Chapter 4- Introduction to Risk Management.ppt

Chapter 4

Introduction toRisk 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


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.


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




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


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


Adjusting the Amount of Insurance

• Insurance is not free!…in fact, it is expensive because: It eliminates the risk of a large loss. It allows profit if prices increase.

• 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


The Buyer’s Perspective

• Auric Enterprises is a manufacturer of widgets, a product that uses gold as an input. We will suppose for simplicity that the price of gold is the only uncertainty Auric faces. In particular, we assume that: Auric sells each widget for a fixed price of $800., a price

known in advance. The fixed cost per widget is $340. Manufacturer of each widget requires 1 oz of gold as an

input. The nongold variable cost per widget is zero. The quantity of widgets to be sold is known in davance.





• 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


Buyer: Hedging With a Forward Contract

• A long forward contract allows a buyer to lock in a price for his input

– Example: a firm, which uses gold as an input, purchases a forward contract, agreeing to buy gold at a price of $420/oz.in 1 year


Buyer: Hedging With a Call Option


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


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

• In order to hedge, a firm must: Pay commissions and bid-ask spreads. Bear counterparty credit risk.

• Profits for such a firm are concave, sothat hedging (i.e., reducing uncertainty)can increase expected cash flow

• Concave profits can arise from– Taxes– Bankruptcy and distress costs– Costly external financing– Preservation of debt capacity– Managerial risk aversion

0

Profit


Reasons to Hedge: Taxes

Aspects of the tax code:

• a loss is offset againsta profit from a different year

• separate taxation of capital and ordinary income

• capital gains taxation

• differential taxationacross 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


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

• A dollar of loss in loss state can cost the company mare than a dollar in profit state.

• Hedging allows a firm to reduce the probability of bankruptcy or financial distress


Reasons to Hedge: Costly External Financing

• Even if a loss is not large enough to threaten the survival of a firm, the firm must pay for the loss, either by using cash reserves or by raising funds externally ( borrowing or issuing new equity securities)

• Raising funds externally can be costly

– There are explicit costs (such as, bank and underwriting fees)– There are implicit costs due to asymmetric information (lender

increases interest rate for firm that in decline)

• 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


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


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


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


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


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


Golddigers Revisited

• Golddigers has a inherent long position on the risky commodity.



• Selling the gain: Collar• A 420- 440 Collar: Golddiggers buys a 420-

strike put option for $8.77 and sells a 440- strike call option for a premium of $2.49.

• If the gold price in 1 year is $450/oz, the call owner will exercise and Golddiggers is obligated to sell gold at the strike price of $440 => premium $2.49 Goldiggers received initially compensates them for the possibility that this will happen.







• 420- 440 Collar still entails paying premium.• 420- put costs $8.77.• 440- call yields a premium of only $2.49.• => Net expenditure is $6.28.• Which direction can we tinker the strike

price of the put option in order to obtain zero- cost collar ?



• Golddiggers can construct a zero-cost collar by long 400.78 put and short 440.78 call.

• When price of gold < 400.78 => Goldiggers can sell gold for $400.78 by ?

• When price in between 400.78 and 440.78 • When price of gold > 440.78 =>In this

region, Golddiggers sell gold at $440.78.




Selecting the Hedge Ratio

• Quantity Uncertainty:The quantity a firm produces and sells may vary

with the prices of inputs or outputs.When the quantity is uncertain => The revenue

is volatile.We can use a “Hedge ratio” to reduce the risk

( the uncertainty of revenue).What is Hedge ratio(H) => the number of

derivative contracts a company can use to hedge against the volatility of Revenue. In other words, the variance of hedged revenue is minimized when H derivative contracts are used.



• Example: Agricultural producers commonly face quantity uncertainty because crop size is affected by factors such as weather and disease. Moreover, we expect there to be a correlation between quantity and price. What quantity of forward contracts should a corn producer enter into to minimize the variability of revenue?





• First, consider scenario A, where quantity is certain: the producer always produces 1m bushels. Let S and Q denote the price and quantity in 1 year. Revenue is SQ. Without hedging, revenue will be $3m (if the corn price

is $3m) or $2m (if the corn price is $2m). On the other hand, if the producer sells forward 1m

bushels at the forward price F = 2.50, revenue is: Hedged Revenue = (S × 1m) - [1m × (S – 2.50)] =

2.5m In general, if the producer enters into forward contracts on

H units, hedged revenue, R(H), will be: Hedged Revenue = R(H) = (S × Q) + [H × (S – F) ]







• , , the variability of hedged revenue:

• :is the variance of revenue.• :is the variance of price.• H :is the number of units that forward

contracts cover.• :is the correlation between Revenue and

Price.



• H that minimizes the variance of hedged revenue will be:


Selecting the Hedge Ratio – An application

• Continues with previous example, consider what happens in Scenario B if we hedge by shorting the expected quantity of production. As a benchmark, column 3 of Table 11 shows that unhedged revenue has variability of $0.654. From table 9, expected production in the negative correlation scenario, B, is:

0.25 × (1 + 0.6 + 1.5 + 0.8 ) = 0.975m• If we short this quantity (0.975m bushels) of forward contracts

(forward price is $2.5), column 5 of Table 11 shows that hedged revenue of 0.814m is even more variable than unhedged revenue => we should calculate H to get exactly the number of forward contracts that we need to sell



• Calculate the H?

• As we saw from the calculation and table 11, the number of forward contracts on bushels that we should sell in order to minimize the variance of revenue of this company is 100,000.





















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Chapter 4- Introduction to Risk Management.ppt

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