Introduction to Risk Management

Basic risk management: the producers

perspective
Basic risk management: the buyers
perspective
Why do rms manage risk?
Golddiggers revisited
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Basic Risk Management
Firms convert inputs into goods and services

output input
commodity
producer buyer
A rm is protable if the cost of what it produces exceeds
the cost of its inputs
A rm that actively uses derivatives and other techniques
to alter its risk and protect its protability is engaging in
risk management
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The Producers Perspective
A producer selling a risky commodity has an inherent long
position in this commodity
When the price of the commodity , the rms prot
(assuming costs are xed)
Some strategies to hedge prot
Selling forward
Buying puts
Sell calls
Buying collars
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Producer: Hedging With a Forward Contract
A short forward contract allows a producer to lock in a
price for his output
Example: a gold-mining rm Golddiggers enters into a
short forward contract, agreeing to sell gold at a price of
$420/oz. in 1 year
The production cost is $380
Producer prot in 1 year, assuming hedging with a short
forward contract at a forward price of $420/oz.
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Producer: Hedging With a Put Option
Buying a put option allows a producer to have higher
prots at high output prices, while providing a oor on
the price
Example: Golddiggers purchases a 420-strike put at the
premium of $8.77/oz, interest rate is 5%
Comparison of unhedged position, 420-strike put option,
and unhedged position plus 420-strike put.
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Producer: Insuring by Selling a Call
A written call reduces losses through a premium, but
limits possible prots
Example: Golddiggers sells a 420-strike call and receives
an $8.77 premium
Comparison of Golddiggers hedging with sale of 420-strike
call versus unhedged.
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Adjusting the Amount of Insurance
Insurance is not free! In fact, it is expensive
There are several ways to reduce the cost of insurance
For example, in the case of hedging against a price decline
by purchasing a put option, one can
Reduce the insured amount by lowering the strike
price of the put option. This permits some additional
losses
Sell some of the gain. This puts a cap on the
potential gain
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The Buyers Perspective
A buyer that faces price risk on an input has an inherent
short position in this commodity
When the price of the input , the rms prot
Some strategies to hedge prot
Buying forward
Buying calls
Selling puts
Selling collars
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Buyer: Hedging With a Forward Contract
A long forward contract allows a buyer to lock in a
price for his input
Example: a rm Auric, which uses gold as an input,
purchases a forward contract, agreeing to buy gold at a
price of $420/oz. in 1 year
The output will sell $460
Prot diagrams for unhedged buyer, long forward, and
buyer hedged with long forward
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Buyer: Hedging With a Call Option
Buying a call option allows a buyer to have higher
prots at low input prices, while being protected against
high prices
Example: a rm, which uses gold as an input, purchases a
420-strike call at the premium of $8.77/oz
Comparison of prot for unhedged gold buyer, gold buyer
hedged with call, and stand-alone call.
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Why Do Firms Manage Risk?
Hedging can be optimal for a rm when losses might be
more harmful than prots are benecial
An extra dollar of income received in times of high prots
is worth less than an extra dollar of income received in
times of low prots
Consider following reasons
Bankruptcy and distress costs
Costly external nancing
Taxes
Preservation of debt capacity
Managerial risk aversion
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Reasons to Hedge: Bankruptcy and Distress Costs
A large loss can threaten the survival of a rm
A rm may be unable to meet xed obligations (such
as, debt payments and wages)
Customers may be less willing to purchase goods of a
rm in distress
Hedging allows a rm to reduce the probability of
bankruptcy or nancial distress
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Reasons to Hedge: Costly External Financing
Raising funds externally can be costly
There are explicit costs (such as, bank and
underwriting fees)
There are implicit costs due to asymmetric
information
Costly external nancing can lead a rm to forego
investment projects it would have taken had cash been
available to use for nancing
Hedging can safeguard cash reserves and reduce the
probability of raising funds externally
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Reasons to Hedge: Taxes
Aspects of the tax code:
separate taxation of
capital and ordinary
income
capital gains
taxation
dierential taxation across
countries
Derivatives can be used to:
convert one form of
income to
another
defer taxation of capital
gains income
shift income from one
country to another
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Reasons to Hedge: Increase Debt Capacity
The amount that a rm can borrow is its debt capacity
When raising funds, a rm may prefer debt to equity
because interest expense is tax-deductible
However, lenders may be unwilling to lend to a rm with a
high level of debt due to a higher probability of bankruptcy
Hedging allows a rm to credibly reduce the riskiness of
its cash ows, and thus increase its debt capacity
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Reasons to Hedge: Managerial Risk Aversion
Firm managers are typically not well-diversied
Salary, bonus, and compensation are tied to the
performance of the rm
Poor diversication makes managers risk-averse, i.e.,
they are harmed by a dollar of loss more than they are
helped by a dollar of gain
Managers have incentives to reduce uncertainty through
hedging
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Nonnancial Risk Management
Risk management is not a simple matter of hedging or not
hedging using nancial derivatives, but rather a series of
decisions that start when the business is rst conceived
Some nonnancial risk-management decisions are
Entering a particular line of business
Choosing a geographical location for a plant
Deciding between leasing and buying equipment
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Reasons Not to Hedge
Reasons why rms may elect not to hedge
Transaction costs of dealing in derivatives (such as,
commissions and the bid-ask spread)
The requirement for costly expertise
The need to monitor and control the hedging process
Complications from tax and accounting considerations
Potential collateral requirements
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Empirical Evidence on Hedging
Half of nonnancial rms report using derivatives
Among rms that do use derivatives, less than 25% of
perceived risk is hedged, with rms likelier to hedge
short-term risk
Firms with more investment opportunities are more likelier
to hedge
Firms that use derivatives have a higher market value and
more leverage
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Golddiggers revisited
Consider some additional strategies
Call and put premiums for gold options
Strike Put Call
Price Premium Premium
$440 $21.54 $2.49
420 8.77 8.77
400 2.21 21.26
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Net prot at expiration: buying a 420-strike put with premium of $8.77
and selling a 440-strike call with premium of $2.49. The prot for gold
prices between $420 and $440 is ($2.49 -$8.77) 1.05= $6.60.
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Comparison of Golddiggers hedged with 420-strike put versus hedged with
420-strike put and written 440-strike call (420440 collar).
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Comparison
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Comparison of unhedged prot for Golddiggers versus zero-cost collar
obtained by buying 400.78-strike put and selling 440.78-strike call.
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