Managing Risk

1. Managing Risk • Certainty Equivalents • Why Manage Diversifiable Risk? • Types of Risk • Traditional Approach to Risk Management • Enterprise Risk Management

2. Risk and Discounted Cash Flow • The risk-adjusted discount rate method discounts for time and risk simultaneously • Cannot handle situations where there is risk, but no time discount Example: Space launch coverage payable at time of launch

3. Certainty Equivalent Method • Discounts separately • risk • time value of money

4. CEQt (1 + rf)t Ct (1 + r)t Certainty Equivalent Method • Rather than discounting future cash flows by one risk-adjusted discount rate to account for both time and risk, reduce the future cash flow to account for risk and then discount that value for time at the risk-free rate PV = = n t=1 n t=1  

5. 1,000,000 (1.12)2 CEQ2 (1.05)2 Example • Risk-free rate is 5% • Investment will pay $1 million in two years • Appropriate risk-adjusted rate is 12% PV = = $797,194 PV = CEQ2 = $878,906 • The ratio of CEQ2 to C2 is 87.89%

6. Certainty Equivalent Problem An 18th century ship-owner sends a vessel out on a 2-year voyage. The value of the cargo will not be known until it returns. The expected value of the cargo is $144,000. The present value of the voyage is $100,000. The risk-free rate is 5 percent.

7. Why Manage Diversifiable Risk? • Based on the CAPM, investors are not willing to pay extra for companies that reduce risk that is not correlated with market risk • Based on the APM, investors are not willing to pay extra for companies that reduce risk that is not correlated with one of the priced “factors” • Risks such as fires, lawsuits, computer failures, employee embezzlement, or product failures are not likely tied to market risk or any macroeconomic factors • Why, then, do firms pay to manage these risks?

8. Reasons for Managing Diversifiable Risks • Nonlinear tax structure • Firms with stable earnings pay less in taxes than firms with equal but variable earnings • Avoiding cash shortfalls • Missing positive NPV projects • Reducing the risk of financial distress • Bankruptcy is costly • Managerial self-interest • Manager compensation for potential unemployment • Rewarding managers appropriately • Other economic effects • Suppliers, customers, employees

9. Types of Risk Common risk allocation • Hazard risk • Financial risk • Operational risk • Strategic risk Bank view – New Basel Accord • Credit risk • Loan and counterparty risk • Market risk (financial risk) • Operational risk

10. Hazard Risk • “Pure” loss situations • Property • Liability • Employee related • Independence of separate risks • Risks can generally be handled by • Insurance, including self insurance • Avoidance • Transfer

11. Managing Hazard Risk • Insurance • Policy terms and conditions • Premiums exceed expected losses • Administrative costs • Adverse selection • Moral hazard (and morale hazard) • Deductibles • Policy limits • Self insurance • Captives • Access to reinsurance market

12. Financial Risk • Components • Foreign exchange rate • Equity • Interest rate • Commodity price • Correlations among different risks • Use of hedges, not insurance or risk transfer • Securitization

13. Financial Risk Management Toolbox • Forwards • Futures • Swaps • Options

14. Forward Contracts • A forward contract obligates one party to sell and another party to buy an asset • The exchange takes place in the future • The price is fixed today • No payment is made until maturity • The buyer has a gain if the asset value increases • The contract price is set at origination so that the value is zero

15. Forward Contract Example • Airline agrees to buy a fuel commodity at a fixed price several months in future • When forward contract is established, airline then sets ticket prices for that period • Southwest Airlines hedges fuel prices more than any other airline • One reason – counterparty risk

16. Futures Contracts • A future obligates one party to buy and another to sell a specified asset in the future at a price agreed on today • Futures are standardized contracts traded on organized exchanges • Price changes are settled each day • Margin accounts must maintained

17. What is the use of a futures contract? • Help reduce uncertainty in future spot price • Agricultural futures were one early contract • Farmer can lock in future price of corn before harvest (protect against drop in price) • User of corn can protect against rise in price • Futures are now available on many assets • Agricultural (corn, soybeans, wheat, etc.) • Financial (interest rates, FX, and equities) • Commodities (oil, gasoline, and metals)

18. Features reducing credit risk Daily settlement or mark-to-market Margin account Clearinghouse Features promoting liquidity Contract standardization Traded on organized exchanges Differences between Forwards and Futures

19. Futures Contract Example • Firm sells (shorts) S&P 500 futures contracts for June 2007 representing a portion of its equity investments • As the S&P 500 index increases, the firm incurs a loss and has to mark its position to market each day, reducing the effect of the equity gain • If the S&P 500 index declines, the firm gains from the futures contract, offsetting some of its investment losses

20. Swap Contracts • An agreement between two parties to exchange (or swap) periodic cash flows • At each payment date, only the net value of cash flows is exchanged • The cash flows are based on a notional principal or notional amount • The notional amount is only used to determine the cash flows

21. Currency Swap • On each settlement date, the US company pays a fixed foreign currency interest rate on a notional amount of another currency and receives a dollar amount of interest on a notional amount in dollars • Since the interest rate is fixed, the only change in value is due to change in FX rate • Using netting, only one party pays the difference between cash flow values

22. Other Swaps • Currency-coupon or cross-currency interest rate swap • Still two different currencies • One interest rate is a fixed rate, one rate is floating • Interest rate swap • Special case of currency-coupon swap: there is only one currency • Two interest rates: one fixed and one floating • Very useful to insurers • Equity swap • One party pays the return on an equity index (such as the S&P 500) while receiving a floating interest rate

23. Credit Derivatives • Total return swap • One party pays interest and capital gains/losses • Other party pays floating (or fixed) interest rate • Credit default swap • Fastest growing derivative • Insurers and reinsurers heavily involved • One party pays a periodic fee • Other party pays any losses incurred in default or from credit downgrade • Similar to insurance, but risk could be highly correlated

24. Operational Risk Causes of operational risk • Internal processes • People • Systems Examples • Product recall • Customer satisfaction • Information technology • Labor dispute • Management fraud

25. Strategic Risk Examples • Competition • Regulation • Technological innovation • Political impediments

26. Traditional Approach to Risk Management • Risks are handled separately (silos) • Corporate risk manager handles hazard risks • CFO or investment department handles financial risks • Managers handle operating risk • CEO (or C-suite) handles strategic risk • Each area has its own approach • Terminology • Risk tolerance • Reports • No overall coordination or aggregation

27. Aggregate Risk Management • Strategic Risk • Regulation • Reputation • Competition • Hazard Risk • Hurricanes • Lawsuits • Injuries • Financial Risk • Credit Risk • Market Risk • Interest Rates • Operational Risk • Internal Fraud • Recalls ERM Approach

28. What is Driving ERM? • Board of Directors concern about what can go wrong • Need for one person or group to be responsible for risk oversight • Chief Risk Officer • Technological advances • Computing power • Analytical techniques • ERM is moving from risk control to risk optimization

29. Next Class • Beyond NPV – Simulation, Options and Trees • Read Chapters 10 and 11