Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 2

Risk and Risk Management

Learning about risk and risk management is an important key to understanding the modern financial landscape. You should be cognizant of the risks and opportunities you face as an investor, as an employee or owner of a business, and as a citizen.

This book deals with the nature of price risk and how you can use derivatives to manage it. A derivative is a contract whose value is derived from the price of some underlying asset. Chapter 1 presented an overview of four well-known derivative contracts that are used to manage risk: forwards, futures, swaps, and options. At the end of Chapter 1, we called your attention to two new professions, financial engineering and risk management.

Financial engineers and risk managers do not just manage a single price risk. Instead, they concern themselves with managing the total risk exposure faced by the firm, known as enterprise risk exposure. Managing this total enterprise risk is commonly known as enterprise risk management, or ERM. Value at risk (VaR) is a concept widely used in enterprise risk management. You will learn about VaR in chapter 20, but you will be introduced to some intricate details and uses of individual derivative securities in Chapters 3 through 19.1

The purpose of this chapter is to introduce you to the concepts of risk and risk management. As a starting point, recall the basic economic fact that firms utilize inputs to create outputs. If the revenues from the outputs sold are greater than all costs, then profits are earned. Output prices are one element of revenue, and input prices are an important component of total costs. Most firms are not in the business of speculating on the prices of inputs and outputs. Firms prefer knowing what prices will be in the future, so that they will have less uncertainty about the level of their profits. Consider the following simple income statement:

Revenues = Price of output times quantity sold

Profit uncertainty is greatly reduced if a firm knows what the prices of its inputs will be and if it can have a guaranteed selling price of its output. Risk cannot be totally avoided, since the firm never knows exactly how much of its output it will be able to sell,2 nor can it totally control the total cost of all of its inputs (e.g., labor expense, R&D expense, input spoilage, or the expense of raw materials used in undeliverable output). Many risks just cannot be managed. Unusual weather, for example, can affect the amount of goods or services that a firm sells, have an impact on its costs, and even cause catastrophic losses that destroy production capabilities.3 Another example of a risk that cannot be controlled is competition. If another firm enters a market,

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