ACF - Hedging (risk management)

What are examples of derivatives?

Futures, forwards, options, swaps, caps & floors

What are the uses of derivatives?

• Place bets (speculation)

• So that the value of derivative position increases when value of your other assets decrease (hedging)

What types of hedging do firms engage in?

• Interest rate risk

• Commodity prices (oil, gold, agricultural products…)

• Foreign exchange

What is interest rate risk? (what type of firms does it impact?)

The fact that many firms’ cash flows decrease when interest rates go up

• firms who sell products where the demand is interest rate sensitive

How does the change in commodity prices impact firms?

• Firms that use commodities as inputs lose money when the commodity price increases

• Firms that sell commodities as outputs lose money when commodity price decreases

What is the impact of foreign exchange on firms? (why do firms hedge against it)

• Firms that sell significant amounts overseas experience a dollar cash flow decrease when the dollar appreciates

• Firms that employ or produce overseas experience a dollar cash flow decrease when the dollar appreciates

According to M&M, why is risk management irrelevant?

Because firm value is independent of financial transactions, there are zero NPV transactions (risk management involves only purely financial transactions)

To determine if it actually has an impact, think about the departures from M&M

What are the departures from M&M?

Taxes

Costs of financial distress

Agency costs

Transaction costs

Inefficient capital markets

What is a fallacy that can arise from hedging?

If a firm hedges, its stock becomes less risky →

hedging is good

However, this is a fallacy since this risk can be diversified away in a portfolio

Investors could hedge on their own If they dislike a certain risk exposure

Why should firms hedge?

1. Hedging can decrease a firm’s expected tax payments (hedging increases profits and can give tax advantages. If profits are constant, the firm does not lose those tax advantages)

2. Hedging can reduce the cost of financial distress

3. Hedging allows firms to better plan their future capital needs and reduce their need to gain access to outside capital markets (considering the pecking order hedging would allow more cash and thus less need to issue equity)

4. Hedging can improve the quality of the investment and the operating decisions

5. Hedging can improve your competitive position

1. Hedging and tax payments (what does it involve?)

There is an asymmetry of taxes:

• Immediately pay taxes on gains

• But don’t get immediate deductions on losses

• Because of asymmetric treatment of gains and losses, firms may reduce their expected tax liabilities by hedging

2. Hedging and cost of financial distress (what does it involve?)

Volatile cash flows increase expected costs of financial distress by increasing the probability of distress

• Hedging reduces the volatility of cash flows

  • Reduced chance of distress for a given debt level

  • Allows higher leverage to exploit tax shields

3. Hedging and debt capacity? (what does it involve?)

A firm’s optimal borrowing level should tradeoff:

• tax benefits

• financial distress costs

• If a firm hedges, the likelihood of financial distress at any given borrowing level decreases, and hence, the firm can take on more debt and reap greater tax benefits

4. Hedging and better investments (what does it involve?)

Internal funds may be cheaper than external ones as:

• information asymmetries exist between the firm and investors

• Shareholder / debtholder conflicts

Hedging thus appears helpful as it allows the firm to have more cash and take on more projects

So, it ensures that the firm has internal funds available to make valuable investments (and not cut them when cash flow falls)

5. Hedging and competitive position (what does it involve?)

If competitors are hedged, they will be in a good position to invest despite adverse movements in prices

Hedging may be particularly valuable if competitors are (or aren’t) hedged

Which firms use derivative the most?

Large firms,

Firms with valuable growth opportunities

Highly levered firms

Primary products, Manufacturing, Services.

Why are large firms more likely to hedge than small firms?

They have more fixed costs; A small change in currency could impact them while they are less able to rescale

Why do small firms hedge more when they hedge?

Because they might have a big need and will need to fill need

Why are firms with valuable growth opportunities more likely to hedge?

Since they are likely to invest, they borrow constantly, and constantly reimburse

Why do highly levered firms tend to hedge more?

To smooth cash flows to avoid financial distress

What are the most important hedging objectives?

To manage:

• Accounting earnings (make EPS higher and smooth them out) - 42%

• Balance sheets accounts - 1%

• Market value of the firm - 8%

• Cash flows - 49%

Hedging or speculation - do companies change their time or size of their hedges as a result of their market view?

Market view: oil prices are too low, think currency is undervalued…

Most firms do not do so (they do not act like running hedge funds)

How are risk management activities organized?

Risk management is often most effectively organized at the corporate (rather than divisional) level

If two divisions want to take offsetting position, a centralized risk management office can net this out (and also calculate total corporate exposure)

If a firm’s motivation for hedging has to so taxes or costs of financial distress, then most hedging should be carried out at the corporate level

• However, if the motivation is improving managerial incentives then individual divisions should be responsible for hedging