Transcript This paper

Overview of the Risk Management
Process and its Impact on
Firm Value
Why Study Risk Management?
This area has experienced explosive growth
due to the development of derivatives
markets.
 It is an area of finance where theory has
been so quickly and completely implemented
into actual practice.
 Derivatives have become so widespread and
central to business practice to gain
competitive advantage and maximize
shareholder value.

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One Simple Example of a Hedge:
You are planning to come to Villanova by
car.
 You have two choices:
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1.
2.
Take the Blue route (476), which is faster if there
is no traffic, or
Take the side roads, which is slower but doesn’t
have much traffic.
What do you do?
 What are the benefits and costs of hedging?

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What is a Derivative?
An instrument whose value is determined (or
derived) from the value of some underlying
variable(s).
 What kind of underlying variables?
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Prices of commodities (wheat, corn, lumber, gold, copper, etc.)
Exchange rates (price of British pound, Euro, etc.)
Interest rates
Stock prices
Index values (e.g. S&P 500)
Credit Quality of a corporate bond
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Examples of Derivatives
Forward contracts
These are conceptually similar
 Futures contracts

Swaps
 Options

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Derivatives and Hybrids are not
new…
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Forwards – started in 12th century
Futures – started in the 17th century
Options – started in the 17th century
Hybrids – at least since the 19th century
Swaps – started with parallel loans in the
1970s (relative to the others, these are
babies!).
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But Derivatives usage also has its risks!

Trading Debacles: Nick Leeson at Barings
PLC ($1.4 Bil. in 1995), Brian Hunter at
Amaranth hedge fund ($6.6B in 2006), and at
Societe Generale ($7.2B in 2008), etc.

Subprime Mortgage Mess: $1-2 Trillion losses
during 2007-2009 that touched nearly all
sectors of the financial services industry.
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2007-2008 Subprime Mortgage Mess in brief
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Unintended Consequences: in 1990s, Clinton
administration pushed for greater credit access for
lower income borrowers.
Regulatory Loopholes: in 1999, Citigroup agreed
to underwrite more risky mortgages if they could be
kept off-balance sheet.
Perfect Storm hits: low interest rates and 2002-07
recovery loosens credit standards further and
investors “stretch” for higher yields.
Incentives Misaligned: mortgage lenders/brokers,
investment bankers, rating agencies, money market
investors, hedge funds, politicians all have incentive
to “turn a good idea into a bad one!”
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Collateralized Debt Obligation (“CDO”)– More
Leverage
Last
Loss
MBS
MBS
MBS
Super-Senior
MBS
MBS
B
A
N
K
S
AAA CDO
MBS
Loss Position
MBS
Pool of AA,
A, BBB
MBS
Yield
MBS
MBS
S
T
Low
Yield
MBS
Credit Risk
W
A
L
L
Low
Risk
MBS
MBS
MBS
MBS
MBS
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AAA CDO
B CDO
Equity
First
Loss
High
Risk
High
Yield
Credit Default Swaps – Infinite Leverage

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Like an insurance contract that pays in the event of default.
FASB requires mark-to-market valuation.
Collateral Call - Protection Buyers can call for partial payment if default event is likely.
Determined by mark-to-market value.
Protection Buyer
Tends to own
reference asset
Protection Seller
Premium Payments
 Hedging or going
“short”
 Benefits when
reference asset price
DECREASES
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 Does not usually
own reference asset
Going “long”
Payment upon Default of
Reference Asset
Reference Asset can be a MBS,
CDO, Bond, or Loan
Benefits when
reference asset price
INCREASES, max at
Par
CDS on CDO – Infinite Leverage
Credit Default Swap
CDO Structure 50X’s
∞
CDO
CDS on
CDO
$90.0
$90.0
Equity $0
CDO
MBS
$90.0
$91.8
Mort. Securitiz 30X’s
Mortgage
Debt
Homeowner 20X’s
House
Mortgage
Debt
$100
$95
Equity $5
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MBS
$91.8
$95
Equity
$3.2
Equity
$1.8
A Note on Market Efficiency:
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An efficient market is characterized by:
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Homogeneous product
Liquid primary and secondary markets
Low transaction costs
Easy access to information about asset values
Ability to hedge positions (e.g., short sales are allowed)
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An efficient market does not mean it is impossible to
make “excess profits” but it does imply that it is very
difficult to do so on a consistent basis.

Most financial markets (especially those in the U.S.)
are semi-strong efficient.
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Types of Risk Management and their
Impact on Firm Value

Tactical Risk Management
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Acting on a “View”
“Arbitraging” international differences in taxation and/or
regulation
Reducing transaction costs (B-A spread, liquidity, info costs)
Strategic Risk Management
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M-M (1958) Irrelevance argument (perfect markets).
Long-term reduction in various costs related to market
imperfections.
Firm can increase value via hedging because it reduces the
costs related to: taxes, financial distress/external financing,
agency problems, and asymmetric information.
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Effect of Market Imperfections on
Firm Value
Stylized Model:
V = V* – Tax – FD – AC – AI
where,
V* = value of firm in perfect M-M (1958) world
Tax = costs associated with tax effects
FD = costs related to financial distress / external
financing
AC = costs related to agency conflicts
AI = costs associated with differences in information
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Why Market Imperfections Matter
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Taxes – due to convexity of tax schedule.
Financial Distress / External Financing costs – direct
and indirect deadweight costs incurred by the firm
when its cash flow is low relative to its debt burden
and investment plans.
Agency Costs – related to conflicts between
managers and owners as well as between owners
and bondholders.
Asymmetric Information – costs related to differences
in information between insiders and outside investors
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A Simple Model of Firm Value
Stylized Income Statement:
EBIAT = {Sales – Operating Costs – DEP}
* (1 – T)
 Stylized Valuation Model:



t 
VTotal
t 0
FCFt
(1  R )
t
where, FCFt  EBIAT t  DEPt  INVt  Other t
where, INVt = Capital Expenditures,
Othert = Change in Net Working Capital.

Total Firm Value and Shareholder Value (SHV) are only
affected by changes in MRT (Magnitude, Riskiness, and Timing
of cash flows).
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Ways to Measure the Impact of Risk
Management on Firm Value

Three key measures:
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RAROC – Risk-adjusted return on capital =
Risk-adjusted Dollar Return / Economic Capital at Risk
EVATM / SVA – Economic Value Added =
Annual Dollar Return – (Hurdle rate * Economic Capital)
Shareholder Value Added =
Economic Capital * [ {(ROA – g) / (Hurdle rate – g)} - 1 ]

Value-at-Risk (VaR) – VaR can be computed several ways. One
“quick and dirty” way is:
VaR = 2.33 * Standard Deviation of Percentage Return * Economic
Capital
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MVA and the Four Value Drivers
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Market Value Added (MVA) is determined by
four drivers:
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Sales growth (g)
Operating profitability (OP = NOPAT / Sales)
Capital requirements
(CR = Operating capital / Sales)
Weighted average cost of capital (WACC)
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MVA for a Constant Growth Firm
MVAt =
┌
│
└
Salest(1 + g)
WACC - g
┐
┐┌
CR
││OP – WACC ((1+g))│
┘
┘└
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Discounted Cash Flow Valuation and
Value-Based Management

Link to DCF Valuation Excel file:

FM 12 Ch 15 Mini Case.xls
(Brigham & Ehrhardt file)
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Risk Profiles and the Fundamental Building
Blocks of Risk Management

A Risk Profile is a simple 2-D graph of the change in
firm value (DV) versus the unexpected change in a
financial price (DP).
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Thus, DV = V due to DP minus V before DP.
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And, DP = P minus expected P.

Building Blocks are payoff profiles of derivative and
hybrid securities (Six key profiles can form all others)
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The Payoff Profiles of Building Blocks
are linear or non-linear...

Forwards, Futures, and Swaps have two linear
payoff profiles (Upward sloping for long positions and
downward sloping for short positions).
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Options have four non-linear payoff profiles:
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Calls – two profiles (one for long and one for short positions)
Puts – two profiles (one for long and one for short positions)
Can create a payoff profile for any hedging strategy
or hybrid security using the above six profiles in a
simple Spreadsheet File.
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Three Examples of Payoff Profiles in
your Personal Life
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What are the “Payoff Profiles” for these items?
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Bonus Compensation (e.g., in addition to your base
salary)
Car Insurance (e.g., the payoff when you have an
accident)
Housing Prices (e.g., change in the value of your home)
Try to solve these on your own (see Solutions here).
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A Brief Overview of the Relevant
Securities: Forward Contracts

Forward Contracts – Obligates its owner to buy (if
in a “long” position) or sell (if in a “short” position) a
given asset on a specified date at a specified price
(the “forward price”) at the origination of the
contract.

Two Key Features:
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Credit risk is two-sided (i.e., both buyer and seller of the
forward can default on the deal).
No money is exchanged until the forward’s maturity date.
The above features increase default risk and restricts
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the availability and liquidity of these contracts.
A Brief Overview of the Relevant
Securities: Futures Contracts
Futures Contracts – Similar to Forwards. Obligates
its owner to buy (if in a “long” position) or sell (if in a
“short” position) a given asset on a specified date at
a specified price (the “futures price”) at the
origination of the contract.
 Key Features:
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Credit risk is two-sided but is reduced substantially because
of two mechanisms:
1) marking-to-market (daily settling up of the account), and
2) margin requirements (i.e., a good-faith deposit).

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Standardized contract specifies exact details of term, asset,
contract size, delivery procedures, place of trading, etc.
Clearinghouse reduces transaction costs and de-couples
buyer from seller by providing anonymity.
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A Brief Overview of the Relevant
Securities: Swaps

Swaps – Obligates two parties to exchange some
specified cash flows at specified intervals over a
specified time period. Like futures contracts, swaps
can be viewed as a portfolio of forward contracts.
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Key Features:

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Credit risk is two-sided but a swap is less risky than a
forward (and more risky than futures) because a swap
reduces the “performance period” (the time interval between
cash payments) but does not require posting a margin.
Swaps can be tailored exactly to customer needs and can be
arranged for longer time periods than futures and forwards
(e.g., 1-5 years vs. 1-2 years for forwards/futures).
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A Brief Overview of the Relevant
Securities: Option Contracts
Options – Grants its owner the right, but not the
obligation, to buy (if purchasing a “call” option) or
sell (if purchasing a “put” option) a given asset on a
specified date at a specified price (the “strike price”)
at the origination of the contract.
 Key Features:
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Calls allow you to bet on increases in the asset’s value.
Puts allow you to bet on decreases in the asset’s value.
The option buyer pays a premium to acquire the option.
The seller of the option does have an obligation to buy/sell
the asset. Much riskier than buying the option.
Options can be: “in-the-money”, “at-the-money”, and “outof-the-money”.
An option is a portfolio of forward contract and a riskless 27
bond. Also, can create forwards from options!
Three Fundamental Ways
to Manage Risk

The “ART” of Risk Management:

Accept the risk (e.g., self-insure)

Remove the risk (divest, diversify)

Transfer the risk (hedging, insurance)
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