Hedging Lecture.ppt

7/29/2019 Hedging Lecture.ppt

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On Hedging

By

RichardMacMinn
mailto:[email protected]://macminn.org/http://localhost/var/www/apps/conversion/RMI/lectures/Hedging/94604p2.pdfhttp://macminn.org/mailto:[email protected]


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Objectives What are the goals of risk

management?

Premises for risk management

Is risk management irrelevant?

Why should the firm hedge?

When should the firm hedge?

Guidelines for hedging


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Premises for risk management The risk management paradigm rests on the

following three premises: Corporate value is created by good investments

Generating internal cash is necessary to fund goodinvestments Companies that dont generate sufficient cash tend to cut

investment more drastically

Cash flow crucial to investment can be disrupted by external

factors such as exchange rates, commodity prices andinterest rates

The risk management program must ensure that thefirm can make the investments that create value


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Historical sketch Pharaoh

Inventory

Middle Ages

Futures

Berle & Means

Diversification

Dresser Industries

Dresser is used as

an example of the

breakdown in the

logic that the

corporation need

not diversify since

investors can

diversify onpersonal account

by buying stock in

petrochemical

firms as well as

oil firms.

Berle and Means represent a precursor to

modern finance. The Berle and Means

argument is that the corporate form was

developed to enable firms to disperse risk

among many small investors. This

notion has also been discussed by

Samuelson in 1967 and MacMinn 1984.

If this is so then the firm need not

diversify risk on corporate account.

Use MacMinn and Martin to discuss the

corollary to the MM58 theorem. The

nexus of contracts is irrelevant.

The story of Joseph.

What is the difference

between dream

interpretation and risk

management? See

Bernstein.

Discuss the natural hedge versus the

futures contract.

Note that the risk averse farmer wants to

sell more forward to reduce income risk and

so normally we see the relation: f < EP, i.e., a

forward price less than the expected spot

price; this is called normal backwardation.
http://www.macminn.com/risk%20management/lectures/forward.MOVhttp://www.jstor.org/stable/2329779http://www.jstor.org/stable/2327878http://www.jstor.org/stable/2327878http://www.jstor.org/stable/2329779http://www.macminn.com/risk%20management/lectures/forward.MOV


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Historical sketch Modern finance

Modigliani and Miller 1958 Corollary to the 1958 Modigliani-Miller theorem

Post-modern paradigm Myers and Majluf MacMinn and Page Froot, Scharfstein and Stein

Internally generated cash is therefore a competitive weapon thateffectively reduces a companys cost of capital and facilitates

investment.p. 94 . . . the role of risk management is to ensure that companies have the

cash available to make value-enhancing investment p. 94

Brander and Lewis

The corollary was

introduced in

MacMinn and Martin.

The role of risk management is to

ensure that the firm has the cash

available for investment when it is

needed. If the firm does and its

competitors do not then it has

achieved a competitive advantage.
http://www.jstor.org/stable/1809766http://www.macminn.org/Fin374/theorems/theorems.htmlhttp://www.jstor.org/stable/1816462http://www.jstor.org/stable/1816462http://www.macminn.org/Fin374/theorems/theorems.htmlhttp://www.jstor.org/stable/1809766


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Example Dresser Industries

During the late 1930s itspent five times theindustry average onresearch and development,

adding 128 new types ofproducts.

Dresser officially becameknown as DresserIndustries, Inc. in 1944 andopened new headquartersoffices in Cleveland thenext year. An

unprecedented boom in theenergy, petrochemical andhousing constructionindustries fueled its post-war growth.
http://www.dresser.com/http://www.halliburton.com/corp/whoweare/about_dresserhistory3.asphttp://www.halliburton.com/corp/whoweare/about_dresserhistory2.asphttp://www.dresser.com/


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Why hedge? The capital investment decision

tt 1

e P q m q P q m qnpv e k q e k q

r1 r

r is the rate of interest

e is the randomexchange rate, i.e.,

dollars per yen

P is the random spot

price

k is the capital cost per

unit of capacity

m is the unit variablecost

q is the output of firm in

market
http://richardmacminn.com/risk%20management/lectures/Technological_Leadership.pdfhttp://interactive.wsj.com/documents/mktindex.htm?forextab.htmhttp://interactive.wsj.com/documents/mktindex.htm?forextab.htmhttp://richardmacminn.com/risk%20management/lectures/Technological_Leadership.pdf


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When to hedge Risk and the optimal investment

Exchange rate Commodity price Interest rate Property loss

Claim An oil company has less incentive to manage risk because

investment opportunities are only good when oil prices arehigh.

Claim An increase in commodity price risk reduces the optimal

investment.

Consider the condition

for an optimal

investment decision.Consider the claim in

view of the first order

condition.


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When to hedge Froot, Scharfstein, and Stein

The goal of risk management is not to insure investors andcorporate managers against oil price risk per se. It is to

ensure that companies have the cash they need to createvalue by making good investments. p. 98

Key issues This approach helps identify what is worth hedging and what

is not.

This approach helps identify how much hedging isnecessary. Is the firm naturally hedged?

How sensitive is the value of the investment to changes ininterest and exchange rates? Commodity prices?


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Guidelines Companies in the same industry should not necessarily select the same

hedge An all equity firm would select its production level to maximize stock value

and differences in marginal costs may imply differences in optimal hedging,i.e.,

Consider the different investment opportunities noted by Froot, Scharfsteinand Stein

Companies may benefit from risk management even if they have nomajor investments in plant and equipment Consider a firm with investment opportunities in human capital, brand

names, or market share Investment in human capital cannot be collateralized Investment in market share may require lowering price and that also is difficult to

collateralize

Even companies with conservative capital structure can benefit fromhedging Why might the firm have chosen a conservative capital structure?

n n

1 1

SS(q) p( ) P( )q c(q) p( ) P( ) c (q) 0q
http://localhost/var/www/apps/conversion/RMI/lectures/Hedging/Froot,%20Sharfstein%20and%20Stein.pdfhttp://localhost/var/www/apps/conversion/RMI/lectures/Hedging/Froot,%20Sharfstein%20and%20Stein.pdfhttp://localhost/var/www/apps/conversion/RMI/lectures/Hedging/Froot,%20Sharfstein%20and%20Stein.pdfhttp://localhost/var/www/apps/conversion/RMI/lectures/Hedging/Froot,%20Sharfstein%20and%20Stein.pdfhttp://localhost/var/www/apps/conversion/RMI/lectures/Hedging/Froot,%20Sharfstein%20and%20Stein.pdf


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Guidelines Multinational companies must recognize that foreign exchange

risk affects not only cash flows but also operating decisions. Example one

Commodity price and cost in euros

The sign of the derivative does not depend on the size of theexchange rate.

Example two Commodity price in dollars and cost in euros

The sign of the derivative does depend on the magnitude of theexchange rate

e P q c(q) e P q c(q) e P c (q)q

P q e c(q) P q e c(q) P e c (q)q

A depreciation inthe dollar implies a

smaller exchange

rate, i.e., fewer

dollars per euro.
http://localhost/var/www/apps/conversion/tmp/scratch_3/example.htmhttp://localhost/var/www/apps/conversion/tmp/scratch_3/example.htm


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Guidelines Companies should pay close attention to hedging

strategies of their competitors This will allow the corporation to assess the capabilities of its

competitors, e.g., can the competitor invest when theexchange rates move against it?

The choice of specific derivatives cannot bedelegated Management must select the tools consistent with the

strategic advantage Financial futures may yield more variability in cash flows

along with the liquidity while the forward does not increasethe variability of cash flows but does incur credit risk


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To hedge or not Risk management cannot be ignored

since that has costs

Risk management cannot be delegated

Pay attention to the source, risk, etc. ofthe cash flows

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Hedging Lecture.ppt