Derivatives and Risk Management

Chapter 23 Derivatives and Risk Management ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

23-1 “Managing Risks” means taking steps to mitigate the effects of adverse events. Buying fire insurance is an attempt to mitigate the adverse consequences of a fire. Risk managers attempt to identify all the risks a firm faces, and then consider what steps might be taken to mitigate them. Buying insurance is one form of mitigation for certain risks. The most prevalent risk most firms face is that customers will not want to buy enough of their products at a price that will permit the firm to earn a profit. Only good general management, not by risk management as we define it, can generally mitigate that particular risk. However, risk managers can often use hedging techniques to guard against adverse price, interest rate, and exchange rate changes. In general, stockholders dislike risk, so if a firm can stabilize its earnings by using hedging techniques and the like without unduly high costs, this will benefit its stock price. Of course, stockholders can themselves diversify. For example, an increase in the price of copper might hurt a firm that uses copper, but copper producers will benefit, so the effect on a diversified investor’s portfolio should be small. Even so, investors prefer predictability in earnings, so even if they can diversify themselves, they probably prefer to have firms diversify, provided the cost is not too high. Another reason for managing risk has to do with capital investment programs. If a firm’s earnings are unstable, it might not be able to obtain financing to meet its capital expenditure program requirements. This can be disruptive and costly, for a start-stop long-term construction program is less efficient than one that proceeds smoothly.

23-2 Swaps are transactions where two parties swap payment streams. For example, one firm might have to make floating rate payments and another firm have to make fixed rate payments. The firms can use a swap under which each agrees to make the other’s payments. Similarly, firms with debt denominated in different currencies can arrange swaps. For example, a U.S. firm may have borrowed in the U.S. to finance its Italian operations, which will provide Euros, which would then have to be converted to dollars to make payments on the debt. If the dollar rises against the Euro, the Euros the firm earns may not buy enough dollars to make the required payments. So, the U.S. firm might want to swap its dollar payment obligation for Euro payments. An Italian firm (or any other Euro bloc firm) that has to make Euro payments derived from U.S. operations would be a logical counter-party to the swap. More likely, though, an international bank would serve as counter-party to both firms, and if it had both ends of the ultimate transaction, it would be hedged itself. Companies whose earnings rise with interest rate (like many banks) might prefer floating rate to fixed rate debt, while other companies

Answers and Solutions: 23 - 1 would want to lock in fixed payment obligations. If two such firms both had the “wrong” kind of debt, they could arrange a swap. Again, a bank would probably be the counter-party, and again, it would be internally hedged.

23-3 See the Excel model for an answer to Question 3. Here we show that both companies get the payment pattern they prefer, and at a lower cost than if they borrowed directly with the desired pattern.

23-4 Futures contracts are deals where one party agrees to buy, and the other agrees to sell, something a specified future date. For example, a T-bond futures contract is a contract to buy (or to sell) $100,000 of a hypothetical 20 year, 6%, Treasury bond at some specified future date. As market interest rates in the economy change, so will the value of the T-bond contract. Interest rate futures are used to hedge against changes adverse changes in interest rates. For example, if a firm plans to issue new bonds to refund a currently outstanding high- rate issue, and if it is that afraid interest rates will rise before it can bring out the new issue, then it can hedge by shorting Treasury bond futures. Then, if market rates do rise, it will earn a profit on its short positions and thus offset the higher interest rate it will have to pay on its refunding bonds.

23-5 See the BOC Excel model for the answer to Question 5. Here we show the number of T-bond futures contracts that would be used in the hedge (500 contract, with a nominal value of $50 million), the cost of setting up the hedge, and the results under different assumptions interest rate changes over the next 6 months.

Answers and Solutions: 23 - 2 ANSWERS TO END-OF-CHAPTER QUESTIONS

23-1 a. A derivative is an indirect claim security which derives its value, in whole or in part, by the market price (or interest rate) of some other security (or market). Derivatives include options, interest rate futures, exchange rate futures, commodity futures, and swaps.

b. Corporate risk management relates to the management of unpredictable events that have adverse consequences for the firm. This effort involves reducing the consequences of risk to the point where there would be no significant adverse impact on the firm’s financial position.

c. Financial futures provide for the purchase or sale of a financial asset at some time in the future, but at a price established today. Financial futures exist for Treasury bills, Treasury notes and bonds, CDs, Eurodollar deposits, foreign currencies, and stock indexes. While physical delivery of the underlying asset is virtually never taken, under forward contracts goods are actually delivered.

e. A hedge is a transaction which lowers a firm’s risk of damage due to fluctuating stock prices, interest rates, and exchange rates. A natural hedge is a transaction between two counterparties where both parties’ risks are reduced. The two basic types of hedges are long hedges, in which futures contracts are bought in anticipation of (or to guard against) price increases, and short hedges, in which futures contracts are sold to guard against price declines. A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position.

f. A swap is an exchange of cash payment obligations, which usually occurs because the parties involved prefer someone else’s payment pattern or type. A structured note is a debt obligation derived from another debt obligation, and permits a partitioning of risks to give investors what they want.

g. Commodity futures are futures contracts which involve the sale or purchase of various commodities, including grains, oilseeds, livestock, meats, fiber, metals, and wood.

Answers and Solutions: 23 - 3 23-2 If the elimination of volatile cash flows through risk management techniques does not significantly change a firm’s expected future cash flows and WACC, investors will be indifferent to holding a company with volatile cash flows versus a company with stable cash flows. Note that investors can reduce volatility themselves: (1) through portfolio diver-sification, or (2) through their own use of derivatives.

23-3 Six reasons why risk management might increase the value of a firm is that it allows corporations to (1) increase their use of debt; (2) maintain their capital budget over time; (3) avoid costs associated with financial distress; (4) utilize their comparative advantages in hedging relative to the hedging ability of individual investors; (5) reduce both the risks and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from fluctuating earnings.

23-4 There are several ways to reduce a firm's risk exposure. First, a firm can transfer its risk to an insurance company, which requires periodic premium payments established by the insurance company based on its perception of the firm's risk exposure. Second, the firm can transfer risk-producing functions to a third party. For example, contracting with a trucking company can in effect, pass the firm's risks from transportation to the trucking company. Third, the firm can purchase derivatives contracts to reduce input and financial risks. Fourth, the firm can take specific actions to reduce the probability of occurrence of adverse events. This includes replacing old electrical wiring or using fire resistant materials in areas with the greatest fire potential. Fifth, the firm can take actions to reduce the magnitude of the loss associated with adverse events, such as installing an automatic sprinkler system to suppress potential fires. Finally, the firm can totally avoid the activity that gives rise to the risk.

23-5 The futures market can be used to guard against interest rate and input price risk through the use of hedging. If the firm were concerned that interest rates will rise, it would use a short hedge, or sell financial futures contracts. If interest rates do rise, losses on the issue due to the higher interest rates would be offset by gains realized from repurchase of the futures at maturity--because of the increase in interest rates, the value of the futures would be less than at the time of issue. If the firm were concerned that the price of an input will rise, it would use a long hedge, or buy commodity futures. At the future's maturity date, the firm will be able to purchase the input at the original contract price, even if market prices have risen in the interim.

Answers and Solutions: 23 - 4 23-6 Swaps allow firms to reduce their financial risk by exchanging their debt for another party's debt, usually because the parties prefer the other's debt contract terms. There are several ways in which swaps reduce risk. Currency swaps, where firms exchange debt obligations denominated in different currencies, can eliminate the exchange rate risk created when currency must first be converted to another currency before making scheduled debt payments. Interest rate swaps, where counterparties trade fixed-rate debt for floating rate debt, can reduce risk for both parties based on their individual views concerning future interest rates.

Answers and Solutions: 23 - 5 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

23-1 Futures contract settled at 100 16/32% of $100,000 contract value, so PV = 1.005  $1,000 = $1,005  100 bonds = $100,500. Using a financial

calculator, we can solve for rd as follows:

N = 40; PV = -1005; PMT = 30; FV = 1000; solve for I = rd = 2.9784%  2 = 5.9569%  5.96%.

If interest rates increase to 6.9569%, then we would solve for PV as follows: N = 40; I = 6.9569/2 = 3.47845; PMT = 30; FV = 1000; solve for PV = $897.4842  100 = $89,748.42. Thus, the contact’s value has decreased from $100,500 to $89,748.42.

23-2 a. In this situation, the firm would be hurt if interest rates were to rise by June, so it would use a short hedge, or sell futures contracts. Since futures contracts are for $100,000 in Treasury bonds, the firm must sell 100 contracts to cover the planned $10,000,000 June bond issue. Since futures maturing in June are selling for 95 17/32 of par, the value of Zinn's futures is about $9,553,125. Should interest rates rise by June, Zinn Company will be able to repurchase the futures contracts at a lower cost, which will help offset their loss from financing at the higher interest rate. Thus, the firm has hedged against rising interest rates.

b. The firm would now pay 13 percent on the bonds. With an 11 percent coupon rate, the bond issue would bring in only $8,898,149, so the firm would lose $10,000,000 - $8,898,149 = $1,101,851:

N = 20; I = 13/2 = 6.5; PMT = 0.11/2  10,000,000 = 550000; FV = 10000000; and solve for PV = $8,898,149.

However, the value of the short futures position began at $9,553,125:

95 17/32 of $10,000,000 = 0.9553125($10,000,000) = $9,553,125, or roughly N = 40; PMT = 300000; FV = 10000000; PV = -9553125; solve for I = 3.200% per six months. The nominal annual yield is 2(6.400%) = 6.40%. (Note that the future contracts are on hypothetical 20-year, 6 percent semiannual coupon bonds which are yielding 6.40 percent.) Now, if interest rates increased by 200 basis points, to 8.40 percent, the value of the futures contract will drop to $7,693,948:

N = 40; I = 6.40/2 = 4.20; PMT = 300000; FV = 10000000; and solve for PV = $7,693,948.

Answers and Solutions: 23 - 6 Since Zinn Company sold the futures contracts for $9,553,125, and will, in effect, buy them back at $7,693,948, the firm would make a $9,553,125 - $7,693,948 = $1,859,177 profit on the transaction ignoring transaction costs. Thus, the firm gained $1,859,177 on its futures position, but lost $1,101,851 on its underlying bond issue. On net, it gained $1,859,177 - $1,101,851 = $757,326.

c. In a perfect hedge, the gains on futures contracts exactly offset losses due to rising interest rates. For a perfect hedge to exist, the underlying asset must be identical to the futures asset. Using the Zinn Company example, a futures contract must have existed on Zinn's own debt (it existed on Treasury bonds) for the company to have an opportunity to create a perfect hedge. In reality, it is virtually impossible to create a perfect hedge, since in most cases the underlying asset is not identical to the futures asset.

23-3 If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR + 2%) – 7.95% + LIBOR = -9.95%. This is less than the 10% rate at which it could directly issue fixed rate debt, so the swap is good for Carter.

If Brence issues fixed rate debt and then swaps, its net cash flows will be: -11% + 7.95% - LIBOR = -(LIBOR + 3.05%). This is less than the rate at which it could directly issue floating rate debt (LIBOR + 3%), so the swap is good for Brence.

Answers and Solutions: 23 - 7 SOLUTION TO SPREADSHEET PROBLEM

23-4 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution to Ch 23-4 Build a Model.xls) and on the instructor’s side of the web site, http://brigham.swcollege.com.

Solution to Spreadsheet Problem: 23 - 8 MINI CASE

ASSUME THAT YOU HAVE JUST BEEN HIRED AS A FINANCIAL ANALYST BY TENNESSEE SUNSHINE INC., A MID-SIZED TENNESSEE COMPANY THAT SPECIALIZES IN CREATING EXOTIC SAUCES FROM IMPORTED FRUITS AND VEGETABLES. THE FIRM'S CEO, BILL STOOKSBURY, RECENTLY RETURNED FROM AN INDUSTRY CORPORATE EXECUTIVE CONFERENCE IN SAN FRANCISCO, AND ONE OF THE SESSIONS HE ATTENDED WAS ON THE PRESSING NEED FOR SMALLER COMPANIES TO INSTITUTE CORPORATE RISK MANAGEMENT PROGRAMS. SINCE NO ONE AT TENNESSEE SUNSHINE IS FAMILIAR WITH THE BASICS OF DERIVATIVES AND CORPORATE RISK MANAGEMENT, STOOKSBURY HAS ASKED YOU TO PREPARE A BRIEF REPORT THAT THE FIRM'S EXECUTIVES COULD USE TO GAIN AT LEAST A CURSORY UNDERSTANDING OF THE TOPICS. TO BEGIN, YOU GATHERED SOME OUTSIDE MATERIALS ON DERIVATIVES AND CORPORATE RISK MANAGEMENT AND USED THESE MATERIALS TO DRAFT A LIST OF PERTINENT QUESTIONS THAT NEED TO BE ANSWERED. IN FACT, ONE POSSIBLE APPROACH TO THE PAPER IS TO USE A QUESTION-AND-ANSWER FORMAT. NOW THAT THE QUESTIONS HAVE BEEN DRAFTED, YOU HAVE TO DEVELOP THE ANSWERS.

A. WHY MIGHT STOCKHOLDERS BE INDIFFERENT WHETHER OR NOT A FIRM REDUCES THE VOLATILITY OF ITS CASH FLOWS?

ANSWER: IF VOLATILITY IN CASH FLOWS IS NOT CAUSED BY SYSTEMATIC RISK, THEN STOCKHOLDERS CAN ELIMINATE THE RISK OF VOLATILE CASH FLOWS BY DIVERSIFYING THEIR PORTFOLIOS. ALSO, IF A COMPANY DECIDED TO HEDGE AWAY THE RISK ASSOCIATED WITH THE VOLATILITY OF ITS CASH FLOWS, THE COMPANY WOULD HAVE TO PASS ON THE COSTS OF HEDGING TO THE INVESTORS. SOPHISTICATED INVESTORS CAN HEDGE RISKS THEMSELVES AND THUS THEY ARE INDIFFERENT AS TO WHO ACTUALLY DOES THE HEDGING.

Mini Case: 23 - 9 B. WHAT ARE SIX REASONS RISK MANAGEMENT MIGHT INCREASE THE VALUE OF A CORPORATION?

ANSWER: THERE ARE NO STUDIES PROVING THAT RISK MANAGEMENT EITHER DOES OR DOES NOT ADD VALUE. HOWEVER, THERE ARE SIX REASONS WHY RISK MANAGEMENT MIGHT INCREASE THE VALUE OF A FIRM. RISK MANAGEMENT ALLOWS CORPORATIONS TO (1) INCREASE THEIR USE OF DEBT; (2) MAINTAIN THEIR CAPITAL BUDGET OVER TIME; (3) AVOID COSTS ASSOCIATED WITH FINANCIAL DISTRESS; (4) UTILIZE THEIR COMPARATIVE ADVANTAGES IN HEDGING RELATIVE TO THE HEDGING ABILITY OF INDIVIDUAL INVESTORS; (5) REDUCE BOTH THE RISKS AND COSTS OF BORROWING BY USING SWAPS; AND (6) REDUCE THE HIGHER TAXES THAT RESULT FROM FLUCTUATING EARNINGS.

C. WHAT IS CORPORATE RISK MANAGEMENT? WHY IS IT IMPORTANT TO ALL FIRMS?

ANSWER: CORPORATE RISK MANAGEMENT IS THE MANAGEMENT OF UNPREDICTABLE EVENTS THAT HAVE ADVERSE CONSEQUENCES FOR THE FIRM. THIS FUNCTION IS VERY IMPORTANT TO A FIRM SINCE IT INVOLVES REDUCING THE CONSEQUENCES OF RISK TO THE POINT WHERE THERE SHOULD BE NO SIGNIFICANT ADVERSE EFFECTS ON THE FIRM’S FINANCIAL POSITION.

D. RISKS THAT FIRMS FACE CAN BE CATEGORIZED IN MANY WAYS. DEFINE THE FOLLOWING TYPES OF RISK: (1) SPECULATIVE RISKS; (2) PURE RISKS; (3) DEMAND RISKS; (4) INPUT RISKS; (5) FINANCIAL RISKS; (6) PROPERTY RISKS; (7) PERSONNEL RISKS; (8) ENVIRONMENTAL RISKS; (9) LIABILITY RISKS; AND (10) INSURABLE RISKS.

ANSWER: 1. SPECULATIVE RISKS ARE THOSE THAT OFFER THE CHANCE OF A GAIN AS WELL AS A LOSS, SUCH AS BUYING AN OWNERSHIP SHARE IN A COMPANY.

2. PURE RISKS ARE THOSE THAT ONLY OFFER THE PROSPECT OF LOSSES, SUCH AS A PRODUCT LIABILITY OR MALPRACTICE LAWSUIT (FROM THE DEFENDANT'S STANDPOINT).

Mini Case: 23 - 10 3. DEMAND RISKS ARE THOSE ASSOCIATED WITH THE DEMAND FOR A FIRM'S PRODUCTS OR SERVICES, SUCH AS NEW PRODUCTS DEVELOPED BY COMPETITORS.

4. INPUT RISKS ARE THOSE ASSOCIATED WITH A FIRM'S INPUT COSTS, INCLUDING MATERIALS AND LABOR. 5. FINANCIAL RISKS ARE THOSE THAT RESULT FROM FINANCIAL TRANSACTIONS, SUCH AS INTEREST RATE AND CURRENCY EXCHANGE RATE RISKS.

6. PROPERTY RISKS ARE ASSOCIATED WITH DESTRUCTION OF A FIRM'S PRODUCTIVE ASSETS, INCLUDING THE THREAT OF FIRE, FLOODS, AND RIOTS.

7. PERSONNEL RISKS ARE RISKS THAT RESULT FROM HUMAN ACTIONS, SUCH AS THEFT AND FRAUD.

8. ENVIRONMENTAL RISKS INCLUDE THOSE RISKS ASSOCIATED WITH POLLUTING THE ENVIRONMENT.

9. LIABILITY RISKS ARE CONNECTED WITH PRODUCT, SERVICE, OR EMPLOYEE LIABILITY, SUCH AS COSTS INCURRED AS A RESULT OF IMPROPER ACTIONS BY EMPLOYEES OR DAMAGES RESULTING FROM DEFECTIVE PRODUCTS.

10. INSURABLE RISKS ARE THOSE WHICH TYPICALLY CAN BE COVERED BY INSURANCE.

E. WHAT ARE THE THREE STEPS OF CORPORATE RISK MANAGEMENT?

ANSWER: THE THREE STEPS ARE:

IDENTIFY THE RISKS FACED BY THE FIRM; MEASURE THE POTENTIAL IMPACT OF THE RISKS IDENTIFIED; AND DECIDE HOW EACH RELEVANT RISK SHOULD BE HANDLED.

Mini Case: 23 - 11 F. WHAT ARE SOME ACTIONS THAT COMPANIES CAN TAKE TO MINIMIZE OR REDUCE RISK EXPOSURES?

ANSWER: THERE ARE SEVERAL ACTIONS THAT COMPANIES CAN TAKE TO MINIMIZE OR REDUCE THEIR RISK EXPOSURE. FIRST, COMPANIES CAN TRANSFER RISK TO AN INSURANCE COMPANY BY PAYING PERIODIC PREMIUMS. SECOND, COMPANIES CAN TRANSFER FUNCTIONS WHICH PRODUCE RISK TO THIRD PARTIES, SUCH AS ELIMINATING RISKS ASSOCIATED WITH TRANSPORTATION BY CONTRACTING WITH A TRUCKING COMPANY. THIRD, PURCHASE DERIVATIVES CONTRACTS TO REDUCE INPUT AND FINANCIAL RISK. FOURTH, COMPANIES CAN TAKE ACTIONS TO REDUCE THE PROBABILITY OF OCCURRENCE OF AN ADVERSE EVENT, SUCH AS REPLACING OLD WIRING TO REDUCE THE POSSIBILITY OF FIRE. FIFTH, ACTIONS CAN BE TAKEN TO REDUCE THE MAGNITUDE OF THE LOSS ASSOCIATED WITH ADVERSE EVENTS, SUCH AS INSTALLING AUTOMATIC SPRINKLER SYSTEMS. FINALLY, COMPANIES CAN SIMPLY AVOID THE ACTIVITIES THAT GIVE RISE TO RISK.

G. WHAT IS FINANCIAL RISK EXPOSURE? DESCRIBE THE FOLLOWING CONCEPTS AND TECHNIQUES THAT CAN BE USED TO REDUCE FINANCIAL RISKS: (1) DERIVATIVES; (2) FUTURES MARKETS; (3) HEDGING; AND (4) SWAPS.

ANSWER: FINANCIAL RISK EXPOSURE REFERS TO THE RISK INHERENT IN THE FINANCIAL MARKETS DUE TO PRICE FLUCTUATIONS.

1. A DERIVATIVE IS A SECURITY WHOSE VALUE STEMS, OR IS DERIVED, FROM THE VALUES OF OTHER ASSETS. OPTIONS AND FUTURES CONTRACTS ARE TWO TYPES OF DERIVATIVES THAT ARE USED TO MANAGE SECURITY PRICE EXPOSURE.

2. FUTURES MARKETS INVOLVE CONTRACTS WHICH CALL FOR THE PURCHASE OR SALE OF A FINANCIAL (OR REAL) ASSET AT SOME FUTURE DATE, BUT AT A PRICE WHICH IS FIXED TODAY. THUS, THESE MARKETS PROVIDE THE OPPORTUNITY TO REDUCE FINANCIAL RISK EXPOSURE.

3. HEDGING IS GENERALLY CONDUCTED WHERE A PRICE CHANGE COULD NEGATIVELY AFFECT A FIRM'S PROFITS. A LONG HEDGE INVOLVES THE PURCHASE OF FUTURE CONTRACTS IN ANTICIPATION OF, OR TO GUARD

Mini Case: 23 - 12 AGAINST, PRICE INCREASES. A SHORT HEDGE, OR SALE OF FUTURES, IS MADE WHEN THE FIRM IS CONCERNED ABOUT PRICE DECLINES IN COMMODITIES OR FINANCIAL SECURITIES. 4. SWAPS INVOLVE THE EXCHANGE OF CASH PAYMENT OBLIGATIONS ON DEBT BETWEEN TWO PARTIES, USUALLY BECAUSE EACH PARTY PREFERS THE TERMS OF THE OTHER'S DEBT CONTRACT. SWAPS CAN REDUCE EACH FIRM'S FINANCIAL RISK. FOR EXAMPLE, CURRENCY EXCHANGE RATE RISK CAN BE ELIMINATED IF A U.S. FIRM WITH A POUND-DENOMINATED DEBT COULD SWAP THEIR DEBT WITH A BRITISH FIRM THAT HAS AN EQUIVALENT DOLLAR-DENOMINATED DEBT.

H. DESCRIBE HOW COMMODITY FUTURES MARKETS CAN BE USED TO REDUCE INPUT PRICE RISK.

ANSWER: ESSENTIALLY, PURCHASE OF A COMMODITY FUTURES CONTRACT WILL ALLOW A FIRM TO MAKE A FUTURE PURCHASE OF THE INPUT MATERIAL AT TODAY'S PRICE, EVEN IF THE MARKET PRICE ON THE GOOD HAS RISEN SUBSTANTIALLY IN THE INTERIM.

Mini Case: 23 - 13