The Nature of Risk Management Alicia Garcia

What is it? A potential gain or loss that occurs as a result of an exchange rate change. A potential gain or loss that occurs as a result of an exchange rate change.

Should Firms Manage Risk? They consider any use of risk management tools, such as forwards, futures and options, as speculative. Or they argue that such financial manipulations lie outside the firm's field of expertise. They consider any use of risk management tools, such as forwards, futures and options, as speculative. Or they argue that such financial manipulations lie outside the firm's field of expertise. They claim that exposure cannot be measured. They are right - - currency exposure is complex and can seldom be gauged with precision. They claim that exposure cannot be measured. They are right - - currency exposure is complex and can seldom be gauged with precision.

Managing Firm’s Economic Value Reduces volatility of firm’s value by reducing volatility of income and return on assets without altering firm’s expected value Reduces volatility of firm’s value by reducing volatility of income and return on assets without altering firm’s expected value Creates value because firm’s expected value is higher in the presence of a risk management strategy Creates value because firm’s expected value is higher in the presence of a risk management strategy

Financial Distress Risk worth managing is that which may have material impact on the value of the firm’s periodic cash flows Risk worth managing is that which may have material impact on the value of the firm’s periodic cash flows Large, highly diversified firms may not be at much risk from risk exposure Large, highly diversified firms may not be at much risk from risk exposure Small, poorly diversified firms are at greater risk because more transactions are large Small, poorly diversified firms are at greater risk because more transactions are large

Risk Aversion Requires corporations give up the chance for upside foreign exchange gains to protect themselves from possible downside foreign exchange losses Requires corporations give up the chance for upside foreign exchange gains to protect themselves from possible downside foreign exchange losses Hedging with options Hedging with options Recognizes risk is concern because of the downside losses rather than the upside gains Recognizes risk is concern because of the downside losses rather than the upside gains Fear of Bankruptcy Fear of Bankruptcy Loss Aversion

Three Preliminary Questions What exchange risk does the firm face, and what methods are available to measure currency exposure? What exchange risk does the firm face, and what methods are available to measure currency exposure? What hedging or exchange risk management strategy should the firm employ? What hedging or exchange risk management strategy should the firm employ? Which of the various tools and techniques of the foreign exchange market should be employed: debt and assets; forwards and futures; and options Which of the various tools and techniques of the foreign exchange market should be employed: debt and assets; forwards and futures; and options

Forward/Futures Require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem. Require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.

Debt as a Hedge Debt -- borrowing in the currency to which the firm is exposed or investing in interest- bearing assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the same purpose as forward contracts. Debt -- borrowing in the currency to which the firm is exposed or investing in interest- bearing assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the same purpose as forward contracts.

Debt Example Money Market Hedge: Fredericks sold Canadian dollars forwards. Alternatively she could have used the Eurocurrency market to achieve the same objective. She would borrow Canadian dollars, then exchange them into francs in the spot market, and hold them in a US dollar deposit for two months. When payment in Canadian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. The cost of the money market hedge is the difference between the Canadian dollar interest rate paid and the US dollar interest rate earned. The cost of the money market hedge is the difference between the Canadian dollar interest rate paid and the US dollar interest rate earned.

Elimination of Downside Losses Options Options As loss aversion As loss aversion Managers have incentive to undertake profitable projects when allowed to hedge using options Managers have incentive to undertake profitable projects when allowed to hedge using options

Last Thought Risk management adds value because it helps ensure that a corporation has sufficient internal funds available to take advantage of profitable investment opportunities. Risk management helps the firm avoid short-run and intermediate-run capital constraints to survive in the long run Risk management adds value because it helps ensure that a corporation has sufficient internal funds available to take advantage of profitable investment opportunities. Risk management helps the firm avoid short-run and intermediate-run capital constraints to survive in the long run

Questions??

Ex. 1: Hedging practice at GE Use a portfolio approach (50%: forward, 25%: option, and 25%: spot) Use a portfolio approach (50%: forward, 25%: option, and 25%: spot) Keep its individual business units well- educated about risk management Keep its individual business units well- educated about risk management Encourage them to bill in premium currencies like Japanese yen and receive invoices in discount currencies such as Italian lira Encourage them to bill in premium currencies like Japanese yen and receive invoices in discount currencies such as Italian lira

Ex. 2: Hedging practice at Baxter Int. Educate a wide range of people within the company in the proper use of risk management tools Educate a wide range of people within the company in the proper use of risk management tools Make many of its risk-management decisions by consensus (as an effective check-and- balance system) Make many of its risk-management decisions by consensus (as an effective check-and- balance system) Try to interact and share information with several investment banks correctly Try to interact and share information with several investment banks correctly

Elimination of downside losses Managers and shareholders → Not worried about impacts of foreign exchange gain, but exchange losses → Not worried about impacts of foreign exchange gain, but exchange losses↓ Options are best justified as hedging tools. Because of asymmetric pay-off structure Because of asymmetric pay-off structure Because of no possibility for loss beyond the amount of the premium paid Because of no possibility for loss beyond the amount of the premium paid Because of costs to symmetric hedges like forwards, money markets, and futures Because of costs to symmetric hedges like forwards, money markets, and futures

Does risk management create value ? If marketing resources are allocated where currencies are overvalued and are taken away from locations where currencies are undervalued… If marketing resources are allocated where currencies are overvalued and are taken away from locations where currencies are undervalued… If production is increased where currencies are undervalued and is decreased where currencies are overvalued… If production is increased where currencies are undervalued and is decreased where currencies are overvalued…↓ The firm as a whole is more profitable. ↓ Risk management may indeed create value as well as Risk management may indeed create value as well as reduce the variability of firm value. reduce the variability of firm value.