Derivatives and Corporate Risk Management

1
Derivatives and Corporate Risk Management

• By
• Richard MacMinn

2
Objectives

• Why manage risks?
• What are the risks?
• Which risks should be managed?
• How can the risks be managed?

3
Why manage risks?
A fundamental lesson in the MM article is that
levering does no increase value because
individual investors can lever on personal
account they can also unlever on personal
account. Hence, the individuals will not pay the
firm for what they can do as well on their
own. It follows that if the firm is to create
value then the firm must do something that the
investor cannot duplicate on personal account.
Discuss.

• Lessons from Modigliani and Miller
• The 1958 Theorem
• The corollary on the cost of capital
• If risk management adds value then it is because
  it
• reduces the tax bill
• eliminates distress costs or other agency costs
• improves managerial incentives

Discuss the proof of the MM58 theorem but go
ahead and prove this corollary.
4
Tax Benefits

• Tax shelters
• Corporate value

5
Distress Costs

• Debt capacity
• Bond value
• Lewellen 1971
• Stock value
• Corporate value
• Stakeholder values
• Financial distress
• Enron example
• Distress costs
• Shapiro, A. C. and S. Titman (1985). "An
  Integrated Approach to Corporate Risk
  Management." Midland Corporate Finance Journal
  3(2) 41-56.

6
Agency Costs

• Agency problems
• Risk-shifting (asset substitution)
• Under-investment
• Investment opportunities
• Financing options
• Pecking order theorem
• Myers, S. C. and N. S. Majluf (1984). "Corporate
  Financing and Investment Decisions When Firms
  Have Information That Investors Do Not Have."
  Journal of Financial Economics 13 187-221.

7
What are the risks?

• Identifying risks
• Risk management cube
• Income statement
• Revenue line
• To who does the firm sell?
• Where does the firm sell, e.g., foreign or
  domestic?
• Cost line (Cost of goods sold or COGS)
• Where does the firm manufacture?
• What are the raw materials?
• What is the technology?
• Balance sheet
• On or off balance sheet?

8
The risks

• Competitive risks
• Strategic considerations
• To what currencies are the firm rivals exposed?
• Do the firms rivals hedge their currency risks?
• Are the rivals commodity exposures denominated
  in dollars or in their domestic currency?
• Competitive exposures
• Currency
• Interest rate
• Commodity
• Equity

9
Currency risks
Let the P denote the corporate payoff in pounds
and Pd be the random domestic price in pounds E
be the random exchange rate, i.e., number of
pounds for yen Pf be the random foreign price in
yen C be the cost in pounds

• What is it?
• P Pd qd E Pf qf C(qd qf)
• What are the operating solutions?
• Production sites in foreign markets
• Foreign currency borrowing
• What are the financial solutions
• Derivatives
• Forwards and swaps
• Options

The financial solution may be lower cost than the
operating solutions. It may also be more
flexible, i.e., easier to reverse or otherwise
change with changing market conditions. The
operating solutions create bundled risks and the
derivatives represent an unbundling that makes
the risk and its cost much more transparent.
A swap is a multi-period forward contract.
Ignoring credit risk, the forward allows the
buyer to lock a price in now at which the
transaction will take place then.
10
Emerging market risks

• Emerging market risks
• Event risks
• Political changes
• Loss of currency convertibility
• Credit risk is more complex
• Government imposed exchange controls mimic
  default risk
• Counter-party risk and country risk become more
  important

11
Which risks should be managed?
12
How can the risks be managed?

• Capital structure
• Forwards and Futures
• Swaps
• Insurance
• Insurance linked securities

13
Forward Contracts
Let Pf denote the price in the foreign spot
market qfx denote the sales in the foreign spot
market qff denote the sales in the foreign
forward market

• Forward contracts
• Unhedged
• Hedged

14
Interest Rate Swap
This is an option on a forward-starting swap. It
gives the owner the right to enter into a swap at
agreed upon terms on an agreed date. The terms
specify the interest rate in the case of an
interest rate swaption.

• Swap
• Option
• Caps, Floors, Collars
• Forward-starting swap
• Swaption

To create a cap sell a call with the exercise
price set where you want the cap. To create a
floor purchase a put option with the exercise
price set where you want the floor.
This is simply a forward contract on a swap, i.e.
the contract is entered now but the swap is made
then.
15
Currency swap

• Richard MacMinn
• Get figure six in the JP Morgan notes put into a
  figure

16
Currency portfolio option
17
Emerging market risk management tools

• Synthetic FX forward contract
• Synthetic swap
• Synthetic Peso loan using a cross currency swap

18
Commodity, equity, and credit risks

• Commodity risks
• Tools
• Inventories can be used to hedge price risk
• Adopting a flexible production schedule can also
  hedge price risk
• Vertical integration can also hedge price risk
• Equity risks
• Tools
• Options
• Acquisitions and divestitures
• Credit risks
• Tools
• Insurance
• Letters of credit
• Credit derivatives

19
Commodity risk management

• Asian option
• Examples
• Copper inventories
• Oil delivery
• BTU management

20
Equity risk management

• Link to page 14

21
Credit risk management

• Link to page 20

22
Concluding Remarks

• Why manage risk?
• Which risks?
• How?