Corporate Risk Management Midterm

Lecture 1-5

Modern Definition of Risk Management

use of market insurance to protect people/ firms from various loss associated with accidents.

Major milestones

• Use of derivatives as instruments to manage insurable and uninsurable risk began and developed quickly

• Financial institutions developed internal risk management models/capital calculations for regulation

• The practice of integrated RM was introduced

Corporate RM is defined as

a set of financial and operational activities that maximize the value of a company or a portfolio by reducing the cost associated with risk

main risk management activities for corporations

• diversification and risk hedging using various instruments, including derivatives and structured products, market insurance, self-insurance, and self-protection.

main costs firms seek to minimize in RM

costs of financial distress, risk premium to partners / stakeholders, expected income taxes, and investment financing.

pure risk

often insurable and not necessarily exogenous in the presence of moral hazard and know in the presence of adverse selection

Market Risk

variation in prices of commodities, exhnage rates, and asset returns

Default Risk

probability of default, recovery rate, and exposure at default

Liquid Risk

risk of not possessing sufficenit funds to meet short-term financial obligations without affecting prices

Firm Characteristics

• Ownership Structure

• Underinvestment problem

• Risk shifting within the Firm

• Taxes

• Hedging Motives and Methods

How Ownership Structure affects the benefits of Hedging

• Portfolio theory manages non-systematic risk, so investors should care as it affects firm’s value

  • if it reduces only firm-specific risk, they don’t care as it’s not affected

  • If it reduces systematic risk, the investors should care as it affects firm value

• Even non-diversified portfolios benefit from hedging

Underinvestment Problem

• arises from the conflict of interest between stockholders and bondholders in firms with large debt obligations

what does hedging do to increase debt capability for the firm

it decreases the underinvestment cost

NPV

Probability * Payoff - Amount Invested

Payoff

Probability* (Price - Cost)

Profit (Loss)

Probability* Payoff+ Probability * Cost - Cost

Interest Rate (X)

Amount Invested = Probability * Payoff + Prob. (Cost (1+X)

Precommitment Problem/ Incentive Incompatibility Problem

due to the fact that shareholders are only allocated with a limited portion of the entire risk of the firm because of the limited liability. As a result, while other parties or stakeholders strongly prefer hedging, the shareholders have incentives NOT to hedge

Effective compensation plans achieve an appropriate balance between two potentially conflicting goals

• strengthening employee’s performance incentives

• insulating them from risks beyond their control

because tax is a convex function of the firm’s profits

hedging can potentially reduce the firm’s total tax burdens over the years

Heding Benefits for tax reasons are higher for

• startups and forms with highly volatile profit

• firms on the border of progressive tax brackets

risk shifting within the firm

• Other stakeholders outside of SH and BH are affected by the firm’s risk and cannot diversify their risk

• Because of limited liability, shareholders are only allocated with a limited portion of the entire risk of the firm

What motivates non-financial firms to hedge risks

avoiding costly lower-tail outcomes (Conditional VaR)

• CVaR measures the significant financial cost that could possibly occur under the certain market condition that prevent firms from going forth with their investment projects

Simple minimization of the volatility of risks

• is not necessarily the most appropriate goal of RM, instead, he argues that we should focus on the probability of lower-tail events (downside risks or Conditional VaR)

To maximize firm value, hedging should focus on

the risks that are more difficult to diversify that incur real cost

Four Major Types of Real Costs

• Expected default cost

• supplementary payments or risk premiums to stakeholders

• expected tax payments

• investment financing

Definition of Default Cost and how it can affect the firm value

D: Cost associated with default not bankruptcy

A: reduce overall firm value

goal of an efficient risk management strategy

default costs (both direct and indirect) at an optimal level, while taking into consideration the cost of hedging instruments

• Direct: Lawyer, consultant, and court expenses

• Indirect: Costs incurred while under bankruptcy protection law

Expected Default Cost =

Probability of Default * Default Costs

Benefit from Hedging =

Profit from Hedge/ Firm Value

Less diversified firms have higher default probability and therefore

higher expected default costs, compared with more diversified firms.

Implications of this observation for stakeholders such as employees and suppliers.

• Stakeholder may request risk premium if firm is less diversified

• Supplier are less lenient on credit terms when a firm is less diversified

Expected Value of Firm =

Prob.* FV min+ Prob* FV max

Expected Tax Payment =

• Jensen’s Inequality Rule

• Based on Convex Curve* FVhigh-FVlow * Probability

interactions between hedging and capital structure of the firm

An efficient risk management strategy can reduce default probability and thus reduce lending cots because the default risk premium imposed by banks or investors can reduce

• CS can impact a firms approach to RM, attributing firms equity to managers is beneficial unless it comes to RM, yet this incentive is often more costly than stock options

why futures / forwards are considered as linear hedging tools

because their payoff is a straightforward, direct relationship to the price of the underlying asset, resulting in a linear payoff structure

Profit to long =

Long futures profit = P_T – F₀

Profit to short =

short futures profit = F₀ – P_T

Future Market Strategy

• Speculation: Seek Profit from price movement

• Hedging: Seek Protection from Price Movement

Examples of Speculation

Short- Price Fall

Long- Price Rise

Examples of Hedging

• Short- Manager worries interest rates wil raise, so they sell

• Long- Manager Buys futures to protect against rise in price

Futures Price =

Strike Price * ( 1 + risk free rate) ^ time

Expected Utility=

Weight of Prob* Prob* SqRt of Wealth

1. Idenitfy Possible Outcomes

2. Determine probabilty of each outcome

3. Determin Utility of Each outcome

4. Apply Formula

Linear Programming

where the objective function is linear and the constraints consist of linear and nonlinear inequalities (decision variables, objective function, constraints)

Nonlinear Programming

Optimization where at least one of the objective functions and constraints is nonlinear

Call Option: 

right to buy asset at specific exercise pruse on or before expriration

Strike Price vs market price of underlying asset

Premium of an option

• the purchase price of an option, or the present value of the option.

1. In

2. Out

3. At 

1. positive CF

2. negative CF

3. CF = asset

Amercian vs European Option

American and exercise whenever before expiration

European must wait until expration date to exercise

The value of the call option (or the payoff to call holder)

S_T – X if S_T > X

= 0 if S_T ≤ X

The writer (the seller) of the call option is in the opposite position:

-(S_T – X) if S_T > X

= 0 if S_T ≤ X

The value of the put option (or the payoff to put holder)

0 if S_T ≥ X

= X – S_T if S_T < X

The writer (the seller) of the call option is in the opposite position

0 if S_T ≥ X

= –( X – S_T) if S_T < X

Protective put

The profit on the protective put is negative and equal to the cost of the put if ST is below So. The profit on the protective put increases one for one with increases in the stock price once the stock price exceeds X.