Appunti risk management

Risk management

Course presentation

In the course we will deal with a specific type of risk, the financial risk (and especially the market risk), mostly considering it for non-financial companies. Examples of financial risks are:

• Interest rate risk: for example, taking a loan without fixing the rate, with an adjustable rate.
• Currency risk: when a company trades in foreign currency it faces a problem that is how much does this translate into its domestic currency? Especially if it is an importer and it deals with a foreign currency and this appreciates against the domestic one, it risks losing money. The same thing happens if it is an exporter and the foreign currency depreciates against the domestic one.
• Commodity price risk: if the product you deal with is very heavy on resources and the price of these resources rises. A textbook example of this risk is oil price risk, because it affects (directly or indirectly) many companies.

Why do we care about these risks? Because they may affect either the revenues or the costs, therefore having an impact on the EBIT/EBITDA. Any risk that a company faces is composed of two parts:

• Endogenous: it relates to us as a specific company (e.g., sales depend on how good we are in marketing, management, selling, etc.).
• Exogenous: it’s due to how lucky we are (e.g., if I sell products for 1 mil $ and in the moment we deliver and get paid the value of the dollar increases because it appreciates against the euro, in this case our revenues rise, for reasons due to external factors).

Assuming there was a way to neutralize the effect of these last elements, should the firm do it? That’s the question we’ll answer today. First things first: is it possible to sterilize those exogenous risks? Yes!

Hedging is the technique through which the company gets rid of those risks, by using financial derivatives. Derivatives are also very popularly used for speculative reasons, thanks to the phenomenon of financial leverage.

Financial leverage

• Take the case of a pure equity firm: if the value of the assets drops by 10%, then the value of equity also drops by 10%.
• If we just change the financial structure in the same identical firm, same assets, that same shock of -10% translates in a drop of -20% in E, since D is fixed (you can give the debt holders less than the face value, but then you’d have 0 as a shareholder).

So, what is the effect of financial leverage? Simply that of amplifying the magnitude of the shocks, and of course this works also the other way around: if the shock was an increase of 10% in the value of assets, this would have translated into a gain of 20% for shareholders. This is due to the fact that the expected return for equity holders increases with leverage because, by rising leverage, they're bearing a higher risk (Modigliani & Miller).

Finally, if this was the case, E would go to 0 and the company would go bankrupt. As we can see there is an amplification factor due to leverage (A/E=1,2,10) that works of course both on the negative and on the positive side (even if, being risk-averse individuals, we tend to overweight the negative outcomes with respect to the positive ones), that is obtained simply by financing part of my assets with debt.

Financial derivatives

Financial derivatives are financial contracts whose value depends on something else (called underlying asset). It’s like cheese that is the derivative of milk.

We will deal with plain vanilla derivatives (as opposed to the so-called exotic ones that are pretty much complicated) that are:

• Forwards and Futures
• Swaps
• Options

We don’t need complicated derivatives to simply hedge against the risks the company deals with or allocate your savings; these 3 categories are enough in most cases.

Speculative vs hedging purposes of derivatives

What does this have to do with risk management? That’s exactly the reason why derivatives are so popular for speculative purposes, and if we understand that we’d know that with hedging purposes is the same story:

Ex. Suppose you have insider info and you know that tomorrow the stock price will go up by 10%, so if you buy a 10€ share today you’d be 10% richer tomorrow. This wouldn’t be worth the risk to go to jail, but what if, through derivatives, you can leverage that? By doing so, you could translate the 10% gain into a 100%.

Taking a step backwards before talking about derivatives, how does purely financial leverage work? Suppose 10€ is the amount you’re willing to invest to buy the stock: next day 11€, so 1€ (=10%) gain. What if, instead, we take up a 90€ loan? Now we can invest 100€ and next day we have 110€, by paying back the loan we’re left with 20€ (=100%) gain.

Through derivatives, we can do exactly the same thing without taking up the loan, and the effects are the same as those of financial leverage.

Why are they also useful for hedging purposes? Suppose that the value of my assets is linked to a certain currency or commodity price, then the money I invested in those assets is exposed to the risk of fluctuations in these prices. How can I offset this risk? Suppose there is a bookmaker that is willing to accept bets, and we place a bet on the negative outcome. For example, my assets are linked to oil price, I bet on the oil price increase, then if this really happens and the oil price increases in my P&L, I have an increase in costs, but since I placed the bet, if I made things right, the money I make from it perfectly offsets this loss. Of course, this is made through derivatives, not bookmakers.

The most important insight to take for now is that we don’t change anything that has to do with our activities, our core business, risk management simply adds to the normal activities of the company also a financial contract (derivative), meant to offset the losses due to external risks.

Why is the leverage still important also if we use derivatives? Because to place that “bet”, it’s not possible to do it in cash. For example, hedging 100 million € risk would mean you needed 100 million € in cash and so on, that’s not possible for most companies. No company can hold in cash the exact same amount of its risk exposure. Instead, with leverage, if you have a 100 million € risk, you just need 1-5 million € and you can still take a position and hedge.

Short run vs long run exposure

Long run: Ex. Pasta makers are exposed to wheat price risk. If the wheat price steadily goes up all the time every year, the company will react by rising its prices. Is there any risk that this will lead to a reduction in its market share? No, because it’s a systematic effect, not an idiosyncratic one, so all pasta makers will face the same problem, and the general level of prices will be adjusted. So how do you hedge in the long run? Simply by adjusting the prices.

Short run: Ex. Oil price risk for airlines: the price of a ticket for the customer doesn’t move coherently with the kerosene cost for the company, and this is possible only thanks to the fact that the airline hedges against the risk it faces in the short run, this way locking the costs, hence the prices. Suppose they didn’t do it: customers buy tickets in advance, while the company buys the kerosene only shortly before the departure. What if this price goes up? They can’t adjust the price, since they’ve already sold the ticket. So, their production cost would go up and they’d probably report losses. That’s why they hedge, so that in case of an increase in oil prices they would not end up in a situation like this, but this also means that, should the price decrease instead, they wouldn’t be able to take advantage of that situation, of course.

Risk relevance

As we can see, most of Barilla’s raw material is wheat, so it faces a significant wheat price risk. This is a crucial element to answer the question: should the firm hedge? Yes, if the risk is relevant. But how do we define the risk relevance?

• Size: importance (%) of the asset to which the risk is related to the total amount of revenues, e.g., almost 40% in this case.
• Volatility: what are the odds of the negative outcome happening? How dispersed is the probability distribution of that particular situation? Ex. You have all of your revenues linked to a certain foreign currency, which is however pegged to your domestic one. In this case, the volatility is 0, there is no exchange rate risk, even if the size in that case is huge. Important: Consider also future volatility, not just past one! Ex. Currency can move between boundaries but is not exactly pegged, so maybe it could exceed those boundaries one day.
• Time horizon: there is a time mismatch between the time that takes the company to be able to adjust the prices (it can’t usually do it in the short run) that affects the risk. Ex. If the company was able to adjust the prices the next day, even if there was a huge risk, its relevance wouldn’t be so high because they could immediately dump the excess costs on clients, but that’s often impossible.

Should the firm hedge?

From now on we will consider that the risks that are in place are relevant, and we will continue to ask ourselves: should the firm hedge?

So why may companies not want to hedge?

Loss of opportunities

Example: we’re facing oil price risk and we hedge.

If you open a hedging position, nothing changes in your natural position. Having derivatives doesn’t mean changing the way you’re doing your core business. In this case, however, there is a trade-off because in the second scenario (prices go down) I may find myself in the awkward position where my competitors (who didn’t hedge) reduce their final prices (since their costs went down with oil price reduction) and I can’t do that because I hedged and my costs are still the same… so I cannot take advantage of the otherwise favorable situation while they can. That’s exactly the reason why competitors within the same sector tend to mimic each other: they either hedge or they don’t (or partially don’t).

Hedging costs?

Many derivatives are not symmetric contracts: this means that they work similarly to insurance policies, where you regularly pay a fee (the insurance premium) and if the insured event happens then you’re reimbursed, if it doesn’t nothing happens and you don’t get anything in return. So, in many cases (e.g., options) managers should consider the fact that there can be a cost while deciding whether to hedge or not.

If the derivative is a symmetric contract, on the other hand, probably you may have commissions or other transaction costs, but those are not really relevant…

So hedging cost isn’t probably a strong enough reason why companies don’t hedge. Probably, the only relevant cost of hedging is in the end that of hiring people that can do it.

Shareholders’ financial education

Volatility can be decomposed into 2 types of risk: Which part of risk does hedging reduce? A little bit of both, but as a shareholder you don’t really care about the reduction of idiosyncratic risk (unless you’re holding shares of only one company, like in the case of some family businesses). On the contrary, do they care about the reduction of systematic risk? Not in a “natural” one, since sectors with lower systematic risk are also typically associated with lower returns, e.g., Tech share and T-Bill that have very different risk-return profiles. Moreover, if we don’t consider financial risk but default one, shareholders still don’t care very much because they’re not the ones that pay the price in case of bankruptcy because they have limited responsibility (other stakeholders do).

Final considerations

When considering the financial structure of the firm, Modigliani & Miller demonstrated that, under perfect market hypothesis (no taxes, both personal and corporate, no information asymmetry whatsoever, same exposure to info and same level of processing it) financial structure decisions are completely irrelevant and so is the choice whether to hedge or not. But perfect markets don’t exist in real life, so by analyzing the various imperfections of the market, M&M found out that debt creates value through tax shield, but if companies take up too much debt they may incur in financial distress (because of info asymmetry between stakeholders and shareholders). Why do we care about Modigliani & Miller? Because here we’re going to deal with the same process: by analyzing the imperfections in the market we will understand when the firm should hedge and when not.

Remember that everything we know about finance is true under one hypothesis, that is that the goal is the maximization of value for shareholders. So, should the firm hedge? The ultimate answer to that question is: the firm should hedge if, through hedging, we increase shareholders’ value.

Forward and futures

Through hedging, we solve uncertainties and are able to protect ourselves. On the other hand, hedging means giving up the opportunities to realize extra gain, as well as extra losses.

Reduction of tax burden

In M&M framework, tax plays a very important role. With debt, there is a possibility for the company to deduct taxes, which means more money to shareholders. In theory, there are 2 possible channels in which taxes could play a role:

• The structure of the tax rate: depending on your income, you pay a certain level of taxes. There is a system of progressive tax rate. The more money you earn, the more money you need to pay. So, usually there is an initial level with a no tax rate and then all the margin income becomes higher and higher and you need to pay more and more taxes. It is like this in almost all countries. What happens then if you have a constant income as opposed to a very volatile income? For instance, you can make 100€ one month and 0€ the next month instead of having a constant income of 100€. Do you end up paying the same taxes, assuming a progressive tax rate? What happens is that when you go from 100€ to 0€, you do pay less taxes but the deduction, the drop in the tax you pay, is less than the increase in taxes you get when you go from 0€ to 100€. This is because there is a progressive tax rate, and this is why you end up paying more taxes.

Therefore, if there is a way to keep your income constant, you do it because it is more convenient. What about companies? How does a company smooth income? With risk management. If you hedge your risk, you reduce the dispersion of the income of the company. If you hedge your risk, you can get rid of volatility and you reduce the dispersion of your income. Also, reducing the time variation of the income ends up in less taxes to be paid. At a corporate level, tax rate is fixed so all this explanation works only in theory and not in practice.

• When a firm makes a loss instead of a gain: if you have a constant revenue of 100€ opposed to a volatile revenue that lies between -100€ and 300€. The expected income here depends on the probability of obtaining the two different payoffs: (50* -100) + (50* 300) = 100

The expected income is the same. Now we can simply use a flat tax (30%) and compute the tax payment in these two cases. In the first, the 30% of 100 is always steady and it is equal to 30€. In the second case, however, it is different. 30% of 300€ is 90€ (45€ since you have the 50% probability for this to happen), but then what happens if you lose -100? You don’t pay taxes on that: 30 + 50 * (300* 30% - 0%) = 45 - 0 = 45

In the end, you only pay 45€. In one case you pay only 30€, in the other case you pay 45€. Again, what’s the difference between these two cases? The dispersion of the income. If we reduce the volatility, we reduce the probability to end up in the negative income and losing money. This is a possible motivation for firms to hedge.

What if when we lose money, instead of simply not paying taxes, we get the money back? If you earn an income, you pay some money but if you don’t, you receive the money back. Let’s assume that this exists.

In the same case as before, this situation will be like this: 30 + 50 * (300 * 30% - 100 * 30%) = 45 - 15 = 30

However, when we lose money, we don’t get money back by the state, we simply do not pay, and this generates a tax burning. Since the state doesn’t give us money back, we should hedge otherwise we will end up paying more taxes.

In reality, we have something called tax carryforward, which means that when we have a loss, we don’t pay any taxes, and we don’t get money, but we get a credit to use over the next years when getting an income. We don’t get immediately the money back, but it is simply deferred.

A B 100 300 -100 -45 Expected Taxes paid -30 -90 - payment+30 Loss carry forward

Therefore, since there is this tax carryforward 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 into consideration how much money is 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... [Text cut off for brevity]