Sources of corporate risk #
Exposure of:
- Earnings
- Revenues, more of market conditions
- cash flows
- Could related to FCFF factors, more of internal
- market value to uncertain external factors or events
- Tariffs for example, totally external
Risk recap: Risk = uncertainty, measured as standard deviation of outcomes
Risk management tries to reduce the uncertainty associated with future outcomes, ideally removes bad outcomes without affect good outcomes - and of course ideally
Market risks #
Price movements in financial markets
- Interest rates, exchange rates, and commodity price risks
- Can be managed (or hedged against) using financial derivatives or other financial contracts - as some may be firm specific, so there may not be derivatives present
Commercial (or operational risks) #
- Inherent in operations of the firm
- Generally subject, to a certain extent, to management’s control or influence
- Failures of internal processes and unanticipated actions by competitors
- Cannot be managed with derivatives or other kinds of financial contracts - it relates more with internal misbehaviors, and cannot be hedged against using simple numbers
External event risks #
- Not necessarily firm specific
- Stem from non-market events such as natural catastrophes or changes in tax or regulatory policies
- Can be managed against using insurance products in many cases - not always the cases, as to speak
Risk Management Basics #
Concepts #
Risk management is the attempt of reducing the uncertainty associated with a firm’s future outcomes
- The ideal objective of risk management is to remove bad outcomes without affecting good outcomes
- Similar to options - future payoff is bounded below by 0
Risk Management Process #
- Risk identification
- Risk assessment
- Selection of appropriate risk management techniques - every technique costs, identify the one with viable costs
- Implementation and monitoring
- The overall goal is to increase firm value
Rationale of Risk Management #
MM’s Irrelevance Theorem #
- In perfect market setups, investors can manage their own risk without any costs, hence they will not appreciate companies doing risk management
- Hence it will not firm value - but does it?
Risk management effects #
Cash flow effects #
Non-linearity of taxes
- Most tax codes in real life are convex - like parabolas
- Reduction in volatility of taxable income can lower expected taxes for firms with convex effective tax functions
- By reducing the effective long-term average tax rate, any strategies that reduce volatility in reported earnings will enhance shareholder value - tax preference items
- Stablizing income by reducing tax payments - higher the volatility, higher the taxable income attained, and higher the expected tax rate
- Stablizing income will also maximize the amount covered by tax loss carry-forward, and it deducts taxable income
Bankruptcy costs
- Bankruptcy costs and probabilities may be added to firm value calculation for each year - discounted backwards to present
- Risk management decreases the probabilities and thus increasing the firm value - and it also suggest that risk management is more valuable as bankruptcy costs gets larger
Avoiding Underinvestment Problem
- Outside funding is costly compared to internal financing
- Low cash flow years will force the firm to either raise costly financing or missing out on investments
- Cash flow hedging is essentially matching cash inflows and outflows, which reduces the need for a company to raise funds externally and allow it to continue investing in value-enhancing projects - e.g. try to change the day of inflow of that cash flow to match some investment opportunities
Managerial self-interest / Better Monitoring
- Managers are typically risk-averse, exposed to firm risk significantly
- Jobs are tied up, paid in stocks and options, cannot diversify due to regulations
- When managers have more firm-specific human capital, allowing them to reduce firm risk through risk management strategies will lower their compensation payments and increase free cash flows to the firm - e.g. a pharmatheutical company has some specialists, and the specialists seek compensations for the risky job. If the pharmatheutical company can be stable producing general medicine, then the specialists bear less risk and seeks less compensation
- Removing uncertainty might also help shareholders monitor and reward managers better - by removing uncertainties, firm value increases and managers receive higher compensations. Shareholders will also know that managers are not playing golf
WACC effects #
Debt/Equity Financing Effects
- Debt Capacity and Borrowing Costs - Risk management lowers a company’s probability of bankruptcy, hence expanding its access to debt and reducing its cost of capital
- Derivative users, relative to non-users, tend to carry higher leverage ratios and lower cost of capital
Risk Management Methods #
Value at Risk (VaR) #
- VaR is an attempt to quantify (downside) risk
- What is a dollar amount VaR such that the probability of an outcome worse than VaR is no more than p?
- It is used a lot by financial institutions for capital adequacy requirements - How much capital is needed?
Calculation of VaR #
- Specify a probability of loss p%
- VaR is the cut-off point such that the area to its left is p%
- This is just a quantile of the distribution
Analysis using VaR #
- Similar to Monte Carlo Simulation analysis to measure project risk
- E.g. There is a 3% chance that NPV is negative
- The 3% VaR is 0 - In 3% of cases, we expect losses to exceed $0 dollars
Risk management tools #
- Options and risk management are tightly linked as they both cut losses
- In risk management, we deal with such as forwards, futures, options and swaps
- Risk management deals with how financial contracts may be used to reduce business risks
Useful tools
- Derivatives
- Financial securities whose payoffs are derived from performance of underlying assets
- Can also be used for speculation and executive pay - call options for CEOs
- Survey suggests that derivatives are widely used to hedge against risks
- Hedging
- Hold one asset and short an offsetting amount of another asset - one is real, the other financial
- Hedging is costly, so as little as possible - only to hedge net exposure not each individual exposure - let’s say you position in the market is bullish, then you only need to hedge against price falls. If you hold both positions, and the overall effect of those positions is bullish, then you only hedge against price falls, not each one of your positions - if talking about natural hedging, if you borrow some money and build a factory in Germany, and you aim to match revenues and costs in the same currency, then you are hedging against interest payment going up by EUROs going up, but you do not need to also hedge against your net revenue’s fall by EURO’s fall as in this case it is not the significant deterrant, and comprises little to your net exposure
- Natural hedging
- Reducing the undesired risk by matching cash flows (formerly mentioned) - it comes to that matching cash flows also have a cost, that is, associated with time value of money. However, you are paying that cost not to the financial market but to the cash receivable entity, so it is a natural hedging, hedging against undesirable cash shortfall
- E.g. matching revenues and costs in the same currency, and cover interest costs in the same currency - It is natural hedging because you may pay extra on interest rates, but you are not paying to the financial markets
- Hedging and regretting: Cost of protective hedging cannot be recovered, and hence you may regret putting a hedge, so hedging is costly