Risk Management and Hedging Concepts

The act of reducing risk by fixing a variable, like a unit cost, at a certain value, eliminating uncertainty.

The profit earned from a single unit of production, calculated as the selling price minus the cost of production.

The uncertainty or variability in a variable, such as unit profit, measured by standard deviation.

The average unit profit we expect to earn, calculated as the expected value of the unit profit distribution.

A proposition that claims the value creation for shareholders is independent of the financing method used, such as risk management techniques. This might influence whether companies choose to hedge or not.

Companies are better off focusing on efficient capital allocation for value creation rather than solely focusing on risk reduction techniques.

The financial decision-making process, determining how to raise funds (e.g., debt, equity) to finance investments. It's influenced by factors like interest rates and risk tolerance of investors.

Involves determining the best use of funds raised through financing decisions. This focuses on selecting profitable projects with the potential to generate future cash flows and returns.

Costs incurred by a company when it goes bankrupt, including direct expenses like legal fees and indirect costs like lost business opportunities.

The reduction in a company's expected financial distress costs due to hedging, which lowers the chance of bankruptcy.

The potential for a company to miss out on new investment opportunities because it is in financial distress and cannot afford the risk, even if the projects are profitable.

The conflict of interest between stockholders and bondholders in a financially distressed company, where stockholders prefer riskier investments that could favor them, while bondholders want safer investments to secure their debt.

A company in financial distress may have to sell assets at a lower price than market value to pay off its debts.

Hedging can help a company avoid financial distress, making it more likely that future investment opportunities will be pursued, reducing the risk of debt overhang.

Direct costs associated with bankruptcy, such as legal fees and administrative expenses, are typically small compared to the indirect costs.

Indirect costs associated with bankruptcy, such as lost business opportunities, customer churn, and difficulty in attracting new talent, are significant and can be difficult to quantify.

The expected profit or dividend of a company remains unchanged whether or not it engages in hedging. Hedging aims to limit price fluctuations, not increase the average return.

The discount rate used to value a company's future cash flows is based on systematic risk. Systematic risk is the risk associated with the overall market, like economic recessions or inflation. This type of risk affects all companies and cannot be diversified away.

Unsystematic risk is specific to a single company or industry and can be reduced through portfolio diversification. Investors aren't compensated for bearing unsystematic risk; their returns aren't higher for taking on more risk.

Hedging deals with unsystematic risk, which can be diversified away. It doesn't affect the discount rate determined by systematic risk, as the market as a whole can't be diversified.

Hedging does not change expected profit. It limits the variability of returns, not the average return. Therefore, hedging does not create economic value in theory.

Companies typically engage in hedging despite no economic rationale for doing so. This suggests a belief that hedging provides value, even though theoretical models show otherwise.

The assumption that in real world scenarios hedging provides value, even though theoretical models show otherwise.

A derivative contract used to agree on the future price of an asset. At maturity, only the price difference is exchanged, not the asset itself.

A futures contract is traded on an exchange, while a forward contract is traded directly between two parties.

The practice of using a futures contract to guarantee a specific price for an asset in the future, regardless of market fluctuations.

Using derivatives to profit from expected price movements in an asset, without actually owning or needing the asset.

Hedging beyond the actual exposure to risk, essentially adding speculative elements to risk management.

Hedging less than the actual exposure to risk, leaving some room for potentially greater profits but also greater losses.

The process of settling a futures contract by only exchanging the price difference at maturity, without actually delivering the underlying asset.

A company utilizing futures contracts to control the cost of an input like coffee beans, mitigating the impact of price fluctuations on their profit margins.

The difference between the agreed-upon price and the market price at maturity, which is paid by the party with the short position to the party with the long position.

A visual representation of the potential gains or losses of a forward contract at maturity based on the price of the underlying asset.

The party in a forward contract who agrees to purchase the underlying asset at the agreed-upon price at maturity.

The party in a forward contract who agrees to sell the underlying asset at the agreed-upon price at maturity.

The point at which the payoff for a forward contract is zero, meaning there is neither profit nor loss.

The payoff for the long position is the difference between the market price of the underlying asset at maturity and the agreed-upon forward price.

The payoff for the short position is the difference between the agreed-upon forward price and the market price of the underlying asset at maturity.

The payoff for the forward contract is a linear function of the market price of the underlying asset, with the slope depending on whether it's a long or short position.

The practice of using financial instruments (like futures, options, or swaps) to reduce the uncertainty of a company's future cash flow.

A financial instrument whose value is tied to and derived from the performance of another underlying variable, such as interest rates, stock prices, exchange rates, etc.

Family firms are more cautious with risk than companies with dispersed ownership because they hold a less diversified portfolio and prioritize long-term stability and intergenerational transfer.

Family firms often prefer to retain control and avoid external financing due to their desire to maintain power and pass it on to future generations.

The increased opacity of family firms' information can make outside financing more expensive, as lenders may be less confident about their financial stability.

The idea that in a perfect world, a company's value creation is unaffected by risk management techniques and should focus on maximizing overall efficiency.

The 'Irrelevance proposition' is based on perfect markets, but in reality, markets are not perfect. Hedging can actually be beneficial for companies, making them more valuable because of a lower cost of capital.

Hedging can help to increase a company's value in real-world markets even though the 'Irrelevance Proposition' theory suggests otherwise.