On Hedging

1. On Hedging By RichardMacMinn

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

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 don’t 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

4. Historical sketch 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. The story of Joseph. What is the difference between dream interpretation and risk management? See Bernstein. • 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.

5. Historical sketch The corollary was introduced in MacMinn and Martin. • 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 company’s 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 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.

6. 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.” Example

7. Why hedge? • The capital investment decision 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

8. 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. 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?

10. 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?

11. 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 A depreciation in the dollar implies a smaller exchange rate, i.e., fewer dollars per euro.

12. 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

13. 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