The Need for Risk

Management
All of life is the management of risk, not its elimination.
Walter Wriston, former
chairman of Citicorp
Corporations and Risks
Corporations are in the business of managing risks.
Pure risk vs. Speculative risk
Pure risk only the possibilities of loss or no loss
Speculative risk either profit or loss is possible
Fundamental risk vs. Particular risk
Fundamental risk affecting the entire economy or large
numbers of persons or groups within the economy
Particular risk affecting only individuals or individual firms
Enterprise risk all major risk faced by a business firm

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Change: The Only Constant
Increased volatility of financial markets since the early
1970s
1971: Fixed exchange rate system broke down flexible and
volatile exchange rates

1973: Oil-price shocks high inflation and wild swings in interest

rates

Oct 19, 1987: Black Monday US stocks collapsed by 23

percent

1994: Federal Reserve Bank, after having kept interest rates low
for 3 years, started a series of 6 consecutive interest rate hikes
bond debacle erasing $1.5 trillion in global capital
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Change: The Only Constant
(contd)
End of 1989: Japan stock price bubble deflated, with Nikkei
index down from 39,000 to 17,000 within 3 years
unprecedented financial crisis in Japan
1997: Asian financial crisis wiping off three-fourths of the
dollar capitalization of equities in Indonesia, Korea, Malaysia and
Thailand
Aug 1998: Russian default global financial crisis and near
failure of a big hedge fund, Long Term Capital Management
(LTCM)
Sep 11, 2001: terrorist attack freezing financial markets for six
days

The only constant across all these events is their

unpredictability.
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Objectives of Risk
Management
Pre-Loss Objectives (before a loss occurs)
Preparing for the potential losses in the most economical way
Reduction of anxiety
Meeting legal obligations
Post-Loss Objectives (after a loss occurs)
Survival
Continued operation
Stability of earnings
Continued growth
Social responsibility

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Why Risk Management Why
Bother?
In the absence of market frictions, investors in
corporations should be able to replicate whatever risk-
management action the firm is taking. Hence it is not
clear that risk management should add value.

Indeed, the Modigliani-Miller (M-M) theorem (1958)

states that under these conditions, the value of a firm
should be unaffected by its financial policies. Thus risk
management is irrelevant.

CAPM firms should not worry about idiosyncratic risks

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Why Bother? (contd)
To understand the effect of hedging with VAR, Figure 20-
3 gives an example of cash-flow distributions. Without
hedging, the 95 percent VAR is $145 million.

Assume the firm decide to hedge, the VAR number is

reduced to $70 million.

Even if hedging reduces risk, however, it does not

change the mean of the distribution when the contracts
are fairly priced.
Thus, without market imperfection, hedging does not add value.

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Why Hedge?
Finance researchers have identified conditions under
which hedging, meaning activities that lower the volatility
of cash flows or firm value, should add value.

Hedging can lower the cost of financial distress.

As Figure 20-3 shows, hedging reduces the probability of
unfavorable left-tail outcomes.
This is valuable if financial distress has deadweight costs, such
as legal fees and cost incurred because the firm cannot be
managed efficiently when undergoing bankruptcy proceedings.
Hedging can reduce cost of capital and enhance ability
to finance growth
High cash flow volatility adversely affects a firms debt capacity
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Why Hedge? (contd)
Hedging can lower taxes.
Greater earnings stability also can reduce average taxes paid
when the firms tax function is convex.
Taxes rates start at zero for negative incomes and then grow
positively and higher for increasing levels of income. The
schedule of the tax authority is akin to a perpetual call options on
profits.
By lowering volatility, the firm can lower the value of this option,
thereby enhancing firm value.

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Why Hedge? (contd)
Hedging can lower agency costs.
Shareholders are continually trying to assess the performance of
managers, by watching earnings. The problem is that earnings
can fluctuate due to factors outside the control of the firm.
By making earnings less volatile through hedging, risk
management makes earnings more informative, which should
lead to better performance assessment.

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Why Hedge? (contd)
Hedging can facilitate optimal investment.
Some companies need steady cash flows to invest in research
and development (R&D) programs.
Firms also may need cash to take advantage of new projects.
In all these cases, companies could go to external markets, e.g.
borrow funds from banks or bondholders to raise cash when
needed.
If external financing is more costly than internal sources of
funds, hedging may add value to the firm.

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Why Hedge? (contd)
Empirical evidence finds that market valuations are
higher for firms that make use of foreign currency
derivatives to hedge.
The value added is significant:
Hedging firms have, on average, market values that are 4.9
percent higher than others.
Campello et al. (2011) found that hedging reduces the
cost of external financing and eases the firms
investment process.
Hedging reduces the incidence of investment restrictions in loan
agreements.

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To Hedge or Not To Hedge
1. Omega Drug sells worldwide and half of its revenues are
received in foreign currencies. Most of its R&D is done
in the U.S. Should it hedge at least some of its foreign
exchange exposure?

2. Omega Oil produces from several oil fields and also

invests to find and develop new fields. Should it lock in
future revenues from its existing fields by hedging oil
prices?
To Hedge or Not To Hedge
1. Probably yes, because pharmaceutical R&D programs
are very expensive, long-term investments. Omega
cannot turn its R&D program on or off depending on a
particular years earnings, so it may wish to stabilize
cash flows by hedging against fluctuations in exchange
rates.

2. Probably not, because its investment opportunities

expand when oil prices rise and contract when they fall.
Locking in oil prices could leave it with too much cash
when oil prices fall and too little, relative to its investment
opportunities, when prices rise.
A Framework for Risk
Management
Three basic premises:
The key to creating corporate value is making good investments.
The key to making good investments is generating enough cash
internally to fund those investments.
Cash flow can often be disrupted by movements in external
factors, potentially compromising a companys ability to invest.

Goal of risk management to ensure that a company

has the cash available to make value-enhancing
investments

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A Framework for Risk
Management

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A Framework for Risk
Management

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To Hedge or Not To Hedge
3. A corn farmer argues: I do not use futures contracts for
hedging. My real risk is not the price of corn. It is that
my whole crop gets wiped out by the weather. Discuss
this viewpoint. Should the farmer estimate his expected
production of corn and hedge to try to lock in a price for
expected production?
To Hedge or Not To Hedge
3. Suppose the weather is bad and the farmers production
is lower than expected. Other farmers are likely to have
been affected similarly.
Corn production overall will be low and as a
consequence the price of corn will be relatively high.
The farmers problems arising from the bad harvest will
be made worse by losses on the short futures position.

This problem emphasizes the importance of looking at the

big picture when hedging. The farmer is correct to
question whether hedging price risk while ignoring other
risks is a good strategy.
To Hedge or Not To Hedge
3. This problem emphasizes the importance of looking at
the big picture when hedging. The farmer is correct to
question whether hedging price risk while ignoring other
risks is a good strategy.