CHAPTER 20 I Corporate Risk Management 665 Mini-Case For your job as the busines
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Question
CHAPTER 20 I Corporate Risk Management 665 Mini-Case For your job as the business reporter for a local newspaper, you before you begin this assignment, I want to make sure we are a are given the task of developing a series of articles on risk man- reading from the same scrpt. rd lke a response to the folowing agement. Much recent local press coverage has been given to the questions before we proceed: losses that some firms have experienced when using financial 1. What is corporate risk management? futures and options. Your editor would like you to address sev- 2 eral specific questions in addition to discussing the proper use of faces? these types of contracts in managing corporate risk. What is the role of insurance in managing the risks that a firm ease prepare your response to the following memoran 3. How can forward contracts bo used as a risk management tool? Please 4. What are the advantages and disadvantages of using forward menting a risk management strategy designed to address the 5. What are swap contracts, and how are they used in the man- dum from your editor: TO: Business Reporter contracts versus exchange-traded futures contracts in imple FROM: Perry White, Editor, Daily Planet problem of commodity price risk? RE: Upcoming Series on Corporate Risk Management n your upcoming series on coporate nsk management, I would to make sure that you address several specific points. In addition, agement of interest rate risk?Explanation / Answer
1.
Corporate risk management refers to all of the methods that a company uses to minimize financial losses. Risk managers, executives, line managers and middle managers, as well as all employees, perform practices to prevent loss exposure through internal controls of people and technologies. Risk management also relates to external threats to a corporation, such as the fluctuations in the financial market that affect its financial assets.
2.
The insurance market offers some opportunities for the risk officer to transfer or limit risk.
Traditionally companies have used insurance to transfer the risks that they do not want to assume. So, for example, most companies will have some form of insurance against fire damage. The company will pay a premium to an insurance company and, in return, it will receive a payout in the event of a fire. Risks covered by this form of insurance will include general property and casualty insurance.
In addition, in many jurisdictions, companies are required to have certain types of liability insurance. These would be both a general public liability insurance, perhaps as cover against injury suffered by a customer, and employee liability insurance, as cover against accidents or injury in the workplace.
Where insurance cover is mandatory, there is often a requirement that this can be shown to be provided by a registered insurance company. For example, companies in the UK have to display their certificate of employee liability cover, which must have been issued by a company registered with FSA to provide insurance business.
3.
The principal reason to enter into a forward contract is to minimize risk, or to reduce the probability of an adverse fluctuation in price of a commodity. By guaranteeing a price, the seller of a forward contract establishes his price. Farmers and other commodities producers gauge today's prices for the commodity against the "spot price," or the price at which the commodity may sell at the delivery date in the future. A buyer of a forward contract may expect the price of the commodity to increase by the delivery date and thus wants to lock in a lower price. So that purchase/ Sale of commodity can be made at desired price( pre- determined price) i.e Forward rate. The commodity can be Good/ Service/ Currency etc.
4.
Futures and forwards are financial contracts which are very similar in nature but there exist a few important differences:
Counterparty risk
In any agreement between two parties, there is always a risk that one side will renege on the terms of the agreement. Participants may be unwilling or unable to follow through the transaction at the time of settlement. This risk is known as counterparty risk.
In a futures contract, the exchange clearing house itself acts as the counterparty to both parties in the contract. To further reduce credit risk, all futures positions are marked-to-market daily, with margins required to be posted and maintained by all participants at all times. All this measures ensures virtually zero counterparty risk in a futures trade.
Forward contracts, on the other hand, do not have such mechanisms in place. Since forwards are only settled at the time of delivery, the profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a loss resulting from a default is much greater for participants in a forward contract.
Secondary Market
The highly standardized nature of futures contracts makes it possible for them to be traded in a secondary market.
The existence of an active secondary market means that if at anytime a participant in a futures contract wishes to transfer his obligation to another party, he can do so by selling it to another willing party in the futures market.
In contrast, there is essentially no secondary market for forward contracts.
5.
Swap contracts
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable that is based on a benchmark interest rate, floating currency exchange rate or index price.
The most common kind of swap is an interest rate swap.
Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, say ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). LIBOR is at 1.7%, low for its historical range, so ABC management is anxious about an interest rate rise.
They find another company, XYZ Inc. that is willing to pay ABC an annual rate of LIBOR plus 1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 6% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.
Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year, and 2) LIBOR rises 2% per year.
Scenario 1
If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bond holders over the five-year period are $225,000:
225000=1000000*(5*0.013+0.017+0.0245+0.032+0.0395+0.047)
In other words, $75,000 more than the $150,000 ABC would have paid if LIBOR had remained flat:
150000=1000000*5*(0.013+0.017)
ABC pays XYZ $300,000:
300000=1000000*5*0.06
and receives $225,000 in return (the same as ABC's interest payments to bond holders). ABC's net loss on the swap comes to $75,000.
Scenario 2
In the second scenario, LIBOR rises by 2% a year. This brings ABC's total interest payments to bond holders to $350,000
350000=1000000*(0.013*5+0.017+0.037+0.057+0.077+0.097)
XYZ pays this amount to ABC, and ABC pays XYZ $300,000 in return. ABC's net gain on the swap is $50,000.