Risk Management in Corporate

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					Derivatives and Corporate Risk


               Richard MacMinn

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           Why manage risks?
           What are the risks?
           Which risks should be managed?
           How can the risks be managed?

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                                                                  A fundamental lesson
                                                                  in the MM article is
                                                                  that levering does no
                                                                  increase value because
                                                                  individual investors

   Why manage risks?                                              can lever on personal
                                                                  account; they can also
                                                                  unlever on personal
                                                                  account. Hence, the
                                                                  individuals will not
       Lessons from Modigliani and Miller                        pay the firm for what
                                                                  they can do as well on
               The 1958 Theorem                                  their own.

               The corollary on the cost of capital
                                                                  It follows that if the
       If risk management adds value then it is because it:      firm is to create value
                                                                  then the firm must do
               reduces the tax bill                              something that the
                                                                  investor cannot
               eliminates distress costs or other agency costs   duplicate on personal
                                                                  account. Discuss.
               improves managerial incentives
                                          Discuss the proof
                                          of the MM58
                                          theorem but go
                                          ahead and prove
                                          this corollary.

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   Tax Benefits
           Tax shelters
           Corporate value

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   Distress Costs
           Debt capacity
               Bond value
                    Lewellen 1971
               Stock value
               Corporate value
               Stakeholder values
           Financial distress
               Enron example
               Distress costs
                    Shapiro, A. C. and S. Titman (1985). "An Integrated Approach to Corporate Risk
                     Management." Midland Corporate Finance Journal 3(2): 41-56.

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   Agency Costs
           Agency problems
               Risk-shifting (asset substitution)
               Under-investment
                    Investment opportunities
                    Financing options
                          Pecking order theorem
                          Myers, S. C. and N. S. Majluf (1984). "Corporate Financing and Investment
                           Decisions When Firms Have Information That Investors Do Not Have."
                           Journal of Financial Economics 13: 187-221.

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   What are the risks?
           Identifying risks
               Risk management cube
               Income statement
                    Revenue line
                          To who does the firm sell?
                          Where does the firm sell, e.g., foreign or domestic?
                    Cost line (Cost of goods sold or COGS)
                          Where does the firm manufacture?
                          What are the raw materials?
                          What is the technology?
               Balance sheet
                    On or off balance sheet?

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   The risks
           Competitive risks
               Strategic considerations
                    To what currencies are the firm rivals exposed?
                    Do the firm’s rivals hedge their currency risks?
                    Are the rivals’ commodity exposures denominated in dollars or
                     in their domestic currency?
               Competitive exposures
                    Currency
                    Interest rate
                    Commodity
                    Equity

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                                                                     Let the P denote the
                                                                     corporate payoff in pounds

   Currency risks                                                    Pd be the random domestic
                                                                     price in pounds
                                                                     E be the random exchange
                                                                     rate, i.e., number of pounds
           What is it?                                              for yen
                                                                     Pf be the random foreign
               P = Pd qd + E Pf qf – C(qd + qf)                     price in yen

           What are the operating solutions?                        C be the cost in pounds

               Production sites in foreign markets
               Foreign currency borrowing                       The financial solution may
                                                                 be lower cost than the

           What are the financial solutions                     operating solutions. It may
                                                                 also be more flexible, i.e.,
                                                                 easier to reverse or
               Derivatives                                      otherwise change with
                                                                 changing market conditions.
                    Forwards and swaps                          The operating solutions
                                A swap is a multi-period
                    Options    forward contract. Ignoring
                                                                 create bundled risks and the
                                                                 derivatives represent an
                                   credit risk, the forward      unbundling that makes the
                                   allows the buyer to lock a    risk and its cost much more
                                   price in now at which the     transparent.
                                   transaction will take place

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   Emerging market risks
           Emerging market risks
               Event risks
                    Political changes
                    Loss of currency convertibility
                    Credit risk is more complex
                          Government imposed exchange controls mimic default risk
                          Counter-party risk and country risk become more important

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   Which risks should be managed?

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   How can the risks be managed?
           Capital structure
           Forwards and Futures
           Swaps
           Insurance
           Insurance linked securities

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                                                            Pf denote the price in the foreign
                                                            spot market
   Forward Contracts                                        qfx denote the sales in the foreign
                                                            spot market
                                                            qff denote the sales in the foreign
           Forward contracts                               forward market

               Unhedged

                         Pu  Pd qd  E Pf qf  C qd  qf 
               Hedged
                         P h  Pd q d  E Pf q fx  f Pf q ff  C  q d  q f 

                              Pd qd  f Pf qf   E  f  Pf q fx  C qd  q f 

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                                                      This is an option on a forward-starting swap. It
                                                      gives the owner the right to enter into a swap at
                                                      agreed upon terms on an agreed date.

   Interest Rate Swap                                 The terms specify the interest rate in the case of
                                                      an interest rate swaption.

           Swap
           Option
           Caps, Floors, Collars
           Forward-starting swap
           Swaption
To create a cap sell a call with the exercise price
set where you want the cap.

To create a floor purchase a put option with the
exercise price set where you want the floor.

 This is simply a forward contract on a swap,
 i.e. the contract is entered now but the swap is
 made then.

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   Emerging market risk management tools
           Synthetic FX forward contract
           Synthetic swap
               Synthetic Peso loan using a cross currency swap

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   Commodity, equity, and credit risks
           Commodity risks
                Tools
                     Inventories can be used to hedge price risk
                     Adopting a flexible production schedule can also hedge price risk
                     Vertical integration can also hedge price risk
           Equity risks
                Tools
                     Options
                     Acquisitions and divestitures
           Credit risks
                Tools
                     Insurance
                     Letters of credit
                     Credit derivatives

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   Commodity risk management
           Asian option
           Examples
               Copper inventories
               Oil delivery
               BTU management

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   Equity risk management
           Link to page 14

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   Credit risk management
           Link to page 20

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   Concluding Remarks
           Why manage risk?
           Which risks?
           How?

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