Week 7: Financial Risk Management and Lessons on Investing (Ch. 20)

The last lecture covers Chapter 20: how firms can reduce their exposure to price and rate fluctuations (hedging) with derivatives: forward contracts, futures contracts, swaps and options. The second part concludes the course with lessons about investing that follow from the theory of risk, return and market efficiency.

Price volatility and the need for hedging

Risk can be large and sudden, as the images of traders in the (former) open outcry trading pits show. The CBOE Volatility Index (VIX) is a real-time market index widely used to evaluate market sentiment and perceived risk. It represents the expected volatility of the S&P 500 over the next 30 days and acts as a barometer of investor fear and uncertainty ('fear index'). From 1990 to 2025 the VIX spiked during the Gulf War, the Asian currency crisis, the Russian default and LTCM, 9/11, the Iraq war, the credit crisis (Lehman, its all-time peak), the euro crisis, COVID and the 2025 US tariffs.

(Book) Three areas in which volatility is particularly important for firms: interest rates (key component of the cost of capital; one basis point is 0.01%), exchange rates (importers and exporters) and commodity prices (oil and other raw materials).

Aim of risk reduction: transfer money from a good state to a bad state, so that the firm's value is less sensitive to price changes (a flatter risk profile). Usually a perfectly flat profile is impossible and unnecessary; the goal is to reduce risk to bearable levels.

(Book) Transactions exposure is short-run financial risk from having to buy or sell at uncertain prices or rates in the near future; it can be hedged. Economic exposure is long-run risk from permanent changes in prices or economic fundamentals; it cannot be hedged permanently (in the long run a business is either economically viable or it fails). Hedging buys time to adapt. Firms should hedge their net exposure at a central level: an oil-producing division and a petrol-retailing division of the same firm may offset each other.

Forward contracts

Example: a Dutch manufacturer must pay USD 2,500,000 in six months for components from the US and enters a forward contract to pay 80 eurocents per dollar. If the spot rate in six months is 82 eurocents per dollar, the gain is €0.02 per USD: 2,500,000 x €0.02 = €50,000. Without the forward the dollars would have cost €2,050,000; with it they cost €2,000,000. Had the dollar fallen to 78 cents, the forward would have cost €50,000 compared with the spot market.

(Book) Two caveats: a forward eliminates not only the risk of an adverse price move but also the gain from a favourable move; and no money changes hands at the start, so there is credit (counterparty) risk: at settlement the losing party has an incentive to default. Forwards are widely used to hedge exchange rate risk.

Futures contracts

Example (cocoa, short hedge): in January Simon, a Ghanaian farmer, expects a harvest of 5,000 tons of cocoa at the end of September. The September cocoa contract on Euronext LIFFE (London International Financial Futures and Options Exchange) trades at £1,735 per ton, with contracts of 10 tons. Simon writes (sells, goes short) 500 September contracts (5,000/10) and thereby locks in the price. (The slide computes 500 x £1,735 = £867,500; strictly the revenue is 5,000 tons x £1,735 = £8,675,000.)

Marking to market, seller: the seller sells a futures contract at the closing price of £1,735 on Friday 9 January. On Monday the price closes at £1,705: the seller receives £30 per contract from the clearing house. On Tuesday it closes at £1,750: the seller pays £45 per contract. On delivery the seller receives £1,750 and delivers the cocoa. Net receipts: 30 - 45 + 1,750 = £1,735, the same as with a forward at £1,735. Buyer: pays £30 on Monday, receives £45 on Tuesday and pays £1,750 at delivery: net payment -30 + 45 - 1,750 = -£1,735, the same as a forward purchase at £1,735.

Price volatility, collateral and margin calls: exchanges require collateral (margin) to back up futures positions; when prices move against a position, a margin call demands extra collateral. In January 2022 the German energy company Uniper had to borrow €10 billion (about two-thirds of its market value) from its parent Fortum and KfW to meet margin calls after gas and power prices rose by several hundred percent. The hedges were economically sound (losses would be offset by higher realised spot prices), but marking to market created an acute liquidity need.

Swap contracts

Interest rate swap example: Company A can borrow at a floating rate of EURIBOR + 1% (or a fixed 10%) but wants a fixed rate. Company B can borrow at a fixed 9.5% (or EURIBOR + 2%) but wants a floating rate. A borrows at EURIBOR + 1% and swaps with the dealer: A pays the dealer a fixed 9.75% and receives EURIBOR + 1%, so A effectively pays a fixed 9.75% (better than 10%). B borrows at a fixed 9.5% and swaps: B pays the dealer EURIBOR + 1.5% and receives 9.5% fixed, so B effectively pays EURIBOR + 1.5% (better than EURIBOR + 2%). The dealer receives 9.75% and pays 9.5% fixed, and receives EURIBOR + 1.5% while paying EURIBOR + 1%: it earns a spread of 0.25% + 0.5% and has a balanced book without interest rate exposure.

Options

The lecture refers to the history of options and their pricing (the Black-Scholes 'Midas formula'). (Book) Two key differences with forwards: with an option only the owner decides whether the transaction happens; and the buyer pays a price for this right, the option premium, while a forward costs nothing at the start.

Option quotations: an Air France-KLM option listing on NYSE Liffe Amsterdam (24 March 2010, share price €10.09) shows American options for June 2010 with strikes 10, 11, 11.5, 12 and 13, with bid and ask prices for calls and puts; the call with strike 11.5 cost €0.65 (ask). Calls are cheaper at higher strikes; puts are more expensive at higher strikes.

Call option payoff versus shares (same investment of €3,250): buying 50 contracts (5,000 calls at €0.65, strike €11.50) or 322.1 shares at €10.09.

With options you can lose the entire investment (if the price stays below €11.50) but earn a multiple when the price rises: options provide strong leverage. The option seller's profit is the mirror image of the buyer's: options are a zero-sum game. Warren Buffett called derivatives 'financial weapons of mass destruction' because of the enormous gains and losses they can generate. Contracts for difference (CFDs), offered by retail platforms such as eToro, likewise allow large potential gains and losses on an investment.

Example (Mrs. Pessimist): Bayer AG trades at €42. She buys a one-year put with a €42 exercise price. If Bayer is at €48 at expiration, the put is worthless: she will not sell shares for €42 that are worth €48. If Bayer is at €30, she can buy a share in the market for €30 and sell it at the exercise price of €42: the put is worth €42 - €30 = €12 per share (her net gain is €12 minus the premium she paid).

Long positions have rights; short positions have obligations (in return for receiving the premium).

(Book) Option hedging: a firm that loses when a price falls can buy a put: this removes the downside while keeping the upside, like an insurance policy that must be paid for. A firm that loses when a price rises (a buyer of oil or foreign currency) can buy a call. Interest rate options: an interest rate cap is a call option on an interest rate (protects a floating-rate borrower against high rates); a floor is a put on an interest rate; buying a cap and selling a floor creates a collar; an option on a swap is a swaption; an option on a cap is a caption. Large firms use derivatives more than small firms; foreign exchange and interest rate derivatives are the most common.

Practice questions (lecture): (1) A US importer wants to hedge against rising yen costs for Japanese components: buy JPY forward (fixes the future dollar cost). (2) A Dutch importer who must pay USD but also wants to benefit if the USD depreciates: buy a USD call option (right to buy USD at a fixed rate; if the USD weakens he lets it expire). (3) In the Bayer example (price €30, strike €42) the put holder's gain is €12 per share. (4) Compared with forwards, futures are standardised and traded on organised exchanges (they are more liquid, marked to market and have lower counterparty risk).

Conclusion of the course and comments on investing

Looking back at the Bojangles' IPO article from the first lecture, you can now interpret every element: the IPO, the underwriters, the option to buy an extra 1,162,500 shares (the green shoe), and the fact that the proceeds went to existing investors (no capital increase). What you know now: how to evaluate a company's situation and performance (ratios); what stocks and bonds are and how to determine their price; how much return and risk to expect on stock markets; that there is no extra return without risk; how companies acquire additional funds; how a start-up grows and can go public; and which instruments a company can use to reduce risk. The decision studies during the course forced students to make their own predictions and decisions about finance and investments (topics included investing behaviour and the influence of social media, sustainability beliefs and preferences, and how investors overvalue public signals).

Evidence on investing (no financial advice):

• Trading volume and success (Barber and Odean, 2000): households with the lowest monthly turnover (0.2%) earned a net annual return of 18.5%, those with the highest turnover (21.5%) only 11.4%. The more people trade, the worse they do, mainly because of trading costs and bad timing.
• Random walk: Burton Malkiel (A Random Walk Down Wall Street, 1973): 'a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts'.
• Warren Buffett and survivorship bias: if very many people try to beat the market, some will succeed ten times in a row by chance; we only hear about the survivors. Buffett himself won a 10-year bet (2008 to 2017) that a cheap S&P 500 index fund would beat a selection of hedge funds.
• Active versus passive funds: active mutual funds do not outperform passive funds on average, but charge substantial fees (for example a front-end load of 4.75% and a gross expense ratio of 1.11% per year for an American growth fund).
• The impact of costs: €10,000 invested for 40 years grows to €102,857 at 6.0% per year and to €180,442 at 7.5% per year: a difference of €77,585 (75% more) caused by 1.5 percentage points of annual costs.

Key insights: (1) stock market developments are mostly not predictable; (2) trading is usually costly, and most traders lose money by selecting the wrong assets or through bad market timing; (3) active mutual funds do not outperform passive funds on average, but have substantial management fees. The solution, at least for most investors: buy (and hold) a well-diversified, cheap index fund (ETF). This follows directly from the course: diversification removes unsystematic risk that is not rewarded, efficient markets make it hard to beat the market, and compounding makes costs very expensive over long horizons.