CHAPTER 20

CORPORATE RISK
MANAGEMENT
FIN303 – Advanced Corporate Finance
Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
LEARNING OBJECTIVES
CHAPTER 20: Corporate Risk Management

1. Explain the factors that make it desirable for firms to manage

their risks.
2. Describe the risks faced by firms and how they are managed.
3. Define forward and futures contracts, and determine their prices.
4. Define interest rate and cross-currency swaps, and understand
how they are valued.
5. Define a call option and a put option, and describe the payoff
function for each of these options.
6. List and describe the factors that affect the value of an option.
7. Identify some of the real options that occur in business, and
explain why traditional NPV analysis does not accurately
incorporate their values.
8. Describe how the agency costs of debt and equity are related to
options.
2
 20.1 WHY COMPANIES
MANAGE CORPORATE RISKS

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
1. EXPLAIN THE FACTORS THAT MAKE IT DESIRABLE
FOR FIRMS TO MANAGE THEIR RISKS.

4
NATURE OF DISCOUNTED CASH FLOWS AND VALUATION
Apply the Free Cash Flow from the Firm Approach (Chap 18)
Size of
future ∞
CFs 𝑭𝑪𝑭𝑭𝒕
𝑽𝑭 = ෍ (18.3)
(𝟏 + 𝑾𝑨𝑪𝑪)𝒕
𝒕=𝟎

A number of different factors will influence the extent to

Rate of FIRM Riskiness
of future
which firms will manage their risks.
return
VALUE CFs Factors include:
 financial reporting,
 corporate taxation,
 the costs of bankruptcy,
Timing  contracting with providers of capital, and
of future
CFs  issues such as agency costs and employee compensation and
retention
5
THE RISK MANAGEMENT PROCESS
Identification
• This would involve the
financial manager surveying
the various business units
and determining the profile
of the business risks
involved.
• Exposures can be simply
classified according to the
way they could affect the
firm’s operations.
6
Evaluation
• Wherever possible, the
impact of the risk is
quantified in monetary
terms. This helps in ranking
the risks according to the
severity of their effect.
• When combined with
estimates of their frequency,
this provides a way of
scoring the result.
Management Review
• The management of the • The final step is to repeat
risks is therefore integrated the process and to keep the
into the company’s strategic risks under review since
goals. At the operational conditions change and firms
level, the company will evolve over time.
establish procedures and
assign responsibility to
oversee the management of
these unacceptable risks.
• Or to use financial
techniques or source
instruments to mitigate the
risks.
 20.2 MANAGING
OPERATIONAL, BUSINESS,
AND FINANCIAL RISKS
FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
2. DESCRIBE THE RISKS FACED BY FIRMS AND HOW
THEY ARE MANAGED.

8
TYPES OF RISK & RISK MANAGEMENT METHODS
Types of risk:

Operational risks Market risks Production risks Price risks

• any risk arising from
execution of a company’s
business functions
• exposure to a change in
the value of some market
factor, such as interest
rates, foreign exchange
rates, equity or commodity
prices.
• all the elements of the • changes in the prices of a
production process that firm’s inputs and outputs
can go wrong: for over time due to changes
instance, fires and in demand and supply
equipment failures

Risk Management Methods

• Hedging: any technique designed to reduce or eliminate risk; for example, taking two positions that will offset each other if
prices change
• Financial risk management: the practice of protecting and creating economic value in a firm by using financial instruments to
manage exposure to risks. Financial instruments may include:
 Insurance contract: that protects against the financial losses (in whole or in part) of specified unexpected events
 Derivatives: financial instruments or securities whose value varies with the value of an underlying asset

9
20.3 FORWARDS AND
FUTURES

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
3. DEFINE FORWARD AND FUTURES CONTRACTS, AND
DETERMINE THEIR PRICES.

11
FORWARD AND FUTURES CONTRACTS
SPOT CONTRACTs FORWARD CONTRACTs
Are arrangements where the buyer and seller
make an immediate exchange.

FORWARD CONTRACTs
Are binding arrangements where prices and
quantities are agreed today for future delivery

FUTURES CONTRACTs
Is similar to a forward contract and is normally
arranged through an organized exchange.

12
FORWARD CONTRACTS – PAYOFF DIAGRAMS
EXHIBIT 20.1 Payoff Diagrams for the Price Risks Facing the A310
Buyer and Airbus Industries
Consider the situation where
Airbus is selling one of its
commercial jets to a customer.
These are usually
manufactured to order and
delivery may take place
several years later.
What are the risks for both sides
if the terms and conditions are
not set at the outset?

13
VALUING A FORWARD CONTRACT
The pricing of forward contracts is known as the cost of carry
Cost of carry:
the net cost of “carrying” or holding an asset for future delivery, equates the gains and losses of both sides such that
neither wins nor loses.

Interest rate (i)
• increase the cost of carry • increase the cost of carry
and hence the forward
price.
Storage costs and
wastage (u)
and the forward price.
Income received prior Benefits of immediate
to delivery (q) ownership (y)
• expressed as a yield (q) • This is known as the
• decrease the cost of convenience yield (y) and
carry and the forward can be thought of as
price because it is a negative storage costs
benefit to the seller • The convenience yield
only applies to
consumption assets and
will be zero for forwards
on financial assets.

14
VALUING A FORWARD CONTRACT
The difference between the cash market EXHIBIT 20.2 Factors That Affect the Cost of Carry in a Forward
price and the forward price (PV − FV) will Contract
be the cost of carry and will include the
costs and benefits from the delay. The
elements that go into the cost of carry and
their effects on the forward price are as
follows:

The full cost of carry formula is therefore:

(𝟏 + 𝐢 + 𝐮)𝐦
𝐏𝐕 × = 𝐅𝐕𝐦 (20.1)
(𝟏 + 𝐪 + 𝐲)𝐦

15
FUTURES CONTRACTS
A major problem therefore is that forward contracts are subject to what is called counterparty credit risk
Counterparty credit risk: when the other party fails to fulfill its obligations.

Futures contracts a standardized, transferable, exchange-traded

contract that requires the delivery of a specified asset at a
predetermined price on a specified future date
They do this in a number of ways:
i. Clearing house: All contracts are made with a clearing house and not directly between
buyers and sellers.

ii. Margin: collateral that the holder of a futures contract has to deposit to cover the credit
risk.

iii. Marked-to-market (daily settlement): The value of futures contracts to the buyer and seller
are updated daily and the amounts are debited and credited to the goodwill deposit.

iv. Standardized contracts: Contracts are standardized to facilitate the market and trading is
carried out through an organized exchange.

16
20.4 SWAPS

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
4. DEFINE INTEREST RATE AND CROSS-CURRENCY
SWAPS, AND UNDERSTAND HOW THEY ARE VALUED.

18
INTEREST RATE SWAPS
Interest Rate Swaps
They are agreements where one party agrees to make a set of fixed interest payments to another party conditional
upon the other party making variable payments in exchange.

Example:
SEBA AG, a German machinery
manufacturer, which borrowed €20 million at
a floating rate from Commerzbank.

The company wants to lock-in the interest it

will pay on this loan and enters into a five-
year interest swap
• Notional Amount = €20 million;
• Fixed rate (also called the coupon) =5%
• Floating rate = Euribor (euro interbank
offered rate).

19
EXHIBIT 20.3 HOW THE INTEREST RATE SWAP TRANSFORMS SEBA AG’S FLOATING
RATE LIABILITY INTO A FIXED RATE LIABILITY

20
CROSS-CURRENCY SWAPS
Cross-currency swap
is like an interest rate swap except that instead of being in one currency, it involves the exchange of principal and
interest in one currency for the principal and interest in another currency

For example, if Airbus enters into a cross-currency swap for €100 million at an agreed exchange rate of $1.3000 =
€1, with fixed interest payments of 3.5 percent in euros and 4.1 percent in dollars for five years where it pays in
dollars and receives in euros, the cash flows will be as follows

21
20.5 FINANCIAL OPTIONS

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
5. DEFINE A CALL OPTION AND A PUT OPTION, AND
DESCRIBE THE PAYOFF FUNCTION FOR EACH OF THESE
OPTIONS.

23
FINANCIAL OPTIONS
FINANCIAL OPTIONS
is a derivative in that, like forwards, futures, and swaps, its value is derived from the value of another asset.
The owner of a financial option has the right, but not the obligation, to buy or sell an asset on or before a specified
date for a specified price.

TERMINOLOGY
• Holder: buyer of an option.
• Writer: seller of an option.
• Option premium: the price of an option that holder pays the seller for that option.
• Underlying asset: The asset that the holder has a right to buy or sell
• Expiration date: The last date on which an option can be exercised
• Strike price (or exercise price): the price at which the option holder can buy or sell the asset

24
TYPES OF OPTIONS
American, European, and Bermudan Options

• Options that can only be exercised on

the expiration date are known as
European options
• American options can be exercised at
any point in time on or before the
expiration date
• Bermudan options can be exercised
only on specific dates during the life
of the option

25
CALL OPTIONS EXHIBIT 20.4 Payoff Functions for a Call Option at Expiration

CALL OPTIONS:
gives the owner the RIGHT to BUY, or “call,” the
underlying asset
Suppose you own an option to buy one share
of Siemens AG, the German engineering
company, for €50 and today is the exercise
date.
If the price of Siemens’ shares < €50 (ST < X)
 not make sense to exercise your option
If the price of Siemens’ shares = €50 (ST = X)
 no benefit to be had from exercising your option
If the price of Siemens’ shares > €50 (ST > X)
 benefit from exercising the option

26
PUT OPTIONS EXHIBIT 20.5 Payoff Functions for a Put Option at Expiration

PUT OPTIONS:
gives the owner the RIGHT to SELL the underlying
asset

Suppose that you own a put option that is

expiring today and that entitles you to sell
shares in Siemens for €50.

If the price of Siemens’ shares < €50 (ST < X)

 benefit from exercising the option
If the price of Siemens’ shares = €50 (ST = X)
 no benefit to be had from exercising your option
If the price of Siemens’ shares > €50 (ST > X)
 not make sense to exercise your option

27
MORE ON THE SHAPES OF OPTION PAYOFF FUNCTIONS
• The payoff functions for options are not straight lines for all possible values of the underlying asset
• Each payoff function has a “kink” at the exercise price which exists because the owner of the option
has a right, but not the obligation, to buy or sell the underlying asset. If it is not in the owner’s interest
to exercise the option, he or she can simply let it expire

28
20.6 OPTION VALUATION

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
6. LIST AND DESCRIBE THE FACTORS THAT AFFECT
THE VALUE OF AN OPTION.

30
OPTION VALUATION
• It is more complicated to determine the value of an option at a point in time before the expiration date
• We don’t know exactly how the value of the underlying asset will change over time
• Therefore, we don’t know if it will make sense to exercise the option
Limits on Option Valuation
1. The value of a call option > 0: since the owner of the 4. When we consider the value of a call option at some
option can always decide not to exercise it if doing so point prior to expiration, we must compare the current
is not beneficial value of the underlying asset with the present value of
2. The value of a call option ≤ the value of the underlying the exercise price, discounted at the risk-free rate
asset: since it would not make sense to pay more for the 5. The present value of the exercise price is the amount an
right to buy an asset than you would pay for the asset investor would have to invest in risk-free securities at
itself any point prior to the expiration date to ensure that he
3. The value of a call option prior to expiration ≥ the value or she would have enough money to exercise the option
of that option at expiration: because there is always a when it expires
possibility that the value of the underlying asset will be
greater than it is today at some time before the option
expires
31
 EXHIBIT 20.6 Possible Values of a Call Option Prior to Expiration
LIMITS ON
OPTION VALUES

32
VARIABLES THAT AFFECT OPTION VALUES
IMPACT ON
Five variables affect the value of a CALL OPTION PUT OPTION
VARIABLES
call option prior to expiration. Four PRICE PRICE
of them are related to the following -
questions:
Underlying asset price (S) +
1. How likely is it that the value of the
Time to expiration (T) + +
underlying asset will be higher than
the strike price the instant before
Exercise price (X) - +
the option expires?
Volatility of underlying asset + +
2. How far above the strike price
might it be? Risk-free interest rate (r) + -

33
 THE BINOMIAL OPTION 20.6 Option Valuation

PRICING MODEL

3
THE BINOMIAL OPTION PRICING MODEL
• Assumption: that investors have no arbitrage opportunities with regard to this
option.
• Arbitrage is the act of buying and selling assets in a way that yields a return above
that suggested by the Security Market Line (SML).
• To value the call option in our simple model, we will first create a portfolio that
consists of the asset underlying the call option and a risk-free loan.
• The relative investments in these two assets will be selected so that the combination
of the asset and the loan have the same cash flows as the call option when it
expires, regardless of whether the value of the underlying asset goes up or down
 This is called a replicating portfolio, since it replicates the cash flows of the option

38
THE BINOMIAL OPTION PRICING MODEL
• The replicating portfolio will consist of:
• “x” shares of the underlying stock;
• A risk-free loan with a face value of “y”
• The value of the call option can be calculated as follows:
• Solve for the values of “x” and “y”
• Multiply the current cost of the underlying stock by “x”
• Subtracting “y” from the above amount will yield the value of the call option

39
THE BINOMIAL OPTION PRICING MODEL – EXAMPLE
Example:
• Suppose that the stock of ABC Corporation currently trades for $50 and that its price will be either
$70 or $40 in one year. We want to determine the value of a call option to buy ABC stock for $55 in
one year
SOLUTION:
We can write two equations that define the
replicating portfolio that we want to construct:
$15 = ($70*x) + (1.05*y)  x=0.5
$0 = ($40*x) + (1.05*y)  y=-19.05

Therefore the value of the call option can be

expressed as follows:
𝑐 = 𝑆0 ∗ 𝑥 + 1 ∗ 𝑦
= ($50*0.5) + (1*(-$19.05))
=$5.95
40
PUT-CALL PARITY
Put-Call Parity:
the relation between the value of a call option on an asset and the value of a put option on the same
asset that has the same exercise price

Discrete Compounded Interest Rate:

𝑋 𝑿
P + S0 = 𝐶 + 𝐏=𝑪+ − S0
(1 + 𝑅𝑟𝑓 )𝑇 (𝟏 + 𝐑 𝐫𝐟 )𝐓
where:
P is the value of the put option
C is the value of the call option
Continuous Compounded Interest Rate: X is the exercise price
𝑋 𝑿 S0 is the current value of the
P + S0 = 𝐶 + 𝐏=𝑪+ 𝒓 𝑻 − S0 underlying asset

𝑒 𝑟𝑐 𝑇 𝒆𝒄 e is the exponential function

T is time to expiration of the option
rc is continuous compounded rate

41
PUT-CALL PARITY
Put-Call Parity:
the relation between the value of a call option on an asset and the value of a put option on the same
asset that has the same exercise price

𝑋 𝑋
P + S0 = 𝐶 + 20.1 P=𝐶+ − S0
𝑒 𝑟𝑐 𝑇 𝑒 𝑟𝑐𝑇
Example: 0.051
P  $5.95  $55e  $50
What is the value of an ABC corporation put option
 $5.95  $52.32  $50
if C = $5.95, X = $55, rc = 0.05, t = 1, and V = $50?
 $8.27

42
20.7 REAL OPTIONS

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
7. IDENTIFY SOME OF THE REAL OPTIONS THAT OCCUR IN
BUSINESS, AND EXPLAIN WHY TRADITIONAL NPV
ANALYSIS DOES NOT ACCURATELY INCORPORATE THEIR
VALUES.

45
REAL OPTIONS
Real options are options on real assets
• NPV analysis does not adequately reflect the
value of real options
• It might not always be possible to directly
estimate the value of the real options associated
with a project
• It is important to recognize that they exist when
we perform a project analysis

46
TYPES OF REAL OPTIONS

Types of
real options

Options to Options to Options to Options to

defer make follow- change abandon
investment on investments operations projects

47
OPTIONS TO DEFER INVESTMENT
• The underlying asset in this option is the stream of cash flows that the investment
would produce, while the exercise price is the amount of money that the company
would have to spend
• The value of an option to defer investment is not reflected in a NPV analysis as it
does not allow for the possibility of deferring an investment decision
• An example from the text is that of an option to defer making an investment
A real estate developer might pay a landowner €100,000 for a one-year option to purchase a property at a
particular price. By accepting the payment, the landowner agrees not to sell the property to anyone else for a year.
Such an option provides the developer with time to make a final decision regarding whether or not to actually
purchase the land and proceed with a project. Since the developer will still have to buy the land if he or she
decides to proceed with the project, the cost of the option reflects the cost of being able to collect more
information before making a final decision.

48
OPTIONS TO MAKE FOLLOW-ON INVESTMENTS
• Some projects open the door to future business opportunities that would not
otherwise be available
• This type of real option is an option to make follow-on investments
• Options to make follow-on investments are inherently difficult to value because
it may not be obvious what the follow-on projects will be
• Even if we know what the projects will be, we are unlikely to have enough
information to estimate what they are worth
• Projects that lead to investment opportunities that are consistent with a
company’s overall strategy are more valuable than otherwise similar projects
that do not
Concerns an investment in a new technology that can be extended to other products.

49
OPTIONS TO CHANGE OPERATIONS
• Options to change operations are related to the flexibility that managers have
once an investment decision has been made
• These include the option to change operations and to abandon a project
• They affect the NPV of a project and must be taken into account at the time the
investment decision is made
• The changes that managers might make can involve something as simple as reducing
output if prices decline or increasing output if prices increase

50
OPTIONS TO ABANDON PROJECTS
• An option to abandon a project is the ability to choose to terminate a project by
shutting it down
• Management will save money that would otherwise be lost if the project kept going.
The amount saved represents the gain from exercising this option

51
CONCLUDING COMMENTS ON NPV ANALYSIS AND REAL OPTIONS
• In order to use NPV analysis to value the option to expand operations, we
would not only have to:
 estimate all the cash flows associated with the expansion
 estimate the probability that we would actually undertake the expansion
 determine the appropriate rate at which to discount the value of the expansion
back to the present

52
20.8 AGENCY COSTS

FIN303 – CHAPTER 20
 LEARNING OBJECTIVES
8. DESCRIBE HOW THE AGENCY COSTS OF DEBT AND
EQUITY ARE RELATED TO OPTIONS.

56
AGENCY COSTS
Agency conflicts arise
• between stockholders and lenders (creditors and bondholders) and
• between stockholders and managers
because the interests of stockholders, lenders, and managers are not perfectly aligned. In fact, their
interests can greatly diverge.

57
AGENCY COSTS OF DEBT
Agency costs that arise in a company EXHIBIT 20.7 Payoff Functions for Stockholders and Lenders
that uses debt financing.
These costs occur because the
incentives of people who lend to a
company differ from those of the
stockholders.

Consider a company that has a single loan

outstanding. This loan will mature next
year and all of the interest and principal
will be due at that time.
i. If the value of the company is less than
the amount owed on the debt; or
ii. If the value of the company is greater
than the amount owed on the loan

58
AGENCY COSTS OF DEBT
Dividend Pay-out Problem
• The incentives that stockholders of a
leveraged firm have to pay
themselves dividends arise because
of their option to default
• If a company faces some realistic
risk of going bankrupt, the
stockholders might decide that they
are better off taking money out of
the firm by paying themselves
dividends
• This situation can arise because the
stockholders know that the
bankruptcy laws limit their possible
losses
59
Asset Substitution Problem Underinvestment Problem
• When bankruptcy is possible, • Stockholders have incentives to turn
stockholders have an incentive to down positive-NPV projects when
invest in very risky projects, some of all of the benefits are likely to go
which might even have negative to the lenders.
NPVs • The underinvestment problem arises
• Stockholders have this incentive from the differences in the payoff
because they receive all of the functions
benefits if things turn out well but
do not bear all of the costs if things
turn out poorly
• Since equity claims are like call
options on the assets of the firm, this
asset substitution problem should not
be surprising
AGENCY COSTS OF EQUITY
Agency costs that arise in a company that EXHIBIT 20.8 Representative Payoff Function for a Manager
managers do not always act in the
stockholders’ best interest.

Consider the connection between managers’

personal wealth and the performance of the
companies for which they work.
i. If a company gets into financial difficulty and a manager
is viewed as responsible, that manager could lose his or
her job and find it difficult to obtain a similar job at
another company; or
ii. If expecting the present value of a manager’s future
earnings to increase with the value of the firm when this
value is above the amount that the company owes to its
lenders. Managers will receive larger bonuses and larger
pay raises, and any shares or options that they receive will
be more valuable.

60
SUMMARY
SUMMARY OF KEY EQUATIONS

62
PRACTICE
THANK YOU FOR YOUR
ATTENTION
Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
Email: HuyenDTT24@fe.edu.vn