Chapter 4

Chapter 4
Introduction to Risk Management
Basic Risk Management

Firms convert inputs into goods and services
output
commodity
input
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.
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The Producers Perspective

A producer selling a risky commodity has an inherent long position in this commodity When the price of the commodity decreases, the firms profit decreases (assuming costs are fixed)
Some strategies to hedge profit

Selling forward Buying puts Buying Collars.
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Producer: Hedging With a Forward Contract

A short forward contract allows a producer to lock in a price for his output
Example: a goldmining firm enters into a short forward contract, agreeing to sell gold at a price of $420/oz. in 1 year
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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 goldmining firm purchases a 420strike put at the premium of $8.77/oz
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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 goldmining firm sells a 420-strike call and receives an $8.77 premium
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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
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The Buyers 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.
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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 firms profit decreases Some strategies to hedge profit
Buying forward Buying calls
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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
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Buyer: Hedging With a Call Option
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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
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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. Profit Profits for such a firm are concave, so that 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
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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
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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
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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
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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
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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
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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. 4-22
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
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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.
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Selling the gain: Collar A 420- 440 Collar: Golddiggers buys a 420strike put option for $8.77 and sells a 440strike 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.
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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 ?
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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.
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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?
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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) ]
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, , 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:
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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
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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

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Chapter 4 - Introduction To Risk Management

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Introduction to Risk Management

Basic Risk Management

The Producers Perspective

Some strategies to hedge profit

Producer: Hedging With a Forward Contract

Producer: Hedging With a Put Option

Producer: Insuring by Selling a Call

Adjusting the Amount of Insurance

The Buyers Perspective

The Buyers Perspective

The Buyers Perspective

Buyer: Hedging With a Forward Contract

Buyer: Hedging With a Call Option

Buyer: Hedging With a Call Option

Why Do Firms Manage Risk?

Reasons to Hedge: Taxes

Derivatives can be used to:

Reasons to Hedge: Bankruptcy and Distress Costs

Reasons to Hedge: Costly External Financing

Reasons to Hedge: Increase Debt Capacity

Reasons to Hedge: Managerial Risk Aversion

Nonfinancial Risk Management

Some nonfinancial risk-management decisions are

Reasons Not to Hedge

Empirical Evidence on Hedging

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio

Selecting the Hedge Ratio An application

Selecting the Hedge Ratio An application

Selecting the Hedge Ratio An application

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