Lecture 4 Flashcards
Producer/Seller perspective
inherent long position
commodity increase - firms profit increase
Strategies to hedge profit: selling forwards buying puts selling calls buying collars
Hedging with a forward contract
a short forward contract allows a producer to lock in a price for output
Hedging with a put option
Buying a put option allows a producer to have higher profits at high output prices while providing a floor on the price
Insuring selling a call
A written call reduces losses through a premium, but limits possible profits
Adjusting the amount of insurance
reduce the insured amount by lowering/raising the strike price of the option - permits some additional losses
sell some of the gain - puts a cap on potential gain
Buyers perspective
inherent short in the market
price increase then profit decrease
Hedge profit: buying forwards buying calls selling puts selling collars
Hedging with a forward contract
a long forward contract allows a buyer to lock in a price for his input
Hedging with a call option
Buying a call option allows a buyer to have higher profits at low input prices, while being protected against high prices
Why do firms manage risk?
Bankruptcy and distress costs Costly external financing taxes preservation of debt capacity managerial risk aversion
Bankruptcy and distress costs
large loss can threaten the survival of a firm
hedging allows a firm to reduce the probability of bankruptcy or financial distress
Costly external financing
Raising funds externally can be costsly - can be explicit costs (bank and underwriting fees) and implicit costs (asymmetric info)
Costly external financing can lead a firm to forego investment projects it would ahve taken had cash been available to use for financing
hedging can safeguard cash reserves and reduce the probability of raising funds externally
Taxes
separate taxation of capital and ordinary income -> convert one form of income to another
Capital gains tax -> defer taxation of capital gains income
Differential taxation across countries -> shift income from one country to another
Increase debt capacity
the amount that a firm can borrow is its debt capacity
may prefer debt to equity for tax deduction reasons
lenders may be unwilling to lend to a firm with a high level of debt due too higher probability of bankruptcy
hedging allows a firm to credibly reduce the riskiness of its cash flows and thus increase its debt capacity
Managerial risk aversion
firm managers are typically not well diversified - salary, bonus, and compensation are tied to the performance of the firm
Poor diversification makes managers risk averse
Managers have incentives to reduce uncertainty through hedging
Reasons not to hedge
Transaction costs of dealing in derivatives
The requirement for costly expertise
The need to monitor and control the hedging process
Complications from tax and accounting considerations
Potential collateral requirements
