3: Decide How Much Risk to
Assume
• Figure 20-1 illustrates the cash flow

distributions for three risk management
strategies.
• The specific strategy chosen will depend

upon the firm’s attitude to risk and the
cost/benefit analysis of risk management
strategies.

20-16
20-17
Step 4: Incorporate Risk into All the
Firm’s Decisions and Processes
• In this step, the firm must implement a

system for controlling the firm’s risk
exposure.
• For example, for those risks that will be

transferred, the firm must determine an
appropriate means of transferring risk
such as buying an insurance policy.

20-18
Step 5: Monitor and Manage the Risk
the Firm Assumes
• An effective monitoring system ensures

that the firm’s day-to-day decisions are
consistent with its chosen risk profile.
• This may involve centralizing the firm’s risk

exposure with a chief risk officer who
assumes responsibility for monitoring and
regularly reporting to the CEO and to the
firm’s board.

20-19
20.2 Managing
Risk with
Insurance
Contracts

Managing Risk with Insurance
Contracts
• Insurance is a method of transferring risk

from the firm to an outside party, in
exchange for a premium.
• There are many types of insurance

contracts that provide protection against
various events.

20-21
20-22
20.3 Managing
Risk by Hedging
with Forward
Contracts

Managing Risk by Hedging with
Forward Contracts
• Hedging refers to a strategy designed to

offset the exposure to price risk.
• Example 20.1 If you are planning to

purchase 1 million Euros in 6 months, you
may be concerned that if Euro strengthens
it will cost you more in U.S. dollars. Such
risk can be mitigated with forward
contracts.

20-24
Forward Contracts (cont.)
• Forward contract is a contract wherein a

price is agreed-upon today for asset to be
sold or purchased in the future. Since the
price is locked-in today, risk from future
price fluctuation is reduced.
• These contracts are privately negotiated
with an intermediary such as an
investment bank.

20-25
• Thus in example 20.1, you could negotiate

a rate today for Euros (say 1 Euro =
$1.35) using a forward contract.
• In 6-months, regardless of whether Euro

has appreciated or depreciated, your
obligation will be to buy 1 million Euros at
$1.35 each or $1.35 million.

20-26
• The following table shows potential future scenarios and the
cash flows. It is seen that Forward contract helps to reduce
risk if Euro appreciates. However, if Euro depreciates,
Forward contract obligates the firm to pay a higher amount.
Future Cost with a Cost without a Effect of

Exchange Rate Forward Forward Forward
of Euro Contract contract Contract
$1.20 $1.35 million $1.20 million Unfavorable
$1.30 $1.35 million $1.30 million Unfavorable
$1.40 $1.35 million $1.40 million Favorable
$1.50 $1.35 million $1.50 million Favorable

20-27
Checkpoint 20.1
Hedging Crude Oil Price Risk Using Forward Contracts

Progressive Refining Inc. operates a specialty refining company that refines
crude oil and sells the refined by-products to the cosmetic and plastic
industries. The firm is currently planning for its refining needs for one year
hence. The firm’s analysts estimate that Progressive will need to purchase 1
million barrels of crude oil at the end of the current year to provide the
feedstock for its refining needs for the coming year. The 1 million barrels of
crude will be converted into by-products at an average cost of $30 per barrel.
Progressive will then sell the by-products for $165 per barrel. The current
spot price of oil is $125 per barrel, and Progressive has been offered a
forward contract by its investment banker to purchase the needed oil for a
delivery price in one year of $130 per barrel.
a. Ignoring taxes, if oil prices in one year are as low as $110 or as high as $140,
what will be Progressive’s profits (assuming the firm does not enter into the
forward contract)?
b. If the firm were to enter into the forward contract to purchase oil for $130 per
barrel, demonstrate how this would effectively lock in the firm’s cost of fuel
today, thus hedging the risk that fluctuating crude oil prices pose for the firm’s
profits for the next year.

20-28
Checkpoint 20.1

20-29
Checkpoint 20.1

20-30
Checkpoint 20.1

20-31
Checkpoint 20.1

20-32
Checkpoint 20.1

20-33
Checkpoint 20.1: Check Yourself
Consider the profits that Progressive might earn if

it chooses to hedge only 80% of its anticipated 1
million barrels of crude oil under the conditions
above.

20-34
Step 1: Picture the Problem
• The figure shows that the future price of

crude oil could have a dramatic impact on
the total cost of 1 million barrels of crude
oil.
• If the price is not managed, it will

significantly affect the future profits of the
firm.

20-35
20-36
Step 2: Decide on a Solution
Strategy
• The firm can hedge its risk by purchasing

a forward contract. This will lock-in the
future price of oil at the forward rate of
$130 per barrel.

20-37
Step 3: Solve
• The table on the next slide contains the

calculation of firm profits for the case
where the price of crude oil is not hedged
(column E), the payoff to the forward
contract (column F) and firm profits where
the price of crude is 80% hedged (column
G).

20-38
Step 3: Solve (cont.)
80% Hedged
80%
Unhedged Hedged
Price of Total Cost Total Total Refining Annual Profit/Loss Annual
Oil/bbl of Oil Revenues Costs Profits on Forward Contract Profits
=(A-
A B=Ax1m C D=$30x1m E=C+B+D G=E+F
$130)x1mx%Hedge
$110 $(110,000,000) $165,000,000 $(30,000,000) $25,000,000 $(16,000,000) $9,000,000
115 (115,000,000) $165,000,000 (30,000,000) $20,000,000 $(12,000,000) 8,000,000
120 (120,000,000) $165,000,000 (30,000,000) $15,000,000 $(8,000,000) 7,000,000
125 (125,000,000) $165,000,000 (30,000,000) $10,000,000 $(4,000,000) 6,000,000
130 (130,000,000) $165,000,000 (30,000,000) $5,000,000 $— 5,000,000
135 (135,000,000) $165,000,000 (30,000,000) $0 $4,000,000 4,000,000
140 (140,000,000) $165,000,000 (30,000,000) $(5,000,000) $8,000,000 3,000,000

20-39
$100 $105 $110 $115 $120 $125 $130 $135 $140 $145
$(100,000,000)
$(105,000,000)
$(110,000,000)
Total Cost of Crude Oil (1 million bbls)
$(115,000,000)
$(120,000,000)
$(125,000,000)
$(130,000,000)
$(135,000,000)
$(140,000,000)
$(145,000,000)
Price of Crude Oil in One Year

20-40
Step 4: Analyze
• The total cost of crude oil increases as the

price of crude oil increases.
• The unhedged annual profits range from a
loss of $5 million to a gain of $25 million.
With 80% hedging, losses are avoided and
the firm ends with profits ranging from $3
million to $5million. The forward contract
obviously benefits the firm when the price
of oil is higher than $130.

20-41
Hedging Currency Risk Using
Forward Contracts
• Currency risk can be hedged using forward

contracts.
• For example, Disney expects to receive

¥500 million from its Tokyo operations in 3
months. Disney can lock-in the exchange
rate to avoid any losses if the Yen weakens
in 3 months.

20-42
• Disney will follow a 2-step procedure to

hedge its currency risk:
1. (Today): Enter into a forward contract which
requires Disney to sell ¥500 million at the
forward rate of say $0.0095/ ¥.
2. (In three months): Disney will convert its
¥500 million at the contracted forward rate,
yielding $4,750,000 (¥500 m ×
$0.0095=$4,750,000).

20-43
• With a forward contract, Disney will

receive $4,750,000 regardless of the
exchange rate in the market.

20-44
Limitations of Forward Contract
1. Credit or default risk: Both parties are

exposed to the risk that the other party
may default on their obligation.
2. Sharing of strategic information: The
parties know what specific risk is being
hedged.
3. It is hard to determine the market values
of negotiated contracts as these contracts
are not traded.

20-45
Limitations of Forward Contract
• These limitations of forward contracts can

be addressed by using exchange-traded
contracts such as exchange traded futures,
options, and swap contracts.

20-46
20.4 Managing
Risk with
Exchange-
Traded
Derivatives

Managing Risk with Exchange-
Traded Derivatives
• A derivative contract is a security whose

value is derived from the value of the
underlying asset or security.
• In the examples considered on forward

contract, the underlying assets were oil
and currency.

20-48
Managing Risk with Exchange-
Traded Derivatives (cont.)
• Exchange traded derivatives cannot be

customized (like forward contracts) and
are available only for specific assets and
for limited set of maturities.

20-49
Futures Contract
• A futures contract is a contract to buy or

sell a stated commodity (such as wheat)
or a financial claim (such as U.S.
Treasuries) at a specified price at some
future specified time.
• These contracts, like forward contracts,

can be used to lock-in future prices.

20-50
Futures Contract (cont.)
• There are two categories of futures

contracts:
– Commodity futures – are traded on
agricultural products, metals, wood products,
and fibers.
– Financial futures – include, for example,
Treasuries, Eurodollars, foreign currencies, and
stock indices.
– Financial futures dominate the futures market.

20-51
Managing Default Risk in Futures
Market
• Default is prevented in futures contract in

two ways:
1.Margin – Futures exchanges require
participants to post collateral called
margin.
2.Marking to Market – Daily gains or
losses from a firm’s futures contract are
transferred to or from its margin account.

20-52
20-53
Hedging with Futures Contract
• Similar to forward contracts, firms can use

futures contract to hedge their price risk.
• If the firm is planning to buy, it can enter
into a long hedge by purchasing the
appropriate futures contract.
• If the firm is planning to sell, it can sell (or
short) a futures contract. This is known as
a short hedge.

20-54
(cont.)
• There are two practical limitations with

futures contract:
– It may not be possible to find a futures
contract on the exact asset.
– The hedging firm may not know the exact date
when the hedged asset will be bought or sold.
– The maturity of the futures contract may not
match the anticipated risk exposure period of
the underlying asset.

20-55
(cont.)
• Basis risk is the failure of the hedge for

any of the above reasons.
• Basis risk occurs whenever the price of the

asset that underlies the futures contract is
not perfectly correlated with the price risk
the firm is trying to hedge.

20-56
(cont.)
• If a specific asset is not available, the best

alternative is to use an asset whose price
changes are highly correlated with the
asset.
• For example, hedging corn with soybean

future if the prices of the two commodities
are highly correlated.

20-57
(cont.)
• If a contract with exact duration is not

available, the analysts must select a
contract that most nearly matches the
maturity of the firm’s risk exposure.

20-58
Option Contracts
• Options are rights (not an obligation) to

buy or sell a given number of shares or an
asset at a specific price over a given
period.
• The option owner’s right to buy is known

as a call option while the right to sell is
known as a put option.

20-59
Option Contracts (cont.)
• Exercise price: The price at which the asset can

be bought or sold.
• Option premium: The price paid for the option.
• Option expiration date: The date on which the
option contract expires.
• American option: These options can be exercised
anytime up to the expiration date of the contract.
• European option: These options can be exercised
only on the expiration date.

20-60
• For example, if you buy a call option on 100
shares of XYZ stock at a premium of $4.50 and
exercise price of $40 maturing in 90 days.
• You can buy the XYZ stock at $40, even though

the market price of the stock maybe above $40.
• If the stock price is below $40, you will choose
not to use your option contract and will lose the
premium paid.

20-61
• For example, if you buy a put option on 100
shares of ABC stock at a premium of $10.50 and
exercise price of $70 maturing in 90 days.
• You can sell the ABC stock at $70, even though

the market price of the stock maybe below $70.
• If the market price of stock is above $70, you will
choose not to use your option contract and will
lose the premium paid.

20-62
A Graphical Look at Option Pricing
Relationships
• Figures 20-5 to Figures 20-8 graphically

illustrate the expiration date profit or loss
from the following option positions:
– Buying a call option (figure 20-5)
– Selling or writing a call option (figure 20-6)
– Buying a put option (figure 20-7)
– Selling or writing a put option (figure 20-8)

20-63
Relationships (cont.)
• The graphs are based on the following

assumptions:
– Exercise price for call and put options = $20

– Call premium = $4
– Put premium = $3

20-64
Relationships (cont.)
Buy Call Write Call Buy Put Write Put
Maximum Unlimited Premium Exercise Premium

Profit Price -
Premium
Maximum Premium Unlimited Premium Exercise
Loss Price -
Premium
Future Market Bullish Bearish Bearish Bullish
Expectation
Break-even Exercise Exercise Exercise Exercise
Point Price + Price + Price Price
Premium Premium – Premium - Premium

20-65
20-66
20-67
20-68
20-69
Checkpoint 20.2
Determining the Break-Even Point and Profit or Loss on

a Call Option
You are considering purchasing a call option on CROCS, Inc. (CROX) common
stock. The exercise price on this call option is $10 and you purchased the
option for $3. What is the break-even point on this call option (ignoring any
transaction costs but considering the price of purchasing the option—the
option premium)? Also, what would be the profit or loss on this option at
expiration if the price dropped to $9, if it rose to $11, or if it rose to $25?

20-70
Checkpoint 20.2

20-71
Checkpoint 20.2

20-72
Checkpoint 20.2

20-73
• If you paid $5 for a call option with an

exercise price of $25, and the stock is
selling for $35 at expiration, what are your
profits and losses? What is the break-even
point on this call option?

20-74
Stock Call Exercise Exercised Profit or Maximum

Price Premium Price or Not Loss Loss=
A B C D E Premium
=Max(O,
A-C)-B Break
$20 ($5) $25 No ($5) Even
$25 ($5) $25 No ($5)
Point
$30 ($5) $25 Yes $0
$35 ($5) $25 Yes $5
$40 ($5) $25 Yes $10

20-75
Step 1: Picture the Problem (cont.)
Profit/Loss from buying Calls
$12
$10
$8
$6
$4
Profit
$2
$0
$0 $5 $10 $15 $20 $25 $30 $35 $40 $45
($2)
($4)
($6)
Future Stock Price

20-76
Strategy
• Break-even Point = Exercise price + Premium
• Profit = (Stock price – Exercise price) – Premium

– If (stock price – exercise price) is negative, the profit or
losses is equal to $0 – Premium.
– In other words, Profit = Max (0, or Stock Price –
Exercise Price) – Premium.

20-77
Step 3: Solve
• Break-even Point = Exercise price +

Premium
= $25 + $5
= $30
• Profit (at stock price of $35)
= (Stock Price – Exercise Price) – Premium
= ($35 - $25) - $5
= $5

20-78
Step 4: Analyze
• The graph in Step 1 shows that the option buyer
will start exercising the option once it crosses
$25.
• The option buyer will earn $1 (before considering

option premium) for every $1 that the stock price
rises above $25.
• Since the option premium is $5, at a stock price
of $30, the option position earns $5 that covers
the premium and leads to a no profit/no loss
situation.

20-79
Reading Option Price Quotes

20-80
20.5 Valuing
Options and
Swaps

Valuing Options and Swaps
• The value of option can be regarded as the

present value of the expected payout when
the option expires.
• The most popular option pricing model is

the Black-Scholes Option Pricing Model
(BS-OPM).

20-82
Black-Scholes Option Pricing Model
• There are six variables that impact the

price of an option:
1. The price of the underlying stock
2. The option’s exercise or strike price
3. The length of time left until expiration
4. The expected stock price volatility
5. The risk free rate of interest
6. The underlying stock’s dividend yield

20-83
(cont.)
Value of Call Value of Put
What IF
option Option
Price of underlying stock Increases Decreases
increases
Exercise price is higher Decreases Increases
Time to expiration is longer Increases Increases
Stock price volatility is higher Increases Increases

over the life of the option
Risk-free rate of interest is Increases Decreases

higher
The stock pays dividend Decreases Increases

20-84
(cont.)
• Black-Scholes option pricing model for call options
is stated as follows:

20-85
Checkpoint 20.3
Valuing a Call Option Using the Black-Scholes

Model
Consider the following call option:
• the current price of the stock on which the call option is
written is $32.00;
• the exercise or strike price of the call option is $30.00;
• the maturity of the option is .25 years;
• the (annualized) variance in the returns of the stock is
.16; and
• the risk-free rate of interest is 4% per annum.
Use the Black-Scholes option pricing model to
estimate the value of the call option.

20-86
Checkpoint 20.3

20-87
Checkpoint 20.3
.272693

20-88
Estimate the value of the above call option

when the exercise price is only $25.

20-89
• Given:
– Current price of stock = $32
– Exercise price = $25
– Maturity = 90 days or 0.25 years
– Variance in stock returns = .16
– Risk-free rate =12% per annum

20-90
Stock Call Exercise Exercised Profit or

Price Premium Price or Not Loss
A B C D E
=Max(O, Profit when stock
A-C)-B
is $25 or $32
$20 ($5) $25 No ($5)
$25 ($5) $25 No ($5)
$30 ($5) $25 Yes $0
$32 ($5) $25 Yes $2
$35 ($5) $25 Yes $5
$40 ($5) $25 Yes $10 Break-even

point

20-91
Profits from Buying Calls
$12
$10
$8
Profits, Exercise Price =$25
$6
$4
$2
$0
$0 $5 $10 $15 $20 $25 $30 $35 $40 $45
($2)
($4)
($6)
Stock Price

20-92
Strategy
• Equation 20-1 can be used to determine

the value of call option using Black-
Scholes option pricing model.

20-93
Step 3: Solve

20-94

20-95

20-96
Step 4: Analyze
• The value of this option is $7.95 using BS-

OPM.
• The current stock price of $32 represents a

$7 profit over the exercise price of $25.
The additional $0.95 can be seen as time
value of call option i.e. premium available
in the market for the possibility that stock
price may rise even higher over the next
90 days.
20-97
Swap Contract
• A swap contract involves the swapping

or trading of one set of payments for
another.
• A currency swap involves exchange of

debt obligations in different currencies.

20-98
Swap Contract (cont.)
• An interest rate swap involves trading of

fixed interest payments for variable or
floating rate interest rate payments
between two currencies.

20-99
Swap Contract (cont.)
• Figure 20-10 illustrates 5-year fixed for floating
interest rate swap and a notational principal of
$250 million.
– Notational principal is the amount used to calculate
payments for the contract but this amount does not
change hands.
• The floating rate = 6-month LIBOR

• The fixed rate = 9.75%
• Interest is paid semi-annually.

20-100
20-101

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Chapter 20

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1. Reasons to manage risk

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5. Understand the advantages and

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• Principle 2: There is a Risk-Return

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Copyright © 2011 Pearson Prentice Hall. All rights reserved.

2. Maintaining the optimal capital budget

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Copyright © 2011 Pearson Prentice Hall. All rights reserved.

4. Comparative advantage in hedging

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Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1. Identify and understand the firm’s major

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• All the listed sources of risk (except

• Risk management generally focuses on

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• This is perhaps the most critical step.

• For example, oil and gas exploration and

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Figure 20-1 illustrates the cash flow

• The specific strategy chosen will depend

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• In this step, the firm must implement a

• For example, for those risks that will be

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• An effective monitoring system ensures

• This may involve centralizing the firm’s risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Insurance is a method of transferring risk

• There are many types of insurance

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Hedging refers to a strategy designed to

• Example 20.1 If you are planning to

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Forward contract is a contract wherein a

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Thus in example 20.1, you could negotiate

• In 6-months, regardless of whether Euro

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Future Cost with a Cost without a Effect of

$1.20 $1.35 million $1.20 million Unfavorable

$1.30 $1.35 million $1.30 million Unfavorable

$1.40 $1.35 million $1.40 million Favorable

$1.50 $1.35 million $1.50 million Favorable

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Hedging Crude Oil Price Risk Using Forward Contracts

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Consider the profits that Progressive might earn if

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The figure shows that the future price of

• If the price is not managed, it will