Derivatives and Corporate Risk Management

1. Derivatives and Corporate Risk Management By RichardMacMinn

2. Objectives • Why manage risks? • What are the risks? • Which risks should be managed? • How can the risks be managed?

3. A fundamental lesson in the MM article is that levering does no increase value because individual investors can lever on personal account; they can also unlever on personal account. Hence, the individuals will not pay the firm for what they can do as well on their own. It follows that if the firm is to create value then the firm must do something that the investor cannot duplicate on personal account. Discuss. Why manage risks? • Lessons from Modigliani and Miller • The 1958Theorem • The corollary on the cost of capital • If risk management adds value then it is because it: • reduces the tax bill • eliminates distress costs or other agency costs • improves managerial incentives Discuss the proof of the MM58 theorem but go ahead and prove this corollary.

4. Tax Benefits • Tax shelters • Corporate value

5. Distress Costs • Debt capacity • Bond value • Lewellen 1971 • Stock value • Corporate value • Stakeholder values • Financial distress • Enron example • Distress costs • Shapiro, A. C. and S. Titman (1985). "An Integrated Approach to Corporate Risk Management." Midland Corporate Finance Journal3(2): 41-56.

6. Agency Costs • Agency problems • Risk-shifting (asset substitution) • Under-investment • Investment opportunities • Financing options • Pecking order theorem • Myers, S. C. and N. S. Majluf (1984). "Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have." Journal of Financial Economics13: 187-221.

7. What are the risks? • Identifying risks • Risk management cube • Income statement • Revenue line • To who does the firm sell? • Where does the firm sell, e.g., foreign or domestic? • Cost line (Cost of goods sold or COGS) • Where does the firm manufacture? • What are the raw materials? • What is the technology? • Balance sheet • On or off balance sheet?

8. The risks • Competitive risks • Strategic considerations • To what currencies are the firm rivals exposed? • Do the firm’s rivals hedge their currency risks? • Are the rivals’ commodity exposures denominated in dollars or in their domestic currency? • Competitive exposures • Currency • Interest rate • Commodity • Equity

9. Currency risks Let the P denote the corporate payoff in pounds and Pd be the random domestic price in pounds E be the random exchange rate, i.e., number of pounds for yen Pf be the random foreign price in yen C be the cost in pounds • What is it? • P = Pd qd + E Pf qf – C(qd + qf) • What are the operating solutions? • Production sites in foreign markets • Foreign currency borrowing • What are the financial solutions • Derivatives • Forwards and swaps • Options The financial solution may be lower cost than the operating solutions. It may also be more flexible, i.e., easier to reverse or otherwise change with changing market conditions. The operating solutions create bundled risks and the derivatives represent an unbundling that makes the risk and its cost much more transparent. A swap is a multi-period forward contract. Ignoring credit risk, the forward allows the buyer to lock a price in now at which the transaction will take place then.

10. Emerging market risks • Emerging market risks • Event risks • Political changes • Loss of currency convertibility • Credit risk is more complex • Government imposed exchange controls mimic default risk • Counter-party risk and country risk become more important

11. Which risks should be managed?

12. How can the risks be managed? • Capital structure • Forwards and Futures • Swaps • Insurance • Insurance linked securities

13. Let Pf denote the price in the foreign spot market qfx denote the sales in the foreign spot market qff denote the sales in the foreign forward market Forward Contracts • Forward contracts • Unhedged • Hedged

14. Swap Option Caps, Floors, Collars Forward-starting swap Swaption Interest Rate Swap This is an option on a forward-starting swap. It gives the owner the right to enter into a swap at agreed upon terms on an agreed date. The terms specify the interest rate in the case of an interest rate swaption. To create a cap sell a call with the exercise price set where you want the cap. To create a floor purchase a put option with the exercise price set where you want the floor. This is simply a forward contract on a swap, i.e. the contract is entered now but the swap is made then.

15. Emerging market risk management tools • Synthetic FX forward contract • Synthetic swap • Synthetic Peso loan using a cross currency swap

16. Commodity, equity, and credit risks • Commodity risks • Tools • Inventories can be used to hedge price risk • Adopting a flexible production schedule can also hedge price risk • Vertical integration can also hedge price risk • Equity risks • Tools • Options • Acquisitions and divestitures • Credit risks • Tools • Insurance • Letters of credit • Credit derivatives

17. Commodity risk management • Asian option • Examples • Copper inventories • Oil delivery • BTU management

18. Equity risk management • Link to page 14

19. Credit risk management • Link to page 20

20. Concluding Remarks • Why manage risk? • Which risks? • How?