INPUT Enter parameters into blue cells
Determine Risk Aversion - Sigma
Probability firm will experience fiscal distress in a decade = which translates into the probability of distress in any 1 year of which translates into a risk aversion Sigma of 1.00 0.10 3.09 % %
EXPLANATION
The risk aversion Sigma represents the level of risk the firm is willing to undertake. The maximum allowable probability of the firm not able to meet financial obligations in 10 years. Translating that quantification to the maximum probablity of financial distress in 1 year. Translating into a risk aversion parameter. It is a nonlinear function with >3 tending "conservative".
Model Parameters
Total firm earnings ($) 58.60 Earnings exposed ($) 11.50 15.0 17.4 0.40 11.0
The main input box to enter parameters for the optimal hedging calculation. Higher proportion of earnings exposed, less internally diversified, and a more likely hedging gain. More volatile the hedgable risk price, the more useful hedging is. In contrast, the more volatile the non-hedgable earnings, hedging is less useful as more earnings volatility comes from other factors. The lower the expected cost of hedging, the more the firm should hedge. The higher the cost of capital, the more the firm saves by freeing up capital reserves.
Volatility of hedgable risk price (SD as % of mean) Volatility of non-hedgable earnings (SD as % of mean) Marginal Cost of hedging (cents per $1 hedged) Risk free rate (%) 5.0 CoC hurdle rate (%)
Result:
Optimal hedge = or 26.7% $3.07 of earnings exposed,
The result gives the optimal proportion of exposure to hedge given all of the parameters. The proportion represents the equilibrium condition where the marginal cost equals marginal benefit. The optimal dollar amount to hedge equals the optimal proportion times the earnings exposed.
EVA or Net Savings
SD Earnings prehedge Capital released Gross savings EVA or Savings $8.37 $0.24 $0.01 $0.002 Cost of hedging --> % of exposure $0.01 0.02% SD Earnings at hedge $8.29
Net savings represent a prehedge capital reserve released (or redeployed). The standard deviation (volatility) of firm earnings before and at the optimal hedge. The freed-up capital is determined by the reduced volatility and size of reserves held per volatility unit. Gross savings represent the difference between investing the capital in the firm and keeping reserve. After deducting the hedging cost, the net savings can be set against the exposure for benchmarking.