Week 9: Lessons of Risk Management FIN 441 Prof. Rogers Fall 2011

Sources Chapter 15 (pp , ) Chapter 16 “Managing Financial Risk and its Interaction with Enterprise Risk Management” “Hedging and Value in the U.S. Airline Industry”

An Application of Black-Scholes: Valuing equity and finding yield on corporate debt Equity can be viewed as a call option on the value of a levered firm’s assets (i.e., shareholders get payoff only if value of firm’s assets > face value of debt). –Also can say that debtholders have written a put option (i.e., shareholders own the right to sell the firm to bondholders if asset value is less than face value of debt) Example on pages –Value of firm’s assets (S) = 1000 –Face value of debt (X) = 800 –Risk-free rate (r) = 4% –Volatility of firm value (σ) = 25% (per year) –Debt matures in 2 years (T) –Use Black-Scholes to show that equity value = , debt value = , debt’s yield = 6.26%

What is “Risk Management?” Practice of –Defining the desired risk level (exposure) –Identifying current risk level (exposure) –Using derivatives (or other hedging instruments) to adjust risk level from current level to desired level

Quick review Recall the first week of class: –Business risks (NOTE: renamed “strategic risks in Chapter 15) Organizations are (should be) designed to “profit” from taking these (i.e., positive NPV projects) –Financial risks (i.e., related to interest rates, exchange rates, commodity prices, and stock prices) Most organizations do not have comparative advantage in taking these types of risks.

Why are derivatives important in risk management? Low-cost instruments to quickly alter exposures to certain types of risks. –Example: contrast using currency derivatives as opposed to relocating a manufacturing plant to a different country Increasing numbers of people trained to understand them. Computing power Relatively low regulation (subject to change!)

Theoretic underpinnings of financial risk management Perfect capital markets = no benefit to corporate risk management –Shareholders can “do it themselves.” Hedging reduces expected costs of financial distress (including underinvestment) Hedging increases debt capacity Hedging reflects management’s incentives

Expected costs of financial distress & underinvestment Firm value = PV of expected free cash flow – expected distress costs Expected distress costs = Probability of distress x costs if distress occurs If hedging reduces probability of encountering distress, then firm value should improve as a result.

What are distress costs? Direct costs associated with bankruptcy (i.e., “formal” distress) –Example: lawyer fees Indirect costs of bankruptcy –Example: Management time Costs encountered prior to “formal” distress –Example: Underinvestment

Underinvestment and hedging Underinvestment = failure to invest in all value-increasing opportunities –Typically caused by firm’s inability to raise capital to invest –Firms “like” internal capital If underinvestment occurs because of firm’s financial troubles AND these are related to hedgeable risk, then hedging can add value to the firm

Hedging and debt capacity Story is tied to optimal capital structure –By reducing risk, hedging increases firm’s optimal proportion of debt –If debt is tax-advantaged form of capital, then income shielded from corporate taxes provides foundation for higher firm value

Hedging and incentives Option compensation for executives is likely to make them more “risk-loving” (i.e., less likely to hedge) Actual shareholdings by executives would more likely provide incentives to hedge It is not clear that hedging because of managerial incentives is associated with higher firm value.

What’s the evidence: Does hedging affect firm value? Foreign currency hedging –Allayannis and Weston (2001): 5% premium for exposed firms who hedge Airlines –Carter, Rogers, and Simkins (2006): 5 – 10% premium for firms that hedge jet fuel at median (approx. 30%) levels Oil & gas producers –Jin and Jorion (2006) show that hedging does not increase firm value

Why is hedging valuable in the airline industry? Why study the airline industry to better understand hedging? –Competitive and homogeneous industry –Focus on single area of risk –High volatility associated with risk –“Bad” risk is not easily passed to consumer –Airlines have significant investment opportunities when industry conditions are bad

Underinvestment problem in the airline industry Part of the research involved studying aggregate airline industry investment –High investment happens when airlines are doing “well” and also when doing “bad” –Hedging profits can come in handy in “bad” industry conditions –Bad industry conditions coincide with high fuel prices What’s the strategy? –Run a “good” airline –Initiate hedges when oil prices are low –Use hedging profits when prices are high to buy troubled airline assets at fire sale prices! –“Bad” airlines are better off just gambling on low oil prices!

Hedging “success” stories of airlines See “boxes” about Southwest and Lufthansa in Carter, Rogers, and Simkins (2006) In 2005, Southwest’s effective cost of jet fuel (per gallon) was $1.03. By contrast, the average Gulf Coast spot price of jet fuel for 2005 was approximately $1.72! In 2004, Southwest won a bidding war for ATA…gains from hedging provided plenty of extra cash flow! Lufthansa began hedging program in –Uses crude oil to “lock in” oil price levels, THEN uses crack spread collars to hedge basis risk (highlights that basis risk can be hedged, too…think about Situation 2 of the hedging project!)

“Derivatives” disasters MG Refining and Marketing –Lost $1.3 billion in in oil derivatives Orange County, California –Lost $1.6 billion in 1994 using excessive leverage. –Not a derivatives disaster Barings Bank –Lost $1.2 billion in 1995 because of rogue trader Procter & Gamble –Lost $160 million in exotic interest rate swaps

MG Refining and Marketing In early 1990s, MGRM identified opportunity to offer very long-term (i.e., years) fixed price deals on petroleum products to various customers MGRM hedged these deals using oil derivatives with short-term maturities Strategy was based on oil markets being in backwardation Why did MGRM lose so much money? Is there a lesson for Situation 1 of the applied hedging project?

Responsibilities of senior management to avoid disasters Senior management needs to ensure that the organization uses derivatives appropriately and responsibly. –Establish written policies –Define roles and responsibilities –Identify acceptable strategies –Ensure that personnel are qualified –Ensure that control systems are in place

Risk management from a broader perspective Enterprise risk management (ERM) –Derivatives are only one mechanism to manage risk Effective tools for managing certain types of financial risks –What are other areas of risk management? Credit risk management Operational risk management Strategic risk management Reputation and legal risk management Financial reporting and disclosure risk management

So, why is our economy in the tank? Don’t get me started! This is a conversation best left to the barroom so I can rant! HOWEVER, as finance students, you should know that part of the story of the financial crisis was related to collateralized debt obligations (CDOs) and credit default swaps (CDS). These instruments are far beyond the scope of a fundamentals course in derivatives. There is a bit of reading on these instruments in Chapter 15 (near end of Chapter 15) –One thing I would like you to know is that CDS are not “swaps” as defined in the class. –Rather CDS are options! –A CDS contract is merely insurance against a “credit event” by a “reference entity” (Example: Chapter 11 filing by GM)