Derivatives

Chapter 4 Introduction to Risk Management

4.1 BASIC RISK MANAGEMENT

• Business is inherently risky.

• Firms convert inputs such as labor, raw materials, and machines
into goods and services.
• Prices can change and what appears to be a profitable activity
today may not be profitable tomorrow.
• Many instruments are available that permit firms to hedge
various risks
• A firm that actively uses derivatives and other techniques to alter
its risk and protect its profitability is engaging in risk
management.
4.1 BASIC RISK MANAGEMENT: THE PRODUCER’S
PERSPECTIVE

Example. Golddiggers is a gold-mining firm planning to mine and sell

100,000 ounces of gold over the next year. They sell all of the next
year’s production precisely 1 year from today, receiving whatever the
gold price is that day.
4.1 BASIC RISK MANAGEMENT: THE PRODUCER’S
PERSPECTIVE

• The price of gold today is $405/oz.

• The fixed cost is $330 and variable cost is $50.
• Rising gold price increases the net income.

• Basically, Golddiggers has a long position in gold

- In this regard, real business is similar to financial investments
Hedging with a Forward Contract

• The simplist way of hedging is a presale.

• Golddiggers can lock in a price for gold in 1 year by entering into
a short forward contract, agreeing today to sell its gold for
delivery in 1 year.
• Suppose the forward price is $ 420.
Hedging with a Forward Contract
• Graphically, you have a upward sloping curve
• Risk management is to make the curve flat so the profit (y axis)
is unrelated to the price (x axis)
• To offset the upward sloping curve, you want a downward
sloping curve
- short forward
Insurance: Guaranteeing a Minimum Price with a Put
Option

• With a forward, if gold prices do rise, Golddiggers will still

receive only $420/oz; there is no prospect for greater profit.
• What else can we do to protect low gold prices?
• Ch 3. A put option provides a way to have higher profits at high
gold prices while still being protected against low prices.
Insurance: Guaranteeing a Minimum Price with a Put
Option
• The graph is the same as in Ch 3 of hedging a long position with
a long put.
• You still want a curve that is somewhat downward sloping.
• A long put curve slopes downward when the price is below the
strike.
- So it hedges only in that region.
Insuring a Long Position: Floors
• Buying the put performs better than shorting the forward if the
price of gold increases. Buying the put keeps the upside.
• Otherwise the short forward outperforms floors. We need to pay
premium for the put.
• Neither strategy is clearly preferable
Oil Hedging
• Many countries are oil producers and their economies reply on
oil export.
- They have a long position in oil
- The government tax revenue highly depends on oil income
• They seek hedging for oil price declines. Global investment
banks are counterparties/insurance sellers.
• States have made use of put options rather than futures that fix
a price, including Mexico, Ecuador, Colombia, Algeria, Texas
and Louisiana
- sets a price floor without giving away any potential upside
• Governments that hedge commodity price exposure face
political risk
- If prices goes up but the government hedged it, public criticism
would be harsh
Insuring by Selling a Call
• There is another way of insuring
• With the sale of a call, Golddiggers receives a premium, which
reduces losses
• The written call limits possible profits.
• Graphically, a short call curve slopes downward too.
4.2 BASIC RISK MANAGEMENT: THE BUYER’S
PERSPECTIVE
Example. Auric Enterprises is a manufacturer of widgets, a product
that uses gold as an input.
• Auric sells each widget for a fixed price of $800.
• The fixed cost per widget is $340.
• The manufacture of each widget requires 1 oz of gold as an
input.
4.2 BASIC RISK MANAGEMENT: THE BUYER’S
PERSPECTIVE

• Because Auric makes a greater profit if the price of gold falls,

Auric’s gold position is implicitly short.
• What Auric can do?
- Buying forward
- Buying calls
- The opposite of a long position
Hedging with a Forward Contract

• Graphically, to hedge a downward sloping curve, we want an

upward sloping one
Insurance: Guaranteeing a Maximum Price with a Call
Option
• Rather than lock in a price unconditionally, Auric might like to
pay the market price if it is less. A cap.
• Graphically, a long call curve is also upward sloping in some
region.
4.3 WHY DO FIRMS MANAGE RISK?

• The Golddiggers and Auric examples illustrate how the two

companies can use forwards, calls, and puts to reduce losses in
case of an adverse gold price move, essentially insuring their
future cash flows.
• Why do firms manage risk?
An Example Where Hedging Adds Value
• Consider a firm that produces one unit per year of a good
costing $10.
• Two states, $11.20 or $9, with 50% probability. Thus, the firm
has either a $1.20 profit or a $1 loss.
• On a pre-tax basis, the firm has an expected profit of
0.5 × (−1) + 0.5 × 1.2 = 0.1
• Suppose 40% of the profit is taxed. On an after-tax basis, the
firm could have an expected loss of $0.14.
An Example Where Hedging Adds Value

• Suppose that there is a forward market for the firm’s output, and
that the forward price is $10.10.
• Hedging raises the expected value of cash flows.
Insuring a Short Position: Caps
• A dollar in state B (price $11.20) is less valuable than a dollar in
state A (price $9), because of the tax in state B.
• Mathematically, the after-tax profit is concave
A+B 1
f( ) > (f (A) + f (B))
2 2
Taxes

• Aspects of the tax code

• a loss is offset against a profit from a different year
- equate present values of the effective rates applied to losses and
profits
• separate taxation of capital and ordinary income
- convert one form of income to another
• capital gains taxation
- defer taxation of capital gains income
• differential taxation across countries
- shift income from one country to another
Reasons to Hedge: Bankruptcy and Distress Costs

• A large loss can threaten the survival of a firm

• A firm may be unable to meet fixed obligations (such as, debt
payments and wages)
• Customers may be less willing to purchase goods of a firm in
distress
• State A: good, State B: bankruptcy, f (B) very small
A+B 1
f( ) > (f (A) + f (B))
2 2
• Hedging allows a firm to reduce the probability of bankruptcy or
financial distress
Reasons to Hedge: Costly External Financing

• Raising funds externally can be costly

• There are explicit costs (such as, bank and underwriting fees)
• There are implicit costs due to asymmetric information
• Costly external financing can lead a firm to forego investment
projects it would have taken had cash been available to use for
financing
• Hedging can safeguard cash reserves and reduce the probability
of raising funds externally
• State A: good, State B: external financing, f (B) very small
A+B 1
f( ) > (f (A) + f (B))
2 2
Reasons to Hedge: Increase Debt Capacity

• Similar to “Bankruptcy and Distress Costs”

• The amount that a firm can borrow is its debt capacity
• When raising funds, a firm may prefer debt to equity because
interest expense is tax-deductible
• However, lenders may be unwilling to lend to a firm with a high
level of debt due to a higher probability of bankruptcy
• Hedging allows a firm to credibly reduce the riskiness of its cash
flows, and thus increase its debt capacity
Reasons to Hedge: Managerial Risk Aversion

• Firm managers are typically not well-diversified

• Salary, bonus, and compensation are tied to the performance of
the firm
• If managers risk-averse, then they are harmed by a dollar of loss
more than they are helped by a dollar of gain
• Managers have incentives to reduce uncertainty through
hedging
• State A: good, State B: job loss, f (B) very small
A+B 1
f( ) > (f (A) + f (B))
2 2
Reasons Not to Hedge

• Reasons why firms may elect not to hedge

• Transaction costs of dealing in derivatives (such as commissions
and the bid-ask spread)
• The requirement for costly expertise
• The need to monitor and control the hedging process
• Complications from tax and accounting considerations
• Potential collateral requirements
Case: Ford

• Ford Motor Co. stunned investors in January 2002 when it

announced a $1 billion write-off on stockpiles of palladium, a
precious metal Ford used in catalytic converters (devices that
reduce polluting emissions from cars and trucks).
• Palladium prices were steady until 1997, when Russia, a major
supplier with a large stockpile of palladium, withheld supply from
the market.
• Prices more than doubled to $350/oz at a time when Ford was
planning to increase its use of the metal.
• By early 2000, prices had doubled again, to $700.
• In 2000, Ford management agreed to allow the purchasing staff
to stockpile palladium.
Case: Ford
• The purchasing staff evidently did not communicate with Ford’s
treasury department, which had hedging experience. Thus, for
example, Ford did not buy puts to protect against a drop in
palladium prices.
- Ford continued to buy palladium in 2001 as prices exceeded
$1000. However, by the middle of the year, palladium prices had
fallen to $350.
• The purchasing staff also did not communicate with Ford’s
research department, which was working to reduce reliance on
palladium.
- By the end of 2001, Ford had developed technology that would
eventually reduce the need for palladium by 50%.
• Ford Chief Financial Officer: “Ford has instituted new
procedures to ensure that treasury department staffers with
experience in hedging are involved in any major commodities
purchases in the future.”
Case: Southwest Airline
• Southwest Airlines is well known for systematcally hedging the
cost of jet fuel.
• In recent years, fuel costs have been as much as a quarter of
operating expenses.
• Since fuel costs have risen over the last decade, Southwest has
benefited from hedging.
• The Company endeavors to acquire jet fuel at the lowest
possible cost. Because jet fuel is not traded on an organized
futures exchange, liquidity for hedging is limited. However, the
Company has found commodities for hedging of jet fuel costs,
primarily crude oil, and refined products such as heating oil and
unleaded gasoline
• The Company currently has a mixture of purchased call options,
collar structures, and fixed price swap agreements in place to
protect against over 85 percent of its jet fuel requirements
Empirical Evidence on Hedging
• Half of nonfinancial firms report using derivatives
• Among firms that do use derivatives, less than 25% of perceived
risk is hedged, with firms likelier to hedge short-term risk
• Firms with more investment opportunities are more likelier to
hedge
• Firms that use derivatives may have a higher market value, more
leverage and lower interest costs
• Gold firms use some derivatives, with the median firm selling
forward about 25% of 3-year production.
- Fifteen percent of firms used no derivatives.
- Substantial variation over time in the amount of hedging by gold
firms.
- Firms tended to increase hedging as the price rose
- Managers reported that they adjusted hedges based on their
views about gold prices.
4.4 GOLDDIGGERS REVISITED

• Insurance is not free!...in fact, it is expensive

• There are several ways to reduce the cost of insurance
• We now examine some additional strategies that permit tailoring
the amount and cost of insurance.
Adjusting the Amount of Insurance
• Reduce the insured amount by lowering the strike price of the
put option.
- Cheaper premium but some additional potential losses
- The low-premium option yields the highest profit if insurance is
not needed (the price is high) and the lowest profit if insurance is
needed (the price is low).
- Managers optimistic about the price of gold will opt for
low-strike-price puts
Selling the Gain: Collars

• 420–440 Collar.
• Suppose that Golddiggers buys a 420-strike put option for $8.77
and sells a 440-strike call option for a premium of $2.49.
Selling the Gain: Collars
Selling the Gain: Collars

• Zero cost collar.

• A 400-strike put and a 440-strike call are equally distant from the
forward price of $420. This equivalence suggests that the
options should have approximately the same premium.