Financial Risk Management: Hedging & Volatility (PDF)

Introduction to Finance LUBS1036 Financial Risk Management Lecture 9 (Semester 2) Hedging and Volatility Sources of financial risk for companies Price volatility Interest rate volatility Exchange rate volatility Commodity price volatility Price Volatil...

Introduction to Finance LUBS1036 Financial Risk Management Lecture 9 (Semester 2) Hedging and Volatility Sources of financial risk for companies Price volatility Interest rate volatility Exchange rate volatility Commodity price volatility Price Volatility: A Historical Perspective Key points: No real change in prices for 150 years (except in wartime) Last 40 years prices have increased dramatically Inflation is still a real financial risk  Interest Rate Volatility: A Historical Perspective Key points: This shows changes in 10-year UK Treasury bond yield Very volatile Companies need to manage their exposure to interest rate changes. Why is that? bond yields, February Monthly changes in 10-year UK government 1994 to March 2016 Figure 20.1 Monthly changes in 10-year UK government bond yields, February 1994 to March 2016 Exchange rate Volatility: A Historical Perspective Key points: International trade increasingly important Exchange rates very volatile, especially since the introduction of the euro Companies need to manage their exposure to exchange rate changes. Why is that?  Commodity Price Volatility: A Historical Perspective Key points: Commodity prices (in this case oil) also very volatile Companies need to manage their exposure to commodity price changes. Why is that? Europe Brent Spot Oil Price ($/barrel), 2000-2016 Figure 20.2 Europe Brent Spot Oil Price ($/barrel), 2000–2016 Hedging and Price Volatility Hedging Reducing a firm’s exposure to price or rate fluctuations. in the US, hedging is known as immunization. Derivative Security A financial asset that represents a claim to another financial asset. A derivative security gets its name from the fact that it derives its value from the performance of another financial asset called the underlying asset or the "underlying". Derivatives securities are one of the three main categories of financial instruments, the other two being equities (i.e., shares) and debt (i.e., corporate and government bonds). Managing Financial Risk Financial Risk Management Financial risk makes the earnings more volatile. We now need to think about how we can assess the level of financial risk for a particular company Managing Financial Risk The Risk Profile A plot showing how the value of the firm is affected by changes in prices or rates. The Risk Profile - Seller Imagine a farmer growing and selling wheat How would the value of the firm change as a result of changes in the price of wheat? Two key points: 1. Upward slope = positive relationship 2. Steepness of the slope indicates the exposure to the risk The Risk Profile - Buyer Imagine a breakfast cereal producer buying wheat How would the value of the firm change as a result of changes in the price of wheat? Two key points: 1. Downward slope = negative relationship 2. Steepness of the slope indicates the exposure to the risk Types of Financial Risk Exposure Types Transactions Exposure Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in the near future. Economic Exposure Long-term financial risk arising from permanent changes in prices or other economic fundamentals. Transactions Exposure It is hard to protect a business from economic exposure. However, companies can protect themselves from transaction exposure using financial derivatives to hedge the risk: Forward contracts Futures contracts Swap contracts Option contracts Hedging with Forward Contracts Recap: Managing Financial Risk The Risk Profile A plot showing how the value of the firm is affected by changes in prices or rates. Hedging with Forward Contracts Forward Contract A legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed on today. Risk Profile: Wheat Example Let’s consider the case of a farmer selling wheat The seller’s concern is a fall in the price of wheat The buyer’s concern is a rise in the price of wheat Let’s look at the buyer’s risk profile Recap: The Buyers Risk Profile Two key points: 1. Downward slope = negative relationship because higher wheat prices mean lower profits 2. Steepness of the slope indicates the level of the exposure to the risk because wheat is a significant cost to the business The Payoff Profile The Payoff Profile A plot showing the gains and losses that will occur on a forward contract as the result of unexpected price changes. Risk Profile and the Forward Contract Payoff Profile Unhedged position: the buyer loses if the price rises, but gains if the price falls (risk profile) With a forward contract: the buyer gains if the price rises but loses if the price falls (pay-off profile) In other words, the forward contract pay-off profile exactly reverses the unhedged risk profile Hedging with Forward Contracts The buyer’s payoff profile for a forward contract on wheat is exactly the opposite of the unhedged risk profile If the buyer enters a forward contract, then the exposure to unexpected changes in wheat prices will be eliminated Forward Contracts: Credit Risk There is an important commercial limitation of forward contracts Suppose the wheat farmer and the cereal producer enter into a forward contract at an agreed price Both parties have eliminated all the price risk from the transaction But, if the actual wheat price is higher than the contract price at harvest time, the farmer (seller) will have an incentive to default because she can get a better price than the contract by selling on the open market If the actual wheat price is lower than the contract price at harvest time, the cereal producer (buyer) will have an incentive to default because they can get a cheaper price buying on the open market Forward Contract Benefits: Eliminates downside risk But… Also eliminates upside risk; and Still exposed to credit risk Credit risk is possibility that the counterparty will not honour the obligation Summary As the name suggests, a forward contract is a legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed on today. A forward contract fixes the future transaction price and so eliminates financial risk on that contract. However, a forward contract will always leave one party disadvantaged by the price agreed and so one party will always have an incentive to default Consequently, whilst forward contracts protect against financial risk of changing prices, they introduce credit risk Credit risk is possibility that the counterparty will not honour the obligation Hedging with Futures Contracts Hedging with Futures Contracts Futures Contract A forward contract with the feature that gains and losses are realised (i.e. paid) each day rather than only on the settlement date Reduces credit risk Forward and Futures Contracts: What’s the Difference? Forward Contract Futures Contract Private bespoke Standardised contracts arrangement between with fixed maturity dates two parties and uniform underlyings Traded OTC Traded on exchanges Settled only at the end Prices are settled daily – of the agreement mark-to-market High credit risk of Clearing houses default - counterparty guarantee transactions – risk low credit risk Hedging with Option Contracts Option Contracts An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time. Types of Option Contracts Call Option Terms An option that gives the owner the right, but not the obligation, to buy an asset. Call Option Pay-Off Profiles A. Buying a call option allows the buyer to profit from a rise in price B. Selling a call option forces the seller to make a loss from a rise in price Speculating with Option Contracts Long John is a derivatives trader. He has been analysing the price of wheat between now and September. The current price is £2 per bushel but he is expecting it to rise. He is not certain however. He wants the option to buy 50,000 bushels of wheat at £2 per bushel using a call option contract. Required: If the market price of wheat is £3 in September what are Long John's gains/losses? Options Contract - Solution Long John wants to benefit from a rise in price, but doesn’t want to risk a loss from a price fall by actually buying the wheat. Instead he can buy call option contracts at £2 per bushel. If the price is £3 Long John will exercise the call option. Why? Because he can buy at £2 and immediately sell for £3. Assuming he bought options over 50,000 bushels, by exercising the option, buying the wheat and then selling it, he will make a profit of £50,000 i.e. £1 per bushel What happens if instead of rising to £3, the price falls to say, £1? Options Contract - Solution Long John wants to benefit from a rise in price, but doesn’t want to risk a loss from a price fall by actually buying the wheat. Instead he buys call contracts at £2 per bushel. If the price is £1 Long John will not exercise the call option. Why? Because even if he wants the wheat, he can buy it on the market at £1. Why would he exercise the option and pay £2 for the same wheat? In effect, a call option provides a one way bet to benefit from a rise in price. For that reasons, option contracts usually carry a fee. Option Contracts Put Option Terms An option that gives the owner the right, but not the obligation, to sell an asset. Put Option Pay-Off Profiles C. Buying a put option allows the buyer to profit from a fall in price D. Selling a put option forces the seller to make a loss from a fall in price Speculating with Option Contracts Short Sam is a derivatives trader. He has been analysing the price of wheat between now and September. The current price is £2 per bushel but he is expecting it to fall. He is not certain however. He wants the option to sell 50,000 bushels of wheat at £2 per bushel using a put option contract. Required: If the market price of wheat is £1 in September what are Short Sam's gains/losses? Options Contract - Solution Short Sam wants to benefit from a fall in price, but doesn’t want to risk a loss from a price rise by short selling the wheat. Instead he can buy put option contracts at £2 per bushel. If the price is £1 Long John will exercise the put option. Why? Because he can sell at £2 and immediately buy for £1. Again assuming he bought options over 50,000 bushels, by exercising the option, buying the wheat and then selling it using the put option, he will make a profit of £50,000 i.e. £1 per bushel What happens if instead of falling to £1, the price rises to say, £5? Options Contract - Solution Short Sam wants to benefit from a fall in price, but doesn’t want to risk a loss from a price increase by short selling the wheat. Instead he buys put contracts at £2 per bushel. If the price is £5 Long John will not exercise the put option. Why? Because by exercising the option he is selling it at £2 per bushel when the market price is £5. Why would he exercise the option and sell wheat for £2 which he has to buy for £5? In effect, a put option provides a one way bet to benefit from a fall in price. For that reasons, option contracts usually carry a fee. Option Summary An option is an agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time A call option is an option that gives the owner the right, but not the obligation, to buy an asset. A put option is an option that gives the owner the right, but not the obligation, to sell an asset. The key benefit of an option is that it provides a one way bet to benefit from price changes. An option allows you to avoid ‘bad’ downside risk, but benefit from ‘good’ upside risk. Because options allow a choice of rejecting ‘bad’ risk and accepting ‘good’ risk they are relatively expensive and typically involve a fee. Suggested Reading Please read Chapter 20 and 21 from: Fundamentals of Corporate Finance, 4th European Ed., McGraw Hill by David Hillier, Stephen Ross, Randolph Westerfield and Bradford Jordan.