Chapter 5 Introduction to Risk Management

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-2 Basic Risk Management Firms convert inputs into goods and services. Output Input commodity producer buyer A firm is profitable if the cost of what it produces exceeds the cost of its inputs. A firm that actively uses derivatives and other techniques to alter its risk and protect its profitability is engaging in risk management.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-3 The Producer’s Perspective A producer selling a risky commodity has an inherent long position in this commodity. When the price of the commodity decreases, the firm’s profit decreases (assuming costs are fixed). Some strategies to hedge profit: –Selling forward –Buying puts –Buying collars

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-4 Producer: Hedging With a Forward Contract A short forward contract allows a producer to lock in a price for his output. –Example: a gold- mining firm enters into a short forward contract, agreeing to sell gold at a price of $420/oz. in 1 year.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-5 Producer: Hedging With a Forward Contract (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-6 Producer: Hedging With a Put Option Buying a put option allows a producer to have higher profits at high output prices, while providing a floor on the price. –Example: a gold- mining firm purchases a 420- strike put at the premium of $8.77/oz

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-7 Producer: Hedging With a Put Option (cont’d) Note: The future value of the put option premium is $8.77  1.05 = $9.21.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-8 Producer: Hedging With a Put Option (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-9 Producer: Hedging With a Put Option (cont’d) Fig. 4.3 shows that there are trade-offs for the two protective strategies, with each contract outperforming the other for some range of prices.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-10 Producer: Insuring by Selling a Call A written call reduces losses through a premium, but limits possible profits by providing a cap on the price. Example A gold-mining firm sells a 420-strike call and receives an $8.77 premium (the firm is said to sold a cap).

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-11 Producer: Insuring by Selling a Call (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-12 Producer: Insuring by Selling a Call (cont’d) If the gold price in 1 year exceeds $420, the gold mining firm will show profits of $420 + $8.77(1.05) – $380 = $49.21 If the gold price in 1 year is less than $420, say P g, then the profit is P g + $9.21 – $380

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-13 Adjusting the Amount of Insurance Insurance is not free!…in fact, it is expensive. There are several ways to reduce the cost of insurance. For example, in the case of hedging against a price decline by purchasing a put option, one can –Reduce the insured amount by lowering the strike price of the put option. This permits some additional losses. –Sell some of the gain. This puts a cap on the potential gain.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-14 Adjusting the Amount of Insurance (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-15 The Buyer’s Perspective A buyer that faces price risk on an input has an inherent short position in this commodity. When the price of the input increases, the firm’s profit decreases. Some strategies to hedge profit: –Buying forward –Buying calls –Selling collars

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-16 The Buyer’s Perspective (cont’d) Case Auric Enterprises is a manufacturer of widgets, a product that uses gold as an input. Assumption: 1.The price of gold is the only uncertainly Auric faces. 2.Auric sells each widget for a fixed price of $800, a price is known in advance. 3.The fixed cost per widget is $340.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-17 The Buyer’s Perspective (cont’d) 4.The manufacture of each widget requires 1oz of gold as an input. 5.The nongold variable cost per widget is 0. 6.The quantity of widgets to be sold is known in advance.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-18 The Buyer’s Perspective (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-19 Buyer: Hedging With a Forward Contract A long forward contract allows a buyer to lock in a price for his input. Example Auric can long a 1-year forward contract on gold with the forward price of $420/oz.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-20 Buyer: Hedging With a Forward Contract (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-21 Buyer: Hedging With a Call Option Buying a call option allows a buyer to have higher profits at low input prices, while being protected against high prices. –Example: a firm, which uses gold as an input, purchases a 420-strike call at the premium of $8.77/oz.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-22 Buyer: Hedging With a Call Option (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-23 Why Do Firms Manage Risk? Hedging can be optimal for a firm when an extra dollar of income received in times of high profits is worth less than an extra dollar of income received in times of low profits. Example Consider a firm that produces 1 unit per year of a good costing $10. Immediately after production, the firms receives a payment of either $11.2 or $9, with 50% probability. On a pre-tax basis, the firm has an expected profit of [0.5($9 – $10)] + [0.5($11.2 – $10)] = $0.10 However, on an after-tax basis, the firm could have an expected loss.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-24 Why Do Firms Manage Risk? (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-25 Why Do Firms Manage Risk? (cont’d) Suppose that there is a forward contract for the firm’s output with the forward price of $ If the firm sells forward, the profit is computed as in Table 4.7.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-26 Why Do Firms Manage Risk? (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-27 Reasons to Hedge: Taxes Aspects of the tax code: a loss is offset against a profit from a different year separate taxation of capital and ordinary income capital gains taxation differential taxation across countries Derivatives can be used to: equate present values of the effective rates applied to losses and profits convert one form of income to another defer taxation of capital gains income shift income from one country to another

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-28 Reasons to Hedge: Bankruptcy and Distress Costs A large loss can threaten the survival of a firm –A firm may be unable to meet fixed obligations (such as, debt payments and wages). –Customers may be less willing to purchase goods of a firm in distress. Hedging allows a firm to reduce the probability of bankruptcy or financial distress.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-29 Reasons to Hedge: Costly External Financing Raising funds externally can be costly –There are explicit costs (such as, bank and underwriting fees). –There are implicit costs due to asymmetric information. Costly external financing can lead a firm to forego investment projects it would have taken had cash been available to use for financing. Hedging can safeguard cash reserves and reduce the probability of costly external financing.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-30 Reasons to Hedge: Increase Debt Capacity The amount that a firm can borrow is its debt capacity. When raising funds, a firm may prefer debt to equity because interest expense is tax-deductible. However, lenders may be unwilling to lend to a firm with a high level of debt due to a higher probability of bankruptcy. Hedging allows a firm to credibly reduce the riskiness of its cash flows, and thus increase its debt capacity.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-31 Reasons to Hedge: Managerial Risk Aversion Firm managers are typically not well-diversified –Salary, bonus, and compensation are tied to the performance of the firm. If managers risk-averse, then they are harmed by a dollar of loss more than they are helped by a dollar of gain. Managers have incentives to reduce uncertainty through hedging.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-32 Reasons to Hedge: Nonfinancial Risk Management Risk management is not a simple matter of hedging or not hedging using financial derivatives, but rather a series of decisions that start when the business is first conceived. Some nonfinancial risk-management decisions are –Entering a particular line of business. –Choosing a geographical location for a plant. –Deciding between leasing and buying equipment.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-33 Reasons Not to Hedge Reasons why firms may elect not to hedge: –Transaction costs of dealing in derivatives (such as commissions and the bid-ask spread). –The requirement for costly expertise. –The need to monitor and control the hedging process. –Complications from tax and accounting considerations. –Potential collateral requirements.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-34 Empirical Evidence on Hedging Half of nonfinancial firms report using derivatives. Among firms that do use derivatives, less than 25% of perceived risk is hedged, with firms likelier to hedge short-term risk. Firms with more investment opportunities are more likelier to hedge. Firms that use derivatives may have a higher market value, more leverage and lower interest costs.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-35 A Gold Mining Co. Revisited Given All options in Table 8.1 are 1 year to expiration.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-36 A Gold Mining Co. Revisited (cont’d) Selling the Gain: Collars The cost of insurance can be reduced by reducing potential profits. A Collar Buy a 420-strike put option and sells a 440- strike call option.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-37 A Gold Mining Co. Revisited (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-38 A Gold Mining Co. Revisited (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-39 A Gold Mining Co. Revisited (cont’d) A Zero-Cost Collar Buy a strike put option and sells a strike call option.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-40 A Gold Mining Co. Revisited (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-41 A Gold Mining Co. Revisited (cont’d) Paylater Strategies A disadvantage to buying a put option is that the Gold mining Co. pays the premium even when the gold price is high and insurance was unnecessary. To avoid this problem is a paylater strategy, where the premium is paid only when the insurance is needed.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-42 A Gold Mining Co. Revisited (cont’d) In the paylater strategy, the goal is to find a strategy where if the gold price is high, there is no option premium. If the gold price is low, there is insurance, but the effective premium is greater than with an ordinary insurance strategy.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-43 A Gold Mining Co. Revisited (cont’d) Example The Gold Mining Co. sells a strike put and buys two 420-strike puts. The premium on the strike put is $17.55 and the premium on the 420-strike put is $ Net premium = $17.55 – (2$8.775) = 0.

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-44 A Gold Mining Co. Revisited (cont’d)

© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.4-45 A Gold Mining Co. Revisited (cont’d) From Fig. 4.12, we observe that when the gold price is high, the paylater strategy with a zero premium outperforms the single put. when the gold price is low, the paylater strategy does worse because it offers less insurance. Thus, the premium is paid later, if insurance is needed.