principles_of_corporate_finance_unit_m_lectures.pdf

Hedging Hedging Definition • A hedge is a financial transaction which offsets the risk of a real asset. • When the real asset rises in value, the hedge loses money. • When the real asset falls in value, the hedge makes money. • Perfect vs imperfect hedging: If the hedge is perfect, the gains from...

Hedging Hedging Definition • A hedge is a financial transaction which offsets the risk of a real asset. • When the real asset rises in value, the hedge loses money. • When the real asset falls in value, the hedge makes money. • Perfect vs imperfect hedging: If the hedge is perfect, the gains from one and the losses from the other are perfectly correlated. Consequences • Risks are transferred, not eliminated. • If the risk is systematic, you must pay someone else to bear the risk. • Thus, even a perfect hedge of a systematic risk loses money on average. The End Good and Bad Reasons to Hedge Should Firms Hedge? • In an MM world there is no place for hedging • Reducing the risk to security holders has no value if they can hedge those risks (or the consequences of those risks) themselves. • Thus, for hedging to be optimal one or more of the M&M assumptions must be violated Good Reasons to Hedge 1. Lower the expected cost of financial distress via the reduction of the probability of bankruptcy • Financial market for the risk may not exist (future of a city: London, NYC) • Non-hedging ways to reduce bankruptcy risk • Lower financial leverage: debt/assets (but valuation consequences) • Lower operating leverage: fixed costs/total costs Example • Suppose firms A and B have the following CF: Firm A Firm B State 1 (50%) 50 100 State 2 (50%) 100 50 • Suppose whenever CF < 60, the firm fails. • Bankruptcy costs 20% of firm value. • If CF = 50, the firm fails and its value will be 50 × (1 − 20%) = 40 due to bankruptcy. • Firm value (for both A and B) without hedging is: 1 1 × 100 + × 40 = 70 2 2 Example (cont.) • Firms A and B can sign a contract. • In State 1, B gives A 25. In State 2, A gives B 25. Firm A Firm B State 1 (50%) State 2 (50%) 75 75 75 75 • There is no bankruptcy. • The firm value is 75 > 70. • Value of hedging = 5 for each firm. Good Reasons to Hedge 2. Lower the risk of being financially constrained • Investment opportunities may arrive when the company’s cash flow is low. • Security sales are costly. • Imperfect capital markets • Perceived risk is higher • Consider carefully the nature of the business. • Are corporate cash flows and the arrival of positive NPV opportunities correlated? • If investment opportunities and cash flows are not constant then hedging can be value-enhancing or value-destroying. • If cash flows and positive NPV opportunities are positively correlated, then hedging is not beneficial. • If cash flows and positive NPV opportunities are negatively correlated, then hedging is beneficial. Reduce Financial Constraints: Example Example: CF and investment opportunities are positively correlated. • Cash flow is either 60 or 100 • Firm has an investment project that costs 75 and returns NPV of 20 in the good state only Unhedged asset cash flow Hedged asset cash flow Bad (50%) Good (50%) 60 80 100 + 20 80 + 20 • If the firm hedges it has an expected CF of 90; if it does not hedge the expected CF is 90 (60 or 120) • No gains from hedging Reduce Financial Constraints: Example (cont.) Example: CF and investment opportunities are negatively correlated. • Cash flow is either 60 or 100 • Firm has an investment project that costs 75 and returns NPV of 20 in the bad state only Unhedged asset cash flow Hedged asset cash flow Bad (50%) Good (50%) 60 80 + 20 100 80 • If the firm hedges it has an expected CF of 90; if it does not hedge the expected CF is 80 (60 or 100) • Gains from hedging Good Reasons to Hedge 3. Managers are risk-averse • Managers’ human capital is tied to the firm. • Managers cannot diversify the risk, though from the point of view of investors the risk is idiosyncratic. • It may make sense to insure the manager, but the firm should hedge only if there is not a cheaper way to provide the managers with insurance. • Why are managers forced to bear the firm’s risk? Who Should Hedge? • Closely held or private firms where investors are not diversified • Opaque firms that experience a significant asymmetric information problem; managers and bondholders may otherwise forego positive NPV projects • Intangible firms that are more exposed to costs of financial distress Bad Reasons to Hedge 4. Speculation • Hedging risk requires sophistication • Many treasury departments of many firms do not have the knowledge and/or guidance on how to reduce risk, especially at the highest level • In many cases those hedging get more credit if they make money rather than avoid losing money • Trading derivatives is more fun than letting shareholders diversify the risk • Many firms have speculated and lost staggering sums • Metallgesellschaft (German industrial firm) • A great need to develop sound monitoring systems within firms The End Insurance Hedging Instruments Typical instruments • Insurance • Derivatives: financial agreements/instruments/contracts whose returns are linked to, or derived from, the performance of underlying assets such as equity, bonds, currencies or commodities • Forward and futures contracts • Options • Swaps Insurance Definition • The insured party pays a fixed amount (the insurance premium) in exchange for the insurance company paying the variable cash flow (the loss) instead of the insured. This exchanges a variable cash flow for a fixed one. • Insurance is against (mostly idiosyncratic) risk • The insurance company diversifies much of the risk internally by selling many policies • The remaining risk is passed to shareholders through the securities market, where the security holders diversify the risk • For example, liability insurance for airline companies Is Insurance “Actuarially Fair”? • Insurance is actuarially fair if it is zero NPV • Insurance companies have advantages/disadvantages in bearing risk • Advantages in bearing risk • Skills in estimating probabilities • Skills in identifying risk-reduction techniques • Diversified risk pool • Disadvantages in bearing risk • Administrative costs • Adverse selection and moral hazard • Risk pool may have correlated risks (eg, AIG offered credit risk insurance) The End Financial Derivatives Hedging Instruments Typical instruments • Insurance • Derivatives: financial agreements/instruments/contracts whose returns are linked to, or derived from, the performance of underlying assets such as equity, bonds, currencies or commodities • Forward and futures contracts • Options • Swaps Forward and Futures Contracts Description • Agreement to trade an asset at a future date at a fixed price set today; the transaction price set today is called the forward/future price. • Many assets have futures markets including agricultural commodities (eg, corn and soybeans), non-agricultural commodities (eg, gold or fuel oil), and financial assets (eg, 30-year government bonds or Swiss francs). • Delivery – the actual commodity is not usually delivered (sometimes delivery is not allowed). • Traders usually reverse their position before the contract expires. Swaps • A swap is an exchange of one set of cash flows (eg, cash flows on a floating rate loan) for another of equivalent market value (eg, cash flows on a fixed rate loan). • Essentially a sequence of futures contracts • Example: interest rate swap • CRST receives floating-rate (eg, LIBOR) but has a fixed-rate liability. • Hanson receives fixed-rate but is liable for LIBOR. • There is a risk mismatch, so CRST and Hanson can enter into an interest rate swap. • CRST agrees to pay a floating rate to Hanson. • Hanson pays a fixed interest rate (the ‘swap rate’) to CRST. • The swap rate is set at 8% such that the transaction has zero NPV at initiation. • A significant risk in swap contracts is counterparty risk – that is, the risk that the hedge evaporates. Swaps: Example LIBOR CRST Hanson PLC Swap rate = 8% 8% Lender LIBOR Lender The End Hedging Costs Cost of Hedging • Risk premium • The risk premium depends on the type of risk. In general, you will have to pay to hedge systematic risk. • Transaction costs • To complete a hedge, the firm will have to pay transaction costs (eg, brokerage commissions and losses to more informed traders). • In the early 1980s, the bid-ask spread for swaps exceeded 100 basis points at times. • By 1995, it was as low as two basis points. • Let us consider an example of how the risk premium is incorporated into future prices. Futures Prices and Expected Spot Prices, Part I • The futures price is set today but will be paid next year. • The spot price is the price at which you can buy or sell the commodity immediately. • Is the futures price an unbiased estimate of the future spot price? • No. If there is a risk premium, then the two differ. Futures Prices and Expected Spot Prices, Part II • Suppose you enter into a futures contract today to sell a commodity (eg, gold) in one year at a fixed price (the futures price). • You (the seller) will receive the futures price but give up the future spot value of the commodity. NPV (futures/seller) = futures price E0 (spot price)
=0 − 1 + rcommodity value (1 + rfutures ) • Assume no default, so rfutures = rrisk-free . Futures Prices and Expected Spot Prices, Part III  futures price = E (spot price) × 1 + rf 1 + rc  • Where rf : risk-free rate, rc : commodity expected return • CAPM: rc = rf + βc × Market risk premium • βc = 0 → rc = rf → futures price = E(spot price) • βc > 0 → rc > rf → futures price < E(spot price) • βc < 0 → rc < rf → futures price > E(spot price) • Intuition: the seller contracts away a systematic risk, so they have to offer a discount in the future price as a compensation for the risk to the buyer The End