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notes on Risk management: profiling and hedging
By A. Damodaran
4 steps of risk profiling the international business.
Step 1: listing the risks
Step 2: categorizing the risks
Market verses firm-specific risks.
Operating verses financial risks.
Continuous risks verses event risks
Catastrophic risks verses smaller risks
Step 3: Measure exposure to each risk
Earnings verses firm value risk exposure (translation exposure for self-contained
subsidiary: FASB 52, unrealized foreign exchange gain or loss. For direct subsidiary,
net income is adjusted for unrealized foreign exchange gain or losses)
Economic exposure can be broken down into transaction exposure and operating
exposure (what we call economic exposure in the text book.
Measuring risk exposure:
1. Qualitative approaches
2. Quantitative approaches
a. Firm specific risk measures (ex, Disney’s firm value decreases as dollar
strengthens.)
b. Sector wide or bottom up risk measures. (it is wise to look at the sector risks
instead of the past risks a firm has encountered. Especially when the firm is
changing from year to year.)
Step 4: risk analysis
A hotel might want to hedge against risks of real estate value but not hedge against hotel
management risk.
To hedge or not to hedge:
Cost and benefit analysis
The cost of hedging:
Explicit costs: insurance premium, call option premium, put option premium.
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Implicit costs: financing choices: using peso debt to finance their peso operations.
Futures contracts: the potential costs when the market prices move up.) it eliminates
the downside risk, but not the upside risk.
The benefits of hedging
A) Tax benefits (if there is progressive taxation): smoother income gets taxed less)
B) Better investment decisions. Managerial risk aversion and capital market frictions.
Managers may reject these diversifiable risks because their human capital are tied up
to the firm. access to loans is affected by firm-specific risks, firms that hedge have
more stable cash flows and can stick with long term investment plans and increase
firm value.
C) Distress cost, indirect costs of financial distress can be large: from 20 to 40% of firm
value. Smaller firms and firms with large debt repayment obligations might find
themselves wise to hedge against large risks that could put them into financial
distress. Large firms with little debt obligations like Coca cola can easily absorb the
costs of foreign exchange movements and has no need to hedge against foreign
exchange risks. The value of the firm will increase if the costs of hedging are lower
than the increased value of the firm due to lower risk and more stable cash flow.
Firms with low debt can lower their firm value by hedging because of the substantial
costs of hedging and relative little benefits due to the small exposure to exchange
rate movement. (Kyle and Noe, 1990)
D) Capital structure. Firms that hedge will borrow more and thus have a lower cost of
capital. (Zou and Adams, 2004)
E) Informational benefits. Demarzo and Darffie (1995) explore this in detail by looking at
How much the hedging behavior is disclosed to investors. Investors believe that more
stable earnings are associated with superior managers.
The prevalence of hedging
Who hedges? Mian (1999) larger firms are more likely to hedge than smaller firms
indicating the economies of scale for larger firms in terms of lower hedging costs. Tufano
(1996) gold mining industry, gold price risk hedging between 1990 and 1993. Managers
o f the gold mining firms that hold stock options are less likely to hedge against gold
price risk than managers that hold stocks of the firm.
What gets hedged?
Exchange rate risk and commodity price risk.
Exchange rate risk
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It is ubiquitous. Not just large multinational firms are exposed to exchange rate
risk. Domestic firms that depend on imports also expose themselves to exchange
rate risk.
It affects earnings.
It is easy to hedge. The fact that investors can not differentiate the earnings drop
due to poor management skills and pure adverse exchange rate movements may
reduce the stock price and this makes the manager want to hedge.
Commodity price risk
Output price hedging
Input price hedging
Does hedging increase value?
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Research results show that hedging provides somewhat mixed results to firm value. It is
positive but small and not significant. Firms that do hedge are not driven by value
enhancement concerns but by managerial risk aversion and management compensation
plans. Smithson (in a book), Mian (1999) and Tufano (1996) mentioned before all testify to
these results.
Alternative techniques for hedging risks: what risks you are involved in depends
on: what assets to invest in and the financing you use to fund it.
Investment choices: spreading the risks by investing in different locations and countries.
Operating hedging,
Financing choices: differential access to local borrowing and mismatch might be inevitable.
Insurance
Smith and Mayers (journal of business, v55)
Derivatives
Options and futures become cheaper now and is accessible to many.
Most widely used derivative contracts (products) are Futures, forwards, options and swaps.
The forward contract:
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Futures contracts
More liquid, traded at the futures exchange
Settle difference on daily bases.
Margin requirement.
Options
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If the value exceeds strike price, the buyer will make a profit. If it doesn’t, then he will lose
the options premium. The options protect you against the downside risk but leave open
(allow you to partake) the upside potential. Futures and forwards protect you against
downside risks and eliminate upside potential.
Transactions and settlement costs for futures hedging: implicit costs,
Options premium for options hedging: explicit costs
Swaps
Currency swap: plain vanilla swap
Picking the right hedging tools
The conclusion remains open.
Does hedge add value to the firm?