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Risk Management Flashcards

1
Q

Reasons to hedge

A
  1. Saving taxes
  2. Avoiding financial distress
  3. Capital needs
  4. Management compensation
  5. Strategic and investment decisions
  6. Climate change as new (financial risk)
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2
Q

MM Proposition I –> absence of market frictions, shareholder are indifferent between…

A

hedging on their own accounts and having their firms
do the hedging for them

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3
Q

If hedging choices do not affect cash flows from real assets, in
the absence of taxes and transaction costs, hedging decisions
do not affect …

A

firm value

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4
Q

Reasons to hedge – Avoiding financial distres

A
  • Financial distress can be costly
  • By hedging risks, a firm can increase its value through a reduction of the
    probability of facing financial distress in the future
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5
Q

Reasons to hedge – Capital needs : definition

A

Investors may value the delay or change as a bad signal for firm’s future prospects and become overly
pessimistic

–> the firm does not get access to external finance (or not at attractive terms)

page 9 (Graph)

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6
Q

Capital needs : characteristic

A
  • Internal resources are cheaper than external (e.g., because of information
    asymmetries, taxes, and transaction costs)
  • capital expenditures (CAPEX) highly depend on internal cash flows
  • Tendency of overinvestment or underinvestment according to firm’s cash flow
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7
Q

Problem with capital expenditures

A

Firms have to plan their CAPEX in advance but often face highly volatile cash flows.
–> They may not have enough cash in the future

  • If a firm cannot undertake or has to alter its strategic investment plan due to changes in the exchange rate
    –> investors could be much more pessimistic on the firm’s future prospects
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8
Q

Solution with capital expenditures

A

hedge cash flows in order to reduce the variability of
cash flows, thereby enhancing firm value

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9
Q

Reasons to hedge – Management compensation

A

The management is compensated based on the operating performance

–> Change of exchange rate not under the control of the management

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10
Q

Reasons to hedge – Management compensation: characteristic

A
  • Managers should only be paid for their «real» performance
  • Compensating or punishing the management for performance or risk outside their control is inefficient
  • Hedging uncontrollable risks leaves the managers, especially risk-averse
    managers, with a larger proportion of manageable risks for performance
    evaluation
  • desirable from a corporate governance point of view as this reduces the “pay for luck” problem
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11
Q

very difficult to design a compensation package that eliminates a
manager’s exposure to all hedgeable risks, why ?

A
  • Problem of evaluation how such risks affect the firm
  • Problem to find benchmarks that account for multidimensional risks
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12
Q

Reasons to hedge – Strategic & investment decisions

A
  • active risk management program can improve management’s decision making process by reducing the profit volatility of individual business unit
  • Less volatile profits for a company’s business units provide management at the
    firm’s central headquarters with better information about where to allocate capital and which managers are the most deserving of promotion
  • Less volatile profits / cash flows also increase debt capacity
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13
Q

A sophisticated risk management will have a better understanding of…

A

future market prices so that managers can allocate capital efficiently across the firm’s units, because investment decisions rely on future opportunities (e.g., scenarios) and not historical prices.

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14
Q

Insurance companies have better abilities to asses risk than industrial companies due to..

A

past experiences.
–> Insuring risks of a planned project enables the firm to better price this project.

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15
Q

Reasons to hedge – Climate change as new financial risk

A
  1. High carbon scenario
  2. Low carbon scenario
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16
Q

High-carbon scenario

A

Rising sea levels, severe storms, floods, and wildfires may disrupt business operations, damage property, and devalue assets

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17
Q

Low-carbon scenario

A

Transformation of the economy to new energy sources
and business models; associated with financial risk about the associated climate
outcomes and policy responses and the resulting economic and financial fallout

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18
Q

Measuring a firm’s risk exposure: Factor models (calculation)

A

CFj = aj + BiF1 + Bi2F2 + … + BikFk + 𝜀𝑖

Fk: macroeconomic factors (e.g interest rate movements)

Bik: cash flow’s sensitivity to these factors

𝜀𝑖: explanation of the risk not captured in the factors (firm specific risk)

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19
Q

A stock’s sensitivity to factor risk as well as firm-specific risk is determined
by…

A

the firm’s capital expenditures and operating and financial decisions

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20
Q

Factor risk is generally not…

A

diversifiable (e.g., exchange rates, oil price), but
often it can be hedged by taking off-setting positions in financial derivatives

21
Q

Firm-specific risk is just the opposite (e.g., technical problems of a plant). It is..

A

diversifiable but not hedgeable. It is only possible to insure against these
risks using insurance contracts

22
Q

Estimating factor models using regression analysis requires the use..

A

of historical data for the risk factors to obtain estimates of the risk factor exposures

23
Q

The dependent variable in these regressions are..

A

the unhedged cash
flows of the firm

24
Q

risk factor exposure estimates will only have..

A

predictive power, if the same risk factors affect the firm similarly in the future

25
OLS-based regression approach does not capture..
non-linear effects of the risk factors on the firm (hence, it may be advisable to also test non-linear specifications)
26
method to estimate risk exposure
Forward look method --> Simulation
27
Simulations are often used in combination with scenario analysis
- Several factors of the model will be held constant (e.g., industry demand) - Implementing different scenarios for important factors (e.g., exchange rates) under the condition that all else is constant
28
Stimulation strategie is useful in ?
rapidly changing industries as regressions estimate the risk factors based on historical data (i.e., are backward-looking) --> but based on strong (distributional) assumption regarding the relevant risk factor
29
Measuring a firm’s risk exposure: Factor-based volatility of a firm’s cash flows
- express the risk exposure of a firm in a single number - One possibility is to model the risk exposure of the cash flows by using different risk factors (e.g., interest rate, exchange rates, GDP, etc.) and aggregating the risk exposures into a single risk metric
30
Factor-based volatility of a firm’s cash flows: first step
1. we regress the cash flows on the identified firm-specific risk factors: factor model calculation
31
Factor-based volatility of a firm’s cash flows: second step
estimate the covariances between each pair of risk factors and calculate the “overall variance of the cash flows”
32
factor-based volatility of the cash flows is..
the square root of the variance
33
Value at Risk (VaR) : definition
defined as the worst possible loss “under normal market conditions” for a given time horizon
34
3 alternative ways to calculate VAR
1. Parametric VaR 2. Historical (non-parametric) VaR 3. Monte Carlo VaR
35
Parametric VaR
Based on the assumption of normally distributed returns of all assets (or cash flows of a firm) and therefore also the portfolio consisting of these assets (or divisions). The VaR is exclusively determined by the expected returns or cash flows and the variance-covariance matrix of the individual assets or divisions
36
Historical (non-parametric) VaR
Based exclusively on the historical data (i.e., return / cash flow observations) of the assets or divisions. Advantage: - No distributional assumption! Disadvantage: - The results strongly depend on the time period used and the approach implies that the past returns or cash flows adequately describe the future returns - long historical time series are required to obtain meaningful results.
37
Monte Carlo VaR
The Monte Carlo approach relies on simulations of the stochastic behavior of returns, cash flows (or risk factors) --> it requires assumptions regarding the return generating stochastic process and well-specified (possibly non-linear) factor models for the returns
38
Problem of parametric VaR
- The distribution of the returns / cash flows is skewed --> assume that returns are normally distributed and thereby neglect higher moments (i.e., stocks / assets with the same expected return and volatility have the same VaR)
39
parametric VaR: what other distribution could be use?
Weibull distribution --> account for fat tails
40
Value at Risk (VaR) – No information on extreme losse
The distribution of the returns / cash flows may comprise extreme values within the tails. The loss within the Value at Risk might be much larger than expected under the assumption of a normal distribution. The expected shortfall can incorporate this problem. --> Identical VaR but different expected loss in case the return falls below the VaR value
41
Measuring a firm’s risk exposure: Expected shortfall
The VaR only considers the frequency of large losses but neglects the magnitude of these losses; this is what the Expected Shortfall does: p%-Expected Shortfall = E(Ri) for Ri < (1 – p)% percentile
42
Channels to reduce risk – Natural Hedge
To reduce currency risk the firm can split up the production and therefore the production costs between both currency areas
43
Channels to reduce risk – Futures
- future contract : agreement to buy or sell a security, currency, or commodity at a prespecified price (forward / future price) at some future date - A future / forward is a mandatory contract so that both parties have to fulfill their positions. --> long position requires the holder to buy the underlying for the future price. Holding the short position obliges to deliver the underlying at the future price - the forward / future price is set so that the contract is a zero present value investment for both parties (PV = 0) - The payoff structure of a future is linear and therefore symmetric (in contrast to other derivative instruments, such as options).
44
Characteristics of firms which hedge – Examples of empirical findings
- Size - Growth opportunities - Leverage
45
Size
- larger firms use more derivatives to hedge - Inconsistent with lower risk of going bankrupt story - Smaller firms tend to have higher fix costs to establish a sophisticated risk management - Larger firms are often only partially hedged and are more exposed to risk factors
46
Growth opportunities
- Firms with more growth opportunities (e.g., high R&D and high M/B) use more derivatives (NSS, 1993). - This ensures to have enough cash flows for investmen - Reduction of the higher financial costs of distress of these firms - Better allocation of costs on lower taxable earnings (addressing asymmetric tax treatment)
47
Leverage
- Graham and Rogers (2002) find “that hedging increases the debt ratio and consequently increases value through the tax benefit of interest deductions.” - If firms with high R&D expenditures and high M/B also have high leverage, they are more likely to hedge.
48
Does ESG engagement affect firms’ financial risk?
- engagement on environmental, social, and governance (ESG) issues can benefit shareholders by reducing firms’ downside risk. - ESG engagement reduces value at risk and lower partial moments, when addressing environmental topics (primarily climate change) - Target firms with large downside risk reductions exhibit a decrease in environmental incidents after engagement activities

Corporate Financne (7 decks)

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