Lecture on Hedging

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Lecture on Hedging Powered By Docstoc
					On Hedging


        Richard MacMinn
   What are the goals of risk
   Premises for risk management
   Is risk management irrelevant?
   Why should the firm hedge?
   When should the firm hedge?
   Guidelines for hedging
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Premises for risk management
   The risk management paradigm rests on the
    following three premises:
           Corporate value is created by good investments
           Generating internal cash is necessary to fund good
                Companies that don’t generate sufficient cash tend to cut
                 investment more drastically
           Cash flow crucial to investment can be disrupted by external
            factors such as exchange rates, commodity prices and
            interest rates
   The risk management program must ensure that the
    firm can make the investments that create value

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                 Historical sketch
                                         The story of Joseph.         Discuss the natural hedge versus the
                                                                      futures contract.
                                         What is the difference
                     Pharaoh            between dream
                                         interpretation and risk
                                                                      Note that the risk averse farmer wants to
                                                                      sell more forward to reduce income risk and
                                         management? See              so normally we see the relation: f < EP, i.e., a
                            Inventory   Bernstein.                   forward price less than the expected spot
                                                                      price; this is called normal backwardation.

Dresser is used as    Middle Ages
an example of the                                               Berle and Means represent a precursor to
breakdown in the
logic that the
                            Futures                            modern finance. The Berle and Means
                                                                argument is that the corporate form was
corporation need                                                developed to enable firms to disperse risk
not diversify since
investors can        Berle & Means                             among many small investors. This
                                                                notion has also been discussed by
diversify on                                                    Samuelson in 1967 and MacMinn 1984.
personal account
by buying stock in
                            Diversification                    If this is so then the firm need not
petrochemical                                                   diversify risk on corporate account.
firms as well as
oil firms.
                            Dresser Industries                 Use MacMinn and Martin to discuss the
                                                                corollary to the MM58 theorem. The
                                                                nexus of contracts is irrelevant.

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Historical sketch
                                                          The corollary was
   Modern finance                                        introduced in
                                                          MacMinn and Martin.
           Modigliani and Miller 1958
           Corollary to the 1958 Modigliani-Miller theorem
   Post-modern paradigm
           Myers and Majluf
           MacMinn and Page
           Froot, Scharfstein and Stein
                “Internally generated cash is therefore a competitive weapon that
                 effectively reduces a company’s cost of capital and facilitates
                 investment.” p. 94
                “. . . the role of risk management is to ensure that companies have the
                 cash available to make value-enhancing investment” p. 94
           Brander and Lewis                  The role of risk management is to
                                               ensure that the firm has the cash
                                               available for investment when it is
                                               needed. If the firm does and its
                                               competitors do not then it has
                                               achieved a competitive advantage.
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   Dresser Industries
           “During the late 1930s it
            spent five times the
            industry average on
            research and development,
            adding 128 new types of
           “Dresser officially became
            known as Dresser
            Industries, Inc. in 1944 and
            opened new headquarters
            offices in Cleveland the
            next year. An
            unprecedented boom in the
            energy, petrochemical and
            housing construction
            industries fueled its post-
            war growth.”

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Why hedge?
   The capital investment decision
                                                                    r is the rate of interest

                           e P q  m q 
                                                                    e is the random
                                                        P qmq 
      npv   e k q                        e  k q         
                                                                    exchange rate, i.e.,

                             1  r 
                    t 1                                   r   
                                                                    dollars per yen
                                                                    P is the random spot
                                                                    k is the capital cost per
                                                                    unit of capacity
                                                                    m is the unit variable
                                                                    q is the output of firm in

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When to hedge
   Risk and the optimal investment
           Exchange rate
                                                 Consider the condition
           Commodity price                      for an optimal
                                                 investment decision.
           Interest rate                        Consider the claim in
                                                 view of the first order
           Property loss                        condition.

   Claim
           An oil company has less incentive to manage risk because
            investment opportunities are only good when oil prices are
   Claim
           An increase in commodity price risk reduces the optimal

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When to hedge
   Froot, Scharfstein, and Stein
           “The goal of risk management is not to insure investors and
            corporate managers against oil price risk per se. It is to
            ensure that companies have the cash they need to create
            value by making good investments.” p. 98
   Key issues
           This approach helps identify what is worth hedging and what
            is not.
           This approach helps identify how much hedging is
                Is the firm naturally hedged?
                How sensitive is the value of the investment to changes in
                 interest and exchange rates? Commodity prices?

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   Companies in the same industry should not necessarily select the same
           An all equity firm would select its production level to maximize stock value
            and differences in marginal costs may imply differences in optimal hedging,
                                              S n
             S(q)   p() P( )q  c(q)        p( ) P( )  c (q)   0
                    1                         q   1

           Consider the different investment opportunities noted by Froot, Scharfstein
            and Stein
   Companies may benefit from risk management even if they have no
    major investments in plant and equipment
           Consider a firm with investment opportunities in human capital, brand
            names, or market share
                 Investment in human capital cannot be collateralized
                 Investment in market share may require lowering price and that also is difficult to
   Even companies with conservative capital structure can benefit from
           Why might the firm have chosen a conservative capital structure?

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                      Multinational companies must recognize that foreign exchange
                       risk affects not only cash flows but also operating decisions.
                            Example one
                                 Commodity price and cost in euros
A depreciation in
the dollar implies a
smaller exchange
                                     e P q  c(q)  
                                                                  e P q  c(q)    e P  c(q) 
rate, i.e., fewer
dollars per euro.                The sign of the derivative does not depend on the size of the
                                  exchange rate.
                            Example two
                                 Commodity price in dollars and cost in euros
                                     P q  e c(q)      q
                                                               P q  e c(q)    P  e c(q) 
                                 The sign of the derivative does depend on the magnitude of the
                                  exchange rate

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   Companies should pay close attention to hedging
    strategies of their competitors
           This will allow the corporation to assess the capabilities of its
            competitors, e.g., can the competitor invest when the
            exchange rates move against it?
   The choice of specific derivatives cannot be
           Management must select the tools consistent with the
            strategic advantage
           Financial futures may yield more variability in cash flows
            along with the liquidity while the forward does not increase
            the variability of cash flows but does incur credit risk

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To hedge or not
   Risk management cannot be ignored
    since that has costs
   Risk management cannot be delegated
   Pay attention to the source, risk, etc. of
    the cash flows

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