Topic 7: Risk Mgmt in a Corporate Context Flashcards
Differences between Financial & Non Financial Companies:
1. Regulatory
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement
Regulatory:
- Financial institution: protects payments system & systemic risk
- Non Financial Co: Focus on corporate governance and disclosure
Differences between Financial & Non Financial Companies:
2. Nature of Assets
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement
Nature of Assets:
- Financial: tradeable, financial assets, market makers, highly diversified portfolio. Cashflows largely contractual. Diversification improves quality of portfolio
- Non financial co: Balance sheet comprises illiquid assets. Risk concentration. Underlying cashflows non contractual. Portfolio diversification creates negligible value.
Differences between Financial & Non Financial Companies:
3. Role of Risk
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement
Role of Risk:
- Financial: role to absorb and/or intermediate risk. Risk mgmt. is key focus and skill of mgmt. Aggregation and integration of company wide risks.
- Non financial co: risk arises from natural physical characteristics of underlying business. Lower focus, less skills in the process. Fragmented approach
Differences between Financial & Non Financial Companies:
4. Risk Measurement
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement
Risk Measurement:
- Financial: ability to statistically measure risk
- Non Financial Co: limited ability to measure most of the risks due to limited observations, linkages and causal relationships
Non financial companies risk is difficult:
financial exposures arising from potential shifts in market prices cannot be separated from the underlying business
“real” or operating responses for a non financial co. to manage risks include: )(4)
- Operating leverage (mix of fixed & variable costs)
- changing production location (eg to foreign country = response to FX exposure posed by import competition
- Adjustments to production volumes (respond to anticipated variations in market prices)
- Modifications to the business portfolio (screening of projects, abandonment of projects or diverstment
Risk in corporate context
- market risk is derived from:
- risk:
Risk in corporate context
- market risk is derived from: underlying business
- risk: should be understood in terms of uncertainty related to business objectives.
Bank perspective vs corporate perspective
1. Focus of risk
list: focus of risk; risk horizon; risk measure, confidence level
BANK: value of trading portfolio (mark to market)
CORP: Cashflow, earnings
Bank perspective vs corporate perspective
2. Risk horizon
list: focus of risk; risk horizon; risk measure, confidence level
BANK: days
CORP: quarters and years
Bank perspective vs corporate perspective
3. Risk measure
list: focus of risk; risk horizon; risk measure, confidence level
BANK: Value at Risk
CORP: Cashflow at risk, earnings at risk
Bank perspective vs corporate perspective
4. Confidence level
list: focus of risk; risk horizon; risk measure, confidence level
BANK: 95%, 99%
CORP: 95%, 99%
Monte Carlo Simulation
- role
- method
- purpose once generated
Monte Carlo
role: understand imperfectly predictable random influences on cashflows that affect firm’s value
method: generate realisations (outcomes) of random influences by drawing on their joint distribution. If there is more than one random influence, they are likely to have a connectedness (which could be measured by correlation coefficient).
Purpose: analyse as if they were a historical distribution
If you cannot generate cashflows analytically:
use simulated cashflows to estimate Cashflow at Risk; quantify exposures and obtain optimal hedge ratio
BHP - key findings
- impact of changing the underlying portfolio (physical assets)
- changing the risk profile through “silo” hedging can destabilise or unwind natural hedges
- no evidence of a ‘value’ differentiation in hedgers vs non hedgers (ie does not create economic capital for use, but does boost debt capacity through reducing unnecessary CF vol
- hedging can be costly (eg backwardation in forward mkts such as oil, copper & interest rates. Premium may not be justified. Consider self insurance model where CaR does not exceed certain risk levels.
- companies with financing strategies and strategic investment programs placing heavy demands on capital resources tend to hedge
- separate risk mitigation from strategic view
FX risk: 3 forms of exposure
3 forms of FX risk exposure
- Transaction exposure (sensitivity to exchange rate. Includes contracts to buy/sell goods, repatriate earnings, pay P & I associated with FX borrowings)
- Competitive exposure (sensitivity of position of firm to currency movements - economic exposures, where FX can affect CFs, mkt share & value. eg, change in quantity of goods sold due to change in competitive position
- Contingent exposure: only materialises if a certain event takes place, eg winning a tender. Trigger point.
- Translation (accounting) exposure - accounting derived change in owner’s equity.
Hedging the 3 forms of FX exposure
- Transaction exposure
- Competitive exposure
- Contingent exposure
- Transaction exposure
- derivatives are suitable, timeframe over next year or so. Smooth out fluctuations in ST mkt movements - Competitive exposure
- Derivatives LESS feasible for LT solutions due to lack of liquidity, counterparty risks, uncertainty of timing & size. Operational strategies are popular to use. (raise productivity, change plant location etc) - Contingent exposure
- use options and compound options (ie options within options)
- tender on the basis that final pricing depends on currency
List operational measures to hedge
1. raise productivity 2, change plant location 3. change product strategy 4. change promotional strategy 5. renegotiate costs 6. diversify into new business areas 7. change pricing strategy
Buy Collar means to…
Sell collar means to…
Buy collar = Buy put, sell call
Sell collar = Sell put buy call
When pricing probability of default, when do you use rf and when do you use alpha
Use rf when pricing debt spread, debt value.
- this is because you are pricing on no arb conditions that apply under any probabilities. This is risk neutral version.
Use alpha when you want to get the ACTUAL, true, physical probability of default.
Difference B-S vs Merton
B-S prices at the beginning, so need to discount back.
Merton prices at the end when debt is due and payable. A0 has grown to AT and Ke(rt) has become K
Risk neutral default probability
- indicated with:
- what rate is used?
Indicated with * (eg p*)
In a risk neutral world, only one rate is used; rf.
When is it appropriate for a firm not to hedge its financial risks
- if correlation between prices and currency is perfect - don’t hedge. There is a natural hedge.
What are some problems that arise with hedging financial risks
- ## for a corporate, market risk is derived from the underlying business.
Monte Carlo simulation
- purpose
- draws on..
- purpose: helps us to understand the imperfectly predictable random influences on cash flows that affect a project’s value.
- generate realisations that draw on joint distribution
- if there’s more than one random influence, they are likely to have a ‘connectedness’, which may be measured by correlation coefficient
- once measured, can be analysed as if it were a historical sample
- eg randomly generate exchange rate, compute associated cashflows, analyse variability to see how exchange rate affects cashflows
- if you cannot compute cashflows analytically; simulate. Use the simulation to generate cashflows to estimate cashflow at risk. Quantify exposures and calculate optimal hedge ratio.
In chapter question:
How can hedging exposures make a company worse off?
if incoming cashflow is less than expected and the hedge is in a loss situation, then the firm is overhedged with excessive losses. Firm is worse off than if it hadn’t hedged.
eg: airline hedges costs buying oil futures. Demand drops, yet number of futures contracts was based on higher estimate
Explain the volatility minimising hedge:
h = (cov(C,G)) / (Var (G))
This is a regression coefficient.
If C is regressed against G (C is the independent, LHS variable), then resulting coefficient on G is calculated using this formula
How does quantity risk alter the volatility minimising hedge and its effectiveness?
- you need more hedging contracts as the relationship between C and G gets stronger and in the same direction. If perfectly correlated, they will behave as if they are one asset. If less than perfect sell less of G.
- The most effective hedge is when correlation is -1, and the variability of G offsets C. This is the perfect hedge
Notes, the importance of the competitive environment (3)
Difference between corporate risk and bank risk
- in the long term corporate exposures are not contractual, they’re competitive and strategic
- A change in FX rate can change production, marketing, sourcing of raw material, market availability and product mix.
- Depends on competitors behaviour and the sensitivity of customers to price changes (MEASURED BY THE ELASTICITY OF DEMAND)
Value at Risk vs Cashflow at Risk
VaR: Potential loss on a risk position which might be exceeded with prespecified probability. mgr tells you a prob & time horizon
CaR: allows a best case scenario to be found for a future risky cashflow.
Hedging business
S = futures exchange rate
c = cashflow
Describe impact of correlation
- If perfectly negatively correlated, this is a NATURAL offset
- If perfectly positively correlated, this is easier to estimate the hedge
- If correlation is zero, possible values are large, and you may have to calculate COVARIANCE (calculate for each of c and S, the value minus the specific average, then cross multiply and add up.)
Variance of the hedge
= squared deviations from the mean
similar to covariance, but multiply the variable by itself
How does competition in the product market affect the way that currency risk is managed?
- More competition manifests as higher elasticity of demand
- Firm is less able to pass on cost increases to its customers
- More price hedging is needed
List 6reasons for caution in using regression analysis
List positives (3)
Caution:
- Based on past information & relationships may not hold for the firm in the future.
- Firm may be exposed to more risks than appear in the regression.
- Regressions assume a linear relationship, relationship may actually be non linear
- Size of sample(?)
- Size of estimation error(?)
- Are the RHS variables correlated?
Positives
- Provides a way to check understanding of exposures
- Firm can use estimated exposures as hedge ratios for the PV of cashflows
- Uses historic data which is readily available
Monte Carlo simulation is used when:
… MCS is used when the future looks different to the past (historic samples won’t do)
MCS is helpful analysing cashflows that are non linear functions of some important driving variables.
- using results of MCS, can calculate optimal hedge ratio. (compute explicitly, or regress
Positive skew in a distribution looks like:
Positive skew: right hand tail is stretched out)
Lessons from Ch 8 Stulz
- optimal amount of hedging depends on the shape of the distribution of the exchange rate
- Demand varies with price
- Competitors influenced by exchange rate
- New entrant would change the demand function making it more sensitive (price elastic)
- normal distribution for cpercentage changes in the exchange rate.
BHP article: 3 major risks to corporate?
Changes in:
- exchange rate
- interest rates
- commodity prices
Key messages BHP (3)
- Businesses should be considered for overall consolidation, at the corporate level of portfolio composition, capital allocation and risk management (no silo approach).
- Account for the interplay between different risks in a portfolio
- Identify difference between risk mitigation (hedging) and risk leverage (strategic position taking)
Things to consider when hedging (corporate)
- Is currency risk a function of reporting currency
- Do risk exposures offset to any degree (natural hedge across business?)
- Is there benefit to shareholders of hedging?
- hedging costs? Are markets liquid? Backwardation?
- What is the relationship between market risk strategy, broader financial strategy and overall corporate strategy
- Separate risk mitigation transactions -b normal hedge accounting treatment. Opportunistic / strategic transactions: profit and loss on mark to market basis
Only hedge if you have to (5)
- No clear evidence for value differentiation between hedgers and non hedgers
- Value is attributed to risk management insofar as it is seen as integral to that strategy
- Investors are indifferent to hedging / not hedging. they want transparency.
- Watch hedging costs (liquidity)
- Natural hedge may exist in a lower cost, business related form
