Topic 7: Risk Mgmt in a Corporate Context

Question 1

Differences between Financial & Non Financial Companies:

1. Regulatory
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement

Answer 1

Regulatory:

• Financial institution: protects payments system & systemic risk
• Non Financial Co: Focus on corporate governance and disclosure

Question 2

Differences between Financial & Non Financial Companies:

2. Nature of Assets
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement

Answer 2

Nature of Assets:

• Financial: tradeable, financial assets, market makers, highly diversified portfolio. Cashflows largely contractual. Diversification improves quality of portfolio
• Non financial co: Balance sheet comprises illiquid assets. Risk concentration. Underlying cashflows non contractual. Portfolio diversification creates negligible value.

Question 3

Differences between Financial & Non Financial Companies:

3. Role of Risk
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement

Answer 3

Role of Risk:

• Financial: role to absorb and/or intermediate risk. Risk mgmt. is key focus and skill of mgmt. Aggregation and integration of company wide risks.
• Non financial co: risk arises from natural physical characteristics of underlying business. Lower focus, less skills in the process. Fragmented approach

Question 4

Differences between Financial & Non Financial Companies:

4. Risk Measurement
List: Regulatory; Nature of assets; Role of Risk; Risk Measurement

Answer 4

Risk Measurement:

• Financial: ability to statistically measure risk
• Non Financial Co: limited ability to measure most of the risks due to limited observations, linkages and causal relationships

Question 5

Non financial companies risk is difficult:

Answer 5

financial exposures arising from potential shifts in market prices cannot be separated from the underlying business

Question 6

“real” or operating responses for a non financial co. to manage risks include: )(4)

Answer 6

1. Operating leverage (mix of fixed & variable costs)
2. changing production location (eg to foreign country = response to FX exposure posed by import competition
3. Adjustments to production volumes (respond to anticipated variations in market prices)
4. Modifications to the business portfolio (screening of projects, abandonment of projects or diverstment

Question 7

Risk in corporate context

• market risk is derived from:
• risk:

Answer 7

Risk in corporate context

• market risk is derived from: underlying business
• risk: should be understood in terms of uncertainty related to business objectives.

Question 8

Bank perspective vs corporate perspective

1. Focus of risk
list: focus of risk; risk horizon; risk measure, confidence level

Answer 8

BANK: value of trading portfolio (mark to market)
CORP: Cashflow, earnings

Question 9

Bank perspective vs corporate perspective

2. Risk horizon
list: focus of risk; risk horizon; risk measure, confidence level

Answer 9

BANK: days
CORP: quarters and years

Question 10

Bank perspective vs corporate perspective

3. Risk measure
list: focus of risk; risk horizon; risk measure, confidence level

Answer 10

BANK: Value at Risk
CORP: Cashflow at risk, earnings at risk

Question 11

Bank perspective vs corporate perspective

4. Confidence level
list: focus of risk; risk horizon; risk measure, confidence level

Answer 11

BANK: 95%, 99%
CORP: 95%, 99%

Question 12

Monte Carlo Simulation

• role
• method
• purpose once generated

Answer 12

Monte Carlo
role: understand imperfectly predictable random influences on cashflows that affect firm’s value
method: generate realisations (outcomes) of random influences by drawing on their joint distribution. If there is more than one random influence, they are likely to have a connectedness (which could be measured by correlation coefficient).
Purpose: analyse as if they were a historical distribution

Question 13

If you cannot generate cashflows analytically:

Answer 13

use simulated cashflows to estimate Cashflow at Risk; quantify exposures and obtain optimal hedge ratio

Question 14

BHP - key findings

Answer 14

• impact of changing the underlying portfolio (physical assets)
• changing the risk profile through “silo” hedging can destabilise or unwind natural hedges
• no evidence of a ‘value’ differentiation in hedgers vs non hedgers (ie does not create economic capital for use, but does boost debt capacity through reducing unnecessary CF vol
• hedging can be costly (eg backwardation in forward mkts such as oil, copper & interest rates. Premium may not be justified. Consider self insurance model where CaR does not exceed certain risk levels.
• companies with financing strategies and strategic investment programs placing heavy demands on capital resources tend to hedge
• separate risk mitigation from strategic view

Question 15

FX risk: 3 forms of exposure

Answer 15

3 forms of FX risk exposure

1. Transaction exposure (sensitivity to exchange rate. Includes contracts to buy/sell goods, repatriate earnings, pay P & I associated with FX borrowings)
2. Competitive exposure (sensitivity of position of firm to currency movements - economic exposures, where FX can affect CFs, mkt share & value. eg, change in quantity of goods sold due to change in competitive position
3. Contingent exposure: only materialises if a certain event takes place, eg winning a tender. Trigger point.
4. Translation (accounting) exposure - accounting derived change in owner’s equity.

Question 16

Hedging the 3 forms of FX exposure

1. Transaction exposure
2. Competitive exposure
3. Contingent exposure

Answer 16

1. Transaction exposure
   - derivatives are suitable, timeframe over next year or so. Smooth out fluctuations in ST mkt movements
2. Competitive exposure
   - Derivatives LESS feasible for LT solutions due to lack of liquidity, counterparty risks, uncertainty of timing & size. Operational strategies are popular to use. (raise productivity, change plant location etc)
3. Contingent exposure
   - use options and compound options (ie options within options)
   - tender on the basis that final pricing depends on currency

Question 17

List operational measures to hedge

Answer 17

1. raise productivity
2, change plant location
3. change product strategy
4. change promotional strategy
5. renegotiate costs
6. diversify into new business areas
7. change pricing strategy

Question 18

Buy Collar means to…

Sell collar means to…

Answer 18

Buy collar = Buy put, sell call

Sell collar = Sell put buy call

Question 19

When pricing probability of default, when do you use rf and when do you use alpha

Answer 19

Use rf when pricing debt spread, debt value.
- this is because you are pricing on no arb conditions that apply under any probabilities. This is risk neutral version.
Use alpha when you want to get the ACTUAL, true, physical probability of default.

Question 20

Difference B-S vs Merton

Answer 20

B-S prices at the beginning, so need to discount back.

Merton prices at the end when debt is due and payable. A0 has grown to AT and Ke(rt) has become K

Question 21

Risk neutral default probability

• indicated with:
• what rate is used?

Answer 21

Indicated with * (eg p*)

In a risk neutral world, only one rate is used; rf.

Question 22

When is it appropriate for a firm not to hedge its financial risks

Answer 22

• if correlation between prices and currency is perfect - don’t hedge. There is a natural hedge.

Question 23

What are some problems that arise with hedging financial risks

Answer 23

• ## for a corporate, market risk is derived from the underlying business.

Question 24

Monte Carlo simulation

• purpose
• draws on..

Answer 24

• purpose: helps us to understand the imperfectly predictable random influences on cash flows that affect a project’s value.
• generate realisations that draw on joint distribution
• if there’s more than one random influence, they are likely to have a ‘connectedness’, which may be measured by correlation coefficient
• once measured, can be analysed as if it were a historical sample
• eg randomly generate exchange rate, compute associated cashflows, analyse variability to see how exchange rate affects cashflows
• if you cannot compute cashflows analytically; simulate. Use the simulation to generate cashflows to estimate cashflow at risk. Quantify exposures and calculate optimal hedge ratio.

Question 25

In chapter question: | How can hedging exposures make a company worse off?

Answer 25

if incoming cashflow is less than expected and the hedge is in a loss situation, then the firm is overhedged with excessive losses. Firm is worse off than if it hadn't hedged. eg: airline hedges costs buying oil futures. Demand drops, yet number of futures contracts was based on higher estimate

Question 26

Explain the volatility minimising hedge: | h = (cov(C,G)) / (Var (G))

Answer 26

This is a regression coefficient. If C is regressed against G (C is the independent, LHS variable), then resulting coefficient on G is calculated using this formula

Question 27

How does quantity risk alter the volatility minimising hedge and its effectiveness?

Answer 27

- you need more hedging contracts as the relationship between C and G gets stronger and in the same direction. If perfectly correlated, they will behave as if they are one asset. If less than perfect sell less of G. - The most effective hedge is when correlation is -1, and the variability of G offsets C. This is the perfect hedge

Question 28

Notes, the importance of the competitive environment (3) | Difference between corporate risk and bank risk

Answer 28

1. in the long term corporate exposures are not contractual, they're competitive and strategic 2. A change in FX rate can change production, marketing, sourcing of raw material, market availability and product mix. 3. Depends on competitors behaviour and the sensitivity of customers to price changes (MEASURED BY THE ELASTICITY OF DEMAND)

Question 29

Value at Risk vs Cashflow at Risk

Answer 29

VaR: Potential loss on a risk position which might be exceeded with prespecified probability. mgr tells you a prob & time horizon CaR: allows a best case scenario to be found for a future risky cashflow.

Question 30

Hedging business S = futures exchange rate c = cashflow Describe impact of correlation

Answer 30

1. If perfectly negatively correlated, this is a NATURAL offset 2. If perfectly positively correlated, this is easier to estimate the hedge 3. If correlation is zero, possible values are large, and you may have to calculate COVARIANCE (calculate for each of c and S, the value minus the specific average, then cross multiply and add up.)

Question 31

Variance of the hedge

Answer 31

= squared deviations from the mean | similar to covariance, but multiply the variable by itself

Question 32

How does competition in the product market affect the way that currency risk is managed?

Answer 32

1. More competition manifests as higher elasticity of demand 2. Firm is less able to pass on cost increases to its customers 3. More price hedging is needed

Question 33

List 6reasons for caution in using regression analysis List positives (3)

Answer 33

Caution: 1. Based on past information & relationships may not hold for the firm in the future. 2. Firm may be exposed to more risks than appear in the regression. 3. Regressions assume a linear relationship, relationship may actually be non linear 4. Size of sample(?) 5. Size of estimation error(?) 6. Are the RHS variables correlated? Positives 1. Provides a way to check understanding of exposures 2. Firm can use estimated exposures as hedge ratios for the PV of cashflows 3. Uses historic data which is readily available

Question 34

Monte Carlo simulation is used when:

Answer 34

... MCS is used when the future looks different to the past (historic samples won't do) MCS is helpful analysing cashflows that are non linear functions of some important driving variables. - using results of MCS, can calculate optimal hedge ratio. (compute explicitly, or regress

Question 35

Positive skew in a distribution looks like:

Answer 35

Positive skew: right hand tail is stretched out)

Question 36

Lessons from Ch 8 Stulz

Answer 36

- optimal amount of hedging depends on the shape of the distribution of the exchange rate - Demand varies with price - Competitors influenced by exchange rate - New entrant would change the demand function making it more sensitive (price elastic) - normal distribution for cpercentage changes in the exchange rate.

Question 37

BHP article: 3 major risks to corporate?

Answer 37

Changes in: 1. exchange rate 2. interest rates 3. commodity prices

Question 38

Key messages BHP (3)

Answer 38

1. Businesses should be considered for overall consolidation, at the corporate level of portfolio composition, capital allocation and risk management (no silo approach). 2. Account for the interplay between different risks in a portfolio 3. Identify difference between risk mitigation (hedging) and risk leverage (strategic position taking)

Question 39

Things to consider when hedging (corporate)

Answer 39

1. Is currency risk a function of reporting currency 2. Do risk exposures offset to any degree (natural hedge across business?) 3. Is there benefit to shareholders of hedging? 4. hedging costs? Are markets liquid? Backwardation? 5. What is the relationship between market risk strategy, broader financial strategy and overall corporate strategy 6. Separate risk mitigation transactions -b normal hedge accounting treatment. Opportunistic / strategic transactions: profit and loss on mark to market basis

Question 40

Only hedge if you have to (5)

Answer 40

1. No clear evidence for value differentiation between hedgers and non hedgers 2. Value is attributed to risk management insofar as it is seen as integral to that strategy 3. Investors are indifferent to hedging / not hedging. they want transparency. 4. Watch hedging costs (liquidity) 5. Natural hedge may exist in a lower cost, business related form