General lessons for the hedger Final week of class FIN 441

Hedging debacles MG Refining & Marketing –Fixed price fuel program for customers –Up to 10-year contracts –“Stack-and-roll” hedging system –Big downward price moves create big futures losses without corresponding gains on the fixed price contracts Procter & Gamble –Lost money on bets that interest rates would not increase significantly –Treasury is NEVER a profit center

Why hedge? Tax arguments –Tax convexity –“Hedging increases debt” argument Reduce financial distress costs –Reduce probability of distress –Reduce probability of underinvestment Reduce cost of capital Managerial arguments –Structure of compensation –Structure of portfolio

Tax arguments Convexity argument is not empirically valid (Graham and Rogers, 2002) More hedging is associated with higher debt ratios  present value of greater interest tax deductions worth average of 1% of firm value (Graham and Rogers, 2002) –Net: hedging provides positive (but small) value contributions by allowing for more debt in capital structure. –Results might imply that hedgers have lower WACC because of more debt in capital structure.

Reduction of distress costs What is “financial distress?” Expected financial distress costs = probability of distress * costs incurred if distress occurs If hedging reduces distress probability, then it also lowers expected distress costs. “Typical” definitions of distress costs suggest that reducing these is unlikely to add much value!

Underinvestment Underinvestment = failure to invest in all positive NPV projects. When capital is hard to raise, firms may be unable to finance valuable investment. Hedging can provide additional cash flow during “bad” outcomes, thus helping firms finance investment.

Hedging and firm value: Evidence Allayannis and Weston (2001) find approximately 5% value premium on firms that hedged FX currency risk. Carter, Simkins, and Rogers (2006) find evidence of a 5% – 10% hedging premium for airlines hedging jet fuel price risk. –Hedging by airlines is best explained by underinvestment story. –Premium is related to hedging’s interaction with capital investment. –Hedging premium is more apparent during periods of high jet fuel prices and oil price volatility. Investors do not appear to value hedging by oil & gas firms (Jin and Jorion, 2006).

Demonstration of the underinvestment rationale for hedging Two identical firms in gold mining (natural long positions) Suppose gold price = $500 per oz. Firm 1 is a “momentum” investor (expands production when prices are high) (i.e., $800+) Firm 2 is a “contrarian” investor (expands production and/or buys competitors when prices are low) (i.e., $300-) Which firm will improve value more from a short hedging strategy (i.e., sell futures, buy put options)?

Enterprise risk management Hedging is synonymous with “financial risk management.” Financial risk management is only one element of a firm’s risk management strategy. Enterprise risk management is relatively new buzzword in managing risk. –Incorporates management of operational, strategic, legal, reputational, financial reporting, and disclosure risks, in addition to financial risks. –Companies are still sorting out how to (or whether to) create ERM systems within their businesses. –ERM creates environment in which “everyone is a risk manager.”

Some important ideas relating “hedging” to broader risk management “Hedging” is a short-run business strategy (that may continue in the long-run). “Hedging” may alter a firm’s strategic risk profile. “Hedging” creates many additional risks (see pages 551 – 554). All firms should have clear understanding of their own benefits of risk management.

A final lesson – The current financial crisis Traditional role of financial institutions: lending (assumption of credit risk) A more recent business model: lend, then “reduce” credit risk by entering into credit default swaps Counterparties to credit default swaps: Other large financial institutions Outcome: Systemic risk caused by circular nature of credit risk