Chapter 30

1. Chapter 30 Risk Management

2. Chapter Outline 30.1 Insurance 30.2 Commodity Price Risk 30.3 Exchange Rate Risk 30.4 Interest Rate Risk

3. Learning Objectives Explain what is meant by the statement that, in a perfect market, insurance is actuarially fair. Compute the value of an actuarially fair insurance premium. Explain why insurance for large risks that are difficult to diversify has a negative beta; evaluate the impact of that beta on price. Discuss five market imperfections that are sources of value for insurance. List and define three costs of insurance.

4. Learning Objectives (cont'd) Describe three risk management strategies firms use to hedge their exposure to commodity price movements. Discuss the use of currency forwards and options contracts to hedge exchange rate risk. Discuss the use of the cash-and-carry strategy in currency hedging. Describe situations in which a firm would prefer currency options to futures for hedging. Use the Black-Scholes formula to compute the value of a currency option.

5. Learning Objectives (cont'd) Define interest rate risk and discuss tools to manage that risk. Define and compute duration of a single asset and of a portfolio. Use duration to measure the change in value attributable to a change in yields. Explain the use of equity duration to manage interest rate risk. Describe the use of swaps in managing interest rate risk; explain how the use of swaps separates the risk of interest changes from the risk of changes in the firm’s credit quality.

6. 30.1 Insurance Insurance is the most common method firms use to reduce risk. Property Insurance A type of insurance companies purchase to compensate them for losses to their assets due to fire, storm damage, vandalism, earthquakes, and other natural and environmental risks

7. 30.1 Insurance (cont'd) Business Liability Insurance A type of insurance that covers the costs that result if some aspect of a business causes harm to a third party or someone else’s property Business Interruption Insurance A type of insurance that protects a firm against the loss of earnings if the business is interrupted due to fire, accident, or some other insured peril

8. 30.1 Insurance (cont'd) Key Personnel Insurance A type of insurance that compensates a firm for the loss or unavoidable absence of crucial employees in the firm

9. The Role of Insurance: An Example Consider an oil refinery with a 0.02% chance of being destroyed by a fire in the next year. If it is destroyed, the firm estimates that it will lose $150 million in rebuilding costs and lost business.

10. The Role of Insurance: An Example (cont'd) The risk from fire can be summarized with a probability distribution:

11. The Role of Insurance: An Example (cont'd) Given this probability distribution, the firm’s expected loss from fire each year is $30,000. 99.98% ×($0) + 0.02% ×($150 million) = $30,000 While the expected loss is relatively small, the firm faces a large downside risk if a fire does occur. The firm can manage the risk purchasing insurance to compensate its loss of $150 million.

12. The Role of Insurance: An Example (cont'd) Insurance Premium The fee a firm pays to an insurance company for the purchase of an insurance policy

13. Insurance Pricing in a Perfect Market Actuarially Fair When the NPV from selling insurance is zero because the price of insurance equals the present value of the expected payment

14. Insurance Pricing in a Perfect Market (cont'd) If rL is the appropriate cost of capital given the risk of the loss, the actuarially fair premium is calculated as follows: Actuarially Fair Insurance Premium rL depends on the risk being insured.

15. Insurance Pricing in a Perfect Market (cont'd) Consider again the oil refinery. The risk of fire is specific to this firm and, therefore, diversifiable. By pooling together the risks from many policies, insurance companies can create very-low-risk portfolios whose annual claims are relatively predictable. In other words, the risk of fire has a beta of zero, so it will not command a risk premium. In this case, rL equals the risk-free interest rate.

16. Insurance Pricing in a Perfect Market (cont'd) Not all insurable risks have a beta of zero. Some risks, such as hurricanes and earthquakes may be difficult to diversify completely. For risks that cannot be fully diversified, the cost of capital rL will include a risk premium.

17. Insurance Pricing in a Perfect Market (cont'd) By its very nature, insurance for non-diversifiable hazards is generally a negative beta asset (it pays off in bad times). Thus, the risk-adjusted rate rLfor losses is less than the risk-free rate rf, leading to a higher insurance premium in the actuarially fair insurance premium equation. While firms that purchase insurance earn a return rL< rf on their investment, because of the negative beta of the insurance payoff, it is still a zero-NPV transaction.

18. Textbook Example 30.1

19. Textbook Example 30.1 (cont'd)

20. Alternative Example 30.1 Problem As the owner of a concession booth in a major airport, you decide to purchase insurance that will pay $2 million in the event the airport terminal is destroyed by terrorists. Suppose the likelihood of such a loss is 0.05%, the risk-free interest rate is 3%, and the expected return of the market is 8%. If the risk has a beta of zero, what is the actuarially fair insurance premium? What is the premium if the beta of terrorism insurance is −3?

21. Alternative Example 30.1 (cont’d) Solution The expected loss is 0.05% × $2 million = $1,000. If the risk has a beta of zero, we compute the insurance premium using the risk-free interest rate: ($1,000)/1.03 = $970.87. If the beta of the risk is not zero, we can use the CAPM to estimate the appropriate cost of capital.

22. Alternative Example 30.1 (cont’d) Solution (cont’d) Given a beta for the loss, βL, of −3, and an expected market return, rmkt, of 8%: rL = rf + βL (rmkt − rf ) = 3% − 3 (8% − 3%) = −12% In this case, the actuarially fair premium is ($1,000)/(1 − 0.12) = $1,136.36. Although this premium exceeds the expected loss, it is a fair price given the negative beta of the risk.

23. The Value of Insurance In a perfect capital market, there is no benefit to the firm from any financial transaction, including insurance. Insurance is a zero-NPV transaction that has no effect on value. The value of insurance comes from reducing the cost of market imperfections.

24. The Value of Insurance (cont'd) Consider the potential benefits of insurance with respect to the following market imperfections: Bankruptcy and Financial Distress Costs By insuring risks that could lead to distress, the firm can reduce the likelihood that it will incur these costs.

25. The Value of Insurance (cont'd) Issuance Costs When a firm experiences losses, it may need to raise cash from outside investors by issuing securities. Insurance provides cash to the firm to offset losses, reducing the firm’s need for external capital thus reducing issuance costs.

26. Textbook Example 30.2

27. Textbook Example 30.2 (cont'd)

28. Alternative Example 30.2 Problem Suppose the risk of a railroad accident for a major railroad is 1.2% per year, with a beta of zero. If the risk-free rate is 6%, what is the actuarially fair premium for a policy that pays $100 million in the event of a loss?

29. Alternative Example 30.2 Problem (continued) What is the NPV of purchasing insurance for an airline that would experience $25 million in financial distress costs and $15 million in issuance costs in the event of a loss if it were uninsured?

30. Alternative Example 30.2 Solution The expected loss is: 1.2% × $100 million = $1,200,000 The actuarially fair premium is: $1,200,000 ÷ 1.06 = $1,132,075

31. Alternative Example 30.2 Solution (continued) The total benefit of the insurance to the railroad is $100 million plus an additional $40 million in distress and issuance costs that it can avoid if it has insurance. The NPV from purchasing the insurance is:

32. The Value of Insurance (cont'd) Tax Rate Fluctuations When a firm is subject to graduated income tax rates, insurance can produce a tax savings if the firm is in a higher tax bracket when it pays the premium than the tax bracket it is in when it receives the insurance payment in the event of a loss.

33. The Value of Insurance (cont'd) Debt Capacity Because insurance reduces the risk of financial distress, it can relax the tradeoff between leverage & financial distress costs and allow the firm to increase its use of debt financing.

34. The Value of Insurance (cont'd) Managerial Incentives By eliminating the volatility that results from perils outside management’s control, insurance turns the firm’s earnings and share price into informative indicators of management’s performance.

35. The Value of Insurance (cont'd) Risk Assessment Insurance companies specialize in assessing risk and will often be better informed about the extent of certain risks faced by the firm than the firm’s own managers.

36. The Costs of Insurance Market imperfections can raise the cost of insurance above the actuarially fair price.

37. The Costs of Insurance (cont'd) Insurance Market Imperfections Three main frictions may arise between the firm and its insurer. Transferring the risk to an insurance company entails administrative and overhead costs. Adverse selection: A firm’s desire to buy insurance may signal that it has above-average risk.

38. The Costs of Insurance (cont'd) Insurance Market Imperfections Three main frictions may arise between the firm and its insurer. Agency costs Moral Hazard: When purchasing insurance reduces a firm’s incentive to avoid risk. For example, after purchasing fire insurance, a firm may decide to cut costs by reducing expenditures on fire prevention.

39. The Costs of Insurance (cont'd) Addressing Market Imperfections Insurance companies try to mitigate adverse selection and moral hazard costs in a number of ways. For example, they may Screen applicants to assess their risk as accurately as possible Investigate losses to look for evidence of fraud or deliberate intent

40. The Costs of Insurance (cont'd) Addressing Market Imperfections Deductible A provision of an insurance policy in which an initial amount of loss is not covered by the policy and must be paid by the insured Policy Limits The provisions of an insurance policy that limit the amount of loss that the policy covers regardless of the extent of the damage

41. Textbook Example 30.3

42. Textbook Example 30.3 (cont'd)

43. The Insurance Decision For insurance to be attractive, the benefit to the firm must exceed the additional premium charged by the insurer. Insurance is most likely to be attractive to firms that are currently financially healthy, do not need external capital, and are paying high current tax rates. They will benefit most from insuring risks that can lead to cash shortfalls or financial distress, and that insurers can accurately assess and monitor to prevent moral hazard.

44. 30.2 Commodity Price Risk Many risks that firms face arise naturally as part of their business operations. For example, the risk from increases in the price of oil is one of the most important risks that faces an airline. Firms can reduce, or hedge, their exposure to commodity price movements. Like insurance, hedging involves contracts or transactions that provide the firm with cash flows that offset its losses from price changes.

45. Hedging with Vertical Integration and Storage Vertical Integration Refers to the merger of a firm and its supplier or a firm and its customer. Because an increase in the price of the commodity raises the firm’s costs and the supplier’s revenues, these firms can offset their risks by merging. Vertical integration can add value if combining the firms results in important synergies. Vertical integration is not a perfect hedge.

46. Hedging with Vertical Integration and Storage (cont'd) Long-term storage of inventory is another strategy for offsetting commodity price risk. For example, an airline concerned about rising fuel costs could purchase a large quantity of fuel today and store the fuel until it is needed. By doing so, the firm locks in its cost for fuel at today’s price plus storage costs. However, storage costs may be too high for this strategy to be attractive.

47. Hedging with Vertical Integration and Storage (cont'd) Long-term storage of inventory also requires a substantial cash outlay upfront. If the firm does not have the required cash, it would need to raise external capital and would suffer issuance and adverse selection costs. Maintaining large amounts of inventory would dramatically increase working capital requirements for the firm.

48. Hedging with Long-Term Contracts Consider Southwest Airlines. In early 2000, when oil prices were close to $20 per barrel, the CFO developed a hedging strategy to protect the airline from a surge in oil prices. By the time oil prices soared above $30 per barrel later that year Southwest had signed contracts guaranteeing a price for its fuel equivalent to $23 per barrel.

49. Hedging with Long-Term Contracts (cont'd) However, had oil prices fallen below $23 per barrel in the fall of 2000, Southwest’s hedging policy would have obligated it to pay $23 per barrel for its oil. Southwest accomplished it’s objective by locking in its cost of oil at $23 per barrel, regardless of what the price of oil did on the open market.

50. Figure 30.1 Commodity Hedging Smoothes Earnings