1. The New Risk Management: The Good, the Bad, and the Ugly
Philip H. Dybvig, Pierre Jinghong Liang, and William J. Marshall
Presented by Xin (Elena) Cao

2. Outline Option-pricing tools
Detailed example of how the new risk management ought to work
Implementation issues, including some general policy issues and some accounting issues

3. What’s new about risk management?
At some time, risk management meant buying corporate insurance, implementing procedures to avoid lawsuits and accidents, and installing safety equipment.
Now firms can use financial instruments to hedge against the risk of changes in interest rates and exchange rates, etc.

4. The Good, the Bad, and the Ugly
The new risk management can be bad: wasting resources without reducing risk and probably even increasing it
The new risk management can also be ugly: generating huge losses (examples: Barings in 1995, Procter and Gamble in 1994)

5. Disaster: Barings Bank in 1995
Nick Leeson, a trader in the Singapore office, was employed to exploit arbitrage opportunities between the Nikkei 225 futures price traded on exchanges in Singapore and Japan
He started to move from trading as an arbitrageur to become a speculator without letting the head office in London know
At some point, he made some losses but he was able to hide from the head office for a while
Subsequently he started to take bigger speculative positions, hoping to recover his previous losses
By the time his activity was uncovered, his total loss accounted for almost $1 billion
Baring bank was bankrupt

6. Tools for the new risk management
Black-Scholes model
Importance: it provides a hedging strategy
Investment = option price derived from the model
Terminal value = terminal value of the option
Lose money on the hedge in good times and make money in bad times  offset original cash flows and reduce the volatility of the total cash flow

7. Review: Black-Scholes model
Call option
Hedging an option is an example of risk management
F(d1) , F(d2): probability of call option ending up in the money at maturity

8. Review: Black-Scholes model
Main assumptions:
Absence of arbitrage
A constant risk-free rate
Continuous stock price
A constant variance of returns per unit of time for the underlying stock

9. Review: Black-Scholes model
If model implied price of a call option is lower than market price, we should exploit the following trading strategy:
Sell/short call option
Borrow money
Buy underlying stock

10. Example: risk management in manufacturing
A manufacturer which uses a large amount of copper as an input
Output price = $100/unit
Expected output = 1,000 units
The price has been committed to in advance because of long-term contracts but the quantity may vary around this expectation.

11. Example: risk management in manufacturing
Case 1: unhedged cash flows
Total sales = output price * units sold
Copper expense = copper price * units sold

12. Example: risk management in manufacturing
Case 2: naïve hedge of the expected quantity required
Either by entering a fixed-price contract with the supplier or by buying that amount of copper futures
Problem here is that this approach to hedging increases risk exposure, since the firm is already more than hedged by increased sales when the industry is doing well and copper prices go up

13. Example: risk management in manufacturing
Case 3: full hedge
Can be implemented either by buying options or by dynamic trading in forward or futures contracts

14. The dynamic hedge
Assumption: the rate at which futures gains or losses will be reinvested is 5% simple interest over six months

15. The dynamic hedge
From the beginning, the company sells 1,400/1.05~1,333 futures at the futures price of $20.
In six months:
If the futures price goes down to $17.50, the company increases the short position to 1,600 contracts.
If the futures price goes up to $22.50, the company reduces the short position to 1,200 contracts.

16. The dynamic hedge Path: 20-22.50-20
Futures losses in six months = -$2.50 * 1,333 = -$3,333
Repayment of the loan in twelve months = -$3,333 * 1.05 = -$3,500
Futures gains in twelve months = $2.50 * 1,200 = $3,000
Net loss from the hedge = $3,000 - $3,500 = -$5,00

17. The dynamic hedge Path: 20-17.50-20
Futures gains in six months = $2.50 * 1,333 = $3,333
Reinvestment of gains in twelve months = $3,333 * 1.05 = $3,500
Futures losses in twelve months = -$2.50 * 1,600 = -$4,000
Net loss from the hedge = $3,500 - $4,000 = -$5,00

18. The dynamic hedge: backward calculation

19. Some fundamental questions
Why should we hedge?
What risks should we hedge?
With what instruments should we hedge?

20. Why should we hedge?
Argument 1: hedging reduces the volatility of value received by shareholders
Problems of this argument:
Most shareholders in a large publicly traded company hold the shares in a well-diversified portfolio. Additional risk is not important to them.
A conflict of interest may exist between the majority of shareholders and large shareholders: expending resources to reduce risk may benefit the large shareholders at the expense of the rest of the shareholders.

21. Why should we hedge?
Argument 2: failure to hedge may cause ancillary damage within the company
As an extreme case, adverse copper price movements may push the company into bankruptcy, which would incur deadweight costs, such as payments to lawyers and accountants and the loss of profitable future projects.
Unhedged risk exposure may tend to increase taxes on average: when the government received additional tax payments when the copper price move is favorable, an unfavorable move does not create a compensating tax deduction, given that tax offsets may only be deferred (and may even be lost).

22. Why should we hedge?
Argument 3: many firms have a policy of smoothing earnings and hedging can reduce earnings volatility
Problems with this argument:
It seems to be an expenditure of the owner’s resources to minimize the amount of information going out to the owners (not in the interest of shareholders).
This use of hedging may make management more comfortable and minimize criticism, but maybe too comfortable that it discourages profitable innovation.

23. Why should we hedge?
Argument 4: hedging makes it easier to give managers incentives to produce profits
For example, by hedging risk, we can make a division manager’s compensation depend closely on value added that the manager can influence instead of what the manager cannot influence (the actual realization of copper prices).
But it may be optimal to manage copper price risk at the division level even if copper prices do not represent a significant contribution to the company’s cash flow.

24. Why should we hedge?
Conclusion: whichever the reason for hedging, we should quantify the benefits from hedging and the trade-offs involved.

25. What risks should we hedge?
For example, we want to hedge a bank’s exposure to interest rate risk.
Direct mismatch of existing assets and liabilities
Full economic value, including the value of future business
A related question of whether to hedge cash flows or value
In practice, hedging cash flows is much different from hedging the company’s entire value.
If the purpose is to eliminate sources of noise beyond the manager’s control, it may be appropriate to hedge particular accounting numbers used in computing compensation instead of hedging cash flows or economic value.

26. With what instruments should we hedge?
Common risks: exposure to interest rates, foreign exchange rates, and commodity prices
Example: to hedge U.S. interest rates, we can use bonds, repurchase agreements, Treasury bond futures, swaps, caps or collars.
Key: your choice would be determined by pricing and transaction costs, adequately matching the tool to hedging needs and accounting applications.

27. Accounting issues
Hedging accounting is a relatively new and technical area, and the accounting profession is only starting to address the important issues involved.
First, we need to determine whether the dynamic hedge transactions qualify for the so-called hedge accounting treatment according to the official pronouncement by the FASB.
Even if the transactions qualify for hedge accounting, effects on financial statements differ depending on which one of the two allowable hedge accounting methods applies: fair value hedge or cash flow hedge.

28. Accounting issues
A fair value hedge refers to companies entering into derivative contracts to hedge the fluctuation of the fair value of existing assets, liabilities, or commitments otherwise not recognized on the company’s balance sheet.
A cash flow hedge refers to companies entering into derivative contracts to hedge the variation of their future cash inflow or outflow.

29. Accounting issues
One interesting feature of the accounting rules is that hedges that are economically equivalent may have very different accounting treatments.
Current accounting standards are deficient for measuring risk.
But the differences in accounting treatments of economically equivalent hedges may allow companies to hedge despite the deficiencies in the accounting standards.

30. Cost issues
It’s tempting to think that the cost of the hedge is the cost of any securities purchased.
In practice, the cost includes transaction costs such as commissions, bid-ask spread, and any internal costs of trading.
For publicly traded contracts in liquid markets, the costs are probably small and easy to measure.
When hedging uses custom contracts provided by investment bankers, the costs are hard to assess (because they are built into pricing) and may be much larger.
On a subtle point, a hedge may be more costly than it appears if its pricing and tax treatment make it inappropriate for the company.

31. Suggestions for risk management policy
Feature 1: it should dictate the degree of centralization and the control systems
For most companies, the benefits of centralization (better control, economies of scale, and cost saving resulting from internal netting) will outweigh the costs (mostly the difficulty of communicating and aggregating needs).
A failure to separate the operations and accounting functions from trading was an essential common cause in the losses.
In previous Barings Bank example, it was only a trader who made almost $1 billion loss.

32. Suggestions for risk management policy
Feature 2: it should specify the goals and scope of the hedging program
Some common questions to ask:
What risks should be hedged and what risks should be borne by the shareholders?
Should hedging be implemented on a divisional or departmental level?
Should the hedging program focus on cash flows, earnings, or something else?

33. Suggestions for risk management policy
Feature 3: it should provide for oversight and evaluation of the effectiveness of hedging
It is entirely possible to design a program that is ineffective or that even increases risk.
Only retrospective analysis of the results can verify that the program is actually reducing risk.

34. Conclusion
With the widespread use of futures contracts and swaps to hedge foreign exchange, interest rate, and commodity risks, many profitable business become not too risky.
Companies work on implementing vague new accounting standards that require them to describe their risk exposure.
Companies need to develop internal controls and policies to work on developing effective hedges whiles avoiding catastrophic losses.

35. My perspective

36. Thank you