How To Hedge Risk

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Prof. Ian Giddy

New York University

Financial Risk Management SIM/NYU

The Job of the CFO

Risk Management is a Process

Corporate Risk Management

Define

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Financial Risk Management

lWhy does it matter?

lWhy and when should we hedge?

lWhat should we hedge? How should we

gauge exposure?

lFinancial risk management must be tied

to the company’s business

The Case For Hedging

lCompany has special information

lCompany has special market access

lSecure cash for investment opportunities

lReduce potential costs of financial

distress, increase debt capacity, and reduce expected taxes

Since currency matching reduces the probability of financial distress, it allows the firm to have greater leverage and therefore a greater tax shield.

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ALL-EQUITY VALUE DEBT RATIO HEDGING CAN REDUCE COSTS OF FINANCIAL DISTRESS

Optimal Capital Structure

Negative

net worth Positivenet worth

Distribution of net worth with hedging

Distribution of net worth without hedging (or with greater exchange rate volatility)

Profile of return to creditors

Costs of bankruptcy to creditors

+

-Hedging, Valuation, Taxes and Financial Distress

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When Should Firms Hedge?

Business risk

Financial risk

Which Firms Should Hedge?

Characteristics of firms for which financial stress is especially costly:

l Firms with:

uProducts that require after-sale servicing

uProducts whose quality is difficult to determine in advance

uProducts with high switching costs

uProducts that rely on third-party servicing

l And firms that have:

uHigh-growth opportunities

uIntangible assets like firm-specific human capital

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What Exposure Should Firms Hedge?

l

Currency risk

uTransactions

uTranslation exposure

uEconomic exposure

u

Interest Rate Risk

u

Commodity Price Risk

Measuring Market Exposure

lDefining corporate exposure:

“How will my company’s value be affected by market price fluctuations?”

lTypes of exposure

uTransactions

uBalance sheet/portfolio

uEconomic

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How Effective is My Company’s Risk Management?

l Don’t measure risk

l No linkage of risk to

value

l No effort to anticipate

l Lack of business risk

policy l Fragmented effort l Narrow focus l Poor risk communications l Lack of an integrated risk assessment framework Warning Signs:

Formalize Risk Management Policy and Control Framework

Define

Define MeasureMeasure ManageManage MonitorMonitor

• Develop an outline of a policy statement, or recommend improvements to existing document

• Benchmark controls versus best practice using the Group of Thirty Recommendations, Treasury Management Association Guidelines, or accumulated knowledge of appropriate practices • Assess centralization issues

related to financial risk management and treasury design

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Identification and Definition of Financial Exposures

Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with

management's desired risk profile.

Translation Exposure, Transaction Exposure, and

Economic Exposure • Long-term versus short-term

exposure

• Intracompany versus third party exposure

• Cross currency exposure • Competitive exposures

Absolute Rate Risk, Convexity, Basis or Correlation Risk

Currency Interest Rate

• Short-term liquidity portfolio • Investment portfolio • Capital markets borrowing • Leasing portfolio

Price Risk, Basis or Correlation Risk

Commodity

• Procurement • Inventory • Sales elasticity

Market Risks: Definitions

Three Views of

Market Price Risk:

lTransactions

lBalance Sheet/Portfolio

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Market Risks: Definitions

Three Views of

Market Price Risk:

lTransactions lBalance Sheet/Portfolio lEconomic risk. Transactions Exposure Transactions Exposure Portfolio Exposure Portfolio Exposure Economic Exposure Economic Exposure Transactions Exposure

lTransactions exposure results from

particular transactions such as an export where a known cash flow in a given

currency will take place at a certain date uExample: If Nokia invoices a NTT of Japan in

Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen.

uThis kind of exposure is readily hedgable using forwards, futures or debt

Transactions Exposure Transactions Exposure Portfolio Exposure Portfolio

Exposure Economic_Exposure Economic Exposure

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But Transactions Exposure Can be Misleading...

lAustin Computer purchases notebook

computers in Taiwan for sale in the US.

lAustin must pay in NT$.

lShould it hedge its anticipated

payments for 1996? Transactions Exposure Exposure Portfolio Exposure Portfolio

Exposure Economic_Exposure Economic Exposure Austin Computer NT$ Transactions Exposure Transactions Exposure Portfolio Exposure Portfolio

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Interest Rate Risk: Portfolio

lPortfolio risk: interest rate fluctuations

can affect the value of a bond investment portfolio

lBond price fluctuations will affect the

balance sheet

lCan be hedged, using duration as a

risk/sensitivity measurement tool

lCan be hedged with futures, bond

options, and swaps.

Transactions Exposure Exposure Portfolio Exposure Portfolio

Exposure Economic_Exposure Economic Exposure Pepsico Pension Assets (each $10m): u1-year E$ deposit u5-year, 6% T-note D=4.6 u10-year Strip Pension liabilities: u$10m 3 years u$10m 5 years u$10m 7 years

l

What is Pepsico pension fund’s risk?

uDuration of the assets (+ve)

uDuration of the liabilities (-ve)

uNet duration is the risk to be hedged!

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Value at Risk: SantosBank

Asset and liability positions for a Brazilian bank’s New York branch. What risk does it

face?

INSTRUMENT SANTOSBANK POSITIONS

30 day ($1,250,000) 90 day ($100,000) 180 day $450,000 1 yr $120,000 2 yr $120,000 3 yr $120,000 4 yr $1,120,000 5 yr $0 7 yr $0 9 yr $0 10 yr ($420,000) 15 yr $0 NET $160,000 TOTAL $3,700,000 Transactions Exposure Exposure Portfolio Exposure Portfolio

BIS: Minimize Value at Risk

Value-at-Risk Value-at-Risk

INSTRUMENT SANTOSBANK POSITIONS

30 day ($1,250,000) 90 day ($100,000) 180 day $450,000 1 yr $120,000 2 yr $120,000 3 yr $120,000 4 yr $1,120,000 5 yr $0 7 yr $0 9 yr $0 10 yr ($420,000) 15 yr $0 NET $160,000 TOTAL $3,700,000

+

=

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Market Price Risk: Economic

l

Economic risk

arises from the real

business risk of the company,

insofar as it is tied to market

interest rates, FX, commodity

prices

l

It affects the

shareholder value,

but

may be difficult to quantify

l

Hedging may require tailored

solutions

Transactions Exposure Exposure Portfolio Exposure Portfolio

Inmet Mining Corp.

lIn 1994 Canadian mining company

Inmet bought 48% of Bougrine, a lead & zinc mine in Tunisia. Inmet had to borrow $33 million at a floating rate. Should it hedge its cost of funds?

lAnswer: Business exposure is to lead &

zinc prices (mine shutdown in Oct 96 because of low zinc prices)

lHedge with digital option linking cost

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Market Price Risks: Summary

Three Views of

Market Price Risk:

lTransactions - lock in

forward rate

lPortfolios

uAvoid duration mismatching

lMinimize Value at Risk

lEconomic risk - business

sensitivity to market prices.

Exposure Economic_Exposure Economic Exposure Volatility in Cashflow 49% Volatility in Earnings 42%

Market Value of the Firm 8%

“Most Important” Objective In Using Derivatives To Hedge

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Next Step: Analyze Current

Exposure Measurement Techniques

Precision of the data Precision of the data

Time horizon of the projections

Frequency of reporting

•Current trade flow data •Portfolio system reports •Accounting information •Budgeted trade flow data •Pricing practices Risk Information Sources: Quantification Adequacy Corporate Exposure Information Sources

Current trade flow data

Portfolio system reports

Accounting information

Budgeted trade flow data

Economic exposure estimates Hard Soft Exposure Database

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Exposure Database: Example

Exposure Database

From Data to Analysis

Exposure Database

Exposure Measurement System

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A Management-Friendly Report

lAn example is FourFifteen™, named

after J.P. Morgan's market risk report produced at 4:15 p.m. each day.

lThe "4:15 Report," a single sheet of

paper, summarizes the Daily Earnings at Risk for J.P. Morgan worldwide.

n nn Portfolio Risk Simulation n nn USD Base. Vols. & correls. as of May 04, 1995.

n n nnnnnnnnnAUDnnnBEFnnnCADnnnnDKKnnFFRnnnDEMnnnITLnnnJPYnnnNLGnnnESBnnnSEKnnnCHFnnGBPXEUnn USD Total n nn 1 Mon n nnnn 1522 n nn 37 n nnn n3 Monn nnn- 200 nn20 - 30 n n nn nn 160 - 50 n nn 6 Mon nn 25 n nnn nn - 5 20 n nn 12 Mo n n nn nn - 105 - 105 n nn 2 Yr n nn 0 n nn 3 Yr n nn 0 n nn 4 Yr n nn 0 n nn 5 Yr n nn 0 n nn 7 Yr n nn 0 n nn 9 Yr n nn 0 n nn 10 Yr n nn 0 n nn 15 Yr n nn 0 n nn 20 Yr n nn 0 n nn 30 Yr n nn 0 n nn Equity n nn 0 n nnn Impliednnnnnnn- 196.1nnnn5922- 29 n n nn nn 54 - 145 n nn Spotn nn 23 n nn 23 n nnn nNetnnnnnn- 196.1nnnn8222- 29 n nn - 122 n nnn Int.nnnnnnn502nnnn2625139 n n nn nn 400 740 n nn Eq. n nnn nFxnnn nnn5,048nnnn426513831820 n nn 8516 n nnn divers.nnnnnnn- 200nnnn- 347- 6- 83 n nn - 451 n nnn nNetnnn nnn5,350nnnn418113831876 n n nn nn 400 8805 n n n RISK n n n ($000) n nn RiskMetricsª n n n Gov't Bonds Zero Cashflow n nn FX

Exposure Report: Example

Portfolio Risk Simulation

USD Base. Vols. & correls. as of May 04, 1995.

AUD BEF CAD DKK FFR DEM ITL JPY NLG ESB SEK CHF GBP XEU USD Total

1 Mo 15 22 37 3 Mo -200 20 -30 160 - 50 6 Mo 25 -5 20 12 Mo -105 - 105 2 Yr 0 3 Yr 0 4 Yr 0 5 Yr 0 7 Yr 0 9 Yr 0 10 Yr 0 15 Yr 0 20 Yr 0 30 Yr 0 Equity 0 Implied - 196.1 59 22 -29 54 -145 Spot 23 23 Net - 196.1 82 22 -29 -122 Int. 502 262 5 139 400 740 Eq. Fx 5,048 4265 1383 1820 8516 divers. -200 -347 -6 -83 -451 Net 5,350 4181 1383 1876 400 8805 RISK ($000) RiskMetricsª

Gov't Bonds Zero Cashflow

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Market Risk Measurement

Volumetric

Volumetric Duration/ Duration/

PVof01 PVof01 Option Option Sensitivity Sensitivity Measures Measures Simulations Simulations Value Value at at Risk Risk • Notional Amounts • Linear risk measures • Swap/ bond equivalents • Non-linear risk measures • Delta, gamma,

vega, theta, rho • No aggregation of risk measures across asset classes or instruments • Limited market scenarios that could include market correlations • Reprice portfolio • Parallel and

non-parallel curve shifts

• Aggregate portfolio risk per scenario

• Distribution of market moves and portfolio values • Includes market correlations • Reprice portfolio • Aggregate risk measures within confidence interval

Where are we now? Where do we need to be?

An Overview of Corporate VAR

Mean

Estimates of Cash Flow Distribution

• Volatilities • Correlations Base rates/ Currency market conditions Model 1 Model 2 Model 3 Interest Rates Equities Commodities Impact on Business 2 Business 1 Business 3 Transactional Database Projected Revenues

Projected Operating Costs

Portfolio Database

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Analyze Exposure Management Activities

Evaluate alternative hedging techniques

Strategic alignment

•Multicurrency borrowing/ investing, currency of invoice, & commercially-based hedging techniques

•Financial instruments such as forwards, futures, swaps and options

•Expected and out-of-pocket costs, benefits and risks of potential strategies; competitors’ actions

•Accordance with overall corporate policy and acceptable from an accounting and regulatory standpoint, if applicable

Cost/benefit analysis Investigate opportunities for

natural offsets

Corporate Exposure Management: Match Tools to Risks

Current trade flow data

Portfolio system reports

Accounting information

Budgeted trade flow data

Economic exposure estimates Hard Soft Inflexible, committed Flexible, optional

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Forwards

Futures Swaps _OTC OptionsExchange

Options Struct._Der. Hybrid Debt Equity Commodity Interest Rates Foreign Exchange 0% 10% 20% 30% 40% 50% 60% 70% Source of Exposure Type of Transaction

1995 CIBC/Wharton End- User Survey Most-Used Instruments

Hedge Identifiable Exposure

11% 12% 6% 61% 48% 33% 10% 20% 30% 40% 50% 60% 70% 80% Sometimes Frequently Wharton/ CIBC Wood Gundy 1995 End-User Survey: Frequency With Market Views Impact

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Wrong Risk Measurement Methods

Risk!

Monitoring and Control

Define

Define MeasureMeasure ManageManage MonitorMonitor

• Monitoring implies

performance measurement • Performance measurement

is the science of attribution • Performance measurement requires a benchmark • Surprises require reassessment and response Uncertain Markets Uncertain Exposures Mistaken Views Risk! Wrong methods

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Evaluate Management Reporting and Risk Management Monitoring Process

Senior Management Independent Risk Management/ Internal Audit Exposure

Information Financial Product _Information Limits &

Benchmarks

Management reporting and focused performance measurement are necessary to identify problems with the current risk management strategies

Summary: Corporate Market Risk Management is a Process

Define

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Ian Giddy

Ian H. Giddy

NYU Stern School of Business

44 West 4th Street, New York, NY 10012 Tel 212-998-0332; Fax 212-995-4233 [email protected]