Are stockholders concerned about whether or not a firm reduces the volatility of its cash flows?

y Not necessarily. y If cash flow volatility is due to systematic risk, it

can be eliminated by diversifying investors portfolios.

Definitions of different types of risk
y Speculative risks offer the chance of a gain as

well as a loss. y Pure risks offer only the prospect of a loss. y Demand risks risks associated with the demand for a firm s products or services. y Input risks risks associated with a firm s input costs. y Financial risks result from financial transactions.

Definitions of different types of risk
y Property risks

risks associated with loss of a firm s productive assets. y Personnel risk result from human actions. y Environmental risk risk associated with polluting the environment. y Liability risks connected with product, service, or employee liability. y Insurable risks risks that typically can be covered by insurance.

Definitions of different types of risk
y

y

y

Credit Risk-- Customer or counterparty may not settle an obligation for full value, either when due or at any time thereafter. Counterparty risk-- The risk that a company s counterparty will fail to perform during the life of the transaction Principal/interest risk -- Failure to recover principal and/or interest on the due date for payment

Definitions of different types of risk
y

y

y

Issuer/position/specific risk -- Risk arising from holding the counterparty s debt securities Currency risk -- Risk to earnings and capital arising from adverse movements in currency exchange rates Liquidity risk -- Risk of loss arising from changes in the ability to sell or dispose of an asset

Definitions of different types of risk
y

y

Operational risk -- Risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems and from external events Regulatory risk Risk of loss arising from failure to comply with legal requirements in the relevant jurisdiction in which the company operates

Risk Management
y Evaluating and controlling risk effectively will ensure

opportunities in a business are not lost, competitive advantage is enhanced and less management time is spent fire-fighting.

Reasons that corporations engage in risk management
y Increase their use of debt. y Maintain their optimal capital budget. y Avoid financial distress costs. y Utilize their comparative advantages in

hedging, compared to investors. y Reduce the risks and costs of borrowing. y Reduce the higher taxes that result from fluctuating earnings. y Initiate compensation programs to reward managers for achieving stable earnings.

What is corporate risk management, and why is it important to all firms?
y Corporate risk management relates to the

management of unpredictable events that would have adverse consequences for the firm. y All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.

What are the three steps of corporate risk management?
1. 2. 3.

Identify the risks faced by the firm. Measure the potential impact of the identified risks. Decide how each relevant risk should be handled.

What can companies do to minimize or reduce risk exposure?
y Transfer risk to an insurance company by paying periodic premiums. y Transfer functions that produce risk to third parties. y Purchase derivative contracts to reduce input and financial risks. y Take actions to reduce the probability of occurrence of adverse events and the magnitude associated with such adverse events. y Avoid the activities that give rise to risk.

What is financial risk exposure?
y Financial risk exposure refers to the risk inherent

in the financial markets due to price fluctuations.
y Example: A firm holds a portfolio of bonds,

interest rates rise, and the value of the bond portfolio falls.

Financial Risk Management Concepts
y Derivative a security whose value is derived from

the values of other assets. Swaps, options, and futures are used to manage financial risk exposures.
y A derivative is a financial instrument that offers a

return based on the return of some other underlying instrument

TRADING OF DERIVATIVE PRODUCTS
y Exchange Traded Contracts have standard terms and

features and are traded on an organized trading facility y OTC Over the Counter contracts are any transactions created by two parties anywhere else.

DERIVATIVE PRODUCTS
y Futures contracts that call for the purchase or sale of

a financial (or real) asset at some future date, but at a price determined today. Futures (and other derivatives) can be used either as highly leveraged speculations or to hedge and thus reduce risk.

DERIVATIVE PRODUCTS
y Forward Contracts-- A forward contract is an

agreement between two parties in which one party, the buyer, agrees to buy from other party, the seller, an underlying asset or other derivative, at a future date at a price established at the start of the contract.

Financial Risk Management Concepts
y Hedging

usually used when a price change could negatively affect a firm s profits.
y Long hedge

involves the purchase of a futures contract to guard against a price increase. y Short hedge involves the sale of a futures contract to protect against a price decline.

y Swaps

the exchange of cash payment obligations between two parties, usually because each party prefers the terms of the other s debt contract. Swaps can reduce each party s financial risk.

How can commodity futures markets be used to reduce input price risk?
y The purchase of a commodity futures contract

will allow a firm to make a future purchase of the input at today s price, even if the market price on the item has risen substantially in the interim.

What is an option?
y A contract that gives its holder the right, but not

the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time. y Most important characteristic of an option:
y It does not obligate its owner to take action.

y It merely gives the owner the right to buy or sell an

asset.

Option terminology
y Call option an option to buy a specified number

of shares of a security within some future period. y Put option an option to sell a specified number of shares of a security within some future period. y Exercise (or strike) price the price stated in the option contract at which the security can be bought or sold. y Option price the market price of the option contract.

Option terminology
y Expiration date

the date the option matures.

y Exercise value the value of an option if it were

exercised today (Current stock price - Strike price).
y Covered option an option written against stock held

in an investor s portfolio.
y Naked (uncovered) option an option written without

the stock to back it up.

Option terminology
y In-the-money call

a call option whose exercise price is a call option whose exercise price

less than the option price of the underlying stock.
y Out-of-the-money call

exceeds the option price.
y LEAPS: Long-term Equity AnticiPation Securities are

similar to conventional options except that they are longterm options with maturities of up to 2 1/2 years.

Option example
y A call option with an exercise price of $25, has the

following values at these prices:
Stock price $25 30 35 40 45 50

Call option price $3.00 7.50 12.00 16.50 21.00 25.50

Determining option exercise value and option premium
Stock price $25.00 30.00 35.00 40.00 45.00 50.00 Strike price $25.00 25.00 25.00 25.00 25.00 25.00 Exercise value $0.00 5.00 10.00 15.00 20.00 25.00 Option Option price premium $3.00 $3.00 7.50 2.50 12.00 2.00 16.50 1.50 21.00 1.00 25.50 0.50

How does the option premium change as the stock price increases?
y The premium of the option price over the

exercise value declines as the stock price increases.
y This is due to the declining degree of

leverage provided by options as the underlying stock price increases, and the greater loss potential of options at higher option prices.

Call premium diagram
Option value 30 25 20 15 10 5
Exercise value Market price

Stock Price

5

10

15

20

25

30

35

40

45

50

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