Why Manage Risk?

Corporate Risk Management

Why manage risk?

 Should a company manage its exposure to financial risk?

 What does risk management really mean?
 How can risk management create value?
 How can risk management help create competitive
advantage?

Dr. Anurag Gupta 2

 Corporate Risk Management

What is risk?

 Risk is different from volatility/uncertainty.

 Latin origin of the word “risk” is through “risco” (Italian),
which means cut off like a rock (referring to the sense of
peril to sailors who had to navigate around dangerous, sharp
rocks.
 Webster’s defines risk as “the possibility of loss or injury,
peril, exposure to loss”.
 Uncertainty is defined as “indefinite, indeterminate”.
 Risk involves uncertainty, but uncertainty may not involve
risk – e.g., after having bought a lottery ticket, you only have
uncertainty, not risk.
 Uncertainty can be converted to risk by your actions – e.g.,
borrowing and spending money in the hope of winning the
lottery converts the uncertainty to risk.

Dr. Anurag Gupta 3

 Corporate Risk Management

Risk is a fact of business life

 Taking and managing risk is part of what companies must do

to create profits and shareholder value.
 In the corporate context, risk includes any event that might
push a company’s financial performance below expectations.
 The four broad types of risks are:
 Market risk
 Credit risk
 Operational risk
 Business risk

Dr. Anurag Gupta 4

 Corporate Risk Management

Market Risk

 Exposure to adverse market price movements, such as

exchange rates, interest rates / spreads, equity prices,
commodity prices, etc.
 E.g., airlines have been heavily affected by rising and falling
oil prices putting several airlines in distress (American
Airlines in bankruptcy) or leading to record profits

Dr. Anurag Gupta 5

 Corporate Risk Management

Credit Risk

 Exposure to the possibility that a borrower or counterparty

might fail to honor its contractual obligations.
 Too many examples in recent decades – most big banks,
subprime lenders, AIG, PE funded companies, etc.

Dr. Anurag Gupta 6

 Corporate Risk Management

Operational Risk

 Exposure to losses due to inadequate internal processes and

systems, and to external events.
 E.g., Archegos Capital Management lost over $10 billion in
2021.
 JP Morgan Chase disaster trade (over $11 billion in losses)
revealed in 2012.
 Scandals continue!

Dr. Anurag Gupta 7

 Corporate Risk Management

Business Risk

 Stems from changes in demand/supply or from competition,

and creates exposure to revenue volatility.
 E.g., On Nov 29, 2011, “American Airlines filed for
bankruptcy protection on Tuesday to cut labor costs in the
face of high fuel prices and dampened travel demand,
capping a prolonged descent for what was once the largest
U.S. carrier”.

Dr. Anurag Gupta 8

 Corporate Risk Management

Risk management in practice

 Various surveys (Wharton-CIBC, etc.).

 Large companies use derivatives more than smaller
companies.
 Most companies hedge anticipated transactions only within
the next 12 months.
 Most companies never use derivatives to reduce funding
costs, or to hedge their balance sheets, or their
economic/competitive exposures.
 Several derivative users sometimes take active positions that
reflect their views of interest rates and exchange rates.
 Most companies “hedge with a view”, i.e., whether they
hedge or not, and how much they hedge, depends on their
views on future market movements (another word for
speculation).

Dr. Anurag Gupta 9

 Corporate Risk Management

Large vs. small firms

 Corporate use of derivatives requires considerable, upfront

investment in personnel, training, computer
hardware/software – might discourage small firms.
 However, smaller firms actually have a greater need for risk
management products and strategies, since unhedged
exposures can cause them more harm.
 Larger firms self-insure more, i.e., they rely more on their
views than smaller firms – if they think exchange rates will
move in their favor, they may not hedge at all, while smaller
firms, in general, hedge a larger fraction of their exposure
irrespective of their market views.

Dr. Anurag Gupta 10

 Corporate Risk Management

What do we learn from risk debacles?

 Management’s view of future price movements was an

important determinant of how (or whether) risk was
managed.
 Risk management did not mean minimizing risk by putting on
a “minimum variance hedge”.
 It meant choosing to bear certain risks based on several
considerations, including the belief that a particular position
would allow the firm to earn abnormal returns (back to
speculation!).
 Is such a practice consistent with the modern theories of
finance and risk management?

Dr. Anurag Gupta 11

 Corporate Risk Management

Costs imposed by higher risk

 Costs of Financial Distress

 Higher tax payments
 Higher expected payments to corporate stakeholders.
 Sub-optimal investment policies

Dr. Anurag Gupta 12

 Corporate Risk Management

Risk management and comparative advantage

 Companies should not expect to profit based on public

information – but what about private information?
 In the course of their operating activities, many companies
acquire specialized information about certain markets.
 Can such information give them a comparative advantage in
taking some of those types of risks?
 How can a company identify such comparative advantages, if
any?
 How can a company translate such comparative advantages
into coherent risk management strategies?

Dr. Anurag Gupta 13

 Corporate Risk Management

Selective hedging – An example

 Should a company allow its market view to affect its hedging

decisions?
 Consider a petrochemicals plant using naphtha as an input.
 The company, in the process of managing its supply of
naphtha, would acquire lots of information about its market.
 Suppose the management hedges 50% of its naphtha
purchases when it has no view about its future prices.
 Now, suppose they believe that the price of naphtha is more
likely to rise than fall – the risk manager might decide to
hedge 100% of their naphtha exposure.
 Instead, if they are convinced that naphtha prices are likely
to drop sharply, they might hedge only 20%.

Dr. Anurag Gupta 14

 Corporate Risk Management

Selective hedging

 There are risks to selective hedging – the company’s

information may not be better than the market’s.
 However, it is also plausible that some companies could have
informational advantages in markets where they operate.
 Share repurchases is an example of that, where companies
buy their own shares on the belief that their current value
fails to reflect the firm’s prospects – they are vindicated more
often than not.
 What role should these “perceived” informational advantages
play in risk management strategies?

Dr. Anurag Gupta 15

The Building Blocks of Risk Management
 Corporate Risk Management

Why derivatives?

 Consider a firm with forex exposure – one way to hedge is to

borrow in the foreign currency, or move production abroad.
 This is an “on-balance-sheet” transaction.
 However, these transactions are costly, inflexible, and often
irreversible.
 Derivatives are off-balance-sheet transactions - can manage
exposure in a similar manner, but at a much lower cost.
 Four fundamental building blocks of derivatives are:
 Forwards
 Futures
 Swaps
 Options

Dr. Anurag Gupta 17

 Corporate Risk Management

Forward contracts

 Obligates the owner to buy a specified asset on a specified

date at a price (forward price) specified at origination.
 Profit/loss at maturity is equal to the difference between the
spot price at maturity and the forward price.
 It has two-sided default risk – the contract owner either
receives or makes a payment based on the price movement
of the underlying asset.
 Payments are only made at the maturity of the contract – no
payment is made either at origination or during the term of
the contract.
 Traded over-the-counter (OTC).

Dr. Anurag Gupta 18

 Corporate Risk Management

Futures contracts

 Basic form is similar to a forward contract.

 However, any change in the value of the a futures contract
(due to changes in the spot price of the underlying asset) is
cash-settled the same day (marked-to-market).
 Default risk reduces significantly since the performance
period of the futures contract is one day – just like a series
of one-day forward contracts.
 All market participants have to post “margins” – further
reduces default risk.
 Exchange traded – the exchange serves as a clearing house,
reduces costs of transaction.
 Standardized contracts.
 Implied forward rates less than futures rates – convexity
adjustment.

Dr. Anurag Gupta 19

 Corporate Risk Management

Swaps

 Obligates two parties to exchange specified cash flows at

specified intervals, on a notional principal amount.
 E.g., in an interest rate swap, one party may agree to pay a
fixed interest rate in exchange for receiving a floating rate
(LIBOR) every six months, on a notional principal.
 Only the net cash flows are exchanged – in principal, it is a
series of forward contracts.
 The two sides of the swap can be indexed to almost
anything, from different interest rates to commodity prices.
 The credit risk in swaps is generally small, not nearly zero
like futures, but less than forwards.
 Customized, OTC contracts.

Dr. Anurag Gupta 20

 Corporate Risk Management

Options

 Option gives its owner a right, not an obligation.

 A call option gives the owner the right to buy an asset at a
specified price (exercise price) on a specified date.
 The call option owner will only exercise the option if the spot
price of the underlying asset on the expiration date is higher
than the exercise price.
 Put options give the right to sell an asset.
 Options are like insurance contracts – you get reimbursed if
certain events happen, otherwise the option will expire
unexercised and you lose the option premium paid upfront.
 European options can only be exercised at the expiration
date, while American options can be exercised at any time
prior to (and including) the expiration date.
 Option buyers are exposed to the credit risk of the sellers.

Dr. Anurag Gupta 21

 Corporate Risk Management

Managing exposures using building blocks

 Hedging using forwards, futures or swaps entails getting

protection on the downside by foregoing the upside
(therefore there is no upfront premium).
 Hedging using options entails getting protection on the
downside while retaining the upside (hence you have to pay
a premium to buy the option).
 They have fundamentally different implications, and the
choice depends on the hedging needs, market views, and
funds available (to spend on the risk management program).
 They can even be used in combination with each other.

Dr. Anurag Gupta 22

 Corporate Risk Management

Combining forwards with swaps

 Suppose a firm knows that, in one year, it will require funds

that will be borrowed at a floating rate, thereby giving the
firm an inverse exposure to interest rates.
 Another firm may be adding a new product line in one year,
the demand for which is extremely sensitive to interest rate
movements – as rates rise, its demand decreases.
 The firm can manage this exposure with a forward start
swap – it’s a forward contract on a swap.

Dr. Anurag Gupta 23

 Corporate Risk Management

Swaps with options

 Suppose a firm with a floating rate liability wants to limit its

outflows should interest rates rise substantially – they are
also willing to give up some gains should there be a dramatic
decline in rates.
 They can enter into a swap where they pay the floating rate
if it stays within a band, but a fixed rate if it goes outside the
band.
 It’s a combination of the long swap, long cap, short floor
portfolio.
 Swaptions are options on swaps, used by firms to hedge
uncertain interest rate exposures, where the uncertainty is
likely to be resolved in the future.

Dr. Anurag Gupta 24

 Corporate Risk Management

Engineering hybrid products

 Just combinations of the building blocks.

 E.g., combining the issuance of a fixed rate loan with a pay-
fixed swap leads to a reverse floater, where the net coupons
fall as the floating rate rises.
 This is can further leveraged by increasing the notional
amount of the swap.
 Bonds are issues with embedded options of all kinds.
 In 1986, Standard Oil issued a bond with an oil warrant –
principal payment at maturity would be a function of oil
prices – “the excess of the crude oil price over $25 multiplied
by 170 barrels of light sweet crude oil”.
 Forest Oil Corporation issued Natural Gas indexed
debentures, where the coupons were linked to gas prices.

Dr. Anurag Gupta 25