Why do firms hedge?

Vinay 1
 Hedging, is it relevant?
Hedging unsystematic risk (Firm Specific)
by firms? Should firms do it? Will investor
allow spending money on a hedging
program by the company? May be not.
Hedging systematic risk? Reduce beta
through a hedging program? Will investors
allow? May be not.
So Is hedging irrelevant?

Vinay 2
 Risk Management Irrelevance
It holds when the fin markets are perfect.
The proposition goes like this; any risk
management program that a firm puts in
place can be replicated by shareholders
through homemade risk management
program. So irrelevant.

Vinay 3
 Multi Factor View
A development over CAPM is multi factor
models.
They say returns depend on various other
factor risk in addition to Market.
Let say one such factor risk is gold price
movement. The investors can hold the
stock with a gold price exposure and
hedge for gold price risk on his own.
So Irrelevance still persists.
Vinay 4
So what is the take?

Vinay 5
Vinay 6
Vinay 7
Vinay 8
 So what is the take?
Since we are talking about value, (NPV of
fixed assets) from an efficient market
perspective, hedging cash flow/price
volatility apparently looks irrelevant.

When there are financial market

imperfections or friction.

Vinay 9
 Hedging can

Reduce cost of Bankruptcy and Fin

Distress
Reduce Expected Taxes
Help plan capital needs
Help in executive compensation
Help in improve the quality of investment
and operating decisions
Vinay 10
 Example
A firm called Pure Gold sells 1 m ounces
of gold in a year and then liquidates.
Assume that this is an all equity firm to
start with. The price of gold per ounce is
$350 and there are no operating costs,
taxes for simplicity. All the cash flow
accrue to shareholders

Vinay 11
Cash flow to shareholders and operating cash flow.

Cash flow to shareholders

Unhedged cash flow
$450M

Expected cash
flow $350M
$250M

Cash flow to the

Expected cash firm
$250M flow $350M $450M

Vinay 12
 Creating the unhedged firm out of the hedged firm.

Unhedged cash flow

Cashflowto
shareholders

Forward
loss Hedged firm cash
$350M
(hedged) flow
Forward
gain

$350M (gold sold at forward)

Vinay 13
 Now
Lets assume that we have certain amount of
debt.
The moment we have debt the possibility of
bankruptcy cost looms large. (Ignore the benefits of
debt).
So the price volatility will adversely effect bankruptcy
costs.
Bankruptcy cost create wedge between firm cash flow
and cash-flow to shareholders. And shareholders
cannot do anything about it.
Value of the firm = PV of CF PV of BC if the firm is
bankrupt.
Vinay 14
 Cash flow to claimholders and bankruptcy costs.

Cash flow to claimholders

Unhedged cash flow
$450M
Expected cash
flow hedged
$350M
Unhedged
$340M
Bankruptcy
cost
$230M

Cash flow to the

Expected cash firm
$250M flow $350M $450M

Vinay 15
Expected bankruptcy cost as a function of volatility.

Expected bankruptcy
costs per ounce

Volatility
per ounce

Vinay 16
 Taxes
If taxes have to be paid paying later is better
than paying sooner. i.e pay taxes when your
income is less and than when your income is
high. Pension plans are good examples. You
can differ taxation on current income through a
pension plan assuming that your retirement
years tax rate will be lower than the current tax.
Suppose a firm current tax status allows it to pay
no tax upto a cashflow of 300m. Over and above
it a tax rate of 50% would be applicable.
(Assume an all equity firm No bankruptcy cost).
Vinay 17
 Taxes and cash flow to shareholders.

Cash flow to shareholders

Taxes
Hedged After-tax cash flow
Unhedged

Cash flow
to firm
$250M$300M$350M $450M
Vinay 18
 Speculators View
Speculators are risk takers and place bets
on their hunches
Financial derivatives allow them to do so
without committing a lot of money

Vinay 19
 Arbitrageurs
Arbitrageurs lock risk-less profits in
derivatives markets by simultaneously
entering into transactions in two markets.

Vinay 20
 Taxonomy of Risks
Avoidable Risks
Risks Elimination
Risk Reduction
Risk Retention

Vinay 21
 Board Course Objectives
Understand the use of futures, options,
swaps
Appreciate and evaluate the models of
pricing and estimation issues of futures,
options and swaps
Heuristic extension of the same for
practical application.

Vinay 22
 Extra Slide: MM Theory
Hedging sounds prudent, but some economists reckon that firms should not
do it because it reduces their value to shareholders. In the 1950s, two
economists, Merton Miller (19232000) and Franco Modigliani, argued that
firms make MONEY only if they make good investments, the kind that
increase their operating cashflow. Whether these investments are financed
through DEBT , EQUITY or retained earnings is irrelevant. Different
methods of financing simply determine how a firms value is divided
between its various sorts of investors (for example, shareholders or
bondholders), not the value itself.
This surprising insight helped win each of them a Nobel prize. If they are
right, there are big implications for hedging. If methods of financing and the
character of financial risks do not matter, managing them is pointless. It
cannot add to the firms value; on the contrary, as hedging does not come
free, doing it might actually lower that value. Moreover, argued Messrs
Miller and Modigliani, if investors want to avoid the financial risks attached
to holding SHARES a firm, they can diversify their portfolio of
shareholdings. Firms need not manage their financial risks; investors can do
it for themselves. Few managers agree.

Vinay 23