Risk Management When Does Hedging Add Value?. Objective.
Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.
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.
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.
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.
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 ofthe 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).
Issue external capital
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 millionExample
The following table describes the company’s policies
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:
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.
Insurance versus variance reduction:
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 levelattempt to take positions in hedges that eliminate these “bad outcomes”.