1. Risk Management When Does Hedging Add Value?

2. 2 Objective The objective of this session is to examine corporate risk management policies. We begin by asking the question: Why should corporations worry about risk management? Answering why one manages risk will determine how best to measure and manage risk.

3. 3 Basic Points Risk management involves managing the volatility of a firm’s underlying cash flows or asset values. Risk management can add value by increasing a corporation’s debt capacity, reducing a corporation’s tax exposure, reducing external financing costs, avoiding financial distress costs, or by allowing the firm to benefit from a comparative advantage in risk bearing. Risk management policies are linked to capital structure decisions and managerial compensation policies.

4. 4 Why Does Risk Management Matter? What is risk management? Risk management refers to policies designed to manage the volatility in the underlying cash flows and/or market value of assets or liabilities of a firm. Distinction: Market or hedgable risks and nonmarket or nonhedgable risks. Market risks refer to risks that can easily be laid off in future markets or swap markets. Interest rate risk: Risk arising from changes in shape or level of the yield curve. Equity market risk: Risk arising from changes in the overall market value of equity securities. Currency risk: Risk arising from changes in the value of one currency relative to another. Credit risk: Risk arising from changes in default risk or credit risk spreads. Commodity risk: Risk arising from changes in the general price level of commodities.

5. 5 Why Does It Matter? Nonhedgable risks: Idiosyncratic risks: variability arising from company specific events. For example, the risk that the CEO leaves for Bermuda (taking with him many of the firms assets). Presumably nonhedgable risks are diversifiable and thus in an efficient market do not effect firm value. Note that this conclusion does not hold for closely held firms.

6. 6 Why Does it Matter? MM Proposition for risk management: In a perfect capital market and absent distress costs, financial policy does not matter. –Market risks: Suppose I undertake a new investment that with a beta of 4. This project raises the overall beta of the firm to 2. Are my stockholders worse off? No, as long as the project has a positive NPV. Suppose Corporate Treasury decides to invest in long term Treasuries and borrow short term. Is this strategy value enhancing? No, as long as the company does not have a comparative advantage in forecasting rates.

7. Should airlines hedge fuel costs? 7

8. 8 U.S. Gulf Coast Price per Gallon for Jet Fuel

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10. 10 Why Does it Matter? –Diversifiable risks: Should the value of the firm depend on the volatility of the underlying cash flows (that investors can diversify away)? No: so long as investors have low cost diversification opportunities and the size of the cash flow pie does not vary with volatility. –Implication for of perfect markets assumption: Concept of market efficiency should discourage corporations from creating corporate financial exposures and diversification should discourage companies from hedging financial exposures incurred through normal business operations.

11. 11 Market Imperfections Market imperfections and the benefits of risk management policies: When does volatility matter? –Taxes, hedging, and the after tax value of the firm: Progressive taxes: If the taxes on expected income are less than the expected taxes on income, then hedging may add value. Implication: Hedging may increase firm value by reducing expected taxes. Risk management for tax management purpose should focus on the left hand tail of the cash flow distribution since this is where taxes are progressive.

12. 12 How Hedging Can Reduce Taxes Suppose a firm invests in oil. Specifically it acquired 1 million barrels of oil at $45 per barrel. The firm expects to hold the oil in inventory and then sell it in a month. The corporate tax rate is progressive in that income under $5 million is tax free and income over $5 million is taxed at a 30% tax rate. The Treasury operation of the firm forecasts two possible outcomes: Now suppose a hedge can be put in place that locks in a price of $50 (the expected price one month hence). Should they do it? Yes Why? Because after-tax income will be $5 million versus expected after-tax income of $4.25 million (50% chance of 0 and 50% chance of $8.5 million). Outcome 1Outcome 2 Price of oil$45$55 Probability of outcome.5 Pre-tax income0$10 million Tax0$1.5 million

13. 13 Market Imperfections –Distress costs: Same basic idea as with taxes. By hedging the firm can avoid the dead weight costs of distress. –Froot, Sharfstein and Stein (1994): Underinvestment problems and the gains from hedging. Empirical fact: Investment and cash flows are correlated: firms prefer to finance new projects out of cash flows not from external financing: This is the pecking order theory of corporate finance. Empirical fact: financial slack isn’t cheap. What are the costs of carrying excess cash? Problem: How do you insure that the cash flows from your operations match your investment needs?

14. 14 Example This example is intended to demonstrate that cash flow variability may be costly because insufficient cash relative to the need for cash may require the firm to: –Issue external capital –Forego investment Consider an Oil Company whose development expenditures are a function of internally generated funds. There are two levels of development expenditures: Development = $200 million generates NPV = $90 million Development = $100 million generates NPV = $60 million

15. 15 Example The following table describes the company’s policies Oil PricesInternal FundsDevelopment Decline100 Stable200 Increase300200 Now suppose that the firm has available a hedge that generates proceeds of $100 if prices fall (i.e., a short forward position) and loses $100 when prices rise: Oil pricesHedgeIncrease In development Value Gain Decline+100 +130 Stable000 Increase-1000

16. 16 Managerial Risk Aversion –Managerial risk aversion and closely held companies: So far we’ve assumed that managers operate in shareholder’s interests and that shareholders can diversify away risks. If large blocks of the stock are held by individuals, then hedging may be value enhancing. Managers may prefer hedging if they hold large positions in the firm’s stock. Compensation policies may affect the incentives to hedge. –Pay in stock: Managers have the incentive to undertake risk reducing activities. –Pay in options: Risk increasing activities may look good. –Risk management policies will depend on (and should be structured to reflect) the compensation policies of the firm. Question: Are middle manager compensation contracts structured as options?

17. 17 Implications –Evaluating whether a firm is hedging or speculating requires information on the firm’s investment opportunities. Complete hedges are not typically optimal. –Risk management should vary with the cost of external financing. –Use risk management focus on aligning the supply and demand for investable funds. –Risk management can affects debt capacity by affecting distress costs and the interest tax shield. –Always ask the question: How does risk affect my company’s ability to add value?

18. 18 Comparative Advantage and Hedging Comparative advantage and position hedges –Semi-strong form market efficiency permits some firms to have valuable information concerning price movements. A good example of this is ADM in the corn market. –Comparative advantage implies that some firm’s may put on positions that reflect their view of the market. Small companies: Hedge through how they contract with suppliers and customers or through the purchase of insurance.

19. 19 Risk Management in Practice What should companies generally worry about? Not the variability of cash flows or market value but rather the likelihood that the cash flows drop below a certain level (triggering underinvestment or financial distress). If the goal of risk management is to reduce the likelihood of bad events, reducing variance per se probably should not be the goal (think about this when examining strategies concerning how to hedge). Rather the focus of should be on the lower tail of the cash flow distribution.

20. 20 Risk Management in Pract ice Insurance versus variance reduction: –Options provide insurance but at a cost of lower expected cash flows. –Forward, futures and swaps reduce variance but do not affect the expected net cash flows (except for distress cost avoidance and taxes).

21. 21 How Is Risk Measured in Practice? Financial corporations generally measure risk exposure through a variant of a VAR model (value at risk). Value at risk provides an estimate of the likelihood that a given loss will occur and is based on the tail of the probability of distribution. –For example, suppose that daily trading profits and losses are normally distributed with a mean profit of $2,000,000 and a standard deviation $1,500,000. You want to put in place capital sufficient to cover the potential daily loss from your operation 99.87 percent of the time. How much do you need?

22. How Much Do You Need? 99.87% of the time occurs unless there is a three standard deviation downside event With a standard deviation of $1.5 million, three standard deviations would be $4.5 million With expected profits of $2 million, capital of $2.5 million provides a cushion to avoid running out of capital except for 0.13% of days (one business day out of 769, about once every three years with 252 business days per year) Warning: this assumes that the daily returns have a constant variance and are normally distributed! 22

23. 23 For most nonfinancial institutions VAR models are not very helpful. The reason is you need to be very confident about the underlying probability distribution. Also, most companies worry about cumulated losses. What to do? Do what you did when figuring out capital structure. Simulate cash flows and calculate the fraction of simulated cash flows that fall below a certain threshold level attempt to take positions in hedges that eliminate these “bad outcomes”. How is Risk Measured in Practice?

24. 24 What Have I Learned? Risk management can add value through increasing a firm’s debt capacity, reducing underinvestment problems and reducing expected tax liabilities. Risk management is linked to compensation policies and capital structure, which are in turn linked to the nature of the firm’s assets and liabilities. Question to ask: How does the use of a derivative add value? Any hedging program should clearly articulate how the hedging program adds value.