LECTURE NO.

11

Derivatives and Risk

Management

From the desk of Adeel Durvesh

Are stockholders concerned about
whether or not a firm reduces the
volatility of its cash flows?

 Not necessarily.
 If cash flow volatility is due to
systematic risk, it can be eliminated
by diversifying investors’ portfolios.
 Definitions of different types
of risk
 Speculative risks – offer the chance of a gain
as well as a loss.
 Pure risks – offer only the prospect of a loss.
 Demand risks – risks associated with the
demand for a firm’s products or services.
 Input risks – risks associated with a firm’s
input costs.
 Financial risks – result from financial
transactions.
Definitions of different types
of risk
 Property risks – risks associated with loss
of a firm’s productive assets.
 Personnel risk – result from human
actions.
 Environmental risk – risk associated with
polluting the environment.
 Liability risks – connected with product,
service, or employee liability.
 Insurable risks – risks that typically can be
covered by insurance.
 Definitions of different types
of risk
 Credit Risk-- Customer or counterparty may
not settle an obligation for full value, either
when due or at any time thereafter.
 Counterparty risk-- The risk that a company’s
counterparty will fail to perform during the life
of the transaction
 Principal/interest risk -- Failure to recover
principal and/or interest on the due date for
payment
Definitions of different types
of risk
 Issuer/position/specific risk -- Risk
arising from holding the counterparty’s
debt securities
 Currency risk -- Risk to earnings and
capital arising from adverse movements
in currency exchange rates
 Liquidity risk -- Risk of loss arising from
changes in the ability to sell or dispose of
an asset
 Definitions of different types
of risk
 Operational risk -- Risk of direct or indirect
loss resulting from inadequate or failed
internal processes, people and systems and
from external events
 Regulatory risk – Risk of loss arising from
failure to comply with legal requirements in
the relevant jurisdiction in which the
company operates
Risk Management
 Evaluating and controlling risk
effectively will ensure opportunities in a
business are not lost, competitive
advantage is enhanced and less
management time is spent fire-fighting.
 Reasons that corporations
engage in risk management
 Increase their use of debt.
 Maintain their optimal capital budget.
 Avoid financial distress costs.
 Utilize their comparative advantages in
hedging, compared to investors.
 Reduce the risks and costs of borrowing.
 Reduce the higher taxes that result from
fluctuating earnings.
 Initiate compensation programs to reward
managers for achieving stable earnings.
What is corporate risk management,
and why is it important to all firms?
 Corporate risk management relates to the
management of unpredictable events that
would have adverse consequences for the
firm.
 All firms face risks, but the lower those
risks can be made, the more valuable the
firm, other things held constant. Of
course, risk reduction has a cost.
What are the three steps of
corporate risk management?
1. Identify the risks faced by the firm.
2. Measure the potential impact of the
identified risks.
3. Decide how each relevant risk
should be handled.
What can companies do to
minimize or reduce risk exposure?
 Transfer risk to an insurance company by
paying periodic premiums.
 Transfer functions that produce risk to third
parties.
 Purchase derivative contracts to reduce input
and financial risks.
 Take actions to reduce the probability of
occurrence of adverse events and the
magnitude associated with such adverse
events.
 Avoid the activities that give rise to risk.
What is financial risk exposure?
 Financial risk exposure refers to the
risk inherent in the financial markets
due to price fluctuations.
 Example: A firm holds a portfolio of
bonds, interest rates rise, and the
value of the bond portfolio falls.
Financial Risk Management
Concepts
 Derivative – a security whose value is
derived from the values of other
assets. Swaps, options, and futures
are used to manage financial risk
exposures.
 A derivative is a financial instrument
that offers a return based on the
return of some other underlying
instrument
TRADING OF DERIVATIVE
PRODUCTS
 Exchange Traded– Contracts have
standard terms and features and are
traded on an organized trading facility
 OTC—Over the Counter contracts are
any transactions created by two parties
anywhere else.