CH24

Learning Objectives

  • After studying this chapter, you should be able to:
    • 24-1 Understand why companies hedge to reduce risk.
    • 24-2 Use options, futures, and forward contracts to devise simple hedging strategies.
    • 24-3 Understand what determines the futures price.
    • 24-4 Explain how companies can use swaps to manage the risk of securities that they have issued.

Introduction to Risk Management

  • Life can face unpredictable shocks, including wars, banking crises, political upheavals, and natural disasters like earthquakes and floods.
  • Case Study: During the COVID-19 pandemic in 2020, the U.S. GDP fell by nearly 10%, severely impacting numerous industries:
    • Air travel: fell by about 90%.
    • Hotel occupancy rates: dropped to about 25%.
    • Major auto manufacturers had to shut down production.
  • Effective risk management became essential for many firms to survive these unforeseen challenges.

Approaches to Risk Management

  • Businesses adopt various strategies to mitigate the impacts of risk:
    1. Building Operational Flexibility:
    • Firms can diversify their sources for materials and sales outlets, ensuring reliance on multiple production locations.
    • Operations should allow for rapid closures in case of crisis, emblematic of real options discussed in previous lessons.
    1. Fail-Safe Protections:
    • Ensure that businesses have adequate safety measures such as sprinklers and alarms.
    • Notable failure examples: BP’s Deepwater Horizon oil rig explosion due to inadequate safety.
    1. Balance Sheet Management:
    • Maintain a healthy equity position to withstand temporary challenges, avoid excessive debt, and retain borrowing capacity for crises.
    1. Insurance Policies:
    • Businesses should insure against risks like fire, accidents, and theft, especially those that can be diversified across policyholders.
    • Insurance less effective against macro-risks (e.g., pandemics, tsunamis).
    1. Specialized Financial Contracts:
    • Use derivatives, including options, futures, and swaps, to lock in prices for financial assets.
      • Derivatives help transfer risk but do not eliminate it.
      • Risk management entails making informed decisions about which risks to retain.

Focus of the Chapter

  • The chapter centers on derivatives and how they can hedge risk.
  • While providing an overview, it emphasizes that:
    • Most significant corporations use derivatives to manage risks:
    • 88% for currency risk management
    • 83% for interest rate risk control
    • 49% for commodity price fluctuations
  • Importance of understanding derivatives essentials for risk management success.

Why Hedge? Understanding Companies' Rationales

Basic Hedging Arguments

  1. Hedging as a Zero-Sum Game:
    • When a firm hedges a risk, it does not eliminate it but transfers it to another party.
    • Example: A heating-oil distributor locking in prices with a refiner does not create value; it merely transfers risk.
  2. Investors’ Alternatives:
    • Investors can hedge themselves, potentially yielding no value increase from corporate hedging unless there are substantial advantages for shareholders.
  • Companies can enhance financial planning and minimize risks of cash shortfalls by hedging, which may also improve their debt capacity.

Hedging with Options

  • Companies, including governments, buy options (put and call) on various instruments to limit risks associated with price fluctuations.
  • Example: The Mexican government hedged oil revenue using put options allowing it to sell oil at $49 per barrel for 250 million barrels.
    • Analysis of Impact:
      • If oil prices drop below $49, the option pays off compensating for revenue loss.
      • Purchasing options incurs costs, likely over $1 billion for the Mexican government.

Hedging: Futures and Forward Contracts

Introduction to Contracts

  • Futures Contracts:
    • Legally binding agreements to buy or sell an asset at a predetermined price at a specified future date.
  • Forward Contracts:
    • Customized futures contracts negotiated privately between parties, lacking standardized terms.

Examples of Futures Contracts Usage

  • Example Illustrations of Cash Flow:
    • Wheat Farming:
    • A farmer sells wheat futures to guarantee a price despite market fluctuations.
    • Obligations under a futures contract require delivery and can create loss if prices fall below futures rate.
  • Futures market mechanics involve daily profits/losses marked to market, meaning actual cash flow adjustments occur daily rather than at maturity.
  • Case Study: A wheat contract allows smoother revenue management for farmers, effectively locking in fixed income.

Measuring and Valuing Futures Contracts

  • Value determined by the present value using interest and, for commodities, considering convenience yield:
    extFuturesPrice=extSpotPriceimes(1+extInterestRate−extConvenienceYield)text{Futures Price} = ext{Spot Price} imes (1 + ext{Interest Rate} - ext{Convenience Yield})^t
  • The forward price reflects a similar structure without daily adjustments.

Swaps: Currency and Interest Rate Swaps

Introduction to Swaps

  • Interest Rate Swaps:
    • Firms exchange fixed and floating interest rate payments on debts, allowing one to stabilize costs against rises.
  • Currency Swaps:
    • Exchange of payment obligations in different currencies, mitigating exchange rate exposure.

Example of Interest Rate Swap

  • A company converting floating-rate debt into a synthetic notional amount to secure fixed costs amidst rate volatility using a swap with a dealer, who earns a spread on the transactions.

Summary of Key Concepts

  1. Understanding risk management through derivative instruments (options, futures, and swaps) is essential for financial stability.
  2. Hedging protects against volatility but does not eliminate risk.
  3. Proper balance sheet management, insurance, and operational flexibility increase resilience against unforeseen shocks.

Ethical Implications of Risk Management

  • Considerations:
    • While derivatives can stabilize firms, speculative uses can lead to significant financial disasters, as illustrated by notable banking crises and rogue trading incidents.
  • Businesses must balance the utility of hedging against potential adverse consequences arising from derivative trading mismanagement.