Transcript Title goes here This is a sample subtitle

RIMS 2007 Webinar Series
“Speak Finance Like a Native”
Module 3
April 17, 2007
The Other Face or
Risk Management –
The Art and Science of
Hedging
Dan McGarvey, CPCU, ARM
Managing Director, Marsh
Your Webcast Host
• Dan McGarvey, CPCU, ARM
• Greenville, SC Office Head
• Retired (old) Naval Officer
• 17 Yr Marsh Veteran
•MBA Univ. of Rhode Island
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My Other Job…
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Thanks for your terrific
feedback from Session 2…
“It was a little less boring
than the first module”
Unnamed Risk Manager
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Your questions are most
welcome…
…and will be answered in
short order
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In Our Last Episodes...
Who
are your owners?
What is their appetite for risk?
Digging to find the answers
Building
a business case
Converting your good ideas to
“finance-speak”
Don’t miss the exciting conclusion
at: www.RIMS.org
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The value of a dollar, depends on
whose it is…
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A dollar received today is worth
more than one promised in the
future…
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Expected Reward
The Risk-Reward Continuum
Equity
Risk
Premium
Where is
your firm?
3.7% (historical T-bill average)
Level of Risk
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Expected Reward
The Beta Factor and the
Volatility Continuum
Where is
your firm?
Volatility (Beta)
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Today’s Theme:
Sometimes I will pay a dollar
today to avoid maybe taking a
beating tomorrow…
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Today’s Theme:
This may be in the form of
insurance premium, but other
times the insurance market may
not offer an optimal solution
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What is Risk?
Fundamentally,
the exposure to
unfavorable
variances in
any expected
outcome
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Some Types of Risk
• Hazard/Casualty
• Systematic
• Unsystematic
• Basis Risk
• Counterparty Risk
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What is a “Hedge”
The concept is really quite simple…
The
Suit
Example
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A Typical Business Cycle...
It’s Feast
or Famine!
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A Typical Business Cycle...
Impact of a
Typical Hedge
“Volatility is not our friend”
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Overview of Pop’s
• Sells in Southwestern US and
approximately 20% in Mexico
• Four flavors of popsicles
• Differentiators:
• Low cost
• Family owned
• Strong brand
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Pop’s Risk Analysis
Start with “pro-forma” annual
business plan and evaluate:
Potential
sources of raw
material cost increases
Potential sources of demand
reduction
Other potential sources of
profitability disruption
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Raw Materials
• Sugar
• Orange Juice
• Wood
• Paper
• Citric Acid
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Raw MaterialsProjected Impact
• Sugar
• Oranges
• Wood
• Paper
• Acid
Highly volatile, a significant
ingredient – major impact
Mitigation strategy established
Volatility exists, but per unit price not
sufficient to generate concern
Material impact, but historically
not a volatile commodity
Limited impact but some volatility
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The Spring Water Issue
• Part of our marketing since ’62
• A neighbor-owned spring has
always provided us water at very
reasonable prices
• Change is in the air…
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Demand Factors
• Economic outlook
• Temperature variances
• Foreign exchange rates (Peso)
• Pricing and elasticity of demand
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Demand Factors
• Economic outlook
Who doesn’t face this variable? (This is
clearly a systematic risk)
• Temperature variances
Very material - but what can we do about
the weather besides talk about it?
• Foreign exchange rates (Peso)
This is an issue – exceeds 20% of sales
•Changing deman
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Orange Juice
• Modeling of regional “degree days” and
OJ prices yields a strong correlation
• This is known as a “natural hedge”
• Further mitigation
is
. likely needed
• Why?
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“Basis Risk”
This is what correlation looks like…
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40
OJ
Price
30
20
10
0
0
Degree days in exces
5
10
15
20
25
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“Basis Risk”
A hedge is only as effective as the reliability
of the correlation upon which it is based …
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40
30
20
10
0
0
5
10
15
20
25
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Operational Mitigation
• Pops produces four flavors – only the
orange variety contains real juice
• Adjusting the mix contained in a box can
help mitigate an OJ price spike impact
• Orange is historically
. the favorite flavor
• Impact on demand?
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Decision Tree Analysis
OJ Price Our Impact on
Respon Demand
Increase
se
No mitigation
+2 cents
Subtract one
Subtract two
No change
10% reduction
20% reduction
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Monte Carlo Analysis
• Allows for “stochastic” (nondeterministic) analysis using multiple
variables and randomly generated “real
world” trials
• Useful when one has modeled a series of
decisions and outcomes that rely upon
one another
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Monte Carlo Analysis
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Sticks
• Though the price is volatile, large
numbers of popsicle sticks may be
safely stored in inventory
• A perfect candidate for the use of
forward purchasing
• Stockpiling is an option too
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“Forward” Purchase
• Any agreement with another party to
purchase some item at a future date for
a pre-agreed price
• In its most simple form, a forward need
not be traded on any exchange. This
can reduce frictional cost.
• A forward normally implies an obligation
to purchase on the agreed date
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Stockpiling
Another option t
Razors – A rea
$
Month
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Sugar
• Highly volatile with no natural hedge
• Spoilable and difficult to stockpile
• Actively traded on an established
exchange
• Our demand is variable
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Options/Futures Markets
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Using “Options”
• For a premium payment, I receive the right
(but not the obligation) to purchase a given
quantity at a pre-agreed price
• This “call” will help me meet future
commodity needs at predictable prices
• Effective for meeting surge needs
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Option vs. Insurance
• Premium
• Commission
• ISDA form
• Strike price
• Option limit
• Expiration
• Counterparty
credit rating
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Terminology…
In
the
Money
Out of
the
Money
Strike Price
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“Puts” and “Calls”
These terms
represent the
identical options
transaction as
viewed from the
two sides of the
transaction
mirror…
..
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Option – 2000 pork bellies at
$100 per – expiring June 30th
Sell a
“Put”
Buy a
“Call”
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I
What is a Collar?
kn
ow
th
is
one
!
Buy a
“call”
Sell a
“put”
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Option Variations
• American Option – Can be
exercised at any time prior to
expiration
• European Option – Exercisable
only on a specified date
• Bermudian Option – Exercisable
only on certain specified dates
•
Asian Option – Exercisable at
the average price over a
specified period
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Paper and Cartons
• Too much volume to make storage of
large quantities practical
• Many qualified suppliers exist
• “Safety stock out” quantity is always
kept on hand
• Demand is predictable
• Active exchange exists
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Using “Futures”
• Obligate you to accept delivery on a
given date at a pre-agreed price
• Lower frictional cost than Options due
to this lesser amount of flexibility
• Effective for meeting
baseline needs
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Peso Conversion
• As the dollar gets stronger against the
Peso, our foreign revenue stream shrinks
• What is the most efficient way to hedge
this while minimizing frictional cost?
• Could a “Swap” work?
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Similar is size to us, but based in Mexico
- with 20% of sales in Texas.
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“Counterparty Risk”
• The effectiveness of a hedge is only as
solid as the willingness and capability of
your counterparty to the transaction to
hold up its end of the bargain
• This is very similar to requiring an A- VII
or better AM Best rating of your insurers
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Citric Acid
• No active options/futures exchange
• Can’t find anyone who profits when the
cost of citric acid increases (except for
the manufacturer)
• Need a willing partner
• Can my bank help?
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A “Derivative”
• A financial instrument whose value is
derived from an underlying index
• The issuer may have no intrinsic interest
in this commodity or index
• “I don’t care about the price of citric
acid, but for a premium I will pretend
that I do”
• A very viable risk management tool
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Pure Spring Water
• Why not acquire the spring?
• Also known as Vertical Integration
• Guarantees availability
• What do you think?
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Sensitivity Analysis
Sensitivity analysis uses economic
modeling to evaluate the potential
bottom line impact of volatility
involving key business variables
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Sensitivity Analysis
In this case, as simple spreadsheet
that includes all the elements of the
Income Statement (revenues and
expenses) for Pop’s could be used
as a starting point…
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Evaluating Overall Impacts…
Standard Deviations
Raw mater
potential pr
variatio
Good Bad
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Parametric Hedge
• A financial instrument whose payout
is not tied to any loss amount actually
sustained, but fixed in advance and
based on a specified event that is
logically projected to create a loss
• Treating a breakdown in the natural
orange juice hedge involving heat with
extended drought
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Hedge Valuation
• You may strike an agreement to
purchase a commodity that you find
out you do not need
• If your hedge is “in the money”, it is
likely worth something to someone else
• You may even buy options and futures
for pure speculation
• Caution – do not try this at home
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Value
The Value of an Option
Strike Price
90 Day
30 Day
1 min.
“One minute option”
Price of underlying commodity
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Value
The Value of an Option
Strike Price
30 day option
Beta = 1.2
Beta = 1.0
30 day option
ce of underlying commodit
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Black and Scholes Valuation
• Current price relative to exercise price
How far in the money am I today?
• Standard Deviation of underlying price
How volatile is the underlying index?
• Time remaining until expiration
How much time left for this to go South?
An increase in any of the above
increases the PV of an option
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The “Greeks”
• Delta
• Gamma
• Vega
• Theta
Change in option price with change
in underlying commodity price
Change in Delta with change in
underlying commodity price
Change in option price with change
in volatility of underlying commodity
Change in option price with change
in time to expiration
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“Delta”
Today’s Spot Price is $90
Our Option (30 day) Strike Price is $90
Does our option have any value?
Slope = Delta
Option
Value
80
90
100
Today’s Price
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Delta Rules
The difference between the underlying
commodity price right now and the
strike price of the option is the largest
determinant of option market price
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So How Do You Lose Lots?
Example: Pop’s manages its exposure to
volatile sugar prices with an open ended
sugar swap with a Hawaiian cruise line.
($1 million per inch off expected)
95% confidence Interval
Out of the
Money
In the
Money
40”
45”
50” 56” !!!
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Dan the “Rogue Trader”
Did I mention this gets worse?
56” or rain is so heavy, it washes away
much of the sugar cane crop!!!
• “Lightening can’t strike twice”
• Bank half the loss for next year
• We’ll pay double if out of the money
How do you manage this risk?
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Value at Risk (VAR)
• A single figure estimate of possible loss
potential in a portfolio
• Monte Carlo analysis used to identify
“perfect storm” loss conditions within
anticipated trading ranges
• Confidence interval must be stipulated
•
•
Akin to MPL in property analysis
VAR limitations are a board level issue
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Value at Risk (VAR)
Traders view
VAR
guidelines the
way you may
view your
“insurance
budget”
Board members may view it differently
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Bonus Term
“Wearing” the Risk – A colloquial
term traders use to describe what we
might call risk allocation. They view
risk as a hot potato to be passed
among parties to a deal until some
poor sap (by design or by default)
ends up “wearing” it.
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The Secrets to Becoming Conversant
in Finance and Accounting
• Finance and Accounting have a language
all their own
• Risk management also has its own set of
terms - which can generate frustration
• Actively listen and ask questions to
increase your vocabulary
• Its not all about numbers and math!
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Shameless Plug:
Thanks to Marsh and RIMS for
their sponsorship of this series
All three modules will be archived at
www.RIMS.org and available for your
access
I hope to see you in New Orleans!
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You are most welcome to join
my Wednesday sessions at
RIMS national..
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Thank You for
Your Kind
Attention
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