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Asset-Liability Risk
Cash Inflows
Liabilities and Equity Cash Short-Term Notes Inventories Trade Payables Accounts Receivable Other Current Liabilities Current Assets Current Liabilities Fixed Assets Long-Term Debt Intangible Assets Equity Total Assets Liabilities and Equity Assets
Cash Outflows
Cash-Flow Risks
Period Cash Revenues Cash Expenses Costs of Goods Interest Net Cash Flow 1 100 60 10 30 2 120 72 10 38 3 90 54 10 26 4 80 48 10 22 5 140 84 10 46 6 160 96 10 54
Risk Management
Product Prices Substitute Prices Exchange Rates
Period Cash Revenues Cash Expenses Costs of Goods Interest Net Cash Flow
Asset-Liability Management
Focus
Main concern is to be able to make all contractual payment to avoid defaults Secondary concern is to minimize risk (variability) Third concern is to increase net cash flows by taking advantage of predictability in variations
Objective
Exposure to Risk
A
general term to describe a firms exposure to a particular risk (e.g. a commodity price) is to classify the exposure as long or short Long exposure means that the firm will benefit from increases in prices or values Short exposure means that the firm will benefit from decreases in prices or values
J. K. Dietrich - FBE 532 Spring, 2006
Long Exposure
A
firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples
The firm owns assets, as in inventories of raw materials or finished goods The firm produces a commodity or product, as in an agribusiness raising wheat or livestock The firm will take possession in the future or a commodity or an asset The firm has bought a commodity or asset
Short Exposure
A
firm (or individual) is short if at the time of the risk assessment if it needs or will need an asset or commodity. As examples
The firm is planning or has promised to deliver raw materials or finished goods The firm uses a commodity or product in production as inputs, like steel or lumber The firm will have possession in the future or a commodity or an asset it does not need or needs to sell The firm has sold a commodity or asset and must deliver
P0
P0
Short
J. K. Dietrich - FBE 532 Spring, 2006
Exposure to Risks
Time/ Situation Have, Will Have, or Will Receive Need, Will Need, or Will Deliver Present or in Present Plan LONG Future Time Period LONG
SHORT
SHORT
Examples of Exposure
Farmer
with wheat is long wheat Honey Baked Ham is short pork before Easter selling season Treasurer with excess cash in three months is short investments Company needing cash in nine months is long financial assets (its liabilities are others assets) to sell
basic types of contracts Futures or forwards Options Swaps (we discuss next week) Many basic underlying assets Commodities Currencies Fixed incomes or residual claims
J. K. Dietrich - FBE 532 Spring, 2006
Futures Contracts
Wall
Clearing
contract (usually with a financial firm as counterparty) Terms are tailor made to needs of corporate, not standardized No exchange of cash until maturity of contract Over-the-counter market not as liquid as organized exchange
price or interest rate risk with contract which moves in opposite direction Cross diagonally in the box Identify contract with price or interest rate which moves as close as possible with the price or interest rate exposure Imperfect correlation is basis risk Not using futures or forwards can be speculation
Hedging
Time/ Situation Have, Will Have, or Will Receive Need, Will Need, or Will Deliver
SHORT
SHORT
Borrowing Hedge
Forward Contracts
Example
1: GE is awarded a contract to supply turbine blades to British Air. On August 1, GE will receive 10 million. How should GE hedge its risk?
Possibilities
Say
the spot price on December 1 is $1.70 per . GE sells its 10 million for $1.75 per , yielding $17.5 million If it had not hedged, its 10 million, at a rate of $1.70 would yield $17 million. The forward is worth $0.5 million.
Possible Outcomes
Spot Rate Value of Deal $1.70 $1.75 $1.80
J. K. Dietrich - FBE 532 Spring, 2006
Key Points
Revenues
Futures
hedging is effective when the magnitude and timing of future currency cash flows is known Pricing in dollars simply shifts risk
Options (Definition)
An
option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date
call is right to buy, put is right to sell strike or exercise price is a fixed price which determines conversion value expiration date
Options
Payoff to Buyer
Strike Price
Asset Value
Strike Price
0
Possible Cost to Writer
Asset Value
Loss
J. K. Dietrich - FBE 532 Spring, 2006
Write Put
J. K. Dietrich - FBE 532 Spring, 2006
Write Call
to hedging risk with futures or forwards except that you only hedge again bad or adverse outcomes Partially offset price or interest rate risk with contract which moves in opposite direction Identify options with price or interest rate which moves as close as possible with the price or interest rate exposure but again imperfect correlation results in basis risk Options only hedge against adverse outcome so they are similar to insurance and cost money
J. K. Dietrich - FBE 532 Spring, 2006
if the timing of foreign currency cash flows is uncertain Example 2: GE submits a bid to supply turbine blades to Lufthansa for 10 million The funds will be received on August 1 only if GE wins How does GE hedge this risk?
Using Options
forward is not the answer: GE may lose the bid and the may rise Options solve the problem; GE buys put options to sell 10m on August 1 at a rate of, say, 1 = $1.70 GE pays a bank $100,000 for the puts
Selling
Hedging costs in either event are $100,000 If the puts are fairly priced GE will not suffer an expected loss even net of hedging costs
J. K. Dietrich - FBE 532 Spring, 2006
the rate is below $1.70, GE exercises the put for $17m, using the 10 million paid by Lufthansa. If the rate is above $1.70, GE lets the option expire, and converts the 10 million at the market rate GE makes at least $17 million if it wins the bid, less the $100,000 cost of the option
call options to hedge the risk of foreign tender offers Hedge risk when quantity of cash flows is uncertain Currency options can be used to protect profit margins and prevent frequent revisions of product prices abroad
Interest-Rate Derivatives
Interest
rates and asset values move in opposite directions Long cash means short assets Short cash means long (someone elses) asset Basis risk comes from spreads between exposure and hedge instrument, e.g. default risk premiums Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown
J. K. Dietrich - FBE 532 Spring, 2006
a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call A collar is a cap and a floor
9400
9500
9600
Loss
J. K. Dietrich - FBE 532 Spring, 2006
risk options Casualty risk options Requirements for developing an option Interest Calculable payoffs Enforceable
J. K. Dietrich - FBE 532 Spring, 2006
P0
0 Loss
P0 Write Put
this weeks discussion to identify areas needing clarification Read and prepare case Union Carbide Corporation Interest Rate Risk Management and identify issues in the case you have questions about Review weekly Objectives and prepare for midterm examination due March 9, 2006
J. K. Dietrich - FBE 532 Spring, 2006