The document discusses whether firms should hedge risk and if hedging is relevant from the perspective of investors. It notes that traditional capital asset pricing model (CAPM) views hedging as irrelevant since investors can replicate any hedging program themselves. However, in the presence of market imperfections like bankruptcy costs, taxes, and additional risk factors, hedging may provide value by reducing costs and improving investment decisions. Overall, while hedging may seem irrelevant from an efficient market view, it can create value when considering real world complexities like financial distress costs and tax benefits.
The document discusses whether firms should hedge risk and if hedging is relevant from the perspective of investors. It notes that traditional capital asset pricing model (CAPM) views hedging as irrelevant since investors can replicate any hedging program themselves. However, in the presence of market imperfections like bankruptcy costs, taxes, and additional risk factors, hedging may provide value by reducing costs and improving investment decisions. Overall, while hedging may seem irrelevant from an efficient market view, it can create value when considering real world complexities like financial distress costs and tax benefits.
The document discusses whether firms should hedge risk and if hedging is relevant from the perspective of investors. It notes that traditional capital asset pricing model (CAPM) views hedging as irrelevant since investors can replicate any hedging program themselves. However, in the presence of market imperfections like bankruptcy costs, taxes, and additional risk factors, hedging may provide value by reducing costs and improving investment decisions. Overall, while hedging may seem irrelevant from an efficient market view, it can create value when considering real world complexities like financial distress costs and tax benefits.
The document discusses whether firms should hedge risk and if hedging is relevant from the perspective of investors. It notes that traditional capital asset pricing model (CAPM) views hedging as irrelevant since investors can replicate any hedging program themselves. However, in the presence of market imperfections like bankruptcy costs, taxes, and additional risk factors, hedging may provide value by reducing costs and improving investment decisions. Overall, while hedging may seem irrelevant from an efficient market view, it can create value when considering real world complexities like financial distress costs and tax benefits.
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Why do firms hedge?
Vinay 1 Hedging, is it relevant? Hedging unsystematic risk (Firm Specific) by firms? Should firms do it? Will investor allow spending money on a hedging program by the company? May be not. Hedging systematic risk? Reduce beta through a hedging program? Will investors allow? May be not. So Is hedging irrelevant?
Vinay 2 Risk Management Irrelevance It holds when the fin markets are perfect. The proposition goes like this; any risk management program that a firm puts in place can be replicated by shareholders through homemade risk management program. So irrelevant.
Vinay 3 Multi Factor View A development over CAPM is multi factor models. They say returns depend on various other factor risk in addition to Market. Let say one such factor risk is gold price movement. The investors can hold the stock with a gold price exposure and hedge for gold price risk on his own. So Irrelevance still persists. Vinay 4 So what is the take?
Vinay 5 Vinay 6 Vinay 7 Vinay 8 So what is the take? Since we are talking about value, (NPV of fixed assets) from an efficient market perspective, hedging cash flow/price volatility apparently looks irrelevant.
When there are financial market
imperfections or friction.
Vinay 9 Hedging can
Reduce cost of Bankruptcy and Fin
Distress Reduce Expected Taxes Help plan capital needs Help in executive compensation Help in improve the quality of investment and operating decisions Vinay 10 Example A firm called Pure Gold sells 1 m ounces of gold in a year and then liquidates. Assume that this is an all equity firm to start with. The price of gold per ounce is $350 and there are no operating costs, taxes for simplicity. All the cash flow accrue to shareholders
Vinay 11 Cash flow to shareholders and operating cash flow.
Cash flow to shareholders
Unhedged cash flow $450M
Expected cash flow $350M $250M
Cash flow to the
Expected cash firm $250M flow $350M $450M
Vinay 12 Creating the unhedged firm out of the hedged firm.
Unhedged cash flow
Cashflowto shareholders
Forward loss Hedged firm cash $350M (hedged) flow Forward gain
$350M (gold sold at forward)
Vinay 13 Now Lets assume that we have certain amount of debt. The moment we have debt the possibility of bankruptcy cost looms large. (Ignore the benefits of debt). So the price volatility will adversely effect bankruptcy costs. Bankruptcy cost create wedge between firm cash flow and cash-flow to shareholders. And shareholders cannot do anything about it. Value of the firm = PV of CF PV of BC if the firm is bankrupt. Vinay 14 Cash flow to claimholders and bankruptcy costs.
Vinay 15 Expected bankruptcy cost as a function of volatility.
Expected bankruptcy costs per ounce
Volatility per ounce
Vinay 16 Taxes If taxes have to be paid paying later is better than paying sooner. i.e pay taxes when your income is less and than when your income is high. Pension plans are good examples. You can differ taxation on current income through a pension plan assuming that your retirement years tax rate will be lower than the current tax. Suppose a firm current tax status allows it to pay no tax upto a cashflow of 300m. Over and above it a tax rate of 50% would be applicable. (Assume an all equity firm No bankruptcy cost). Vinay 17 Taxes and cash flow to shareholders.
Cash flow to shareholders
Taxes Hedged After-tax cash flow Unhedged
Cash flow to firm $250M$300M$350M $450M Vinay 18 Speculators View Speculators are risk takers and place bets on their hunches Financial derivatives allow them to do so without committing a lot of money
Vinay 19 Arbitrageurs Arbitrageurs lock risk-less profits in derivatives markets by simultaneously entering into transactions in two markets.
Vinay 21 Board Course Objectives Understand the use of futures, options, swaps Appreciate and evaluate the models of pricing and estimation issues of futures, options and swaps Heuristic extension of the same for practical application.
Vinay 22 Extra Slide: MM Theory Hedging sounds prudent, but some economists reckon that firms should not do it because it reduces their value to shareholders. In the 1950s, two economists, Merton Miller (19232000) and Franco Modigliani, argued that firms make MONEY only if they make good investments, the kind that increase their operating cashflow. Whether these investments are financed through DEBT , EQUITY or retained earnings is irrelevant. Different methods of financing simply determine how a firms value is divided between its various sorts of investors (for example, shareholders or bondholders), not the value itself. This surprising insight helped win each of them a Nobel prize. If they are right, there are big implications for hedging. If methods of financing and the character of financial risks do not matter, managing them is pointless. It cannot add to the firms value; on the contrary, as hedging does not come free, doing it might actually lower that value. Moreover, argued Messrs Miller and Modigliani, if investors want to avoid the financial risks attached to holding SHARES a firm, they can diversify their portfolio of shareholdings. Firms need not manage their financial risks; investors can do it for themselves. Few managers agree.
