Chapter 4 Enterprise Risk Management and related Topics The changing scope of risk management Enterprise Risk Management ERM (FMEA) Corporate Walue of ENTERPRISE RISK Insurance Market dynamics MANAGEMENT The Next step in Husiness Mana口eme S BEt具L Loss Forecasting Financial Analysis in RM Decision Making Other Risk Management Tools 4-1
4-1 Chapter 4 Enterprise Risk Management and Related Topics • The Changing Scope of Risk Management • Enterprise Risk Management – ERM （FMEA） • Insurance Market Dynamics • Loss Forecasting • Financial Analysis in RM Decision Making • Other Risk Management Tools
The Changing scope of RM Today the risk manager's job Involves more than simply purchasing insurance Is not limited in scope to pure risks The risk manager may be using Financial risk management Enterprise risk management CUHK VS UW-Madison 4-2
4-2 The Changing Scope of RM • Today, the risk manager’s job: – Involves more than simply purchasing insurance – Is not limited in scope to pure risks • The risk manager may be using: – Financial risk management – Enterprise risk management • CUHK vs. UW-Madison:
The Changing Scope of Risk Management Financial Risk Management refers to the identification analysis, and treatment of speculative financial risks Commodity price risk is the risk of losing money if the price of a commodity changes Interest rate risk is the risk of loss caused by adverse interest rate movements Currency exchange rate risk is the risk of loss of value caused by changes in the rate at which one nations currency may be converted to another nation's currency Financial risks can be managed with capital market nstruments TOCKS
4-3 The Changing Scope of Risk Management • Financial Risk Management refers to the identification, analysis, and treatment of speculative financial risks: – Commodity price risk is the risk of losing money if the price of a commodity changes – Interest rate risk is the risk of loss caused by adverse interest rate movements – Currency exchange rate risk is the risk of loss of value caused by changes in the rate at which one nation's currency may be converted to another nation’s currency • Financial risks can be managed with capital market instruments
1. Hedging a Commodity Price Risk Using Futures Contracts Exhibit 4.1 Checking the price of futures contracts, he notices that the price of December corn is 54 9o per bushel. He would like to hedge the risk that the price of corn will be lower at harvest time and can do so by the appropriate use of futures contracts.Because Managing corn fit ures contrac间的如m Financial whether the price of corn has increased or decreased by December. By using futures contracts and ignoring transaction costs he has locked-in total revenue of $98,ooo Risk--Two If the market price of corn drops to $4. o per bushel in December: Revenue from sale of corn 20,000×$450 Soo, ooo Examples Sale of four contracts at $4.90 in May 98 Purchase of four contracts at S4 5o in December go, ooo Gain on futures transaction 8000 Total revenue 000 If the market price of corn increases to Ss. o per bushel in December. Revenue from sale of corn 20000×5500=5100,000 Sale of four contracts at $4.9o in May ooo Purchase of four contracts at Ss. oo in December Loss on futures transaction (2000) Total revenue s98000 2. Using Options to Protect Against Adverse Stock Price Movements Options on stocks can be used to protect against adverse stock price movements. A call option gives the owner the right to buy noo shares of stock at a given price during a specified period, A put option gives the owner the right to sell oo shares of stock at a given price during a specified period. While there are many options strategies used to reduce risk, one simple alternative is discussed here: buying put options to protect against a decline in the price of stock that is already owned Consider someone who owns ioo shares of a stock priced at $43 per share, The owner may be concerned that the price of the stock will fall. At the same time, however, the owner may not wish to sell the stock as the sale would trigger taxation of a capital gain. In addition, the owner may believe that the price of the stock could increase The stockholder could purchase a put option to reduce the risk of a price decline Assume there is a put option available with a strike(exercise) price of S4o. The owner of the stock could purchase the option. If the price of the stock increases, the stock owner has lost the purchase price of the option(called the premium), but the stock price has increased. But what if the price of the stock declines, say to S33 per share? In the absence of the put option, the stock owner has lost Sio(543-533) per share on paper. As owner of the put option, however, the stock holder has the right to sell 1oo shares at S40 per share. Thus, the option is "in the money" by S7 per share(S4o-$33), ignoring the option premium. The put option could be sole to offset the paper loss, Using put options in this way protects against losing money if the price of the stock declines
Exhibit 4.1 Managing Financial Risk—Two Examples
Exhibit 4.1: Managing Financial risk Example 1 A corn grower estimates in May that he wil harvest 20.000 bushels of corn by December The price on futures contracts for december corn is $4.90 per bushel Corn futures contracts are traded in 5000 bushel units How can he hedge the risk that the price of corn will be lower at harvest time?
Exhibit 4.1: Managing Financial Risk – Example 1 • A corn grower estimates in May that he will harvest 20,000 bushels of corn by December. – The price on futures contracts for December corn is $4.90 per bushel. – Corn futures contracts are traded in 5000 bushel units • How can he hedge the risk that the price of corn will be lower at harvest time?
Exhibit 4.1: Managing Financial risk Example 1 He would sell four contracts in May totaling 20.000 bushels in the futures market 20,000×$490=$98,000 In December he would buy four contracts to offset his futures position If the market price of corn drops to $4. 50 per bushel, cost is 20,000 X$4.50= 90,000 If the market price of corn increases to $5.00 per bushel, cost is 20,000 X $5.00=$100,000
Exhibit 4.1: Managing Financial Risk – Example 1 • He would sell four contracts in May totaling 20,000 bushels in the futures market. – 20,000 x $4.90 = $98,000 • In December, he would buy four contracts to offset his futures position. – If the market price of corn drops to $4.50 per bushel, cost is 20,000 x $4.50 = 90,000 – If the market price of corn increases to $5.00 per bushel, cost is 20,000 x $5.00 = $100,000
Exhibit 4.1: Managing Financial risk Example 1 Note: it doesn t matter whether the price of corn has increased or decreased by december If Price is $4.50 in December: Revenue from sale $90,000 Sale of four contracts at $4. 90 in May $98,000 Purchase of four contracts at $4.50 in December $90,000 Gain on futures transaction $8,000 Total revenue $98,000
Exhibit 4.1: Managing Financial Risk – Example 1 • Note: it doesn’t matter whether the price of corn has increased or decreased by December. If Price is $4.50 in December: Revenue from sale $90,000 Sale of four contracts at $4.90 in May $98,000 Purchase of four contracts at $4.50 in December $90,000 Gain on futures transaction $8,000 Total revenue $98,000
Exhibit 4.1: Managing Financial risk EXample 1 If Price is $5.00 in December: Revenue from sale $100,000 Sale of four contracts at $4.90 in May 98,000 Purchase of four contracts at $5.00 in December 100,000 Loss on futures transaction ($2,000) Total revenue $98,000 By using futures contracts and ignoring transaction costs he has locked in total revenue of $ 98,000
Exhibit 4.1: Managing Financial Risk – Example 1 • By using futures contracts and ignoring transaction costs, he has locked in total revenue of $98,000. If Price is $5.00 in December: Revenue from sale $100,000 Sale of four contracts at $4.90 in May $98,000 Purchase of four contracts at $5.00 in December $100,000 Loss on futures transaction ($2,000) Total revenue $98,000
Exhibit 4.1: Managing Financial risk Example 2 Options on stocks can be used to protect against adverse stock price movements A call option gives the owner the right to buy 100 shares of stock at a given price during a specified period A put option gives the owner the right to sell 100 shares of stock at a given price during a specified period One option strategy is to buy put options to protect against a decline in the price of stock that is already owned
Exhibit 4.1: Managing Financial Risk – Example 2 • Options on stocks can be used to protect against adverse stock price movements. – A call option gives the owner the right to buy 100 shares of stock at a given price during a specified period. – A put option gives the owner the right to sell 100 shares of stock at a given price during a specified period. • One option strategy is to buy put options to protect against a decline in the price of stock that is already owned
Exhibit 4.1: Managing Financial risk Example 2 Consider someone who owns 100 shares of a stock priced at $43 per share To reduce the risk of a price decline, he buys a put option with a strike(exercise) price of $40 If the price of the stock increases, he has lost the purchase price of the option(called the premium), but the stock price has increased
Exhibit 4.1: Managing Financial Risk – Example 2 • Consider someone who owns 100 shares of a stock priced at $43 per share. • To reduce the risk of a price decline, he buys a put option with a strike (exercise) price of $40. – If the price of the stock increases, he has lost the purchase price of the option (called the premium), but the stock price has increased
