mcdonald 2eppt ch04 - ut mathematics sell gold at a price ... sell some of the gain. this puts a cap...

Chapter 4

Introduction toRisk Management

Copyright © 2006 Pearson Addison-Wesley. 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 producesexceeds the cost of its inputs

• A firm that actively uses derivatives and othertechniques to alter its risk and protect its profitabilityis engaging in risk management


The Producer’s Perspective

• A producer selling a risky commodity has aninherent long position in this commodity

• When the price of the commodity >, thefirm’s profit > (assuming costs are fixed)

• Some strategies to hedge profit

Selling forward Buying puts Buying collars


Producer: Hedging With aForward Contract

• A short forward contract allows a producer tolock in a price for his output

Example: a gold-mining firm entersinto a short forwardcontract, agreeingto sell gold at a priceof $420/oz. in 1 year


Producer: Hedging With a Put Option

• Buying a put option allows a producer tohave higher profits at high output prices, whileproviding a floor on the price

Example: a gold-mining firmpurchases a 20-strike put at thepremium of $8.77/oz


Producer: Insuring by Selling a Call

• A written call reduces losses through apremium, but limits possible profits byproviding a cap on the price

Example: a gold-mining firm sellsa 420-strike calland receives an$8.77 premium


Adjusting the Amount of Insurance

• Insurance is not free!…in fact, it is expensive

• There are several ways to reduce the costof insurance

• For example, in the case of hedging againsta price decline by purchasing a put option,one can Reduce the insured amount by lowering the strike

price of the put option. This permits someadditional losses

Sell some of the gain. This puts a cap on thepotential gain


The Buyer’s Perspective

• A buyer that faces price risk on an input hasan inherent short position in this commodity

• When the price of the input >, the firm’sprofit

• Some strategies to hedge profit

Buying forward Buying calls Selling collars


Buyer: Hedging With a Forward Contract

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

Example: a firm,which uses gold asan input, purchasesa forward contract,agreeing to buy goldat a price of $420/oz.in 1 year


Buyer: Hedging With a Call Option

• Buying a call option allows a buyer to havehigher profits at low input prices, while beingprotected against high prices

Example: a firm,which uses gold asan input, purchasesa 420-strike call atthe premium of$8.77/oz


0

Profit

Why Do Firms Manage Risk?

• Hedging can be optimal for a firm when an extra dollar of incomereceived in times of high profits is worth less than an extra dollarof income received in times of low profits

• 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


Aspects of the tax code:

• a loss is offset againsta profit from a different year

• separate taxation of capitaland ordinary income

• capital gains taxation

• differential taxationacross countries

Reasons to Hedge: Taxes

Derivatives can be used to:

equate present values of theeffective rates applied tolosses and profits

convert one form of incometo another

defer taxation of capitalgains income

shift income from one countryto 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 goodsof a firm in distress

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


Reasons to Hedge:Costly External Financing

• Raising funds externally can be costly There are explicit costs (such as, bank and underwriting fees) There are implicit costs due to asymmetric information

• Costly external financing can lead a firm to foregoinvestment projects it would have taken had cashbeen available to use for financing

• Hedging can safeguard cash reserves and reduce theprobability of raising funds externally


Reasons to Hedge:Increase Debt Capacity

• The amount that a firm can borrow is itsdebt capacity

• When raising funds, a firm may prefer debt toequity because interest expense is tax-deductible

• However, lenders may be unwilling to lend to a firmwith a high level of debt due to a higher probabilityof bankruptcy

• Hedging allows a firm to credibly reduce the riskinessof its cash flows, and thus increase its debt capacity


Reasons to Hedge:Managerial Risk Aversion

• Firm managers are typically notwell-diversified Salary, bonus, and compensation are tied to the

performance of the firm

• Poor diversification makes managers risk-averse, i.e., they are harmed by a dollarof loss more than they are helped by adollar of gain

• Managers have incentives to reduceuncertainty through hedging


Nonfinancial Risk Management

• Risk management is not a simple matter ofhedging or not hedging using financialderivatives, but rather a series of decisionsthat start when the business is first conceived

• Some nonfinancial risk-managementdecisions 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 (suchas, 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 reportusing derivatives

• Among firms that do use derivatives, less than25% of perceived risk is hedged, with firmslikelier to hedge short-term risk

• Firms with more investment opportunities aremore likelier to hedge

• Firms that use derivatives have a highermarket value and more leverage

mcdonald 2eppt ch04 - ut mathematics sell gold at a price ... sell some of the gain. this puts a cap...

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