In our second part we will be talking about managing
financial risk and how volatility in recent years has increased the necessity
of managing this risk, especially for companies that have exposure due to the nature
their operations.
To measure a firm’s exposure to financial risk it
would be helpful to depict it graphically, and this is done by the risk
profile. First, in its basic format, the
risk – return comparison is a graph that in the vertical axis you have return,
and in the horizontal, risk, or standard deviation. We observe the different
risks, and for holding only cash, our risk is small compared to the return,
whereas, up to the right, stocks have a higher risk, and a higher return.
To measure a firm’s exposure to risk is the risk
profile. In the accompanying graph, we see a steep in slope, and a plot showing
the relationship between changes in price for some good, and changes in the
value of the firm. Wheat is a very common example because wheat prices can be
volatile at times. Thus it is a good depiction of the company’s exposure to wheat
price fluctuations. From the slope of the line, and due to the fact that it is
steep, a company can benefit from increase in wheat prices. But on the other
hand, if wheat prices fluctuate the company may want to protect itself, because
a decrease in prices, will have an adverse effect on the value of the firm.
If we have two different companies say one wheat
producer, and the other a wheat processor, then price volatility will have opposite
effects for the two companies. The two can come together engage in a contract
so one can lock in a low price to deliver, and the other lock in a set price to
pay; hence both are protected from price fluctuations. Thus both have hedged
against future risk, but there will not always be a total elimination of risk. For example if a company is a wheat grower,
knowing exactly the quantity before the crop season is impossible, so some
portion may be not hedged.
Unforeseen events like temporary changes in prices in
the short run are also reasons to hedge. Sudden increases in oil prices are one
such example to due to political risk. Such short term shocks are known as
transitory changes. In the short run, such sudden changes in prices can cause a
company to have a short run financial distress, even though in the long run it
may be healthy.
This sudden increase in prices cannot be absorbed by
the company because it cannot pass it on the customers. So in a case where a
company is faced with a negative cash flow, it has to find ways to hedge so
that it will not come against being unable to meet its short term obligations.
Consider the case where a company is not totally free of
debt, and has a bond due soon. What if interest rates are not known with
certainty at a time the bonds is due payable. This is a typical transaction
exposure firms face in the short run.
Price fluctuations also occur in the long run
especially due to macroeconomic conditions. This is economic exposure so
hedging is very hard to predict. In the case of wheat, it is impossible to
predict what the long term future price of wheat will be.
This gave rise to forward contracts which is a binding
agreement between two parties calling for the sale of an asset in the future,
at a price agreed upon today. One party delivers the goods, the other party
accepts, on a certain date called the settlement date.
The buyer of the forward contract has the obligation
to take delivery and pay, the seller has the obligation to make delivery and
accept payment. The buyer benefits from the forward contract if prices
increase, because he has already locked in a lower price. The seller also
benefits if prices fall because a higher selling price has been locked in the
contract. One party can win at the expense of the other, so that is why is
called a zero sum game.
If we look at the payoff profile which is essential in
understanding forward contracts, it shows the gains and losses on the contract
that could result from price swings. Since oil, besides wheat, is also a
product traded, the buyer of the forward contract is obligated to accept
delivery at a future date at a set price. The graph on the left shows the long
position, where K is the strike price, but I do not want to go into further
detail. For now, at prices above K, we see profits. As oil prices rise, the
buyer of the forward contract benefits because he has locked in a lower price
to pay, than the market. If oil prices fall, the buyer loses because he ends up
paying more.
Looking at the
payoff profile on the right, for the seller, things are reversed. This can also
be applied to a utility company that uses oil to generate power. If the utility
buts a forward contract (long) then its exposure to unexpected oil price
changes will be eliminated. The graph shows that for the utility company, the net
effect is zero because if oil prices rise, the benefits from lower oil prices
(solid line) will offset the losses on the forward contract (broken line).
In the forward contract there is no money changing
hands at the initiation. The contract is an agreement to transact in the future
so there is no upfront cost. There is a credit risk though when the settlement
date approaches. The party that has lost has an incentive to default on the
agreement.
To diminish this risk, Futures contracts came into
existence. They are exactly the same as
a Forward contract, except that in the forwards, gains and losses are realized
at expiration. With Futures, they are daily settled so the next day the broker
puts up new margin for the investor, if the investor wishes, and has the money,
otherwise the broker closes the account. The broker bears absolutely no risk. This daily settlement is called marking to
market. The risk is greatly reduces compared to forwards.
With Futures contracts there are two types that are
traded: commodity futures and financial futures. With financial, the underlying
goods are financial assets like bonds, stocks, currencies. With commodities,
the underlying goods are crude oil, heating oil agricultural products, copper. Upon
research looking into types of future contracts, I came across the
Intercontinental Exchange, which is part of the NYSE EURONEXT.
If one follows the path Markets, ICE ENDEX, futures markets, there are futures
contracts for “Established in 2013 in conjunction with N.V. Nederlandse
Gasunie, a leading European gas infrastructure company, ICE Endex provides
transparent and widely accessible markets for trading natural gas and power
derivatives, gas balancing markets and gas storage services in Europe and is
based in Amsterdam.” There are Futures contracts available for “Belgian Power Baseload
futures” and the description says “Contracts are for physical delivery of power
to and from the high voltage grid of Belgium. Delivery is made equally each
hour throughout the delivery period from 00:00 (CET) on the first day of the
month until 24:00 (CET) on the last day of the month.”
In the Chicago Mercantile Exchange, there are futures
contracts for metals, interest rates, currency futures, energy futures. An
interesting table was found with contracts traded in the CME. If one notices the
Open Interest column, it is the number of contracts open until expiration.
|
||||||
| Globex | Open OutCry | Clear Port | Volume | Open Interest | ||
| EXCHANGE | ||||||
| EXCHANGE | 12,575,554 | 1,245,806 | 928,270 | 14,749,630 | 91,313,374 | |
| EXCHANGE FUTURES | 10,978,211 | 102,308 | 360,195 | 11,440,714 | 47,926,680 | |
| EXCHANGE OPTIONS | 1,597,343 | 1,143,498 | 567,927 | 3,308,768 | 43,362,083 | |
| OTC CLEARED ONLY | 0 | 0 | 148 | 148 | 24,611 | |
| FUTURE, OPTIONS, & FORWARDS | ||||||
| Agriculture | 979,065 | 113,320 | 26,600 | 1,118,985 | 7,953,089 | |
| Energy | 1,355,323 | 22,698 | 245,358 | 1,623,379 | 28,776,602 | |
| Equities | 4,252,199 | 83,107 | 4,354 | 4,339,660 | 7,539,218 | |
| FX | 516,667 | 2,442 | 5,018 | 524,127 | 1,686,177 | |
| Interest Rate | 5,205,836 | 1,009,562 | 627,246 | 6,842,644 | 42,662,863 | |
| Metals | 266,464 | 14,677 | 19,694 | 300,835 | 2,676,641 | |
| Real Estate | 0 | 0 | 0 | 0 | 94 | |
| Weather | 0 | 0 | 0 | 0 | 18,675 | |
| FUTURES | ||||||
| Agriculture | 898,506 | 36,900 | 25,316 | 960,722 | 4,106,779 | |
| Energy | 1,273,090 | 1,632 | 142,918 | 1,417,640 | 19,876,214 | |
| Equities | 3,411,215 | 5,258 | 4,354 | 3,420,827 | 3,722,220 | |
| FX | 485,778 | 209 | 5,018 | 491,005 | 1,232,116 | |
| Interest Rate | 4,655,215 | 52,480 | 172,046 | 4,879,741 | 18,147,596 | |
| Metals | 254,407 | 5,829 | 10,543 | 270,779 | 839,796 | |
| Real Estate | 0 | 0 | 0 | 0 | 94 | |
| Weather | 0 | 0 | 0 | 0 | 1,850 | |
| OPTIONS | ||||||
| Agriculture | 80,559 | 76,420 | 1,174 | 158,153 | 3,822,656 | |
| Energy | 82,233 | 21,066 | 102,402 | 205,701 | 8,899,431 | |
| Equities | 840,984 | 77,849 | 0 | 918,833 | 3,816,998 | |
| FX | 30,889 | 2,233 | 0 | 33,122 | 454,061 | |
| Interest Rate | 550,621 | 957,082 | 455,200 | 1,962,903 | 24,515,267 | |
| Metals | 12,057 | 8,848 | 9,151 | 30,056 | 1,836,845 | |
| Real Estate | 0 | 0 | 0 | 0 | 0 | |
| Weather | 0 | 0 | 0 | 0 | 16,825 | |
| FORWARD SWAPS | ||||||
| Agriculture | 0 | 0 | 110 | 110 | 23,654 | |
| Energy | 0 | 0 | 38 | 38 | 957 | |
| Equities | 0 | 0 | 0 | 0 | 0 | |
| FX | 0 | 0 | 0 | 0 | 0 | |
| Interest Rate | 0 | 0 | 0 | 0 | 0 | |
| Metals | 0 | 0 | 0 | 0 | 0 | |
| OPTIONS FORWARD SWAPS | ||||||
| Agriculture | 0 | 0 | 0 | 0 | 0 | |
| Energy | 0 | 0 | 0 | 0 | 0 | |
| Equities | 0 | 0 | 0 | 0 | 0 | |
| FX | 0 | 0 | 0 | 0 | 0 | |
| Interest Rate | 0 | 0 | 0 | 0 | 0 | |
| Metals | 0 | 0 | 0 | 0 | 0 | |
| DIVISION | ||||||
| CBOT DIVISION | 3,852,274 | 367,138 | 244,083 | 4,463,495 | 18,533,613 | |
| CME DIVISION | 63,329 | 9,127 | 0 | 72,456 | 754,586 | |
| COMEX DIVISION | 252,704 | 14,632 | 16,937 | 284,273 | 2,495,931 | |
| GEM DIVISION | 35,354 | 267 | 213 | 35,834 | 191,963 | |
| IMM DIVISION | 2,762,502 | 38,880 | 49,265 | 2,850,647 | 11,942,032 | |
| IOM DIVISION | 4,240,910 | 793,019 | 369,695 | 5,403,624 | 28,445,299 | |
| KCBT DIVISION | 0 | 0 | 0 | 0 | 0 | |
| NYMEX DIVISION | 1,368,481 | 22,743 | 248,077 | 1,639,301 | 28,949,950 | |
Sometimes due to the large amounts of futures
contracts available companies do not find the right contract suited for them,
so they have to settle for something close the contract desired. For example
oil, there are so many different grades. Using a related contract is known as
cross hedging. The company does not want to buy or sell the underlying by cross – hedging. It means
that if it sells a contract to hedge, it will buy the same at a later date. There
are also issues with maturities. A company may want to hedge for a long period
and there are only short maturity contracts available. In this case it will
have to roll over short term contracts but there is inherent risk.
An example is the German firm Metallgesellschaft,
which went bankrupt in 1993 after losing $1 billion in the oil markets through
derivatives. A US subsidiary company, called MG Corporation, began marketing
gasoline, heating oil, and diesel. It entered into contracts to supply products
for fixed prices for 10 years. If prices rose the company would lose money. The
mistake made by MG was that it entered into short term contracts. If prices
rose the derivatives gained in value. Not so, since oil prices fell in the
short run, and MG incurred huge losses. It was hedging long term contracts with short
term.
There are also SWAPS in interest rates and currencies.
Currency Swap is where two companies wish to hedge and exchange specific amount
of currency of another in order to obtain debt financing. Interest rate Swaps
is where two companies wish to exchange interest rates. One has a fixed rate
and wishes to exchange for a floating. Commercial banks usually are in the Swap
market to protect from a rising interest
rates.
