Corporate Risk Management - Hedging PDF

CORPORATE RISK MANAGEMENT [HEDGING] = ACT OF REDUCING RISK ➔ GROSS PROFIT = REVENUES - COSTS UNCERTAIN PROFIT = (OUTPUT PRICE x QUANTITY SOLD) - (INPUT PRICE x QUANTITY BOUGHT) ➔ Assumption is that revenues are fixed (ie price of output is fixed) RISK comes from costs, meaning...

CORPORATE RISK MANAGEMENT [HEDGING] = ACT OF REDUCING RISK ➔ GROSS PROFIT = REVENUES - COSTS UNCERTAIN PROFIT = (OUTPUT PRICE x QUANTITY SOLD) - (INPUT PRICE x QUANTITY BOUGHT) ➔ Assumption is that revenues are fixed (ie price of output is fixed) RISK comes from costs, meaning from FLUCTUATIONS OF INPUT PRICE - risk is managed by both industrial companies (risk sources: foreign exchange rate and price of commodities it employs) and financial institutions, ie bank (risk sources: foreign exchange rate and interest rate) - there is a Chief Risk manager and a Hedging Department in each company : objective is to reduce risk as much as possible (total reduction in virtually impossible) Suppose that revenues are fixed (the selling price is known as of today, say €70). Unit cost has the following distribution: UNIT PROFIT IS UNCERTAIN and has the following distribution: EXPECTED UNIT PROFIT is €5, but there is a positive POSITIVE STANDARD DEVIATION = VOLATILITY = RISK ➔ HEDGING = if the company could FIX UNIT COST today at a level, say, EQUAL TO ITS EXPECTED VALUE, the uncertainty over the future unit profit would disappear : to do so there must be a STANDARD DEVIATION = 0 Meaning, hedging is to turn this: (1) into this: From a prob dist (1) to a prob distribution with SAME MEAN but NO STANDARD DEVIATION = expected profit remains the same but there is (close to) no risk. [IS HEDGING BENEFICIAL?] Most companies and almost 100% of banks manage risk, but is hedging beneficial? Agents (shareholders, managers, stakeholders, etc) are risk-averse, since hedging reduces risk it would seem beneficial. However there is an “IRRELEVANCE PROPOSITION” that states that: 1. (fundamental proposition) Companies create value by investing (make stakeholders richer) regardless of where they take the money from 2. As such, the difference between a company that creates value and one that does not (ie destroys value) is the way a company invests money : what truly matters is how effectively the company uses its capital. = the distinction between value creation and value destruction is not based on where the money comes from (financing decision) but rather on how it is used (investment decision). Meaning: risk management reduces risk but the EXPECTED PROFIT and/or DIVIDEND WILL REMAIN THE SAME regardless of whether there is hedging or not (because it does not depend from iT: hedging only limits potential price fluctuations, it doesn't increase or decrease the average outcome) - expected dividend does not change Moreover, the CAPM Model shows that: I. the DISCOUNT RATE (R) used to value a company's future cash flows is based on SYSTEMATIC RISK, which is the risk of the market as a whole (e.g., economic recessions, inflation), such a risk affects all companies and cannot be diversified away. II. UNSYSTEMATIC RISK on the other hand is specific to a single company or industry, and can be diversified by INVESTORS through PORTFOLIO DIVERSIFICATION. As a result, investors are not remunerated by the market for bearing unsystematic risk = no higher return if you reduce risk, and reducing it (eg through hedging) DOES NOT CHANGE THE DISCOUNT RATE or increase the company’s value.  => Investing into something which is very risky or something that is risk-free does not change the discount rate (R) provided the risk in question is unsystematic. ➔ To sum up: 1. Hedging deals with UNSYSTEMATIC RISK, which can be diversified away by investors, who do not require additional returns for it: HEDGING DOES NOT AFFECT THE DISCOUNT RATE, used to value a company's future cash flows which is determined by systematic risk, which affects the market as a whole and cannot be diversified. 2. As such, HEDGING DOES NOT CHANGE EXPECTED PROFIT: hedging only reduces variability, not the average return. 3. Meaning that VALUE OF COMPANY IS NOT AFFECTED and, in theory, hedging does not create economic value. So why should companies hedge? There is no economic rationale for companies to hedge Companies do hedge (for the most part) because the proposition does not hold in reality, companies think that hedging produces value, so they do. Causes of hedging include: 1. [FINANCIAL DISTRESS COSTS] ➔ Hedging REDUCES the EXPECTED COSTS OF FINANCIAL DISTRESS If realized profits are smaller than X, the company goes bankrupt and bears financial distress costs (likelihood is area underneath prob distribution) = hedging brings about a lower likelihood of going into financial distress. Financial Distress costs are high (assumption does not consider this): 1. DIRECT bankruptcy costs = Legal/administrative costs in bankruptcy and liquidation (court, lawyers, accountants). Direct bankruptcy costs are small (< 1% of overall market value) (Warner, 1977, JF). 2. INDIRECT costs of bankruptcy : major ones = Costs involved with the difficulties of running a business while it is going through bankruptcy. These costs are difficult to quantify, but substantial. Examples:  I. Missed positive NPV investment opportunities II. Loss of customers that value post-sale services III. Loss of willing suppliers IV. Difficulty retaining and recruiting employees V. Forced sales of assets at reduced prices. [DEBT OVERHANG] ➔ Hedging makes it more likely that FUTURE ATTRACTIVE INVESTMENTS WILL BE MADE by the firm & REDUCES PROBABILITY OF DEBT OVERHANG, and all that results from it, since it reduces the probability for a company to go into financial distress. * Debt Overhang = a situation where a company with existing debt is reluctant to invest in new, profitable projects because the benefits of those investments would largely go to existing debt holders, leaving little or no value for shareholders. This conflict of interest between stockholders and bondholders is particularly strong when a company is in financial distress. Eg: two projects (A and B) that require investing €3M today (and the firm has cash) + There is a debt outstanding of €5M expiring 1 year hence (and the company is in financial distress): Stockholders will prefer project B : it is much riskier, and its NPV is negative (= –€3M + PV(€0.1M)). However, there is a 1% chance that they get something (vs. a 0% chance for project A, as all 5M would be used to repay debt ). Bondholders will prefer project A: it is a safe project with a positive NPV (= –€3 + PV(€5M)). *NPV (Net Present Value) is a financial metric used to evaluate the profitability of an investment or project. It represents the difference between the present value of cash inflows and the present value of cash outflows over a specific period. [TAXES] ➔ Hedging can REDUCE TAXES since it helps stabilize a company's earnings. Unhedged Scenario: - In good times (growth), the company makes a net income of €140M. - In bad times (recession), it faces a net loss of €100M. This large swing leads to an expected net income of only €20M due to big losses in recessions (Growth State (50% probability): Net income is €140M. Recession State (50% probability): Net income is –€100M (a loss). Expected Net Income Calculation: multiply each outcome by its probability and sum them =>Expected Net Income = (0.5 × €140M) + (0.5 × €100M) = 20) Hedged Scenario: - Earnings are steady at €35M in both growth and recession, leading to a higher expected net income of €35M. Tax laws allow companies to use carryforwards and carrybacks to offset losses against taxable income in other periods. Example: let's say a company has two possible years: Year 1 (growth) and Year 2 (recession). - Unhedged Scenario Example: I. Year 1 (Growth): The company makes €140M in profit and pays taxes on it (e.g., 30%, which is €42M). This leaves a net income of €98M after tax. II. Year 2 (Recession): The company loses €100M, so it pays no tax that year. Total over 2 years: the profit in Year 1 is taxed, but the loss in Year 2 can only be used to reduce future profits (carryforward), so the company doesn’t get immediate tax relief. The average net income ends up being lower over these two years. - Hedged Scenario Example: I. Year 1 (Growth): The company makes a steady profit of €35M and pays taxes on it (30%, which is €10.5M), leaving €24.5M. II. Year 2 (Recession): The company also makes €35M and pays the same amount in taxes and keeps €24.5M. The company consistently makes €35M each year, paying steady taxes and keeping steady net income. Hedging reduces the chance of large losses, ensuring the company PAYS TAXES MORE REGULARLY instead of facing potential losses that must be carried forward. This leads to a more stable and predictable tax obligation. The tax burden in the unhedged recession state results in no tax payment due to the loss, while in the growth state, the company pays a higher tax amount (€60M). Hedging evens out income and therefore evens out tax payments as well, minimizing the impact of high-tax periods. [IMPERFECT MARKETS] Other reasons for hedging: 1. Hedging may INCREASE DEBT CAPACITY = if your profit is always the same, having never gone negative, or perhaps it is increasing over time, banks are more willing to lend money. 2. It is less costly for the firm to hedge than for individuals to hedge.  3. NONSYSTEMATIC RISK should be hedged when owners are not well diversified: due to market imperfections= owners and investors are not fully diversified in reality. - *family firms hedge more (very much not diversified + their human capital, not just the company’s, is in the firm) 4. It reduces agency costs of managerial discretion on the company’s cash flows. 5. It also reduces sources of fluctuation of market value, and hence helps shareholders to assess the skills of the company’s managers 6. Reducing risk, hedging should also imply a LOWER RISK-ADJUSTED, COMPENSATION to MANAGERS - eg: Company gives executives stock options as incentives Options are financial instruments where you are given a possibility to buy something in the future if it is convenient for you or to not buy it if it is not convenient = managers can either gain money if price of stock goes up or do not lose money, just instrument, if it goes down = managers get the possibility to buy company shares at a high discount - Stock Options are a cost to the company (managers gain money, company lose money) : If the stock price rises significantly, the company will have to provide the stock at a discounted price, which means the company loses out on the full value of those shares. - Companies want to both minimize and incentivize their stock options. Granting stock options makes companies riskier: since stock price can fluctuate, making the cost of the options difficult to predict, companies must hedge to reduce the price of the incentivizing instrument that are stock options = hedging helps the company control the potential fluctuations in stock prices, making it easier to plan and predict the financial impact of granting stock options. The irrelevance proposition above is based on perfect markets, but markets are not perfect: hedging is widely BENEFICIAL: 1. Beneficial in terms of VALUE + companies that hedge are WORTH MORE 2. Worth more because they can raise capital at a lower cost : when a company hedges, it's seen as less risky by the market, as a result, it can borrow money at a lower interest rate (lower cost of debt) and attract investors with a lower return (lower cost of equity)= cost of their debt capital is less & cost of equity capital is less. * [HEDGING AND FAMILY FIRMS] Most of the empirical literature on hedging has focused on the US, where firms are characterized by dispersed ownership. What about optimal risk management in closely-held family firms?: 1. FAMILIES are MORE RISK AVERSE than other shareholders: - they hold an under-diversified portfolio - they are long-term investors, aimed at firm survival and successful intergenerational transition. 2. Families wish to RETAIN CONTROL and pass it on to their heirs: - They are reluctant to issue new equity and seek external financing 3. Family firms are more INFORMATIONALLY OPAQUE: - this could make outside financing more expensive. [HOW TO EDGE] [FINANCIAL HEDGING] = reducing the uncertainty over a company’s cash flow through financial instruments. How? 1. Detect where risk comes from in company (eg: fact that price of energy products fluctuates, or you need agricultural products whose price fluctuates all the time and quite a lot depending on external factors; capital held in foreign currency) 2. Estimate overall position at risk : some risk may cancel out one another 3. Actually hedge through financial instruments Main way of hedging is entering the derivatives market: the financial Instruments used for hedging are FINANCIAL DERIVATIVES: 1. Futures and Forwards 2. Options 3. Swaps - mainly employed are 1 and 3 A derivative is an instrument whose value depends on the value of an underlying variable, derivatives can depend on: I. Interest rates (and bonds) II. Common stocks or index (e.g., a stock index value) III. Foreign exchange rates IV. Commodity prices V. Other. Thus, the value of a derivative is “derived” from the performance of another primary or underlying variable. + Origin of the derivative market : initially created as tools for hedging, but once investors noted that by means of this instrument they could change expected return and risk pattern of a portfolio (reduce, enhance, etc) they began using them for speculation (=betting on price movements). Companies also hedge: partial hedging (under-hedging) or hedging beyond exposure (over-hedging) introduces speculative elements. 1. [FORWARDS/FUTURES CONTRACT] = A forward or futures contract allows you to agree today to buy or sell an asset in the future at a price decided now. At maturity, the contract is usually CASH-SETTLED : only the price difference is exchanged, not the actual asset - Futures are exchange traded vs Forwards are traded btwn customer and bank. Example: Imagine a coffee shop that buys coffee beans from a supplier. The price of coffee beans can go up or down depending on market conditions. To protect itself from rising prices, the coffee shop enters into a futures contract (a type of derivative) with the supplier. How it works:  - The coffee shop agrees to buy 1,000 pounds of coffee beans in six months at $3 per pound, no matter what the market price is at that time. - If the market price rises to $4 per pound in six months, the coffee shop benefits because it still pays only $3 per pound as per the contract. - If the market price drops to $2 per pound, the coffee shop still pays $3 per pound, which is a downside. => This contract reduces the uncertainty for the coffee shop by locking in a price (hedging against price increases). *Speculation: if someone else (e.g., an investor) bought the same futures contract but doesn’t actually need coffee beans, they might do so to bet on prices increasing. If the market price rises above $3, they could sell the contract for a profit without ever dealing with coffee beans. *Cash settlement: if the futures contract is cash-settled, it is purely financial, with only the price difference exchanged, not the physical coffee beans. Meaning the coffee shop wouldn't actually receive or deliver 1,000 pounds of coffee beans. Instead, at the contract's maturity: - If the market price of coffee beans is $4 per pound (higher than the agreed $3), the seller (supplier) would pay the coffee shop the difference: $1 per pound × 1,000 pounds = $1,000. - If the market price is $2 per pound (lower than the agreed $3), the coffee shop would pay the seller the difference: $1 per pound × 1,000 pounds = $1,000. In both cases, the coffee shop is insulated from price changes because the financial settlement offsets gains or losses, ensuring a consistent effective cost of $3 per pound (The coffee shop doesn’t truly lose money when they pay back the difference, because they are already benefiting from the lower market price). PAYOFF DIAGRAMS of forward contracts show how the MARKET VALUE OF THE CONTRACT AT MATURITY depends on the PRICE OF THE UNDERLYING ASSET (value of the coffee futures/forward contract at maturity depends on the price of coffee beans): the market value of a forward contract at maturity is expressed as a function of the underlying asset. F = forward price = buyer agrees to purchase the asset at a fixed price F. S = market price of underlying asset at maturity. Line(s) = payoff(s) These graphs are used to visualize the potential gains or losses for: 1. The buyer = LONG POSITION = make money when price goes up (seller must cash-pay difference) The payoff is a straight line which: I. Slopes upward (= as S increases the buyer's payoff improves) II. Starts at -F when S = 0 (meaning S - F = -F) III. Crosses the break-even point at S=F : S - F= 0 (no profit no loss) At maturity, the payoff is: Payoff(Long) = S - F - if S < F there is a gain - if S > F there is a loss => The payoff increases as the price of the underlying asset S rises above the agreed forward price F. 2. The seller = SHORT POSITION = make money when price goes down (buyer must cash-pay back The payoff is a straight line which: I. Slopes downward (= as S decreases the seller's payoff improves) II. Starts at +F when S = 0 (meaning F - S = +F) III. Crosses the break-even point at S=F : F - S= 0 (no profit no loss) At maturity, the payoff is: Payoff(Short) = F - S - if S < F there is a loss - if S > F there is a gain => The payoff increases as the price of the underlying asset S falls below the forward price F. ➔ Hedging with futures or forwards means using the futures market to offset potential losses in the cash market = taking a POSITION IN THE FUTURES MARKET that is OPPOSITE to the POSITION ALREADY HELD IN CASH MARKET : - SHORT HEDGE (or selling hedge) : if you hold a long cash position, i.e. you own an asset in the cash market, you sell futures contracts to protect against falling prices (i.e. you short hedge). Example: the coffee supplier has an asset (coffee beans) and knows they will be selling 1,000 pounds of coffee beans in six months, but they are worried that the price might drop by then, reducing their revenue. To protect against this risk, the supplier enters into a futures contract to sell coffee beans at a fixed price ($3 per pound) in six months. This is a short hedge because the supplier is securing a selling position to protect themselves against the possibility of falling prices. - LONG HEDGE (or buying hedge) : if you hold a short cash position, i.e. you have a liability in the cash market, you buy futures contracts to protect against rising prices (i.e. you long-hedge). Example : the coffee shop has a liability in the sense that it will need to buy coffee beans in the future. The price of coffee beans could rise, making the  purchase more expensive. To protect against this risk, the coffee shop enters into a futures contract to buy the beans at a fixed price ($3 per pound) in six months. This is a long hedge because the coffee shop is securing a buying position to protect itself against the possibility of rising prices. In both cases, the futures position acts as a counterbalance to the cash market risk. P&L = profit and loss X= price of underlying asset Example: you expect to receive £500,000 eight months hence. How can you hedge your cash position? Your concern regards a depreciation of the pound vs. euro, that is a decline of the EUR/GBP exchange rate. Hence, you contract to sell £500,000 at a 1.18 rate in eight months time. Your positions are: - cash position is long = you own an asset - hedge position is short = you sell a futures or forward contract regarding that asset 2. [OPTIONS] = an option is a financial contract that gives the buyer the right (but not the obligation) to buy or sell an asset at a set price (strike price: K) on or before a specific date. PAYOFF DIAGRAMS express the market value of an option contract at maturity, and represent the option as a function of the underlying asset: K = strike price S = market price There are: 1. CALL OPTION = buyer has the right to buy the asset at the strike price (K) If S > K the buyer gains, and makes a profit = S - K - max(S -K, 0) : 2. PUT OPTION = buyer has the right to sell the asset at the strike price (K) If S < K the buyer loses, and encounter a loss = K - S - max(K - S,0) Example: If you buy a call option on coffee beans at $3 per pound, and the price goes up to $4, you make a profit of $1 per pound. If the price drops to $2, you don’t exercise the option, losing only the premium you paid for the option. PROFIT DIAGRAMS showcase market value of an option at maturity minus the premium as a function of the underlying asset (=net gain) => PREMIUM (= what you pay for the option) 3. [SWAPS] = a financial contract where two parties agree to exchange cash flows or assets over a period of time. The parties involved agree to exchange one stream of cash flows for another, often to better align with their business needs or financial goals. The key feature of swaps is that they typically involve no initial exchange of principal (= the parties involved agree to exchange one stream of cash flows for another, often to better align with their business needs or financial goals) but only the exchange of interest payments or other cash flows over time. In the context of hedging, swaps are financial instruments used by companies to reduce risk by LOCKING IN FUTURE CASH FLOWS or financial conditions: hedging through swaps helps companies protect themselves from fluctuations in interest rates, exchange rates, or commodity prices, depending on their exposure. 1. INTEREST RATE SWAP = one party pays a fixed interest rate, while the other pays a floating rate based on market conditions : foreign interest rate fluctuations - eg: Company A has a loan with a floating interest rate (e.g., LIBOR + 2%) and is concerned that interest rates will rise, making their payments more expensive. Company B has a loan with a fixed interest rate and would prefer the flexibility of a floating rate to benefit from potentially lower rates. Through an interest rate swap, Company A agrees to pay Company B a fixed rate, and Company B agrees to pay Company A a floating rate. This hedge allows Company A to secure a stable, fixed interest rate, while Company B can take advantage of future fluctuations in interest rates. 2. CURRENCY SWAP = two parties exchange cash flows in different currencies : allows companies to hedge against foreign exchange rate fluctuations = - eg: Company A (based in the U.S.) has revenue in euros but has to pay its debt in U.S. dollars. Company A is worried that the euro might depreciate relative to the dollar, making their payments more expensive. Company B (based in the Eurozone) needs to make payments in euros but has dollar-denominated debt. Through a  currency swap, Company A and Company B agree to exchange cash flows in their respective currencies at fixed exchange rates, effectively locking in their future currency payments and protecting both companies from unfavorable exchange rate movements. 3. COMMODITY SWAPS : used by companies that are exposed to fluctuations in the prices of commodities like oil, gas, agricultural products, etc = in a commodity swap, one party agrees to exchange a fixed price for a floating price (often based on market rates) for a commodity over a period of time - eg: Company C is an airline that is concerned about rising fuel prices. To hedge against the risk of increasing fuel prices, Company C enters into a commodity swap agreement with another company, agreeing to pay a fixed price for fuel over the next year. The counterparty agrees to pay Company C the difference if fuel prices rise above the fixed price. This hedging strategy locks in a price for fuel, ensuring that Company C can manage its future fuel costs without worrying about market volatility. [OPERATIONAL HEDGING] = mainly used by multinational firms, specifically to reduce the risks of foreign exchange fluctuations in their operations. These firms can hedge using operations, meaning by PURCHASING PRODUCTION INPUTS FROM THE SAME NATIONS THEY SELL THEIR OUTPUT TO, eg: relocate production to another country so that revenues and operating cost are in the same currency (no difference due to foreign exchange, only profit) no revenue to change currency. - eg: a company that sells goods in Europe might set up a factory there. The revenue from sales and the cost of production are both in euros, so there’s no need to worry about the euro-to-dollar exchange rate. Most companies hedge in an operational way, and whatever risks remain (such as short-term fluctuations), they often address using financial hedging tools, like futures or options. —-- Operational and financial hedging are COMPLEMENTARY STRATEGIES: most companies employ both strategies to manage their overall risks. 1. Operational hedging can be effective in managing long-term risks like the risk of currency changes affecting a company’s global business model over time (economic exposure)f 2. Financial hedging can be effective for hedging short-term risks such as daily or monthly fluctuations in currency exchange rates (transaction exposure). Both strategies work together to help companies manage different types of risk efficiently.