Corporate Risk Management

07/05/20 1
 Introduction

Global trends are leading to …


The rising importance of risk management In financial
institutions
 More complex markets
 Global markets
 Greater product Complexity Increased
New businesses (e-banking,
Risk


merchant banking,…)
 Increasing competition
 New players
 Regulatory imbalances

07/05/20 2
 Introduction

In the future . . .

The leading institutions will be

distinguished by their intelligent
management of risk.

07/05/20 3
 Introduction
CLASSIFICATION OF RISKS
•Technological risks
• Economic risks
• Financial risks
• Performance risks
• Legal and regulatory risks

07/05/20 4
 Introduction
 Risk is multidimensional
Market Risk
Credit Risk
Financial
Risks Operational Risk

Reputational Risk
Business and strategic risks

07/05/20 5
 Introduction
 One can “slice and dice” these multiple dimensions of risk*
“Specific
Risk”
Equity Risk Trading Risk
Market Risk General
Interest Rate Risk
Market
Gap Risk Risk
Currency Risk
Credit Risk
Commodity Risk
Counterparty
Operational Risk
Risk
Financial Transaction Risk
Risks
Reputational Issuer Risk
Risk Portfolio
Concentration
Business and Risk Issue Risk
strategic risks

* For more details, see Chapter-1, “Risk Management” by Crouhy, Galai and Mark
07/05/20 6
 What is Risk?
 No single definition.
 Risk is defined as uncertainty
concerning the occurrence of a loss.
 In finance, risk is defined as variability
of returns.
 Measure of financial risk:
 Standard Deviation

07/05/20 7
 Nature of Risk
 The word “Risk” can be used to
describe any situation in which there is
an uncertainty about the outcome
 In financial world, risk can be defined
as “any possibility of an event which
can impair corporate earning or cash
flow over short/medium/long term
horizon

07/05/20 8
 Is risk bad?
 No, risk is not bad.
 Risk-return framework.
 No gain without pain.
 One cannot expect higher return unless one
exposes oneself to higher level of risks.
 Investors differ in their risk bearing capacity.
 Risk averse
 Risk neutral
 Risk seeker

07/05/20 9
 Types of Risk
 Objective Risk
 Relative variation of actual loss from expected
loss.
 It varies inversely with square root of number of
cases under observation.
 Law of large numbers: As number of exposures
increases the actual loss will approach the
expected loss.
 Measures: Standard deviation, coefficient of
variation
07/05/20 10
 Types of Risk
 Subjective Risk
 Uncertainty based on a person’s mental
condition or state of mind.
 High subjective risk leads to more conservative
behavior.
 Impact of subjective risk varies depending on
the individual.
 Low subjective risk leads to less conservative
behavior.
07/05/20 11
 Categories of Risk
 Pure Risk: situation in which possibilities are
loss and no loss.
 Speculative Risk: either profit or loss is
possible.
 Differences:
 Law of large numbers can be easily applied to
pure risks.
 Insurers typically insure pure risks.
 Society may benefit from speculative risks.

07/05/20 12
 Categories of Risk
 Fundamental Risk: affects entire
economy or large sections of it.
Examples: War, inflation, etc.
 Particular Risk: affects individuals.
 Enterprise Risk: encompasses all major
risks faced by a firm.
 Pure, speculative, strategic, operational &
financial risks.

07/05/20 13
 Categories of Risk
 Systematic Risk: Risk that cannot be
diversified. Also called market risk.
 Non-systematic Risk: Risk that can be
eliminated by diversification. Also called
Unique/Specific risk.

07/05/20 14
 Types of Pure Risk
 Personal Risk:
 Premature death.
 Insufficient income after retirement.
 Poor health or disability.
 Unemployment.
 Property Risk:
 Direct – physical damage or Indirect -
consequential
 Liability Risk – legally liable

07/05/20 15
 Sources of Risk
 Economic policies of the government
 Technological factors
 Corporate governance
 Political and Social Issues
 Market related factors
 Demographic factors

07/05/20 16
 Need for the Risk Mgmt.
 To deal with Globalization which has resulted
pressure on margins
 To ensure wealth maximization
 To deal with Agency cost
 To deal with increasing complexities of the
businesses
 Managing reasonable and well understood
risk is necessary in order to earn adequate
returns

07/05/20 17
 Benefits of the Risk Mgmt.
 Brings order and system to the process of risk
quantification
 Enable the assigning of value of estimated risk
of loss, e.g. VaR
 Flags extreme risky situations for necessary
mitigative actions
 Improve risk awareness
 Increases valuations and reduce cost of capital
 More objective performance appraisal based
on risk adjusted capital employed
07/05/20 18
 Risk Policy
 Policy needs to identify issues in RM
 Defining RM framework in context of organisation
background, polices and regulatory framework
 The level of organisation at which RM is expected to
be implemented
 Identifications of risk and its consequences
 Risk preference of the stakeholders
 Clarity of objectives
 Identification of external and internal factors that
limits the application of RM strategies
 Tools and techniques to be adopted
 Establishing ground rules for successful RM
07/05/20 19
 Methods of handling risk
 Avoidance – avoid the risk of divorce by not marrying!!!!!
 Loss Control
 Loss prevention – “Durghatna se der bhali !!!!!!!!”
 Loss reduction
 Retention
 Active retention: Individual is aware of risk and deliberately
plans to retain it.
 Passive retention: Ignorance, indifference.
 Non-insurance Transfers
 Transfer of risks by contracts.
 Hedging price risks with the help of derivatives
 Limited liability company.
 Insurance

07/05/20 20
 Risk Classification
 Managerial Perspective
 Risk that need to be avoided
 Risk that should be transferred
 Risk that to be actively managed
 Functional Perspective
 Credit Risk
 Market Risk
 Operational Risk
07/05/20 21
 Credit Risk
 Credit risk or counter-party risk is the risk to
each party of a contract that the other will not
live up to its contractual obligations
 It is also known as default risk
 Default may be due to its inability or
unwillingness of debtor to meet commitments
in relation to trading, lending, settlement and
other financial transactions

07/05/20 22
 Market Risk
 It is the risk of fluctuations in the
portfolio value because of movements
in such variables
 Price Risk
 Unfavourable movements in price of a
security, commodity or any other obligation
 It can be classified into different categories

07/05/20 23
 Operational Risk
 Basel Committee has defined operational
risk as “the risk of default or indirect loss
resulting from an inadequate or failed
internal processes, people, systems or
from external events.”

07/05/20 24
 What is Risk Management?
 Does it mean ‘reduction of risk’?
 Risk Management (RM) is a process
that identifies loss exposure faced by a
firm and selects the most appropriate
techniques for treating such exposures.
 Points to note:
 It is a dynamic process.
 Does not talk about risk reduction.

07/05/20 25
Steps in RM process
 Identify loss exposures.
 Analyze the loss exposures.
 Select appropriate technique for
treating the loss exposures.
 Implement and monitor the risk
management program.

07/05/20 26
 Steps in RM process-1
 Identify loss exposures.
 Property loss: buildings, plants, inventory, etc.
 Liability loss: defective products, pollution, law
suits, etc.
 Business income loss.
 Human resources loss: death of key employees,
injuries, etc.
 Crime loss: theft, fraud, cyber crimes, etc.

07/05/20 27
 Steps in RM process-1
 Identify loss exposures.
 Employee benefit loss: failure to comply with govt.
regulations, etc.
 Foreign loss: currency risks, kidnapping,
nationalization, etc.
 Reputation.
 Sources: inspections, financial statements,
historical loss data, analysis of operations, etc.

07/05/20 28
 Steps in RM process-2
 Analyze the loss exposures.
 Estimation of frequency and severity.
 Loss frequency: probable number of losses in a
given time frame.
 Loss severity: probable size of loss.
 Maximum possible loss: worst loss that could
happen.
 Maximum probable loss: worst loss that is
likely to happen.

07/05/20 29
 Steps in RM process-3
 Selecting the appropriate technique.
 Risk Control: techniques that reduce frequency
and severity of losses.
 Avoidance: means a loss exposure is not acquired
or existing loss exposure is abandoned.
 Loss prevention: measures that reduce frequency of
a particular loss.
 Loss reduction: measures that reduce severity of a
loss after it occurs.

07/05/20 30
 Steps in RM process-3
 Selecting the appropriate technique.
 Risk Financing: techniques that provide for
funding of losses:
 Retention: active or passive.
 Can be used if no other method is available, losses are highly
predictable, worst possible loss is not serious.
 Advantages: save money, lower expenses, encourage
loss prevention, increase cash flow.
 Disadvantages: possible higher losses, higher
expenses, higher taxes.

07/05/20 31
 Steps in RM process-3
 Selecting the appropriate technique.
 Non-insurance transfers: pure risk & its potential
financial consequences are transferred to another party.
Examples: leases, hold-harmless agreements.
 Insurance: appropriate for loss exposures that have a
low probability but high severity.
 Advantages: indemnification, reduction of uncertainty, tax
deductible, risk management services provided by insurers.
 Disadvantages: cost of premiums, time & effort in negotiating
insurance, less incentive to follow loss-control program.

07/05/20 32
 Steps in RM process-4
 Implement and monitor the RM program.
 Policy statement.
 Cooperation with other departments.
 Periodic review and Evaluation.

07/05/20 33
Derivatives as
Risk Management Tools

07/05/20 34
 What is a derivative?
 A derivative is an instrument whose
value depends on the values of other
more basic underlying variables.
 Underlying could be a stock, commodity,
index, etc.
 Example: NSE allows trading in
derivatives on stocks like HDFC Bank,
ACC, etc and indices like Nifty.

07/05/20 35
 Uses of Derivatives
 To hedge risks.
 Hedging: An investment made in order to reduce the risk
of adverse price movements in a security, by taking an
offsetting position in a related security.
 To speculate (take a view on the future direction of
the market).
 Speculation: A trading strategy where one side of a
position is taken (and thus risk bearing) where the trader
expects to make a positive profit.
 To lock in an arbitrage profit.
 Arbitrage: A trading strategy which generates (weakly)
positive profits with probability one.

07/05/20 36
 Types of Traders
 Hedgers: Use derivatives to reduce the
risks they face from potential future
movements in a market variable.
 Speculators: Use them to bet on future
movements of a market variable.
 Arbitrageurs: Use them to lock in a risk-
less profit.

07/05/20 37
 Role of different
types of traders
 Hedgers: provide depth to the market.
 Speculators: provide liquidity and
volume to the market.
 Arbitrageurs: assist in price discovery
and correct price abnormalities.

07/05/20 38
What is hedging?
 An investment made in order to reduce the risk
of adverse price movements in a security, by
taking an offsetting position in a related security.
 Perfect Hedge: Is one that completely eliminates
the risk.
 Hedge & Forget: No attempt is made to adjust
the hedge once it has been put in place.
 In practice the risk manager keeps adjusting the
hedges.
Long Hedge
 It is a hedge that involves taking a long
position in a futures contract.
 A long futures hedge is appropriate
when you know you will purchase an
asset in the future and want to lock in
the price.
 Long Hedge- Example
 Example: It is 1st August now. A Flour miller requires
100,000 kgs of wheat on 1st January. Spot price is Rs.
14/kg. January futures price is Rs. 12/kg.
 Strategy:
 Take a long position in a futures contract.

 Close the position on/before 1st January.

 Outcome:
 Suppose in January spot price is Rs. 12.5/kg.
 Cost of wheat will be Rs. 12.5/kg in spot market
 Company gains Rs. 0.50/kg from futures
 Suppose in January spot price is Rs. 11.5/kg.
 Cost of wheat will be Rs. 11.5/kg in spot market
 Company loses Rs. 0.50/kg from futures
 Result: Company locks a price of Rs. 12/kg.
Long Hedge- Example
 The company could have bought wheat on 1st
August but this would have meant:
 Paying Rs. 2 per kg more.
 Incurring storage costs.
 Foregoing interest on blocked money.
Short Hedge
 It is a hedge that involves taking a
short position in a futures contract.
 A short futures hedge is appropriate
when you know you will sell an asset in
the future & want to lock in the price.
 Short Hedge- Example
 Example: It is 1st August now. A wheat farmer knows that
he will sell 100,000 kgs of wheat on 1st January. Spot
price is Rs. 14/kg. January futures price is Rs. 12/kg.
 Strategy:
 Take a short position in a futures contract.

 Close the position on/before 1st January.

 Outcome:
 Suppose in January spot price is Rs. 11.5/kg.
 Company gets Rs. 0.50/kg from futures and Rs. 11.5/kg from
sale of wheat in spot market
 Suppose in January spot price is Rs. 12.5/kg.
 Company loses Rs. 0.50/kg from futures and gets Rs.12.50/kg on
sale of wheat in spot market.
 Result: Farmer locks a price of Rs. 12/kg.
A case study: Crude Oil
A case study: Crude Oil
A case study: Crude Oil
Arguments for/against
hedging
 For:
 Companies should focus on the main business they are
in and take steps to minimize risks arising from interest
rates, exchange rates, and other market variables.
 Against:
 Shareholders are usually well diversified and can make
their own hedging decisions.
 It may increase risk to hedge when competitors do not.
 Explaining a situation where there is a loss on the
hedge and a gain on the underlying can be difficult.
 Hedging & Competitors
Chan Effect Effect Effect  If industry is such
ge in on on on that prices of goods
copp price profits profits produced fluctuate
er of wire of X of Y to reflect cost of
price inputs it may not be
a good strategy to
+ + nil + hedge.
 Example: Copper
wire manufacturers.
- - nil -  X: Does not hedge.
 Y: Hedges.
Basis Risk
 Hedging is not straight-forward because:
 Asset to be hedged is different from asset underlying
the futures contract.
 Hedger is uncertain about exact date when asset is
sold/bought.
 Futures contract may be closed well before expiration.
 This leads to basis risk.
 Basis is the difference between spot price of the
asset & futures price of contract
 Basis risk arises because of the uncertainty about
the basis when the hedge is closed out.
Basis Risk
 What should be the basis at the expiration of
contract if asset to be hedged and asset underlying
the futures contract are the same.
 The basis should be zero.
 Prior to expiration basis could be +ve or –ve.
 Strengthening of basis: When spot price increases
by more than futures price, the basis increases.
 Weakening of basis: When futures price increases
by more than spot price, the basis decreases.
 Long Hedge
 Suppose that
F1 : Initial futures price at time t1
F2 : Final futures price at time t2
S2 : Final asset spot price at time t2
 You hedge the future purchase of an asset by entering
into a long futures contract at t1 & close the position at
t2.
 What is the total cost of asset ?

Price paid for asset S2 + Loss on hedge F1 - F2
 S2 + F1 - F2 = F1 + Basis
 Shot Hedge
 Suppose that
F1 : Initial futures price at time t1
F2 : Final futures price at time t2
S2 : Final asset spot price at time t2
 You hedge the future sale of an asset by entering into a
short futures contract at t1 & close the position at t2.
 What is the total price of asset ?

Price realized for asset S2 + Profit on hedge F1 - F2
 S 2 + F1 - F2 = F1 + Basis
Choice of Contract
 Has two components:
 Choice of asset underlying the contract.
 Ideally same asset.

 Else, careful analysis is required. Choose one with high

correlation to asset price.

 Choice of delivery month.
 Contract with later delivery month is chosen.

 Erratic behavior of futures prices in delivery month.

 Avoid risk of taking delivery.
 Rule of thumb: Delivery month as close as possible to but
later than expiration of hedge is chosen.
 Example: Delivery months are Jan, March & May. For
hedge expiring in Feb which contract will be used?
 March.
 Quiz
 Futures can be used for either
speculation or hedging. How?
 If you have an exposure to the price of
an asset, futures can be used for
hedging.
 If you don’t have an exposure to the
price of an asset, entering into futures is
speculation.
07/05/20 55
 Arbitrage Example
 Suppose that:
 The spot price of gold is Rs.10000.
 The quoted 1-year futures price of gold is Rs.
11100.
 The 1-year interest rate is 10 % per annum.
 No income or storage costs for gold.
 No transaction costs.
 Is there an arbitrage opportunity?

07/05/20 56
 Arbitrage Example
If the spot price of gold is S & the futures
price is for a contract deliverable in T years is
F, then
F = S (1+r )T
where r is the 1-year risk-free rate of interest.
In our examples, S=10000, T=1, and r=0.10
so that
F = 10000(1+0.10) = 11000

07/05/20 57
 Arbitrage Example-1
 What will you do?
 Borrow Rs. 10000 @ 10% p.a from bank.
 Buy gold.
 Go short on gold futures contract of price Rs.
11100.
 At end of one year, sell gold at Rs. 11100, give
Rs. 1000 as interest to bank and walk away with
Rs. 100 as risk free profit!
 So you have found a Money Making Machine!

07/05/20 58
 Do such machines exist?
 Yes, they do.
 But for very short periods.
 As soon as traders start building up
positions the price of futures contracts will
change to eliminate the arbitrage
opportunity.
 Another important consideration are
transactions costs.

07/05/20 59
 Futures Contracts
 Available on a wide range of underlyings:
 Indices
 Stocks
 Commodities
 Exchange traded.
 Specifications designed by exchange:
 What can be delivered,
 Where it can be delivered, &
 When it can be delivered
 Settled daily: Marked to market.

07/05/20 60
 Futures Contracts
 Most futures contracts are closed out before
maturity.
 Closing out a futures position involves entering
into an offsetting trade.
 A few contracts (for example, those on stock
indices) are settled in cash.
 If a futures contract is not closed out before
maturity, it is usually settled by delivering the
assets underlying the contract.

07/05/20 61
 Newspaper Quotes
 Prices:
 Open, High, Low
 Close: Average of the prices at which the contract
traded immediately before close of trading.
 Open Interest: This is the total number of
outstanding contracts. Equal to number of long
(short) positions.
 Trading Volume: Volume of trading in the
contract during the day.

07/05/20 62
 The relationship between the prevailing price
trend and open interest
Price Open Interest Interpretation
Market is
Rising Rising
Strong
Market is
Rising Falling
Weakening
Market is
Falling Rising
Weak
Market is
Falling Falling
Strengthening 63
07/05/20
Specification of futures contracts
 Asset:
 Financial assets are generally well defined & unambiguous.
 In case of commodities variation in quality is possible.
Exchanges stipulate the grades that are acceptable.
 When there are alternatives about what is delivered, where
it is delivered, and when it is delivered, the party with the
short position chooses.
 Contract Size:
 Specifies the amount of the asset that has to be delivered.
 Differs from commodity to commodity, stock to stock.

07/05/20 64
 Specification of futures contracts
 Delivery arrangements: Place and mode need to
be specified in detail.
 Delivery month:
 Futures contract is referred to by its delivery month.
 The delivery period is fixed by exchange. For example,
In NSE, last Thursday of the expiry month is expiry day.
 Price steps:
 Are fixed by exchange. In NSE, Price steps are Rs. .05.
 Price Bands: The maximum upward/downward
movement allowed by exchange in one day. In
NSE, for stock futures operating range is 20% of
base price.

07/05/20 65
 Convergence of Futures to Spot

Price

FP SP

SP FP

Time

07/05/20 66
 Profit from a Long Forward or
Futures Position
Profit

Price of Underlying
at Maturity

07/05/20 67
 Profit from a Short Forward or
Futures Position
Profit

Price of Underlying
at Maturity

07/05/20 68
 Futures vs. Forwards
 Exchange traded
 Standardized contracts
 Range of delivery dates
 Settled daily
 Contract is usually
closed out prior to
maturity
07/05/20
 Private contract
 Not standardized
 Usually one specified
delivery date
 Settled at end of
contract
 Delivery or final cash
settlement usually
takes place.
69
 Margins
 The cleaning member will be required to post a certain
amount of money, known as a margin, on all trades
cleared

 This margin will be based on the value of the contract

cleared

 The margin account will be updated daily, using marking-

to-market procedure

 If the margin account balance falls below a certain level, a

margin call will be issued by the clearing corporation and
the member will have to put up additional costs as margin
07/05/20 70
 Cost of Carry
 Relationship between future and spot prices can
be summarized in terms of cost of carry.
 Cost of carry = storage cost + interest paid to
finance the asset - the income earned on the
asset.
 If cost of carry = c,
 For investment assets:
 F0 = S0 ecT
 For consumption assets:
 F0 = S0 e(c-y)T

07/05/20 71
 Practice question
 Suppose that the spot price of a commodity is
Rs. 291 per kg. The interest rate is 2.5% p.a.
and storage costs are assumed to be zero.
 A futures contract of Rs. 300 that expires six
months from now is available.
 Is there an arbitrage opportunity?
 Explain the steps involved in earning an
arbitrage profit and compute the profit/loss
per contract.

07/05/20 72
 Practice question: Answer
 Compute the price, F0 of this futures contract that
does not give rise to arbitrage.
 F0=S0e(r+u)T
 F0 = 291e .025(.5) = Rs. 294.66
 Clearly the spot price is too cheap and the future
is too expensive.
 Borrow Rs. 291, Buy the commodity and short a
future.
 After 6 months sell the asset for Rs. 300 and
return to lender Rs.294.66.
 Make an arbitrage profit of Rs. 5.34 for every kg.

07/05/20 73
 Quiz Time
 Assume that you enter into a long position in a January gold
futures (100 grams) contract at INR 10,079 on October 15, 2007.
On January 16, 2008, you decide to close your position when the
futures price is INR11,269. One contract is for 10 grams of gold.
What is your profit?

07/05/20 74
 Quiz Time
 Jet Airways requires 2,000,000 barrels of aviation fuel every month. Since the
price of aviation fuel depends on the price of crude oil, Jet Airways faces price
risk. At the beginning of each month, Jet Airways goes for a long hedge in
crude oil futures contract for 2,000,000 barrels, with expiry by the end of that
month.
 What is meant by a long hedge?
 What is the purpose of the long hedge undertaken by Jet Airways?
 Would Jet Airways be able to completely eliminate the price risk of aviation fuel? Explain
 assume that the standard deviation of the crude oil futures is USD 2.5 and the
standard deviation of aviation oil price is USD 3.2. The correlation coefficient
between crude oil futures price and aviation oil price is 0.96.
 Calculate the optimal hedge ratio. Explain what Jet Airways needs to do to hedge the price risk.
 What is the hedging effectiveness of this hedge undertaken by Jet Airways on the basis of the
optimal hedge ratio?
 If the size of a crude oil futures contract is 100 barrels, calculate the number of contracts that
Jet Airways should enter into.

07/05/20 75
 Solution
 A long hedge means that the hedger needs to purchase a commodity
or asset at a future time, and is using futures contracts to hedge the
risk of price increase.
 Jet Airways requires aviation fuel every month, and fuel prices are
highly volatile. In order to forecast future cash flows more efficiently,
Jet Airways will undertake a long hedge using futures.
 Jet Airways cannot completely eliminate the price risk, because it
requires aviation fuel—on which no futures are available. They would
be required to cross-hedge using crude oil futures; as a result, price
risk will remain, but it will be small on account of the high correlation
between crude oil and aviation fuel prices.

07/05/20 76
 Solution
This means that, for each barrel of aviation oil required,
a long position in 1.2288 barrels of crude oil futures
should be taken. Since Jet Airways requires 2,000,000
barrels of aviation oil, the position in futures should be

This means that 92.16% of the variation in aviation fuel

price will be hedged.

•If the contract size of crude oil futures is 100 barrels,

Jet Airways should take a long position in 24,576 crude
oil futures contracts.

07/05/20 77
 Options vs. Futures
 Option holder has the right to do
something while in a Futures contract
certain action has to be performed.
 Option holder may not exercise his right.
 Futures contract can be entered at no
cost while Option buyer has to pay some
money up-front.

07/05/20 78
 Types of Options
 A call is an option to buy.
 A put is an option to sell.
 A European option can be exercised
only at the end of its life.
 An American option can be exercised at
any time.

07/05/20 79
 Call & Put Options
 A holder of call option expects stock
price to become higher than strike
price.
 A holder of put option expects stock
price to become lower than strike price.

07/05/20 80
 Option Positions
 Long Position: One who has bought the option.
 Short Position: One who has sold (or written)
the option.
 Different combinations are possible:
 Long call
 Long put
 Short call
 Short put

07/05/20 81
 Long Call on eBay
 Profit from buying one eBay European call
option: option price = $ 5, strike price = $100,
option life = 2 months
30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130

07/05/20 82
 Short Call on eBay
 Profit from writing one eBay European call
option: option price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
07/05/20 83
 Long Put on IBM
 Profit from buying an Oracle European put
option: option price = $7, strike price = $70
30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

07/05/20 84
 Short Put on IBM
 Profit from writing an IBM European put option:
option price = $7, strike price = $70
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
07/05/20 85
 Long Call Benefit if the
Right to buy the underlying rises.
underlying at Profits
strike price substantial
Buy Lose if the underlying
is steady/ falling.
Loss limited to
Premium
Call Options
Benefit if the
underlying is
steady/ falling.
Short Call
Profit limited to
Sell Obligation to
Premium
sell the
underlying at
strike price Lose if the underlying
rises. Loss substantial
07/05/20 86
 Long Put Benefit if the
Right to sell the underlying falls.
underlying at Profits
strike price substantial
Buy
Lose if the underlying
is steady/ rising.
Loss limited to
Premium
Put Options
Benefit if the
underlying is
steady/ rising.
Short Put
Profit limited to
Sell Obligation to
Premium
Buy the
underlying at
strike price Lose if the underlying
falls. Loss substantial
07/05/20 87
 It is vital to know who has the Right to transact
vs. who may be Obliged to transact in order to
determine the direction of cash flows at expiry

BUYER SELLER
Has the Right to Buy Has the Potential Obligation
the Asset to Sell the Asset if
CALL Exercised

Has the Right to Sell Has the Potential Obligation

the Asset to Buy the Asset if
PUT Exercised

07/05/20 88
 Money-ness :
 At-the-money option: Would give the holder a zero cash flow if the
option is exercised immediately.
 In-the-money option: Would give the holder a positive cash flow if the
option is exercised immediately.
 Out-of-the-money option: Would give the holder a negative cash flow if
the option is exercised immediately.

Call Options Put Options

In the money Spot price > Strike price Spot price < Strike
price
At the money Spot price = Strike price Spot price = Strike
price
Out of the Spot price < Strike price Spot price > Strike
money price

07/05/20 89
 Intrinsic Value and Time Value
An option premium or value of the option can be broken
in to two parts
Intrinsic Value:
Intrinsic value of option is the amount by which the
option is ITM (in the money)
If option is ATM and OTM, the intrinsic value is zero
For call = Max {0, S-K}, For Put = Max {0, K-S}
Time Value:
Time value of option is the difference between its
premium and intrinsic value
Call/Put Premium - Max {0, S-K}/ Max {0, K-S}

07/05/20 90
Example
 On October 25, company’s stock price closed at
Rs. 5000
 The following option prices were quoted.
Compute intrinsic and time value of these options

Strike Price Call Put

Premium Premium
4900 120 10
5000 35 40
5100 5 125
07/05/20 91
Example
Strike Intrinsic Time Value
Value
Call 4900 100 20
Call 5000 0 35
Call 5100 0 5
Put 4900 0 10
Put 5000 0 40
Put 5100 100 25

07/05/20 92
 Factor affecting option pricing
Variable Effect of Increase in each variable
on
Value of call Value of Put
Spot Price Increase Decrease
Strike Price Decrease Increase
Volatility Increase Increase
Time to Expiry Increase Increase
Interest rate Increase Decrease
Dividend Decrease Increase
07/05/20 93
 Hedging Example- Options
 An investor owns 1,00 MT of Soya Oil
currently worth Rs. 280 per MT.
 A two-month put with a strike price of
Rs. 270 costs Rs 10. The investor
decides to hedge by buying 10
contracts (of 10 MT each).

07/05/20 94
 Value of Soya Oil with and
without Hedging
40,000 Value of
Holding

35,000

No Hedging
30,000 Hedging

25,000

Soya Price
20,000
200 250 300 350 400

07/05/20 95
 Speculation Example
 An trader with Rs 4,000 to invest feels
that “X” commodity price will increase
over the next 2 months.
 The current price is Rs. 800 Per MT and
the price of a 2-month call option with a
strike of Rs. 815 is Rs. 10.
 What alternative strategies are available?

07/05/20 96
 Speculation Example
 Strategy 1
 Buy 5 MT of “X” commodity.
 After 2 months price becomes Rs. 830.
 Trader sells 5 MT.
 Trader makes profit of Rs. 5*30 = Rs.
150.

07/05/20 97
 Speculation Example
 Strategy 2
 Buy 400 two-month call options of “X”
 After 2 months price becomes Rs. 830.
 Trader exercises call options.
 Makes profit of Rs. 400*15 - 4000 = Rs.
2000

07/05/20 98
 Speculation Example
 Use of derivatives amplifies the profits
which can be had from directly dealing
in the market variable.
 What about losses?
 They too get amplified!

07/05/20 99
 Forward Market Hedge: an Example

You are a U.S. importer of British woolens and

have just ordered next year’s inventory.
Payment of £100M is due in one year.
Question: How can you fix the cash outflow in
dollars?
Answer:
One way is to put yourself in a position that
delivers £100M in one year—a long forward
contract on the pound.
07/05/20 100
 Forward Market Hedge
Suppose the The importer will be better off if
forward exchange the pound depreciates: he still
rate is $1.50/£. buys £100m but at an exchange
$30m rate of only $1.20/£ he saves
If he does not $30 million relative to $1.50/£
hedge the £100m
payable, in one $0
year his gain Value of £1 in
(loss) on the $1.20/£ $1.50/ $1.80/£$ in one year
unhedged position £
–$30m
is shown in green.
But he will be worse off Unhedged
if the pound appreciates. payable

07/05/20 101
 Forward Market Hedge
If you agree to buy £100 Long
million at a price of $1.50
If he agrees per pound, you will make
forward
to buy £100m $30 million if the price of a
pound reaches $1.80.
in one year at $30m
$1.50/£ his
gain (loss) on
the forward $0
Value of £1 in
are shown in $1.20/£ $1.50/ $1.80/£$ in one year
blue. £
–$30m If you agree to buy £100 million at a price of
$1.50 per pound, you will lose $30 million if
the price of a pound is only $1.20.

07/05/20 102
 Forward Market Hedge
The red line Long
shows the forward
payoff of the
hedged $30
payable. Note m
that gains on Hedged
one position $0
Valuepayable
of £1 in
are offset by $1.20/ $1.50/ $1.80/ $ in one year
losses on the £ £ £
other position. –$30
m
Unhedged
payable
07/05/20 103
 Options Market Hedge
 Options provide a flexible hedge against the
downside, while preserving the upside potential.
 To hedge a foreign currency payable buy calls on
the currency.
 If the currency appreciates, your call option lets you
buy the currency at the exercise price of the call.
 To hedge a foreign currency receivable buy puts
on the currency.
 If the currency depreciates, your put option lets you
sell the currency for the exercise price.

07/05/20 104
 Options Market Hedge
The importer will be better off if
Suppose the the pound depreciates: he still
forward exchange buys £100m but at an exchange
rate is $1.50/£. rate of only $1.20/£ he saves
$30m
If an importer who $30 million relative to $1.50/£
owes £100m does
not hedge the
$0
payable, in one Value of £1 in
year his gain (loss) $1.20/£ $1.50/ $1.80/£$ in one year
on the unhedged £
position is shown –$30m
in green.
But he will be worse off Unhedged
if the pound appreciates. payable
07/05/20 105
 Options Markets Hedge
Profit Long call on
Suppose our
£100m
importer buys a
call option on
£100m with an
exercise price of
$1.50 per
pound. –$5m Value of £1 in
$1.55/ $ in one year
He pays $.05
$1.50/
£
per pound for
£
the call.
loss

07/05/20 106
 Options Markets Hedge
Profit Long call on
The payoff of the
portfolio of a call £100m
and a payable is
shown in red.
$25m
He can still profit
from decreases in
the exchange rate
below $1.45/£ but –$5m Value of £1 in
has a hedge $1.20/£ $ in one year
against $1.45 /
unfavorable £
increases in the
exchange rate.
$1.50/£ Unhedged
loss payable
07/05/20 107
 Options Markets Hedge
Profit Long call on
If the exchange
£100m
rate increases to
$1.80/£ the
importer makes $25
$25 m on the call
but loses $30 m on
m
the payable for a
maximum loss of –$5 m
Value of £1 in
$5 million. $1.80/£$ in one year
This can be $1.45/£
–$30
thought of as an
insurance m
$1.50/ Unhedged
premium. loss £ payable
07/05/20 108
 Options Markets Hedge
IMPORTERS who OWE
foreign currency in the
future should BUY CALL
OPTIONS.
 If the price of the currency
goes up, his call will lock in
an upper limit on the dollar
cost of his imports.
 If the price of the currency
goes down, he will have the
option to buy the foreign
currency at a lower price.
07/05/20
EXPORTERS with accounts
receivable denominated in
foreign currency should BUY
PUT OPTIONS.
 If the price of the currency goes
down, puts will lock in a lower
limit on the dollar value of his
exports.
 If the price of the currency goes
up, he will have the option to sell
the foreign currency at a higher
price.
109
 Hedging Exports
with Put Options
 Show the portfolio payoff of an exporter who
is owed £1 million in one year.
 The current one-year forward rate is £1 = $2.
 Instead of entering into a short forward
contract, he buys a put option written on £1
million with a maturity of one year and a strike
price of £1 = $2.
 The cost of this option is $0.05 per pound.

07/05/20 110
 Options Market Hedge:
Exporter buys a put option to protect the
dollar value of his receivable.

le
ab
iv
$1,950,000

ce
re
ed
dg
He
S($/£)360
–$50k
Long put
l e
ab

$2 $2.05
iv
ce
re
ng
Lo

–$2m

07/05/20 111
 Swaps
 A swap is an agreement to exchange cash
flows at specified future times according to
certain specified rules.
 Usually the calculation of cash flows involves
the future values of one or more market
variables.
 Used for converting a liability/investment
from:
 fixed rate to floating rate.
 floating rate to fixed rate.
07/05/20 112
 Definitions
 In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps:
 Single currency interest rate swap
 “Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 In this a company agrees to pay a fixed rate on a notional
principal in return of a floating rate from another company
on same notional principal for same period.
 Cross-Currency interest rate swap
 This is often called a currency swap; fixed for fixed rate
debt service in two (or more) currencies.
07/05/20 113
An Example of
an Interest Rate Swap
 Consider this example of a “plain vanilla” interest
rate swap.
 Bank A is a AAA-rated international bank located
in the U.K. who wishes to raise $10,000,000 to
finance floating-rate loan.
 Bank A is considering issuing 5-year fixed-rate
bonds at 10 percent.
 It would make more sense to for the bank to issue
floating-rate bonds at LIBOR to finance floating-rate
loans.

07/05/20 114
 An Example of
an Interest Rate Swap
 Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a
five-year economic life.
 Firm B is considering issuing 5-year fixed-rate
bonds at 11.75 percent.
 Alternatively, firm B can raise the money by
issuing 5-year floating rate bond at LIBOR + ½
percent.
 Firm B would prefer to borrow at a fixed rate.

07/05/20 115
 An Example of
an Interest Rate Swap
The borrowing opportunities of the two
firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 116
 An Example of
an Interest Rate Swap
Swap The swap bank makes
this offer to Bank A:
Bank You pay LIBOR – 1/8
10 3/8%
% per year on $10
LIBOR – 1/8% million for 5 years and
Bank we will pay you 10
3/8% on $10 million for
A
5 years
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 117
 An Example of
an Interest Rate Swap
½ % of $10,000,000 = Here’s what’s in it for Bank A:
$50,000. That’s quite a Swap
They can borrow externally at
cost savings per year for 10% fixed and have a net
Bank
5 years. 10 3/8% borrowing position of

LIBOR – 1/8% -10 3/8 + 10 + (LIBOR – 1/8) =

Bank LIBOR – ½ % which is ½ %
10% better than they can borrow
A floating without a swap.

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 118
 An Example of
an Interest Rate Swap
The swap bank makes Swap
this offer to company B:
You pay us 10 ½ % per Bank
10 ½%
year on $10 million for 5 LIBOR – ¼%
years and we will pay
you LIBOR – ¼ % per Company
year on $10 million for 5
B
years.
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 119
 An Example of
an Interest Rate Swap
½ % of $10,000,000 =
Here’s what’s in it for B: Swap $50,000 that’s quite a
cost savings per year for
Bank
10 ½% 5 years.
They can borrow externally at LIBOR + ½ % LIBOR – ¼%
and have a net borrowing position of
Company LIBOR
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25%
+ ½%
which is ½ % better than they can borrow B
floating without a swap.

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 120
 An Example of
an Interest Rate Swap
The swap bank Swap ¼ % of $10 million
makes money too. = $25,000 per year
Bank for 5 years.
10 3/8 % 10 ½%

LIBOR – ¼%
LIBOR – 1/8%
Bank Company LIBOR
10% LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
+ ½%
A 10 ½ - 10 3/8 = 1/8 B
A saves ½ % ¼ B saves ½ %
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

07/05/20 121
 Example
 Companies A and B have offered following rates for 5 yr loan

Fixed Floating Rate

Rate
A 12.0% LIBOR + 0.1%
B 13.4% LIBOR + 0.6%

A requires floating rate loan and B requires fixed

rate loan. Design a swap which is equally attractive
for both companies and Bank will get 0.1% margin
07/05/20 122
 Example: Solution
 ‘A’ has comparative advantage in fixed rate
market but wants to borrow floating.
 ‘B’ has comparative advantage in floating
rate market but wants to borrow fixed.
 Difference between spreads = 1.4 – 0.5 =
0.9% p.a.
 Bank wants 0.1%. So remaining 0.8% will
be shared.

07/05/20 123
 RISK MANAGEMENT PRACTICES
Surveys suggest the following:
• Managing risk is considered important; it comes next only to minimizing
borrowing costs and maintaining /improving the firm’s credit. However,
formal statements of risk management policy are rare.
• Firms often reduce some exposure, leaving others un-hedged. The
principal emphasis is on hedging transaction exposures.
• While banks and financial institutions use gap analysis and duration
analysis, non-financial companies commonly use simulation analysis.
• The most widely used instrument is the foreign exchange forward
contract. Futures contract are used mainly by companies where the
treasury is run as a profit centre.
• Companies which do not manage risk cite lack of knowledge and
understanding, non- availability of suitable instruments, and resistance
by senior management as the principal reasons. 124
07/05/20
GUIDELINES FOR RISK MANGEMENT
• Align risk management with corporate strategy

• Proactively manage uncertainties

• Employ a mix of real and financial methods

• Know the limits of risk management tools

• Don’t put undue pressure on corporate treasuries to

generate profits

• Learn when it is worth reducing risk

07/05/20 125
 RISK MANAGEMENT TOOLS
Risk Risk Management Tools
Exposures Off-B/S On-B/S
Financial Production
Firm Fire Insurance Loss
Specific Prevention
and Control
Law suit Payoffs to Warrants Convertible Joint
R& D Projects Debentures Ventures
Commodity Prices Forwards Hybrids Technology
Choice
Interest Rates Futures Oil Indexed Plant
Notes Siting
Foreign Exchange Swaps Vertical
Rates Options Integration
07/05/20 126