LT (10) Risk Management and Hedging Flashcards
What is Hedging?
Financial transactions which offset the risk of a real asset
When the real asset rises in value, the hedge loses money
When the real asset falls in value, the hedge makes money
Perfect vs. imperfect hedging: If the hedge is perfect, the gains from one and the losses from the other are perfectly correlated
What are the consequences of hedging?
Risks are transferred, not eliminated
If the risk is systematic you must pay someone else to bear the risk
Thus even a perfect hedge of a systematic risk loses money on average
What are the advantadges and disadvantadges to bearing risk? (Insurance companies.)
Insurance companies have advantages/disadvantages in bearing risk
Advantages in bearing risk:
Skills in estimating probabilities
Skills in identifying risk-reduction techniques Diversified risk-pool
Disadvantages in bearing risk
Administrative costs
Adverse selection/moral hazard
Risk pool may have correlated risks (AIG offered credit risk insurance)
Why should firms hedge?
In a MM world there is no place for hedging
Reducing the risk to security holders has no value if they can hedge those risks (or the consequences of those risks) themselves
Thus for hedging to be optimal one or more of the M&M assumptions must be violated.
Good reason to hedge:
1) Lower the expected cost of financial distress via the reduction of the probability of bankruptcy
Financial market for the risk may not exist (future of a city: London, NYC,. . . )
Non-hedging ways to reduce bankruptcy risk
Lower financial leverage: debt / assets (but valuation consequences. . . )
Lower operating leverage: fixed costs / total costs
2) Lower the risk of being financially constrained
Investment opportunities may arrive when the company’s cash flow is low
Security sales are costly
Imperfect capital markets
Perceived risk is higher
Consider carefully the nature of the business
Are corporate cash-flows and the arrival of positive NPV opportunities correlated?
If investment opportunities and cash flows are not constant then hedging can be value enhancing or value destroying
Cash flows and Positive NPV opportunities are positively correlated → Hedging is not beneficial
Cash flows and Positive NPV opportunities are negatively correlated → Hedging is beneficial
3) Managers are risk averse
Managers’ human capital is tied to the firm
Managers cannot diversify the risk, though from the point of view of investors the risk is idiosyncratic
It may make sense to insure the manager, but the firm should hedge only if there is not a cheaper way to provide the managers with insurance.
What type of firms should hedge?
Closely held or private firms where investors are not diversified
Opaque firms that experience a significant asymmetric information problem. Managers and bondholders may otherwise forego +NPV projects
Intangible firms that are more exposed to costs of financial distress
What is a bad reason to hedge?
Speculation
Hedging risk requires sophistication
Many treasury departments of many firms do not have the knowledge and/or guidance on how to reduce risk, especially at the highest level
In many cases those hedging get more credit if they make money rather than avoid losing money
Trading derivatives is more fun than letting shareholders diversify the risk
Many firms have speculated and lost staggering sums Metallgesellschaft (German industrial firm)
A great need to develop sound monitoring systems within firms
What instruments are used to hedge?
Typical Instruments
Insurance
Derivatives: Financial agreements/ instruments/ contracts whose returns are linked to, or derived from, the performance of underlying assets such as equity, bonds, currencies or commodities.
Forward and future contracts
Options
Swaps
What is insurance?
Definition
The firm pays a fixed amount (the insurance premium) in exchange for the insurance company paying the variable cash flow (the loss) instead of the firm. This exchanges a variable cash flow for a fixed one.
Insurance is against (mostly idiosyncratic) risk
The insurance company diversifies much of the risk internally by selling many policies
The remaining risk is passed to shareholders through the securities market, where the security holders diversify the risk. e.g. liability insurance for airline companies.
What are forward/ future contracts?
Agreement to sell an asset at a future date at a fixed price set today. The transaction price set today is called the forward/future price
Many assets have future markets including agricultural commodities (e.g. corn and soybeans), non-agricultural commodities (e.g. gold or fuel oil), and financial assets (e.g. 30 year government bonds or Swiss Francs).
Delivery the actual commodity is not usually delivered (sometimes delivery is not allowed)
Traders usually reverse their position before the contract expires
What is a swap?
A swap is an exchange of one set of cash flows (e.g. cash flows on a floating rate loan) for another of equivalent market value (e.g. cash flows on a fixed rate loan)
Essentially a sequence of futures contracts
Example: Interest rate swap
CRST receives floating-rate (e.g. LIBOR) but has a fixed-rate liability
Hanson receives fixed-rate but liable for LIBOR
Risk mismatch, so CRST and Hanson can enter into an interest rate swap
CRST agrees to pay a floating rate to Hanson
Hanson pays a fixed interest rate (the ‘swap rate’) to CRST
The swap rate is set at 8% such that the transaction has zero NPV at initiation
A significant risk in swap contracts is counterparty risk that is, the risk that the hedge evaporates
What are the costs of hedging?
Risk premium
The risk premium depends on the type of risk. In general, you will have to pay to hedge systematic risk
Transaction costs
To complete a hedge, the firm will have to pay transactions costs (e.g. brokerage commissions and losses to more informed traders)
In the early 1980s the bid-ask spread for swaps exceeded 100 basis points at times
By 1995, it was as low as 2 basis points
Is the futures price an unbiased estimate of the future spot price?
No. If there is a positive risk premium then the two differ.
What is the relationship between future price and future spot price?
NPV(futures/seller) = futures price/(1 + rfutures)− E0(spot price)/(1 + rcommodity value) = 0
Assume no default, so rfutures = rrisk-free
Futures price = E(spot price) × (1 + rf/1 + rc)
where rf : risk-free rate, rc : commodity expected return CAPM: rc = rf + βc × Market Risk Premium
βc = 0 → rc = rf → futures price = E(spot price)
βc > 0 → rc > rf → futures price < E(spot price)
Intuition: seller contracts away a systematic risk, so she has to offer a discount in future price as a compensation for risk to the buyer.
