Fuel Hedging (PowerPoint download) by dffhrtcv3


									General lessons for the
     Final week of class
           FIN 441
             Hedging debacles
• MG Refining & Marketing
  –   Fixed price fuel program for customers
  –   Up to 10-year contracts
  –   “Stack-and-roll” hedging system
  –   Big downward price moves create big futures losses
      without corresponding gains on the fixed price
• Procter & Gamble
  – Lost money on bets that interest rates would not
    increase significantly
  – Treasury is NEVER a profit center
                Why hedge?
• Tax arguments
  – Tax convexity
  – “Hedging increases debt” argument
• Reduce financial distress costs
  – Reduce probability of distress
  – Reduce probability of underinvestment
• Reduce cost of capital
• Managerial arguments
  – Structure of compensation
  – Structure of portfolio
              Tax arguments
• Convexity argument is not empirically valid
  (Graham and Rogers, 2002)
• More hedging is associated with higher debt
  ratios  present value of greater interest tax
  deductions worth average of 1% of firm value
  (Graham and Rogers, 2002)
  – Net: hedging provides positive (but small) value
    contributions by allowing for more debt in capital
  – Results might imply that hedgers have lower WACC
    because of more debt in capital structure.
   Reduction of distress costs
• What is “financial distress?”
• Expected financial distress costs =
  probability of distress * costs incurred if
  distress occurs
• If hedging reduces distress probability,
  then it also lowers expected distress costs.
• “Typical” definitions of distress costs
  suggest that reducing these is unlikely to
  add much value!
• Underinvestment = failure to invest in all
  positive NPV projects.
• When capital is hard to raise, firms may be
  unable to finance valuable investment.
• Hedging can provide additional cash flow
  during “bad” outcomes, thus helping firms
  finance investment.
 Hedging and firm value: Evidence
• Allayannis and Weston (2001) find approximately 5%
  value premium on firms that hedged FX currency risk.
• Carter, Simkins, and Rogers (2006) find evidence of a
  5% – 10% hedging premium for airlines hedging jet fuel
  price risk.
   – Hedging by airlines is best explained by underinvestment story.
   – Premium is related to hedging’s interaction with capital
   – Hedging premium is more apparent during periods of high jet
     fuel prices and oil price volatility.
• Investors do not appear to value hedging by oil & gas
  firms (Jin and Jorion, 2006).
Demonstration of the underinvestment
       rationale for hedging
• Two identical firms in gold mining (natural long
• Suppose gold price = $500 per oz.
• Firm 1 is a “momentum” investor (expands
  production when prices are high) (i.e., $800+)
• Firm 2 is a “contrarian” investor (expands
  production and/or buys competitors when prices
  are low) (i.e., $300-)
• Which firm will improve value more from a short
  hedging strategy (i.e., sell futures, buy put
   Enterprise risk management
• Hedging is synonymous with “financial risk
• Financial risk management is only one element of a
  firm’s risk management strategy.
• Enterprise risk management is relatively new buzzword
  in managing risk.
   – Incorporates management of operational, strategic, legal,
     reputational, financial reporting, and disclosure risks, in addition
     to financial risks.
   – Companies are still sorting out how to (or whether to) create
     ERM systems within their businesses.
   – ERM creates environment in which “everyone is a risk manager.”
    Some important ideas relating
“hedging” to broader risk management
• “Hedging” is a short-run business strategy
  (that may continue in the long-run).
• “Hedging” may alter a firm’s strategic risk
• “Hedging” creates many additional risks
  (see pages 551 – 554).
• All firms should have clear understanding
  of their own benefits of risk management.
     A final lesson – The current
             financial crisis
• Traditional role of financial institutions:
  lending (assumption of credit risk)
• A more recent business model: lend, then
  “reduce” credit risk by entering into credit
  default swaps
• Counterparties to credit default swaps:
  Other large financial institutions
• Outcome: Systemic risk caused by circular
  nature of credit risk

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