On Hedging

By

Richard MacMinn
9/7/2013 2
Objectives
What are the goals of risk
management?
Premises for risk management
Is risk management irrelevant?
Why should the firm hedge?
When should the firm hedge?
Guidelines for hedging
9/7/2013 3
Premises for risk management
The risk management paradigm rests on the
following three premises:
Corporate value is created by good investments
Generating internal cash is necessary to fund good
investments
Companies that dont generate sufficient cash tend to cut
investment more drastically
Cash flow crucial to investment can be disrupted by external
factors such as exchange rates, commodity prices and
interest rates
The risk management program must ensure that the
firm can make the investments that create value
9/7/2013 4
Historical sketch
Pharaoh
Inventory
Middle Ages
Futures
Berle & Means
Diversification
Dresser Industries
Dresser is used as
an example of the
breakdown in the
logic that the
corporation need
not diversify since
investors can
diversify on
personal account
by buying stock in
petrochemical
firms as well as
oil firms.
Berle and Means represent a precursor to
modern finance. The Berle and Means
argument is that the corporate form was
developed to enable firms to disperse risk
among many small investors. This
notion has also been discussed by
Samuelson in 1967 and MacMinn 1984.
If this is so then the firm need not
diversify risk on corporate account.
Use MacMinn and Martin to discuss the
corollary to the MM58 theorem. The
nexus of contracts is irrelevant.
The story of Joseph.
What is the difference
between dream
interpretation and risk
management? See
Bernstein.
Discuss the natural hedge versus the
futures contract.
Note that the risk averse farmer wants to
sell more forward to reduce income risk and
so normally we see the relation: f < EP, i.e., a
forward price less than the expected spot
price; this is called normal backwardation.
9/7/2013 5
Historical sketch
Modern finance
Modigliani and Miller 1958
Corollary to the 1958 Modigliani-Miller theorem
Post-modern paradigm
Myers and Majluf
MacMinn and Page
Froot, Scharfstein and Stein
Internally generated cash is therefore a competitive weapon that
effectively reduces a companys cost of capital and facilitates
investment. p. 94
. . . the role of risk management is to ensure that companies have the
cash available to make value-enhancing investment p. 94
Brander and Lewis
The corollary was
introduced in
MacMinn and Martin.
The role of risk management is to
ensure that the firm has the cash
available for investment when it is
needed. If the firm does and its
competitors do not then it has
achieved a competitive advantage.
9/7/2013 6
Example
Dresser Industries
During the late 1930s it
spent five times the
industry average on
research and development,
adding 128 new types of
products.
Dresser officially became
known as Dresser
Industries, Inc. in 1944 and
opened new headquarters
offices in Cleveland the
next year. An
unprecedented boom in the
energy, petrochemical and
housing construction
industries fueled its post-
war growth.

9/7/2013 11
Why hedge?
The capital investment decision


( )
( )
t
t 1
e Pq mq
Pq mq
npv ek q e k q
r
1 r

| |
= + = +
|
\ . +

r is the rate of interest

e is the random
exchange rate, i.e.,
dollars per yen
P is the random spot
price
k is the capital cost per
unit of capacity
m is the unit variable
cost
q is the output of firm in
market

9/7/2013 12
When to hedge
Risk and the optimal investment
Exchange rate
Commodity price
Interest rate
Property loss
Claim
An oil company has less incentive to manage risk because
investment opportunities are only good when oil prices are
high.
Claim
An increase in commodity price risk reduces the optimal
investment.

Consider the condition
for an optimal
investment decision.
Consider the claim in
view of the first order
condition.

9/7/2013 13
When to hedge
Froot, Scharfstein, and Stein
The goal of risk management is not to insure investors and
corporate managers against oil price risk per se. It is to
ensure that companies have the cash they need to create
value by making good investments. p. 98
Key issues
This approach helps identify what is worth hedging and what
is not.
This approach helps identify how much hedging is
necessary.
Is the firm naturally hedged?
How sensitive is the value of the investment to changes in
interest and exchange rates? Commodity prices?
9/7/2013 14
Guidelines
Companies in the same industry should not necessarily select the same
hedge
An all equity firm would select its production level to maximize stock value
and differences in marginal costs may imply differences in optimal hedging,
i.e.,




Consider the different investment opportunities noted by Froot, Scharfstein
and Stein
Companies may benefit from risk management even if they have no
major investments in plant and equipment
Consider a firm with investment opportunities in human capital, brand
names, or market share
Investment in human capital cannot be collateralized
Investment in market share may require lowering price and that also is difficult to
collateralize
Even companies with conservative capital structure can benefit from
hedging
Why might the firm have chosen a conservative capital structure?
( ) ( )
c
' = = =
c

n n
1 1
S
S(q) p( ) P( )q c(q) p( ) P( ) c (q) 0
q
9/7/2013 15
Guidelines
Multinational companies must recognize that foreign exchange
risk affects not only cash flows but also operating decisions.
Example one
Commodity price and cost in euros



The sign of the derivative does not depend on the size of the
exchange rate.
Example two
Commodity price in dollars and cost in euros



The sign of the derivative does depend on the magnitude of the
exchange rate


( )
e Pq c(q) ( ) ( ) ( )
e Pq c(q) e P c (q)
q
c
' =
c
( )
Pq ec(q) ( ) ( ) ( )
Pq ec(q) P ec (q)
q
c
' =
c
A depreciation in
the dollar implies a
smaller exchange
rate, i.e., fewer
dollars per euro.

9/7/2013 16
Guidelines
Companies should pay close attention to hedging
strategies of their competitors
This will allow the corporation to assess the capabilities of its
competitors, e.g., can the competitor invest when the
exchange rates move against it?
The choice of specific derivatives cannot be
delegated
Management must select the tools consistent with the
strategic advantage
Financial futures may yield more variability in cash flows
along with the liquidity while the forward does not increase
the variability of cash flows but does incur credit risk
9/7/2013 17
To hedge or not
Risk management cannot be ignored
since that has costs
Risk management cannot be delegated
Pay attention to the source, risk, etc. of
the cash flows