Documente Academic
Documente Profesional
Documente Cultură
February 2017
massimiliano.barbi@unibo.it
Corporate risks
Yield curve
Interest rate risk
risk Repricing
risk
Exchange rate
Market risk risk
Commodity
price risk
Credit risk
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Hedging
Revenues Output price × quantity sold
– Costs Input price × quantity sold
= Profits Uncertain profit
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Hedging
Unit profit (= cash flow to the company’s shareholders) is
uncertain and has the following CDF:
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
4 120 100 80 60 40 20 0 -20 -40
Hedging
Expected CF per unit is €35, but there is volatility ( risk):
If the company could set the unit cost today (at, say, its expected
value, €65), the uncertainty over the future unit profit would
disappear ( hedging).
Unit CF 100
Hedging loss
35
Hedging gain
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Hedging and value
Should a company hedge its future prospects?
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Hedging and value: financial distress costs
1. Hedging reduces the expected costs of financial distress.
Hedged
Unhedged
X E(CF) CF
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Hedging and value: financial distress costs
• Direct bankruptcy costs.
• Legal/administrative costs in bankruptcy and liquidation (court, lawyers,
accountants).
• Direct bankruptcy costs are small (< 1% of overall market value) (Warner,
1977, JF).
• Indirect bankruptcy costs.
• Costs involved with the difficulties of running a business while it is going
through bankruptcy.
• These costs are difficult to quantify, but substantial. Examples:
• missed positive NPV investment opportunities;
• loss of customers that value post-sale services;
• loss of willing suppliers;
• difficulty retaining and recruiting employees;
• forced sales of assets at reduced prices.
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Hedging and value: financial distress costs
• Suppose that the quantity sold is 1M, and that r = 0%. Revenues
(R) are constant (€100 per unit, hence €100M), and operating
costs are random (unit C N(€65, €38), hence C N(€65M,
€38M)).
• The firm has a debt of €15M, and bankruptcy is costly
(bankruptcy costs are €3M).
• The value of the firm (assume just one period) is:
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Hedging and value: financial distress costs
• Also, PV(bankruptcy costs) are an increasing function of SD(CF):
PV(BC), 1.4
€M 1.2
1
0.8
0.6
0.4
0.2
SD(CF), €
0
0 20 40 60 80 100 120
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Hedging and value: debt overhang
2. Hedging makes it more likely that future attractive investments
will be made by the firm.
Payoff 1 year hence
Probability Project A Project B
30% €5M €0M
30% €5M €0M
9% €5M €0M
1% €5M €10M
• Both project A and project B require investing €3M today (and the
firm has cash).
• There is a debt outstanding of €5M expiring 1 year hence (the
company is in financial distress).
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Hedging and value: debt overhang
• Stockholders will prefer project B.
• It is much riskier, and its NPV is negative (= –€3M + PV(€0.1M)).
However, there is a 1% chance that they get something (vs. a 0%
chance for project B).
• Bondholders will prefer project A.
• It is a safe project with a positive NPV (= –€3 + PV(€5M)).
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Hedging and value: taxes
3. Hedging can reduce taxes.
Unhedged Hedged
Growth Recession Growth Recession
Probability 50% 50% 50% 50%
Gross profit €M 300 0 150 150
D&A €M 80 80 80 80
Interest expense, €M 20 20 20 20
EBT, €M 200 -100 50 50
Taxes (30%), €M 60 0 15 15
Net income, €M 140 -100 35 35
V = PV[E(CF – taxes)]
= PV[E(CF)] – PV[E(taxes)]
• Suppose also that the maximum amount that the firm can borrow
is €25M net of taxes in terms of face value (debt holders are not
willing to risk a haircut in case of default).
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Hedging and value: debt capacity
• With a 5% interest rate, the firm can borrow today B, where B is
found as:
V = PV[E(CF – taxes)]
• It is less costly for the firm to hedge than for individuals to hedge.
• Nonsystematic risk should be hedged when owners are not well
diversified.
• It reduces agency costs of managerial discretion on the company’s
cash flows.
• It also reduces sources of fluctuation of market value, and hence
helps shareholders to assess the skills of the company’s managers.
• Reducing risk, hedging should also imply a lower risk-adjusted
compensation to managers (e.g., stock options).
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Derivatives: a primer
A derivative is an instrument whose value depends on the value of
an underlying variable, e.g.:
interest rates and bonds;
common stocks or indexes (e.g., a stock index value);
foreign exchange rates;
commodity prices;
other.
Thus, the value of a derivative is “derived” from another
primary or underlying variable.
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Derivatives
Derivatives play an important role in financial and commodity
markets, allowing market participants to:
hedge and control risks;
reflect a view on the future direction of the market (speculating);
lock in an arbitrage profit.
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Derivatives
Derivatives
Forwards Options
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Global OTC derivatives
Notional, $ bln Mrk value, $ bln
800,000 40,000
700,000 35,000
600,000 30,000
500,000 25,000
400,000 20,000
300,000 15,000
200,000 10,000
100,000 5,000
0 0
H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Market value Notional
Source: Bank for International Settlements
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Global OTC derivatives
Source: Bank for International Settlements
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Global ET derivatives
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Global ET derivatives
Data based on the number of contracts traded and/or cleared at 76 exchanges worldwide
Source: Futures Industry Association, 2016 Annual Global Futures and Options Volume
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Global ET derivatives
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Global ET derivatives
Source: Futures Industry Association, 2016 Annual Global Futures and Options Volume
ICE Futures Singapore began trading in November 2015
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