On Hedging By RichardRichard MacMinnMacMinn

8/14/20152 Objectives What are the goals of risk management? Premises for risk management Is risk management irrelevant? Why should the firm hedge? When should the firm hedge? Guidelines for hedging

8/14/20153 Premises for risk management The risk management paradigm rests on the following three premises: Corporate value is created by good investments Generating internal cash is necessary to fund good investments Companies that don’t generate sufficient cash tend to cut investment more drastically Cash flow crucial to investment can be disrupted by external factors such as exchange rates, commodity prices and interest rates The risk management program must ensure that the firm can make the investments that create value

8/14/20154 Historical sketch Pharaoh Inventory Middle Ages Futures Berle & Means Diversification Dresser Industries Dresser is used as an example of the breakdown in the logic that the corporation need not diversify since investors can diversify on personal account by buying stock in petrochemical firms as well as oil firms. Berle and Means represent a precursor to modern finance. The Berle and Means argument is that the corporate form was developed to enable firms to disperse risk among many small investors. This notion has also been discussed by Samuelson in 1967 and MacMinn SamuelsonMacMinn If this is so then the firm need not diversify risk on corporate account. Use MacMinn and Martin to discuss the corollary to the MM58 theorem. The nexus of contracts is irrelevant. Berle and Means represent a precursor to modern finance. The Berle and Means argument is that the corporate form was developed to enable firms to disperse risk among many small investors. This notion has also been discussed by Samuelson in 1967 and MacMinn SamuelsonMacMinn If this is so then the firm need not diversify risk on corporate account. Use MacMinn and Martin to discuss the corollary to the MM58 theorem. The nexus of contracts is irrelevant. The story of Joseph. What is the difference between dream interpretation and risk management? See Bernstein. The story of Joseph. What is the difference between dream interpretation and risk management? See Bernstein. Discuss the natural hedge versus the futures contract. Note that the risk averse farmer wants to sell more forward to reduce income risk and so normally we see the relation: f < EP, i.e., a forward price less than the expected spot price; this is called normal backwardation. Discuss the natural hedge versus the futures contract. Note that the risk averse farmer wants to sell more forward to reduce income risk and so normally we see the relation: f < EP, i.e., a forward price less than the expected spot price; this is called normal backwardation.

8/14/20155 Historical sketch Modern finance Modigliani and Miller 1958 Modigliani and Miller Corollary to the 1958 Modigliani-Miller theorem Post-modern paradigm Myers and Majluf MacMinn and Page Froot, Scharfstein and Stein “Internally generated cash is therefore a competitive weapon that effectively reduces a company’s cost of capital and facilitates investment.” p. 94 “... the role of risk management is to ensure that companies have the cash available to make value-enhancing investment” p. 94 Brander and Lewis The corollary was introduced in MacMinn and Martin. The role of risk management is to ensure that the firm has the cash available for investment when it is needed. If the firm does and its competitors do not then it has achieved a competitive advantage.

8/14/20156 Example Dresser Industries Dresser “During the late 1930s it spent five times the industry average on research and development, adding 128 new types of products.” “Dresser officially became known as Dresser Industries, Inc. in 1944 and opened new headquarters offices in Cleveland the next year. An unprecedented boom in the energy, petrochemical and housing construction industries fueled its post- war growth.”

8/14/20157 Halliburton Co. (HAL) Corporate history Key factsfacts Recent stock price historystock price history

8/14/20158 Halliburton Company Income before taxes and capital expenditures

8/14/20159 Halliburton Company Capital expenditures HAL.xls Cash From Operations 864, , , , ,0 002,2921, %-54% 337%-100%-32%-150%-220% Capital Expenditures as a proportion of Cash from Operations85%106%218%295%75%35%49%-66%62% Capital Expenditures 731, , , , , Percentage change 20%-4%-38%11%-100%-4%-33%12%

8/14/ Why hedge? Omega drug example Omega Payoffs from Omega Drug InvestmentsOmega R&DDiscounted Cash FlowsNet Present Value

8/14/ Why hedge? The capital investment decisioncapital investment r is the rate of interest e is the random exchange rate, i.e., dollars per yen exchange rate P is the random spot price k is the capital cost per unit of capacity m is the unit variable cost q is the output of firm in market r is the rate of interest e is the random exchange rate, i.e., dollars per yen exchange rate P is the random spot price k is the capital cost per unit of capacity m is the unit variable cost q is the output of firm in market

8/14/ When to hedge Risk and the optimal investment Exchange rate Commodity price Interest rate Property loss Claim An oil company has less incentive to manage risk because investment opportunities are only good when oil prices are high. Claim An increase in commodity price risk reduces the optimal investment. Consider the condition for an optimal investment decision. Consider the claim in view of the first order condition.

8/14/ When to hedge Froot, Scharfstein, and Stein “The goal of risk management is not to insure investors and corporate managers against oil price risk per se. It is to ensure that companies have the cash they need to create value by making good investments.” p. 98 Key issues This approach helps identify what is worth hedging and what is not. This approach helps identify how much hedging is necessary. Is the firm naturally hedged? How sensitive is the value of the investment to changes in interest and exchange rates? Commodity prices?

8/14/ Guidelines Companies in the same industry should not necessarily select the same hedge An all equity firm would select its production level to maximize stock value and differences in marginal costs may imply differences in optimal hedging, i.e., Consider the different investment opportunities noted by Froot, Scharfstein and SteinFroot, Scharfstein and Stein Companies may benefit from risk management even if they have no major investments in plant and equipment Consider a firm with investment opportunities in human capital, brand names, or market share Investment in human capital cannot be collateralized Investment in market share may require lowering price and that also is difficult to collateralize Even companies with conservative capital structure can benefit from hedging Why might the firm have chosen a conservative capital structure?

8/14/ Guidelines Multinational companies must recognize that foreign exchange risk affects not only cash flows but also operating decisions. Example oneone Commodity price and cost in euros The sign of the derivative does not depend on the size of the exchange rate. Example two Commodity price in dollars and cost in euros The sign of the derivative does depend on the magnitude of the exchange rate A depreciation in the dollar implies a smaller exchange rate, i.e., fewer dollars per euro.

8/14/ Guidelines Companies should pay close attention to hedging strategies of their competitors This will allow the corporation to assess the capabilities of its competitors, e.g., can the competitor invest when the exchange rates move against it? The choice of specific derivatives cannot be delegated Management must select the tools consistent with the strategic advantage Financial futures may yield more variability in cash flows along with the liquidity while the forward does not increase the variability of cash flows but does incur credit risk

8/14/ To hedge or not Risk management cannot be ignored since that has costs Risk management cannot be delegated Pay attention to the source, risk, etc. of the cash flows