1. Chapter 4 Introduction to Risk Management 4-1

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-2 Basic Risk Management Firms convert inputs into goods and services output input commodity producer (=seller) buyer A firm that actively uses derivatives and other techniques to alter its risk and protect its profitability is engaging in risk management

3. Basic Risk Management A producer selling a commodity (a seller of an underlying asset) earn higher profit when the price of the commodity increase. A Seller of an underlying can hedge profit (or hedge against price falls) –By Selling Forward, or –By Buying Put Option, or –By Buying Collars 4-3

4. Basic Risk Management A company buying a commodity as input, (a buyer of an underlying) earn higher profit when the price of the commodity falls. A Buyer of an underlying can hedge against price risk (price increases) –By Buying Forward, or –By Buying Call Option, or –By Selling Collars 4-4

5. 4-5 Example: Gold Mining Firm Consider a gold mining firm with fixed and variable cost. What should gold mining firm do if the prices go down? –As long as the Price > the Variable Cost, it would be wise to produce gold even if that will generate losses. –That is because producing above variable cost reduces losses relative to shutting the mine. Dr. Cevat Ertuna

6. 4-6 Example: Gold Mining Firm What can gold mining firm (Seller of gold) do to hedge against the price fall? –Gold mining company can lock in a price (assure a price, lets say K) by entering in a short forward contract. –This hedging strategy will guarantee a fixed price and fix profit at a certain level (K – Total Cost). If the prices are high gold mining company cannot benefit from it, however, if the prices are low, gold mining company will still enjoy a certain profit. Dr. Cevat Ertuna

7. 4-7 Example: Gold Mining Firm Gold mining firm is a seller (selling gold, from options perspective, the underlying asset). Using short forward contract, company locks in to a fixed income. No downside risk & No upside profit prospect –It can protect itself from downside risk –At the cost of forgoing upside profit potential Dr. Cevat Ertuna

8. Example: Hedging with Forward Dr. C. Ertuna 4-8

9. Example: Hedging with Forward Dr. C. Ertuna 4-9

10. 4-10 Example: Gold Mining Firm What can gold mining firm (Seller of gold) do to hedge against the price fall? –Gold mining company can buy a put contract. –This hedging strategy will guarantee a minimum price and guaranteed minimum profit at a certain level (K – Total Cost). If the prices are high gold mining company can benefit from it, and if the prices are low, gold mining company will still enjoy a certain profit. Dr. Cevat Ertuna

11. 4-11 Example: Gold Mining Firm Gold mining firm is a seller (selling gold, from options perspective, the underlying asset). Using long put contract, company locks in to a guaranteed minimum income. No downside risk & Upside profit potential –It can protect itself from downside risk while keeping upside profit potential –At the cost of put premium. Dr. Cevat Ertuna

12. Example: Hedging with Put Dr. C. Ertuna 4-12

13. Example: Hedging with Put Dr. C. Ertuna4-13

14. 4-14 Example: Gold Mining Firm What can gold mining firm (Seller of gold) do to hedge against the price fall? –Gold mining company can buy a collar. –This hedging strategy will guarantee a minimum price and guaranteed minimum profit at a certain level (K – Total Cost). If the prices are high gold mining company can benefit from it up to certain level, and if the prices are low, gold mining company will still enjoy a certain profit. Dr. Cevat Ertuna

15. 4-15 Example: Gold Mining Firm Gold mining firm is a seller (selling gold, from options perspective, the underlying asset). Using long put contract, company locks in to a guaranteed minimum income. No downside risk & Some Upside profit potential –It can protect itself from downside risk while keeping some of the upside profit potential –At the cost of less than put premium. Dr. Cevat Ertuna

16. Example: Hedging with Collar Dr. C. Ertuna 4-16

17. Example: Hedging with Collar Dr. C. Ertuna 4-17

18. Adjusting Cost of the Hedge The cost of hedge can be reduced –By lowering the Strike Price of Put, or – By using Collar (that is forgoing some of the gain received if the underlying price is high) Adjusting cost of the hedge, however, will automatically lead to change in the amount of insurance. 4-18

19. Adjusting Cost of the Hedge Dr. C. Ertuna4-19

20. Adjusting Cost of the Hedge Dr. C. Ertuna 4-20

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-21 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

22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-22 Reasons to Hedge: Costly External Financing Even if losses of a firm do not create bankruptcy threat 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 raising funds externally

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-23 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

24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-24 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 Reasons to Hedge: Taxes 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

25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-25 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 Poor diversification makes managers risk-averse, i.e., 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

26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-26 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

27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-27 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

28. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-28 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 have a higher market value and more leverage