The New Risk Management: The Good, the Bad, and the Ugly Philip H. Dybvig, Pierre Jinghong Liang, and William J. Marshall Presented by Xin (Elena) Cao

Outline Option-pricing tools Detailed example of how the new risk management ought to work Implementation issues, including some general policy issues and some accounting issues

What’s new about risk management? At some time, risk management meant buying corporate insurance, implementing procedures to avoid lawsuits and accidents, and installing safety equipment. Now firms can use financial instruments to hedge against the risk of changes in interest rates and exchange rates, etc.

The Good, the Bad, and the Ugly The new risk management can be bad: wasting resources without reducing risk and probably even increasing it The new risk management can also be ugly: generating huge losses (examples: Barings in 1995, Procter and Gamble in 1994)

Disaster: Barings Bank in 1995 Nick Leeson, a trader in the Singapore office, was employed to exploit arbitrage opportunities between the Nikkei 225 futures price traded on exchanges in Singapore and Japan He started to move from trading as an arbitrageur to become a speculator without letting the head office in London know At some point, he made some losses but he was able to hide from the head office for a while Subsequently he started to take bigger speculative positions, hoping to recover his previous losses By the time his activity was uncovered, his total loss accounted for almost $1 billion Baring bank was bankrupt

Tools for the new risk management Black-Scholes model Importance: it provides a hedging strategy Investment = option price derived from the model Terminal value = terminal value of the option Lose money on the hedge in good times and make money in bad times  offset original cash flows and reduce the volatility of the total cash flow

Review: Black-Scholes model Call option Hedging an option is an example of risk management F(d1) , F(d2): probability of call option ending up in the money at maturity

Review: Black-Scholes model Main assumptions: Absence of arbitrage A constant risk-free rate Continuous stock price A constant variance of returns per unit of time for the underlying stock

Review: Black-Scholes model If model implied price of a call option is lower than market price, we should exploit the following trading strategy: Sell/short call option Borrow money Buy underlying stock

Example: risk management in manufacturing A manufacturer which uses a large amount of copper as an input Output price = $100/unit Expected output = 1,000 units The price has been committed to in advance because of long-term contracts but the quantity may vary around this expectation.

Example: risk management in manufacturing Case 1: unhedged cash flows Total sales = output price * units sold Copper expense = copper price * units sold

Example: risk management in manufacturing Case 2: naïve hedge of the expected quantity required Either by entering a fixed-price contract with the supplier or by buying that amount of copper futures Problem here is that this approach to hedging increases risk exposure, since the firm is already more than hedged by increased sales when the industry is doing well and copper prices go up

Example: risk management in manufacturing Case 3: full hedge Can be implemented either by buying options or by dynamic trading in forward or futures contracts

The dynamic hedge Assumption: the rate at which futures gains or losses will be reinvested is 5% simple interest over six months

The dynamic hedge From the beginning, the company sells 1,400/1.05~1,333 futures at the futures price of $20. In six months: If the futures price goes down to $17.50, the company increases the short position to 1,600 contracts. If the futures price goes up to $22.50, the company reduces the short position to 1,200 contracts.

The dynamic hedge Path: 20-22.50-20 Futures losses in six months = -$2.50 * 1,333 = -$3,333 Repayment of the loan in twelve months = -$3,333 * 1.05 = -$3,500 Futures gains in twelve months = $2.50 * 1,200 = $3,000 Net loss from the hedge = $3,000 - $3,500 = -$5,00

The dynamic hedge Path: 20-17.50-20 Futures gains in six months = $2.50 * 1,333 = $3,333 Reinvestment of gains in twelve months = $3,333 * 1.05 = $3,500 Futures losses in twelve months = -$2.50 * 1,600 = -$4,000 Net loss from the hedge = $3,500 - $4,000 = -$5,00

The dynamic hedge: backward calculation

Some fundamental questions Why should we hedge? What risks should we hedge? With what instruments should we hedge?

Why should we hedge? Argument 1: hedging reduces the volatility of value received by shareholders Problems of this argument: Most shareholders in a large publicly traded company hold the shares in a well-diversified portfolio. Additional risk is not important to them. A conflict of interest may exist between the majority of shareholders and large shareholders: expending resources to reduce risk may benefit the large shareholders at the expense of the rest of the shareholders.

Why should we hedge? Argument 2: failure to hedge may cause ancillary damage within the company As an extreme case, adverse copper price movements may push the company into bankruptcy, which would incur deadweight costs, such as payments to lawyers and accountants and the loss of profitable future projects. Unhedged risk exposure may tend to increase taxes on average: when the government received additional tax payments when the copper price move is favorable, an unfavorable move does not create a compensating tax deduction, given that tax offsets may only be deferred (and may even be lost).

Why should we hedge? Argument 3: many firms have a policy of smoothing earnings and hedging can reduce earnings volatility Problems with this argument: It seems to be an expenditure of the owner’s resources to minimize the amount of information going out to the owners (not in the interest of shareholders). This use of hedging may make management more comfortable and minimize criticism, but maybe too comfortable that it discourages profitable innovation.

Why should we hedge? Argument 4: hedging makes it easier to give managers incentives to produce profits For example, by hedging risk, we can make a division manager’s compensation depend closely on value added that the manager can influence instead of what the manager cannot influence (the actual realization of copper prices). But it may be optimal to manage copper price risk at the division level even if copper prices do not represent a significant contribution to the company’s cash flow.

Why should we hedge? Conclusion: whichever the reason for hedging, we should quantify the benefits from hedging and the trade-offs involved.

What risks should we hedge? For example, we want to hedge a bank’s exposure to interest rate risk. Direct mismatch of existing assets and liabilities Full economic value, including the value of future business A related question of whether to hedge cash flows or value In practice, hedging cash flows is much different from hedging the company’s entire value. If the purpose is to eliminate sources of noise beyond the manager’s control, it may be appropriate to hedge particular accounting numbers used in computing compensation instead of hedging cash flows or economic value.

With what instruments should we hedge? Common risks: exposure to interest rates, foreign exchange rates, and commodity prices Example: to hedge U.S. interest rates, we can use bonds, repurchase agreements, Treasury bond futures, swaps, caps or collars. Key: your choice would be determined by pricing and transaction costs, adequately matching the tool to hedging needs and accounting applications.

Accounting issues Hedging accounting is a relatively new and technical area, and the accounting profession is only starting to address the important issues involved. First, we need to determine whether the dynamic hedge transactions qualify for the so-called hedge accounting treatment according to the official pronouncement by the FASB. Even if the transactions qualify for hedge accounting, effects on financial statements differ depending on which one of the two allowable hedge accounting methods applies: fair value hedge or cash flow hedge.

Accounting issues A fair value hedge refers to companies entering into derivative contracts to hedge the fluctuation of the fair value of existing assets, liabilities, or commitments otherwise not recognized on the company’s balance sheet. A cash flow hedge refers to companies entering into derivative contracts to hedge the variation of their future cash inflow or outflow.

Accounting issues One interesting feature of the accounting rules is that hedges that are economically equivalent may have very different accounting treatments. Current accounting standards are deficient for measuring risk. But the differences in accounting treatments of economically equivalent hedges may allow companies to hedge despite the deficiencies in the accounting standards.

Cost issues It’s tempting to think that the cost of the hedge is the cost of any securities purchased. In practice, the cost includes transaction costs such as commissions, bid-ask spread, and any internal costs of trading. For publicly traded contracts in liquid markets, the costs are probably small and easy to measure. When hedging uses custom contracts provided by investment bankers, the costs are hard to assess (because they are built into pricing) and may be much larger. On a subtle point, a hedge may be more costly than it appears if its pricing and tax treatment make it inappropriate for the company.

Suggestions for risk management policy Feature 1: it should dictate the degree of centralization and the control systems For most companies, the benefits of centralization (better control, economies of scale, and cost saving resulting from internal netting) will outweigh the costs (mostly the difficulty of communicating and aggregating needs). A failure to separate the operations and accounting functions from trading was an essential common cause in the losses. In previous Barings Bank example, it was only a trader who made almost $1 billion loss.

Suggestions for risk management policy Feature 2: it should specify the goals and scope of the hedging program Some common questions to ask: What risks should be hedged and what risks should be borne by the shareholders? Should hedging be implemented on a divisional or departmental level? Should the hedging program focus on cash flows, earnings, or something else?

Suggestions for risk management policy Feature 3: it should provide for oversight and evaluation of the effectiveness of hedging It is entirely possible to design a program that is ineffective or that even increases risk. Only retrospective analysis of the results can verify that the program is actually reducing risk.

Conclusion With the widespread use of futures contracts and swaps to hedge foreign exchange, interest rate, and commodity risks, many profitable business become not too risky. Companies work on implementing vague new accounting standards that require them to describe their risk exposure. Companies need to develop internal controls and policies to work on developing effective hedges whiles avoiding catastrophic losses.

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