Chapter 4 Introduction to Risk Management 4-1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-2 Basic Risk Management Firms convert inputs

Chapter 4

Introduction to Risk Management

4-1

Copyright © 2009 Pearson Prentice Hall. All rights reserved.4-2

Basic Risk Management• Firms convert inputs into goods and services

output input

commodity

producer (=seller) buyer

• A firm that actively uses derivatives and other techniques to alter its risk and protect its profitability is engaging in risk management

Basic Risk Management

• A producer selling a commodity (a seller of an underlying asset) earn higher profit when the price of the commodity increase.

• A Seller of an underlying can hedge profit (or hedge against price falls)–By Selling Forward, or –By Buying Put Option, or–By Buying Collars

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Basic Risk Management

• A company buying a commodity as input, (a buyer of an underlying) earn higher profit when the price of the commodity falls.

• A Buyer of an underlying can hedge against price risk (price increases)–By Buying Forward, or –By Buying Call Option, or–By Selling Collars

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Example: Gold Mining Firm

• Consider a gold mining firm with fixed and variable cost.

• What should gold mining firm do if the prices go down?– As long as the Price > the Variable Cost, it

would be wise to produce gold even if that will generate losses.

– That is because producing above variable cost reduces losses relative to shutting the mine.

Dr. Cevat Ertuna

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• What can gold mining firm (Seller of gold) do to hedge against the price fall?– Gold mining company can lock in a price

(assure a price, let’s say K) by entering in a short forward contract.

– This hedging strategy will guarantee a fixed price and fix profit at a certain level (K – Total Cost). If the prices are high gold mining company cannot benefit from it, however, if the prices are low, gold mining company will still enjoy a certain profit.

Dr. Cevat Ertuna

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• Gold mining firm is a seller (selling gold, from option’s perspective, the underlying asset).

• Using short forward contract, company locks in to a fixed income.

• No downside risk & No upside profit prospect– It can protect itself from downside risk– At the cost of forgoing upside profit potential

Dr. Cevat Ertuna

Example: Hedging with Forward

Dr. C. Ertuna

Gold mining company hedged with forward contractK = $450 per oz.

Gold Price in 1 Year

Fixed Cost

Variable Cost

Net Income on Unhedged Position

Net Income on Hedged Position

$350 -$330 -$50 -$30 $70$400 -$330 -$50 $20 $70$450 -$330 -$50 $70 $70$500 -$330 -$50 $120 $70

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Example: Hedging with Forward

Dr. C. Ertuna

$350 $400 $450 $500

-$30

-$10

$10

$30

$50

$70

$90

$110

$130


Net Income onUnhedged Position

Gold Prices in 1 Years

Pro

fit

Net Income of Hedged (with For-ward) and Unhedged Positions

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• What can gold mining firm (Seller of gold) do to hedge against the price fall?– Gold mining company can buy a put contract.– This hedging strategy will guarantee a

minimum price and guaranteed minimum profit at a certain level (K – Total Cost). If the prices are high gold mining company can benefit from it, and if the prices are low, gold mining company will still enjoy a certain profit.

Dr. Cevat Ertuna

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• Using long put contract, company locks in to a guaranteed minimum income.

• No downside risk & Upside profit potential– It can protect itself from downside risk while

keeping upside profit potential– At the cost of put premium.

Dr. Cevat Ertuna

Example: Hedging with Put

Dr. C. Ertuna

Gold mining company hedged with long put contractK_put = $450 r_cc = 4,879%

T = 1 Put Prem = $22,92Gold

Price in 1 Year

Total Cost

Net Income onUnhedged

PositionProfit on Long Put

Net Income on Hedged

Position$350 -$380 -$30 $75,9 $45,9$400 -$380 $20 $25,9 $45,9$450 -$380 $70 -$24,1 $45,9$500 -$380 $120 -$24,1 $95,9

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Example: Hedging with Put

Dr. C. Ertuna

$350 $400 $450 $500

-$30.0

-$10.0

$10.0

$30.0

$50.0

$70.0

$90.0

$110.0

$130.0


Net Income onUnhedged Position


Pro

fit

Net Income of Hedged (with Put) and Unhedged Position

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• What can gold mining firm (Seller of gold) do to hedge against the price fall?– Gold mining company can buy a collar.– This hedging strategy will guarantee a

minimum price and guaranteed minimum profit at a certain level (K – Total Cost). If the prices are high gold mining company can benefit from it up to certain level , and if the prices are low, gold mining company will still enjoy a certain profit.

Dr. Cevat Ertuna

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• Using long put contract, company locks in to a guaranteed minimum income.

• No downside risk & Some Upside profit potential– It can protect itself from downside risk while

keeping some of the upside profit potential– At the cost of less than put premium.

Dr. Cevat Ertuna

Example: Hedging with Collar

Dr. C. Ertuna

Gold mining company hedged with long collerK_put = $450 Put Prem = $22,92 r_cc = 4,879%

K_cal = $500 Call Prem = $12,12 T= 1Gold Price in 1 Year Total Cost

Net Income onUnhedge

d PositionProfit on Long Put

Profit on Short Call

Net Income on Hedged

Position$350 -$380 -$30 $75,9 12,71 $58,6$400 -$380 $20 $25,9 12,71 $58,6$450 -$380 $70 -$24,1 12,71 $58,6$500 -$380 $120 -$24,1 12,71 $108,6$550 -$380 $170 -$24,1 -37,29 $108,6

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Example: Hedging with Collar

Dr. C. Ertuna

$350 $400 $450 $500 $550

-$30.0

-$10.0

$10.0

$30.0

$50.0

$70.0

$90.0

$110.0

$130.0

$150.0

Net Income on Hedged PositionNet Income onUnhedged Position


Profi

t

Net Income of Hedged (with Collar) and Unhedged Position

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Adjusting Cost of the Hedge

• The cost of hedge can be reduced –By lowering the Strike Price of Put, or– By using Collar (that is forgoing

some of the gain received if the underlying price is high)

• Adjusting cost of the hedge, however, will automatically lead to change in the amount of insurance.

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Dr. C. Ertuna

Adjusting Cost of Hedge, hence, Amount of Insurancer_cc = 4,879% K_put = $450 $400

T = 1Put Prem = $22,92 $6,28Gold Price

in 1 Total Cost

Profit on Long 450

Put

Profit on Long 400 Put

Net Income

with

Net Income

with 400-$350 -$380 $75,9 $43,7 $45,9 $13,7$400 -$380 $25,9 -$6,3 $45,9 $13,7$450 -$380 -$24,1 -$6,3 $45,9 $63,7$500 -$380 -$24,1 -$6,3 $95,9 $113,7

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Dr. C. Ertuna4-20

$350 $400 $450 $500

-$30.0

-$10.0

$10.0

$30.0

$50.0

$70.0

$90.0

$110.0

$130.0

Net Income with 450-putNet Income with 400-put


Profi

t

Net Income of Hedged Position with 400 and 450 Strike Put


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 goods of a firm in distress

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


Reasons to Hedge: Costly External Financing

• Even if losses of a firm do not create bankruptcy threat 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 forego investment projects it would have taken had cash been available to use for financing

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

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

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Reasons to Hedge: Increase Debt Capacity

• The amount that a firm can borrow is its debt capacity

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

• However, lenders may be unwilling to lend to a firm with a high level of debt due to a higher probability of bankruptcy

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


Aspects of the tax code:

• a loss is offset againsta profit from a different year

• separate taxation of capital and ordinary income

• capital gains taxation

• differential taxationacross countries

Reasons to Hedge: TaxesDerivatives can be used to:

equate present values of the effective rates applied to losses and profits

convert one form of income to another

defer taxation of capital gains income

shift income from one country to another


Reasons to Hedge:Managerial Risk Aversion

• Firm managers are typically not well-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 dollar of loss more than they are helped by a dollar of gain

• Managers have incentives to reduce uncertainty through hedging


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Reasons Not to Hedge

• Reasons why firms may elect not to hedge– Transaction costs of dealing in derivatives

(such as, 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


Nonfinancial Risk Management

• Risk management is not a simple matter of hedging or not hedging using financial derivatives, but rather a series of decisions that start when the business is first conceived

• Some nonfinancial risk-management decisions are

– Entering a particular line of business– Choosing a geographical location for a plant– Deciding between leasing and buying equipment


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Empirical Evidence on Hedging

• Half of nonfinancial firms report using derivatives• Among firms that do use derivatives, less than

25% of perceived risk is hedged, with firms likelier to hedge short-term risk

• Firms with more investment opportunities are more likelier to hedge

• Firms that use derivatives have a higher market value and more leverage

Documents

Chapter 4 Introduction to Risk Management 4-1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4-2 Basic Risk Management Firms convert inputs