Risk Management Flashcards
Reasons to hedge - saving taxes
MM Proposition 1: with perfect capital markets and no taxes the value of the firm is independent of its capital structure
- if hedging choices do not affect CF from real assets, in the absence of taxes and transaction costs, hedging decisions don’t affect firm value
hedge - avoiding financial distress
a firm can increase its value through a reduction of the probability of facing financial distress in the future, which can be costly.
It prevents consumers from factoring in a certain probability that a firm will be in financial distress.
hedge - capital needs
Internal resources are cheaper than external - CAPEX is highly dependent on internal CF.
There is a tendency to over- or underinvest according to CF - firms have to plan CAPEX in advance but often face highly volatile CF (they may not have enough cash in the future) - possibility is to hedge CF to reduce variability thereof, enhancing firm value (easier to also get external financing if needed)
hedge - management compensation
Managers should only be paid for real performance - compensation or punishment for risk outside control is inefficient.
Hedging uncontrollable risks leaves managers with a larger proportion of manageable risks for performance evaluation - also desirable for corporate governance, since the reduction of pay-for-luck problem
(but, difficult to design compensation package eliminating a manager’s exposure to hedgeable risks)
hedge - strategic and investment decisions
active risk management program can improve management’s decision-making process by reducing the profit volatility of individual BU.
less volatile profits for BU provide central management with better info about where to allocate capital and who deserves a promotion.
Also, they increase debt capacity (tax shield).
Sophisticated risk management will have a better understanding of future market prices, so managers can allocate capital efficiently - investment decisions rely on future opportunities.
hedge - climate change as new (financial risk)
High-carbon scenario: significant physical risk, little transition risk
low-carbon scenario: moderate physical risk, substantial transition risk
how to measure a firm’s risk or risk exposure
factor models: a stock’s sensitivity to factor risk, as well as firm-specific risk, is determined by CAPEX and operating and financial decisions
- factor risk is not diversifiable, but it can be hedged by taking off-setting positions in financial derivatives (firm-specific risk is just the opposite)
estimating factor models using regression analysis requires historical data for risk factors to obtain estimates of the risk factor exposures.
- dependent variable in regressions are unhedged CF
- risk factor exposure estimates will only have predictive power if the same risk factors affect the firm similarly in the future
- OLS-based regression approach doesn’t capture non-linear effects of the risk factors on the firm
measuring a firm’s risk exposure: simulation
forward-looking method to estimate risk exposure
- useful in rapidly changing industries as regressions estimate the risk factors based on historical data
- based on strong assumptions regarding relevant risk factors
- simulations often in combination with scenario analysis
measuring a firm’s risk exposure: factor: based volatility of a firm’s CF
useful to express risk in a single number:
- model risk exposure by using different risk factors and aggregating risk exposures into a single metric
1. regress CF on identified firm-specific factors
2. estimate covariances between each pair of risk factors and calculate the overall variance of CF
3. factor-based volatility is the square root of variance
measuring a firm’s risk exposure: value at risk
VaR: the worst possible loss under normal market conditions for a given time horizon. three ways to calculate:
1. parametric VaR: assumption of normally distributed returns of all assets and the portfolio consisting of these assets. Exclusively determined by the expected returns or CF and the variance-covariance matrix of assets
2. historical VaR: based on historical data of assets and divisions. Adv: distributional assumption. Disadv: results depend on the time period and a long time horizon is needed
3. Monte Carlo VaR: relies on stimulations of the stochastic behavior of returns, CF and requires assumptions regarding return generating stochastic process and well-specified factor models for returns
VaR - the problem of parametric VaR
distribution of the returns/ CF is skewed: we generally assume returns are normally distributed and thereby neglect higher moments - other distributions may better fit a particular underlying (e.g. Weibull distribution)
VaR: no information on extreme losses
the distribution of the returns /CF may compromise extreme values within the tails. The loss within the VaR might be much larger than expected under the assumption of a normal distribution. The expected shortfall can incorporate this problem.
channels to reduce risk - natural hedge
When manufacturing in CH, selling in the UK - exposure to changes in the exchange rate
- to reduce currency risk: firm can split up production and therefore the production costs between both currency areas
channels to reduce risk - futures
a future contract is an agreement to buy/ sell security, currency, or commodity at a prespecified price at some future date.
A future is a mandatory contract so that both parties have to fulfill their positions. The long position requires the holder to buy the underlying for the future price. Holding the short position obliges delivering the underlying at the future price.
The spot market is for immediate delivery and payment.
The future price is set so that the contract is a zero PV investment for both parties. The payoff structure of a future is linear and therefore symmetric.
channels to reduce risk - money market hedge
Borrowing one currency on a short-term basis and converting it to another currency immediately. In the absence of transaction costs and arbitrage, a money market hedge is exactly like a futures contract.
