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Overview of the Risk Management Process and its Impact on Firm Value

Overview of the Risk Management Process and its Impact on Firm Value. Why Study Risk Management?. This area has experienced explosive growth due to the development of derivatives markets.

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Overview of the Risk Management Process and its Impact on Firm Value

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  1. Overview of the Risk Management Process and its Impact on Firm Value

  2. Why Study Risk Management? • This area has experienced explosive growth due to the development of derivatives markets. • It is an area of finance where theory has been so quickly and completely implemented into actual practice. • Derivatives have become so widespread and central to business practice to gain competitive advantage and maximize shareholder value.

  3. One Simple Example of a Hedge: • You are planning to come to Villanova by car. • You have two choices: • Take the Blue route (476), which is faster if there is no traffic, or • Take the side roads, which is slower but doesn’t have much traffic. • What do you do? • What are the benefits and costs of hedging?

  4. What is a Derivative? • An instrument whose value is determined (or derived) from the value of some underlying variable(s). • What kind of underlying variables? • Prices of commodities (wheat, corn, lumber, gold, copper, etc.) • Exchange rates (price of British pound, Euro, etc.) • Interest rates • Stock prices • Index values (e.g. S&P 500) • Credit Quality of a corporate bond

  5. Examples of Derivatives • Forward contracts • Futures contracts These are conceptually similar • Swaps • Options

  6. Derivatives and Hybrids are not new… • Forwards – started in 12th century • Futures – started in the 17th century • Options – started in the 17th century • Hybrids – at least since the 19th century • Swaps – started with parallel loans in the 1970s (relative to the others, these are babies!).

  7. But Derivatives usage also has its risks! • Trading Debacles: Nick Leeson at Barings PLC ($1.4 Bil. in 1995), Brian Hunter at Amaranth hedge fund ($6.6B in 2006), and at SocieteGenerale ($7.2B in 2008), etc. • Subprime Mortgage Mess: $1-2 Trillion losses during 2007-2009 that touched nearly all sectors of the financial services industry.

  8. 2007-2008 Subprime Mortgage Mess in brief • Unintended Consequences: in 1990s, Clinton administration pushed for greater credit access for lower income borrowers. • Regulatory Loopholes: in 1999, Citigroup agreed to underwrite more risky mortgages if they could be kept off-balance sheet. • Perfect Storm hits: low interest rates and 2002-07 recovery loosens credit standards further and investors “stretch” for higher yields. • Incentives Misaligned: mortgage lenders/brokers, investment bankers, rating agencies, money market investors, hedge funds, politicians all have incentive to “turn a good idea into a bad one!”

  9. Collateralized Debt Obligation (“CDO”)– More Leverage Last Loss Low Risk Low Yield MBS WALL ST BANKS MBS Pool of AA, A, BBB MBS Super-Senior AAA CDO Loss Position Credit Risk Yield MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS AAA CDO MBS B CDO MBS Equity MBS First Loss High Risk High Yield

  10. Credit Default Swaps – InfiniteLeverage Like an insurance contract that pays in the event of default. FASB requires mark-to-market valuation. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value. Protection Buyer Protection Seller Premium Payments • Tends to own reference asset • Hedging or going “short” • Benefits when reference asset price DECREASES • Does not usually own reference asset • Going “long” • Benefits when reference asset price INCREASES, max at Par Payment upon Default of Reference Asset Reference Asset can be a MBS, CDO, Bond, or Loan

  11. CDS on CDO – Infinite Leverage Credit Default Swap ∞ CDO $90.0 CDS on CDO $90.0 CDO Structure 50X’s Increasing Leverage MBS $91.8 CDO $90.0 Equity $0 Equity $1.8 Mort. Securitiz 30X’s Mortgage Debt $95 MBS $91.8 Homeowner 20X’s House $100 Mortgage Debt $95 Equity $3.2 Equity $5

  12. A Note on Market Efficiency: • An efficient market is characterized by: • Homogeneous product • Liquid primary and secondary markets • Low transaction costs • Easy access to information about asset values • Ability to hedge positions (e.g., short sales are allowed) • An efficient market does not mean it is impossible to make “excess profits” but it does imply that it is very difficult to do so on a consistent basis. • Most financial markets (especially those in the U.S.) are semi-strong efficient.

  13. Types of Risk Management and their Impact on Firm Value • Tactical Risk Management • Acting on a “View” • “Arbitraging” international differences in taxation and/or regulation • Reducing transaction costs (B-A spread, liquidity, info costs) • Strategic Risk Management • M-M (1958) Irrelevance argument (perfect markets). • Long-term reduction in various costs related to market imperfections. • Firm can increase value via hedging because it reduces the costs related to: taxes, financial distress/external financing, agency problems, and asymmetric information.

  14. Effect of Market Imperfections on Firm Value Stylized Model: V = V* – Tax – FD – AC – AI where, V* = value of firm in perfect M-M (1958) world Tax = costs associated with tax effects FD = costs related to financial distress / external financing AC = costs related to agency conflicts AI = costs associated with differences in information

  15. Why Market Imperfections Matter • Taxes – due to convexity of tax schedule. • Financial Distress / External Financing costs – direct and indirect deadweight costs incurred by the firm when its cash flow is low relative to its debt burden and investment plans. • Agency Costs – related to conflicts between managers and owners as well as between owners and bondholders. • Asymmetric Information – costs related to differences in information between insiders and outside investors

  16. A Simple Model of Firm Value • Stylized Income Statement: EBIAT = {Sales – Operating Costs – DEP} * (1 – T) • Stylized Valuation Model: where, INVt = Capital Expenditures, Othert = Change in Net Working Capital. • Total Firm Value and Shareholder Value (SHV) are only affected by changes in MRT (Magnitude, Riskiness, and Timing of cash flows).

  17. Ways to Measure the Impact of Risk Management on Firm Value • Three key measures: • RAROC – Risk-adjusted return on capital = Risk-adjusted Dollar Return / Economic Capital at Risk • EVATM / SVA – Economic Value Added = Annual Dollar Return – (Hurdle rate * Economic Capital) Shareholder Value Added = Economic Capital * [ {(ROA – g) / (Hurdle rate – g)} - 1 ] • Value-at-Risk (VaR) – VaR can be computed several ways. One “quick and dirty” way is: VaR = 2.33 * Standard Deviation of Percentage Return * Economic Capital

  18. MVA and the Four Value Drivers • Market Value Added (MVA) is determined by four drivers: • Sales growth (g) • Operating profitability (OP = NOPAT / Sales) • Capital requirements (CR = Operating capital / Sales) • Weighted average cost of capital (WACC)

  19. ┐ ┌ ┐ ( ) CR │ │ │ │ Salest(1 + g) OP – WACC (1+g) WACC - g ┘ └ ┘ └ MVA for a Constant Growth Firm MVAt =

  20. Discounted Cash Flow Valuation and Value-Based Management • Link to DCF Valuation Excel file: • FM 12 Ch 15 Mini Case.xls (Brigham & Ehrhardt file)

  21. Risk Profiles and the Fundamental Building Blocks of Risk Management • A Risk Profile is a simple 2-D graph of the change in firm value (DV) versus the unexpected change in a financial price (DP). • Thus, DV = V due to DPminus V beforeDP. • And, DP = P minusexpected P. • Building Blocks are payoff profiles of derivative and hybrid securities (Six key profiles can form all others)

  22. The Payoff Profiles of Building Blocks are linear or non-linear... • Forwards, Futures, and Swaps have twolinear payoff profiles (Upward sloping for long positions and downward sloping for short positions). • Options have fournon-linear payoff profiles: • Calls – two profiles (one for long and one for short positions) • Puts – two profiles (one for long and one for short positions) • Can create a payoff profile for any hedging strategy or hybrid security using the above six profiles in a simple Spreadsheet File.

  23. Three Examples of Payoff Profiles in your Personal Life • What are the “Payoff Profiles” for these items? • Bonus Compensation(e.g., in addition to your base salary) • Car Insurance (e.g., the payoff when you have an accident) • Housing Prices (e.g., change in the value of your home) • Try to solve these on your own (see Solutions here).

  24. A Brief Overview of the Relevant Securities: Forward Contracts • Forward Contracts – Obligates its owner to buy (if in a “long” position) or sell (if in a “short” position) a given asset on a specified date at a specified price (the “forward price”) at the origination of the contract. • Two Key Features: • Credit risk is two-sided (i.e., both buyer and seller of the forward can default on the deal). • No money is exchanged until the forward’s maturity date. • The above features increase default risk and restricts the availability and liquidity of these contracts.

  25. A Brief Overview of the Relevant Securities: Futures Contracts • Futures Contracts – Similar to Forwards. Obligates its owner to buy (if in a “long” position) or sell (if in a “short” position) a given asset on a specified date at a specified price (the “futures price”) at the origination of the contract. • Key Features: • Credit risk is two-sided but is reduced substantially because of two mechanisms: 1) marking-to-market (daily settling up of the account), and 2) margin requirements (i.e., a good-faith deposit). • Standardized contract specifies exact details of term, asset, contract size, delivery procedures, place of trading, etc. • Clearinghouse reduces transaction costs and de-couples buyer from seller by providing anonymity.

  26. A Brief Overview of the Relevant Securities: Swaps • Swaps – Obligates two parties to exchange some specified cash flows at specified intervals over a specified time period. Like futures contracts, swaps can be viewed as a portfolio of forward contracts. • Key Features: • Credit risk is two-sided but a swap is less risky than a forward (and more risky than futures) because a swap reduces the “performance period” (the time interval between cash payments) but does not require posting a margin. • Swaps can be tailored exactly to customer needs and can be arranged for longer time periods than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures).

  27. A Brief Overview of the Relevant Securities: Option Contracts • Options – Grants its owner the right, but not the obligation, to buy (if purchasing a “call” option) or sell (if purchasing a “put” option) a given asset on a specified date at a specified price (the “strike price”) at the origination of the contract. • Key Features: • Calls allow you to bet on increases in the asset’s value. • Puts allow you to bet on decreases in the asset’s value. • The option buyer pays a premium to acquire the option. • The seller of the option does have an obligation to buy/sell the asset. Much riskier than buying the option. • Options can be: “in-the-money”, “at-the-money”, and “out-of-the-money”. • An option is a portfolio of forward contract and a riskless bond. Also, can create forwards from options!

  28. Three Fundamental Ways to Manage Risk • The “ART” of Risk Management: • Accept the risk (e.g., self-insure) • Remove the risk (divest, diversify) • Transfer the risk (hedging, insurance)

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