Risk Management

Question 1

What are reasons to hedge?

Answer 1

To increase firm value through following channels:
- reduction of tax payments
- avoiding financial distress
- securing capital needs in order to reduce variability of CFs and prevent cash shortfalls since external resrouces are more expensive and it makes investors reluctant
- Hedging uncontrollable risk by designing management compensation packages helps managers to concentrate on what can be controlled and makes it possible to reward them only for their “real” performance
- Active risk management programs can reduce profit volatility of individual business units and allocate capital more efficiently
- Secure against natural disasters to prevent disruptions of business operations and devaluation of assets

Question 2

What are three ways to measure a firm’s risk exposure?

Answer 2

1. Factor model (basically APT): backwards-looking
   –> Markte risk is not diversifiable but hedgeable
   –> Firm-specific risk is diversifiable but not hedgeable
2. Simulation: forward-looking
3. Factor-based volatility of a firm’s cash flows
   Volatility is the overall variance of the Cash Flows

Question 3

What is the Value at Risk (VaR), how can it be calculated, and what are its shortfalls?

Answer 3

= the worst possible loss under normal market conditions for a given time horizon

1. Parametric VaR
2. Historical (non-parametric) VaR
3. Monte Carlo VaR

Shortfalls: Only considers the frequency of the large losses but neglects the magnitude of these losses
Solution: Expected Shortfall

Question 4

What are three channels to reduce risk?

Answer 4

1. Natural Hedge:
   Reduce currency risk of a firm by splitting up production and therefore production costs between both currency areas
2. Futures
   Mandatory agreements to buy/sell a security, currency, or commodity at a prespecified price (future price fixed today) at some future date.
3. Money Market Hedge
   Involves borrowing one currency on a short-term basis and converting into antoher currency immediately.

Question 5

Which firms hedge?

Answer 5

Large firms (often only partially so more exposed to risk)
Firms with growth opportunities (to ensure sufficient CF for investments)
Firms with a high dividend payout
Firms with a high debt ratio (high leverage)