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33 Cards in this Set
- Front
- Back
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Types of risk
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Strategic risk
- Risk that materially affects firm’s ability to survive - E.g. Kodak and digital photography Business risk - Uncertainty related to earnings - Sales volume, unit price, environment etc. Operational risk - Inadequate or failed internal processes, people, systems |
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Types of financial risk
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Liquidity risk
- How fast can we convert assets to cash? - Will the company have sufficient funds available if cash is needed? - Solution: credit lines Credit risk - Counterparty will not honour their commitment - Solution: credit insurance or derivatives, payoff if counterparty defaults payments Market risk |
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Market risk
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Uncertainty of earnings (or firm value) resulting from variation in market prices
- Currency risk - Interest rate risk - Commodity risk Can be protected against, hedged, using derivatives - Forwards and futures - Swaps - Options |
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Risk Management
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- Control, assessment and reduction of a firm`s exposure to risks from various sources through derivatives, insurance, diversification etc.
- To manage risk is necessary • To be able to evaluate exposure to risk • To decide which risks should be hedged • To know hedging techniques (derivatives) - Active risk management is on the rise and derivatives are being used by more and more companies More volatile macro factors Multinationals are becoming more important Better understanding of and access to derivatives |
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Fundamental principle of hedging, positive or negative exposure
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Firm’s CF depends positively on factor F → enter derivative contract whose payoff depends negatively on F
- Buy put option - Write call option - Sell forwards or futures Firm’s CF depends negatively on F → enter derivative contracts whose payoff depends positively on F - Buy call option - Write put option - Buy forwards or futures |
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Estimating exposures (beta)
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Regression
+ Quantitative, systematic, objective - Assumes that historical data is representative of future Cash flow projections, scenario analysis + More forward looking - Subjective |
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Hedging=Modifying payoff diagram
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Hedging= modifying payoff diagram
- Payoff diagram = payoff as function of factor (underlying) • Horizontal axis: factor (price of underlying) • Vertical axis: payoff - Linear derivatives (forwards, futures, swaps) can be used to modify slope of whole payoff diagram - Non-linear derivatives (options) can be used to induce kinks in payoff diagrams |
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Hedging with forwards and futures
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- Positive exposure (e.g. producer-seller) → sell forward or futures
- Negative exposure (e.g. user-buyer) → buy forward or futures - Pros: → Lock in price or exchange rate → Cheap / free: no cash changes hands today - Cons: → Cannot benefit from positive movements in prices |
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Hedging with swaps
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- Like a series of forwards
- Pros: → Lock in price or exchange rate → Cheap / free: no cash changes hands today - Cons: → Cannot benefit from positive movements in prices |
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Hedging with options
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- Positive exposure (producer-seller) → buy put option and/or write call option
- Negative exposure (buyer-user) → buy call option and/or write put option - Pros: → Hedge negative moves → Enjoy positive moves - Cons → Costly: option premium → Collar strategy will help but trades away some positive effects |
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Option Collars
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- Hedging by buying option may be costly → because of the option premium
- Buying hedging options can be financed by writing opposite options • Positive exposure → finance buying puts by writing calls • Negative exposure → finance buying calls by writing puts - Pros: → Cheaper hedge - Cons: → Limits upside potential (which may be the key reason for option hedging) |
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Types of foreign exchange risk:
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- Transaction risk
- Translation risk - Economic risk |
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Transaction risk
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Individual transaction in foreign currency
- Selling products and services, exports - Buying products and services, imports - Selling assets - Buying assets - Borrowing or lending money Value of future defined in foreign currency → value in domestic currency subject to currency fluctuation Domestic currency depreciates, value in domestic currency appreciates Domestic currency appreciates --> value in domestic currency depreciates |
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Hedging transaction risk
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Relatively easy
- Netting: income and expenses at same time in same foreign currency - Positive exposure to foreign currency • Exporting, selling assets, lending • Sell foreign currency forward • Buy put option on foreign currency - Negative exposure • Importing, buying assets, borrowing • Buy foreign currency forward • Buy call option on foreign currency KONE - Partial hedge depending on stage of contract 20% → 100% |
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Translation risk
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- Translation of foreign subsidiary’s financial statements as part of consolidated financial statement
→ Foreign currency to domestic currency - Foreign currency depreciates, value of sales, earnings, assets, liabilities, etc.: everything in domestic currency devalues - Foreign currency value goes up → Everything in domestic currency goes up |
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Importance of translation risk
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- Exchange rate reflects economic fundamentals → translated value of foreign subsidiary likely to be true economic value
- Risk of covenant violation Foreign currency up Domestic value of foreign assets down Consolidated assets up Debt-to-asset up Covenant violation, real costs |
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Hedging translation risk
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- Difficult
- Long-term risks - Difficult to forecast subsidiary values fair in nature - Very long-term derivatives may not be available - Why hedge if translation gives correct value? - Short-term risk of covenant violation may be easier to hedge Sell foreign currency short Foreign currency Foreign assets profit from forward consolidated +- 0 Foreign currency foreign assets losses on forward consolidated assets +- 0 |
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Economic risk
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- Aka competitive risk
- Risk of losing competitive advantage due to exchange rate changes - Foreign competitor Foreign currency down Domestic price of foreign products down Foreign price of domestic products up Domestic foreign sales down earnings down |
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Hedging economic risk
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Financial hedging difficult
- Very long-term derivatives may not be available - Need to answer questions like • How much less products will we sell in foreign country if its currency depreciates x%? • How much less products will we sell domestically if foreign currency depreciates by x%? - If answers are available sell foreign currency forward or buy put options on foreign currency Natural hedge - Move production to same country as competitors |
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How do firms view economic risks
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How do firms view exchange rate risks?
Relative importance - Economic risks: high - Transaction and translation risks: moderate Instruments - Forward contracts most common - Some firms use swaps - Very few firms use options |
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Hedging interest rate risk
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Changes in interest rates affect business conditions
- Higher interest rates make it harder for consumers to find financing Changes in interest rates affect interest income and expenses, and hence, earnings Hedging interest rate - Hedging effects on business conditions may be difficult - Need to answer questions like “ How much less products will we sell if interest rates rise by x%?” - Answer depends on Capital structures of customers NPVs of customer projects Effect on interest rate change on funding conditions of customers - Interest rate down sales up profit on hedge earnings +-0 - Interest rate up sales down losses on hedge earnings +-0 |
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Is decreasing CoC the primary motive for hedging?
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Most likely not
Modigliani-Miller: Investors can hedge risks themselves → no need for firms to hedge - Assuming perfect information and no frictions In reality, hedging is cheaper and easier for firms - Some motivation for firm to hedge - Should observe decrease in firm hedging as frictions have reduced but we rather observe an increase Increasing expected CFs more likely motive for hedging than decreasing CoC |
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Hedging to increase expected CFs
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- Concave earnings
- Reduce costs of financial distress - Decrease taxes - Improve planning of capital needs - Improve management compensation contracts - Improve investment and operating decisions |
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Concave earnings
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Hedging increases expected earnings if earnings if a concave function of risk factor → firms should hedge
Concave: curve open downward (δ^2 Earnings)/(δF^2 )<0 E[Earnings (F)]<Earnings (E[F]) |
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Causes for concave earnings
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- Factor affects sales non-linearly: increase smaller than decrease
- Inability to transfer cost increases full to customers - Financial distress - Asymmetric taxes Financial distress → concavity Bankruptcy has direct and indirect costs - Direct: loss to debt-holder, generally relatively small - Indirect: disruption to business, can be large Indirect costs realise already before bankruptcy - Customers don’t buy from firm in financial distress: fear of losing service etc. - Management busy with managing finance not business - Valuable employees leave - Long-term projects abandoned to save cash Vicious cycle: fear of distress → less sales, less investments → distress |
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Hedging to improve debt capacity
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- Commitment to hedge → lower risk of bankruptcy → lower ex ante bankruptcy costs → better borrowing terms
- Hedging may • Increase debt capacity • Increase investment (WACC more projects with NPV>0) • More efficient use of tax shield and other advantages of debt |
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Taxes and hedging
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UK firm exports its products → earnings depend on GBP exchange rates
Without taxes: Profits are taxed at 40%, no deductions for losses → With taxes firm should hedge |
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Hedging and planning for capital needs
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- Internal sources of capital are cheaper than external sources (issuing new equity or debt)
- Some firms may have limited/no access to external financing at all - Hedging can help secure sufficient funding for profitable future projects |
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Hedging improves managerial compensation
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- Financial performance affected by things outside of management’s control → macro factors
- Hedging effect on macro factors leaves financial performance more dependent on management’s actions and abilities - By eliminating extraneous excuses for poor performance, hedging makes simple performance-based contracts more efficient - Positive self-selection: firms encouraging use of hedging for such reasons will attract managers who are confident in their professional skills |
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Hedging improves decision-making
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- Hedging → lower profit volatility of business units → better evaluation of managers profitability
- More informed decisions regarding • Where to allocate resources • Who to promote or fire - Hedging → Better managerial decisions |
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Using futures pricing in decision-making
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- Better understanding of derivatives markets allows managers to base their investment decisions on futures prices of commodities that are the focus of their business
- E.g.: gold-miner if the future prices decline, he should overthink his business |
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Motives to hedge: summary
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- Taxes: more asymmetric taxation → more hedging
- Financial distress: high financial distress costs → more hedging - Capital planning: inflexible investment needs -_> more hedging - Hedging also improves ➢ Managerial compensation ➢ Decision making |
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Firm and stakeholder opinions on hedging
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What do firms say?
- Reducing riskiness of CFs by far most important motive for risk management - Increased profit next, but much less important Hedging and stakeholders Shareholder - Equity is call option on firm’s assets → more valuable when more volatile - May not like hedging if it only decreases volatility Debt-holders - Prefer hedging as it usually decreases probability of bankruptcy Employees and customers - Hedging → stable business, stable jobs - Like it Managers - May like hedging to reduce undiversified personal risk - May dislike it if: Rewarded with stock options Achievements are rewarded but mistakes not punished → asymmetry convex payoff |
