CHAPTER 23

ENTERPRISE RISK MANAGEMENT

KEY CONCEPTS AND SKILLS

Understand the risk exposure companies face
and how to hedge these risks
Understand the difference between forward
contracts and futures contracts and how they
are used for hedging
Understand how swaps can be used for hedging
Understand how options can be used for
hedging

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CHAPTER OUTLINE
Insurance
Managing Financial Risk
Hedging with Forward Contracts
Hedging with Futures Contracts
Hedging with Swap Contracts
Hedging with Option Contracts

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EXAMPLE: DISNEYS RISK

MANAGEMENT POLICY
Disney provides stated policies and procedures
concerning risk management strategies in its
annual report
The company tries to manage exposure to interest rates,
foreign currency, and the fair market value of certain
investments
Interest rate swaps are used to manage interest rate
exposure
Options and forwards are used to manage foreign
exchange risk in both assets and anticipated revenues
The company uses a VaR (Value at Risk) model to identify
the maximum 1-day loss in financial instruments
Derivative securities are used only for hedging, not
speculation

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ENTERPRISE RISK MANAGEMENT

(ERM)
ERM is the process of identifying and
assessing risks and seeking to mitigate
potential damage
Modern ERM views risks in the context of
the entire company
Many companies have created a new clevel executive position, the chief risk
officer (CRO)

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THE RISK MANAGEMENT PROCESS

Identify the specific types of risk that will
impact the firm
Some risks are obvious; others are not
Some risks may offset each other, so it is
important to look at the firm as a portfolio of
risks and not just look at each risk separately
You must also look at the cost of managing
the risk relative to the benefit derived
Risk profiles are a useful tool for determining
the relative impact of different types of risk
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FOUR TYPES OF RISK

Broadly speaking, risks fall into four types:
1. Hazard risks involve damage done by
outside forces such as natural disasters,
theft, and lawsuits
2. Financial risks arise from such things as
adverse exchange rate changes,
commodity price fluctuations, and interest
rate movements
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FOUR TYPES OF RISK

3. Operational risks encompass impairments
or disruptions in operations from a wide variety
of business-related sources including human
resources; product development, distribution,
and marketing; and supply chain
management
4. Strategic risks include large-scale issues
such as competition, changing customer
needs, social and demographic changes,
regulatory and political trends, and
technological innovation
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INSURANCE
Insurance is the most widely used risk
management tool
It is generally used to protect against hazard risks

Whether to purchase insurance is an NPV

question
Large firms often self-insure against less costly
events

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MANAGING FINANCIAL RISK

While firms often purchase insurance for
hazard risks, financial risks are often
reduced through hedging
Hedging, or immunization, is the process
by which firms reduce exposure to price or
rate fluctuations
Derivative securities are often used for hedging

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RISK PROFILES
Basic tool for identifying and measuring
exposure to risk
Graph showing the relationship between
changes in price versus changes in firm value
Similar to graphing the results from a
sensitivity analysis (as in Chapter 11)
The steeper the slope of the risk profile, the
greater the exposure and the greater the
need to manage that risk
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RISK PROFILE FOR A WHEAT

GROWER

RISK PROFILE FOR A WHEAT

BUYER

REDUCING RISK EXPOSURE

The goal of hedging is to lessen the
slope of the risk profile
Hedging will not normally reduce risk
completely
For most situations, only price risk can be
hedged, not quantity risk
You may not want to reduce risk completely
because you miss out on the potential upside as
well

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REDUCING RISK EXPOSURE

Financial risk, or the risk of price fluctuation, has two
components:
Short-run exposure (transactions exposure) arises
from the need to buy or sell at uncertain prices or rates
in the near future
Can often be hedged with a variety of tools, such as
derivatives
Long-run exposure (economic exposure) arises from
permanent changes in prices or other economic
fundamentals
Almost impossible to hedge
Requires the firm to be flexible and adapt to
permanent changes in the business climate
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FORWARD CONTRACTS
A contract where two parties agree on the price of
an asset today to be delivered and paid for at some
future date
Forward contracts are legally binding on both parties
They can be tailored to meet the needs of both parties and
can be quite large in size

Positions
Long agrees to buy the asset at the future date
Short agrees to sell the asset at the future date
Because forwards are negotiated contracts and
there is no exchange of cash initially, they are
usually limited to large, creditworthy corporations

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FIGURE 23.3
PAYOFF PROFILES FOR A FORWARD CONTRACT

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HEDGING WITH FORWARDS

Entering into a forward contract can virtually
eliminate the price risk a firm faces
It does not completely eliminate risk unless there is no
uncertainty concerning the quantity

Because it eliminates the price risk, it prevents the

firm from benefiting if prices move in the
companys favor
The firm also has to spend some time and/or money
evaluating the credit risk of the counterparty
Forward contracts are most often used to hedge
exchange rate risk

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HEDGING OIL PRICE RISK FOR AN

OIL BUYER

FUTURES CONTRACTS
Futures contracts traded on an organized securities
exchange
Futures contracts are available on a wide range of
physical assets, debt contracts, currencies, and equities
Require an upfront cash payment called margin
Margin is small relative to the value of the contract
Marked-to-market on a daily basis
Clearinghouse guarantees performance on all contracts
The clearinghouse and margin requirements virtually
eliminate credit risk

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FUTURES QUOTES
See Table 23.1 for a sample of Wall Street
Journal futures quotes
The contract size is important when
determining the daily gains and losses for
marking-to-market
The change in settlement price times the
contract size determines the gain or loss for
the day
Long an increase in the settlement price leads to a gain
Short an increase in the settlement price leads to a loss

Open interest is how many contracts are

currently outstanding
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HEDGING WITH FUTURES

The risk reduction capabilities of futures are similar
to those of forwards
The margin requirements and marking-to-market
require an upfront cash outflow and liquidity to
meet any margin calls that may occur
Futures contracts are standardized, so the firm may
not be able to hedge the exact product or quantity
it desires
Cross-hedging: hedging an asset with contracts
written on a closely related, but not identical, asset

Credit risk is virtually nonexistent due to the

Clearinghouse
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SWAPS
A swap is a long-term agreement
between two parties to exchange cash
flows based on specified relationships
Swaps can be viewed as a series of
forward contracts
First introduced to the public in 1981
when IBM and the World Bank entered
into a swap agreement
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SWAPS
There are three basic categories of swaps:
1. Currency swaps two parties agree to exchange a
specific amount of one currency for a specific amount
of another at specific dates in the future
2. Interest rate swaps two parties agree to exchange
payments where one payment is fixed and the other
payment is based on a variable market interest rate
3. Commodity swaps - an agreement to exchange a
fixed quantity of a commodity at fixed times in the
future

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EXAMPLE: INTEREST RATE SWAP

Consider the following interest rate swap
Company A can borrow from a bank at 8% fixed or LIBOR + 1.0%
floating (borrows fixed)
Company B can borrow from a bank at 9.5% fixed or LIBOR + 0.5%
(borrows floating)
Company A prefers floating and Company B prefers fixed
By entering into a swap agreement, both A and B are better off than
they would be borrowing from the bank with their preferred type of
loan, and the swap dealer makes 0.5%

Pay

Receive

Net

LIBOR + 0.5%

8.5%

-LIBOR

8.5%

LIBOR + 0.5%

9%

LIBOR + 0.5%

Swap Dealer w/B

LIBOR + 0.5%

9%

Swap Dealer Net

LIBOR + 9%

LIBOR + 9.5%

Company A
Swap Dealer w/A
Company B

-9%

+0.5%
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FIGURE 23.6
ANOTHER INTEREST RATE SWAP EXAMPLE

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OPTION CONTRACTS
The owner of an option contract has the right, but not
the obligation, to buy (sell) an asset for a set price on or
before a specified date

Call option owner has right to buy the asset

Put option owner has right to sell the asset
Exercise or strike price specified contract price
Expiration date specified contract date

Contract owner has the right to exercise the option; the

contract writer, or seller, is obligated
Call option writer is obligated to sell the asset if the option
is exercised
Put option writer is obligated to buy the asset if the option
is exercised
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OPTION CONTRACTS
Unlike forwards and futures, options allow
a firm to hedge downside risk, but still
participate in upside potential
A firm must pay an up front cost for this
option benefit
The up front cost of the option is called
an option premium
Forward contracts have no up-front cost
Futures have an initial margin requirement
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PAYOFF PROFILES: CALLS

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PAYOFF PROFILES: PUTS

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HEDGING COMMODITY PRICE RISK

WITH OPTIONS
Commodity options are generally futures options
Exercising a call futures option
Owner of the call receives a long position in the futures
contract plus cash equal to the difference between the
exercise price and the futures price
Seller of the call receives a short position in the futures
contract and pays cash equal to the difference between
the exercise price and the futures price

Exercising a put futures option

Owner of the put receives a short position in the futures
contract plus cash equal to the difference between the
futures price and the exercise price
Seller of the put receives a long position in the futures
contract and pays cash equal to the difference between
the futures price and the exercise price
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HEDGING EXCHANGE RATE

RISK WITH OPTIONS
May use either futures, options on currency, or
straight currency options
Used primarily by corporations that do business
overseas
U.S. companies want to hedge against a
strengthening dollar (receive fewer dollars when you
convert foreign currency back to dollars)
Using options: buy puts (or sell calls) on foreign currency
Protected if the value of the foreign currency falls relative
to the dollar
Still benefit if the value of the foreign currency increases
relative to the dollar
Buying puts is less risky, but more costly, than selling calls

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HEDGING INTEREST RATE

RISK WITH OPTIONS
Can use futures options
Large OTC market for interest rate options
Caps, floors, and collars
Interest rate cap prevents a floating rate from going
above a certain level (buy a call on interest rates)
Interest rate floor prevents a floating rate from going
below a certain level (sell a put on interest rates)
Collar buy a call and sell a put
The premium received from selling the put will help
offset the cost of buying the call

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COMPREHENSIVE PROBLEM
A call option has an exercise price of $50.
What is the value of the call option at expiration
if the stock price is $35? $75?

A put option has an exercise price of $30.

What is the value of the put option at expiration
if the stock price is $25? $40?

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