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Risk Management Framework, Debacles & An Options Review

Risk Management Framework, Debacles & An Options Review. Reasons exist for active financial risk management. SMOOTH EARNINGS!!! Match Supply of Internally-generated funds with Demand for funds for Capital Expenditures Match Employee’s incentives with Investors

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Risk Management Framework, Debacles & An Options Review

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  1. Risk Management Framework,Debacles &An Options Review

  2. Reasons exist for active financial risk management SMOOTH EARNINGS!!! • Match Supply of Internally-generated funds with Demand for funds for Capital Expenditures • Match Employee’s incentives with Investors • Match Information Advantage with Transaction Ability & Cost of Transaction

  3. Risk Programs • Identification of risk sources • Evaluation of bearing risk vs. transfer, and competitive response • Creation of financial positions to transfer • Position description • Standardized vs. Proprietary positions • Pricing through arbitrage • Position maintenance and review

  4. A Framework Example:United Grain Growers

  5. Core Businesses • Primary: Grain Distributor • Store, Sort and Transport • Board Grain: Wheat, Barley and Oats w/ Floor Price • Non-Board Grain: All Others w/ Variable Price • Secondary: De-Facto Vertical Integration • Crop Production Services (Spring) • Farm Supplies (Fertilizer, Seed and Support) • Livestock Services (Feed) • Farm Business Communication (Extension)

  6. Biz Interruption Cargo/Marine Civil Disturb Commodity Competition Consumer Contracts Credit Counterparty BofD/Officers Data Disease/Spoil IT Failure Employee Inj. All Risks • Employee Liab. • Employee Perf. • Environmental • FX • HQ Calamity • Indus. Spying • Intell. Property • Interest Rates • Inventory • Labor Strike • Leverage • Key Executive • M&A • Major Property • Pension Liab. • Process Comp. • Product Liab. • Product Perf. • Political Risk • R&D • Regulatory • Stock Market • Strategy • Technology • Transportation • Unionization • Weather

  7. Main Risks Risk Mgmt Technique Weather None Toxins Insurance/Control Counterparty Diversify/Contracts Credit Diversify/Contracts Inventory (Spoilage) Oprtns/Insurance Commodity Futures/Options

  8. Debacles • Gibson Greeting Cards 1993 • Metallgesellschaft 1993 • Proctor & Gamble 1993 • Orange County 1994 • http://www.gsm.uci.edu/~jorion/oc/case.html • Barings Bank 1995 • Long Term Capital Management 1998

  9. Basic Options Review

  10. Options • Right to Buy/Sell a specified asset at a known price on or before a specified date. • Call Option - Right to buy • Put Option - Right to sell • When Option Bought/Sold, Premium is exchanged.

  11. Option Specifications • Current Price of Specified Asset - S(S as we consider options on stocks first) • Specified Price of Buy/Sell - X(or Strike Price, so some use K) • Last time to Buy/Sell – Expiry ( T ) (or Expiration date) • Note: There will be other factors when we actually start calculating prices, but for now we will take all market prices as given.

  12. Basic Option Payoffs: Call Option Out of the Money In the Money Payoff Payoff Price Price Current Stock Price Option Exercise Price Stock Payoffs Call Option Payoffs Call Option Payoff = Max[ 0 , S - X ] (Intrinsic Value)

  13. Basic Option Payoffs: Put Option In the Money Out of the Money Payoff Payoff Price Price Current Stock Price Option Exercise Price Stock Payoffs Put Option Payoffs Put Option Payoff = Max[ 0 , X - S ] (Intrinsic Value)

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