Appunti risk management

Why should companies hedge?

Taxes paid: -30 -90 - payment+30

Loss carryforward

Therefore, since there is this tax carry forward mechanism, it is not the reason why we should hedge. The tax story is not a valuable reason for a company to hedge. Then what is it?

Mitigation of other investment problems

When companies plan future investments and expenditure, they project a CAPEX with some years in advance. After planning investment, you need to plan how to finance it. In projecting the financing side of the investment, companies take in consideration how much money are generated within the company. For instance, if you need to invest 100€, this 100€ can come either from new equity, from self-generated funds or from debt.

Suppose that the company projects to invest 100€ and this investment comes 80% from self-generated funds and 20% as external financing or equity. Considering the 80% part, if you have to think that here we are thinking about the future and about how much money the

company will make in the future, which is going to be the cash flow that the company will be able to produce. Of course, we don’t have 100% certainty that we’ll collect 80€. Instead, there is a possibility for the firm to earn 80€ as well as 100€ as 60€.

8100 (50% probability)
80 60 (50% probability)
100 20

What happens if instead of 80€ the firm makes 100€? This is not a problem, it’s just better.
What, instead, the cash flow is 60€? The company will need an extra round of financing, then, considering it is short in cash, is to ask for additional external financing that is very expensive since it is a last-minute option.
So, how do firm react to this? Since 60€ is the worst-case scenario, the company just prefers to invest 80€ (60€ internally generated funds + 20€ external financing) in total, so to be covered in this bad case.
The company underinvest, to be sure to meet the expectation. Underinvestment means investing.

less thanwhat it would be optimal.How this has to do with the hedging problem? Again, if trough hedging it is possible to reduce the dispersionof the possible cash flows (for example to a probability of 70/90 instead of a probability of 60/100) the worst-case scenario will go up and the company will invest more. Then, the underinvestment problem could bereduced.

Costs of financial distress

Which are the costs of financial distress?

• People want to leave the company: the first to leave the company will be the best ones, becausethey can easily find another job (higher market power)
• Managers want to be paid more since they risk more
• Suppliers want to be paid immediately: considering the amount of account payables that a companyusually owns, you would need a lot of liquidity for promptly pay all the suppliers
• Clients may have problem with the after-sale phase, so they prefer to buy from more reliablecompanies
• Banks are not willing to lend you money, or they will ask for a higher

interest rate or for a covenantTherefore, what matter is not the real cost of bankruptcy, is what happens when the company goes in financial difficulties. When the company goes into financial difficulties things get nasty, especially between the stakeholders. In particular, between stakeholders on one side and shareholders on the other side. Shareholders have incentive to harm the stakeholders' interests. What happens if we hedge? We have less dispersion of income and the company can reduce the risk to get into financial distress. Therefore, hedging help in avoiding financial distress. In the end, the only motivation that is highly supportive for the hedging practise is the financial distress. Each of us have a cognitive bias that make us think we are better than the average and that we can control something even if it is not under our control. There are risks that you can't control, and people tend to underestimate them as well as companies. Ex. If the CEO of a big pasta-producing

company such as Barilla believe that the price of wheat will not go upand he thinks he knows this since he has always been in the business and he has experience, he will decidenot to totally hedge to take advantage of the wheat price to go down. In fact, the right choice to make if thisis true would be not to hedge.The problem is, the CEO believes he can control something that is behind his control, like the price of thewheat. But when it comes to forecasting future prices, this is impossible for everyone, analysists included.9As a result to this behaviour issue, some companies decided to change the hedge ratio (the amount to whichthere is hedge).

Risk management process

The risk management process is composed of 5 phases:

1. Identify the source of risk of exposure: is the nature of the risk financial, currency, commodity orenergy?
2. Quantify the risk exposure: what is the extent of the potential loss?
3. Assess the impact of exposure on the firm's business and financial strategies:

Is hedging always beneficial? To whom and under which conditions?

4. Assess honestly your firm's ability to design and implement a risk management program: does enough expertise exists within the firm to operate the program?

5. Select the appropriate risk management products

From now on, we'll only be talking about step 5.

The idea of this graph is to relate the firm's value to the price of a risk factor.

On the y axe there is the firm's value or margin, so that on the right part is good and on the left part is not. If the firm increases its EBITDA, the firm value increases and we move on the right.

On the x axe there is the price of the risk factor. If the origin is the current price, if the price decrease and we are wheat producers, we sell the wheat for less. If we are wheat buyers, everything will be the other way around.

Forward contract

A forward contract is an agreement to transact later. When we purchase something, we exchange a product or service against money. If

We translate this transaction if the future time, we have a forward contract. However, the price of the transaction is set now, in the present.

The contract specifications are the elements you write in the contract. In the contract you will indicate what are you buying, when you will exchange or transact that (settlement date), at which price this transaction will happen (forward/delivery price, which is never equal to the current price that is the spot price).

Spot price = S = contract price for a transaction that is taking place immediately

Forward price = F = settlement price that will not take place until a predeterminate date in the future

Delivery price = k = price we commit to sell 10

OTC (over the counter) is any contract that is written outside of a regulated market. OTC is way more important than regulated market and the number of derivatives traded in the OTC market is way bigger than the number of contracts in the financial market. How do you settle a contract outside the financial

market?You only need to contact the bank and say what you would like to buy or sell.

Who should buy and sell forward contract? What is it useful for? To hedge our risk.

Suppose we are going to receive a payment from a client a payment of 1 million dollar in 3 months' time.

We have a risk, because we'll have to convert these 1 million dollars into euros. The fact that we don't know in 3 months from now how the exchange rate between euros and dollars will go, creates uncertainty.

We can use a forward contract to lock the exchange rate. We simply agree with the bank to sell to it 1 million dollars against euros and today we agree on the price for this exchange, as we would have done in 3 months' time.

What you do with the forward contract is what you would have done in the future. Today you take the commitment to sell, if you want to sell in the future and to buy, if you want to buy in the future.

The outcome of this transaction is that if we commit with a price and the

exchange rate gets unfavourable, then we are lock in and this is not a problem. On the other hand, if it gets favourable, we can't take advantage of it. What happens in maturity? Natural position (us and our client) + derivative position (us and our bank) = hedged position The first one is not a financial contract, the second one it is. In 3 months, our clients will pay us 1 million dollars, then we'll need to settle the contract with the bank. There are two possible ways to settle it, either cash or physically with an underlying asset. This distinction is meaningless when we are talking about currencies, because if you provide a currency or an interest rate you are always providing cash. The distinction instead makes sense if the underlying asset is a commodity, then the contract could be settled both physically (delivering the good) or in cash. k = 100 (price we committed to sell) At maturity, if S (spot price) is 115 and we sold it for 100, we are losing money in this contract. We

committedtto sell to less to what the asset is worthing now.

At the settlement date, there must be a financial transaction in cash. Either we pay the bank, or the bank pays us. What if we have to pay the bank? The bank is not sure we are reliable and there is a credit risk, so the bank asks for a covenant or a collateral. Every time we do a forward contract, we need to find a collateral to provide. Each covenant can be used for only one contract.

What happen when it is maturity time? We’ll have to check the difference between the spot price we fixed and the actual price: ΔS = S – St 0 if this difference is positive you make a profit, if it is negative, we make a loss.

S = the price we would have receive for selling today

0S = spot price in the future

tThe payoff of this financial contract. What happens if the price increases or decreases? We set the price to pay to be k, which is our delivery price. The final payoff could be downward sloping or upward sloping.

11Since we are selling,

Se il prezzo aumenta, finiamo per vendere a un prezzo inferiore e perdiamo un'opportunità e incorriamo in un flusso di cassa negativo (115 > 100). Il payoff sarebbe in discesa, vendiamo per k (100) qualcosa che varrà S (115). Considerando che graficamente abbiamo la posizione naturale rispetto alla posizione derivata, quando le mettiamo insieme otteniamo una linea costante che è parallela all'asse x. Ciò significa che le cose si compensano a vicenda. S rappresenta il rischio e l'incertezza a cui l'azienda è esposta. Se S aumenta di uno, (k-S) diminuisce di 1 e si compensano a vicenda. Se la posizione di copertura è parallela, significa che se il prezzo cambia, il reddito totale per l'azienda non cambia. Hai eliminato il rischio e non sei più esposto. Poiché il contratto è su misura, è facile trovare una posizione di copertura che corrisponda completamente a quella naturale. Entrambi hanno lo stesso asset sottostante, quindi corrispondono completamente.