Overview of the Risk Management Process and its Impact on Firm Value.

Overview of the Risk Overview of the Risk Management Process and its Management Process and its

Impact on Impact on Firm ValueFirm Value

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Why Study Risk Management?Why Study Risk Management?

This area has experienced This area has experienced explosive explosive growthgrowth due to the development of due to the development of derivatives markets.derivatives markets.

It is an area of finance where theory has It is an area of finance where theory has been so been so quicklyquickly and and completelycompletely implemented into actual practice.implemented into actual practice.

Derivatives have become so widespread Derivatives have become so widespread and central to business practice to and central to business practice to gain gain competitive advantage and maximize competitive advantage and maximize shareholder valueshareholder value..

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One Simple Example of a Hedge:One Simple Example of a Hedge:

You are planning to come to Villanova by You are planning to come to Villanova by car.car.

You have You have two choicestwo choices::1.1. Take the Take the Blue routeBlue route (476), which is faster if (476), which is faster if

there is no traffic, orthere is no traffic, or

2.2. Take the Take the side roadsside roads, which is slower but , which is slower but doesn’t have much traffic.doesn’t have much traffic.

What do you do?What do you do? What are the What are the benefitsbenefits and and costscosts of of

hedging?hedging?

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What is a Derivative?What is a Derivative?

An instrument whose value is determined An instrument whose value is determined (or (or derivedderived) from the value of some ) from the value of some underlyingunderlying variable(s). variable(s).

What kind of underlying variables?What kind of underlying variables? Prices of commodities (wheat, corn, lumber, gold, Prices of commodities (wheat, corn, lumber, gold,

copper, etc.)copper, etc.) Exchange rates (price of British pound, Euro, etc.)Exchange rates (price of British pound, Euro, etc.) Interest ratesInterest rates Stock pricesStock prices Index values (e.g. S&P 500)Index values (e.g. S&P 500) Credit Quality of a corporate bondCredit Quality of a corporate bond

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Examples of DerivativesExamples of Derivatives

Forward contractsForward contracts Futures contractsFutures contracts

SwapsSwaps OptionsOptions

These are conceptually similar

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Derivatives and Hybrids are Derivatives and Hybrids are notnot new…new…

ForwardsForwards – started in 12 – started in 12thth century century FuturesFutures – started in the 17 – started in the 17thth century century OptionsOptions – started in the 17 – started in the 17thth century century HybridsHybrids – at least since the 19 – at least since the 19thth century century SwapsSwaps – started with parallel loans in – started with parallel loans in

the 1970s (relative to the others, these the 1970s (relative to the others, these are babies!).are babies!).

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But Derivatives usage also has its But Derivatives usage also has its risks!risks!

Trading Debacles:Trading Debacles: Nick Leeson at Barings Nick Leeson at Barings PLC ($1.4 Bil. in 1995), Brian Hunter at PLC ($1.4 Bil. in 1995), Brian Hunter at Amaranth hedge fund ($6.6B in 2006), and Amaranth hedge fund ($6.6B in 2006), and at Societe Generale ($7.2B in 2008), etc.at Societe Generale ($7.2B in 2008), etc.

Subprime Mortgage Mess:Subprime Mortgage Mess: $1-2 $1-2 TrillionTrillion losses during 2007-2009 that touched losses during 2007-2009 that touched nearly all sectors of the financial services nearly all sectors of the financial services industry. industry.

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2007-2008 Subprime Mortgage Mess in 2007-2008 Subprime Mortgage Mess in briefbrief

Unintended Consequences:Unintended Consequences: in 1990s, Clinton in 1990s, Clinton administration pushed for greater credit access administration pushed for greater credit access for lower income borrowers.for lower income borrowers.

Regulatory Loopholes:Regulatory Loopholes: in 1999, Citigroup in 1999, Citigroup agreed to underwrite more risky mortgages agreed to underwrite more risky mortgages ifif they could be kept off-balance sheet.they could be kept off-balance sheet.

Perfect Storm hits:Perfect Storm hits: low interest rates and 2002- low interest rates and 2002-07 recovery loosens credit standards further and 07 recovery loosens credit standards further and investors “stretch” for higher yields.investors “stretch” for higher yields.

Incentives Misaligned:Incentives Misaligned: mortgage mortgage lenders/brokers, investment bankers, rating lenders/brokers, investment bankers, rating agencies, money market investors, hedge funds, agencies, money market investors, hedge funds, politicians all have incentive to politicians all have incentive to “turn a good idea “turn a good idea into a bad one!”into a bad one!”

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Collateralized Debt Obligation (“CDO”)– Collateralized Debt Obligation (“CDO”)– More LeverageMore Leverage

Pool of AA, A, BBB

MBS

Equity

MBS

Super-Senior

AAA CDO

AAA CDOB CDO

Loss P

osition

Cre

dit R

isk

Yie

ld

FirstLoss

HighRisk

HighYield

LastLoss

LowRisk

LowYield

WALL ST BANKS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

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Credit Default Swaps – Credit Default Swaps – InfiniteInfinite LeverageLeverage

Does not usually own reference asset

Going “long”

Benefits when reference asset price INCREASES, max at Par

Tends to own reference asset

Hedging or going “short”

Benefits when reference asset price DECREASES

Protection SellerProtection Buyer

Payment upon Default of Reference Asset

Premium Payments

Reference Asset can be a MBS, CDO, Bond, or Loan

Like an Like an insurance contractinsurance contract that pays in the event of default. that pays in the event of default. FASB requires mark-to-market valuation.FASB requires mark-to-market valuation. Collateral CallCollateral Call - Protection Buyers can call for - Protection Buyers can call for partialpartial payment if default event payment if default event

is likely. Determined by mark-to-market value.is likely. Determined by mark-to-market value.

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House

$100

Mortgage Debt

$95

Equity $5

MBS

$91.8

CDO

$90.0

Equity $1.8

CDO

$90.0

CDS on CDO

$90.0

Equity $0

Mortgage Debt

$95

MBS

$91.8

Equity $3.2

Homeowner 20X’s

Increasing Leverage

Mort. Securitiz 30X’s

CDO Structure 50X’s

Credit Default Swap ∞CDS on CDO – CDS on CDO – Infinite LeverageInfinite Leverage

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A Note on Market Efficiency:A Note on Market Efficiency: An An efficient marketefficient market is characterized by: is characterized by:

Homogeneous productHomogeneous product Liquid primary and secondary marketsLiquid primary and secondary markets Low transaction costsLow transaction costs Easy access to information about asset valuesEasy access to information about asset values Ability to hedge positions (e.g., short sales are allowed)Ability to hedge positions (e.g., short sales are allowed)

An efficient market An efficient market does notdoes not mean it is impossible to mean it is impossible to make “excess profits” but it does imply that it is very make “excess profits” but it does imply that it is very difficult to do so on a consistent basis.difficult to do so on a consistent basis.

Most financial markets (especially those in the U.S.) Most financial markets (especially those in the U.S.) are are semi-strongsemi-strong efficient. efficient.

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Types of Risk Management and Types of Risk Management and their Impact on Firm Valuetheir Impact on Firm Value

Tactical Risk ManagementTactical Risk Management Acting on a “View”Acting on a “View” ““Arbitraging” international differences in taxation and/or regulationArbitraging” international differences in taxation and/or regulation Reducing transaction costs (B-A spread, liquidity, info costs)Reducing transaction costs (B-A spread, liquidity, info costs)

Strategic Risk ManagementStrategic Risk Management M-M (1958) Irrelevance argument (perfect markets).M-M (1958) Irrelevance argument (perfect markets). Long-term reduction in various costs related to market imperfections.Long-term reduction in various costs related to market imperfections. Firm can increase value via hedging because it reduces the costs related to: Firm can increase value via hedging because it reduces the costs related to: taxes, taxes,

financial distress/external financing, agency problems, and asymmetric financial distress/external financing, agency problems, and asymmetric informationinformation..

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Effect of Market Imperfections Effect of Market Imperfections on Firm Valueon Firm Value

Stylized Model:Stylized Model:V = V* – Tax – FD – AC – AIV = V* – Tax – FD – AC – AI

where,where,V* = value of firm in perfect M-M (1958) worldV* = value of firm in perfect M-M (1958) worldTax = costs associated with tax effectsTax = costs associated with tax effectsFD = costs related to financial distress / external financingFD = costs related to financial distress / external financingAC = costs related to agency conflictsAC = costs related to agency conflictsAI = costs associated with differences in informationAI = costs associated with differences in information

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Why Market Imperfections Why Market Imperfections MatterMatter

TaxesTaxes – due to convexity of tax schedule. – due to convexity of tax schedule. Financial Distress / External Financing costsFinancial Distress / External Financing costs – –

direct and indirect deadweight costs incurred by direct and indirect deadweight costs incurred by the firm when its cash flow is low relative to its the firm when its cash flow is low relative to its debt burden and investment plans.debt burden and investment plans.

Agency CostsAgency Costs – related to conflicts between – related to conflicts between managers and owners as well as between managers and owners as well as between owners and bondholders.owners and bondholders.

Asymmetric InformationAsymmetric Information – costs related to – costs related to differences in information between insiders and differences in information between insiders and outside investors outside investors

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A Simple Model of Firm ValueA Simple Model of Firm Value

Stylized Income Statement:Stylized Income Statement: EBIAT = {Sales – Operating Costs – DEP} EBIAT = {Sales – Operating Costs – DEP}

* (1 – T)* (1 – T) Stylized Valuation Model:Stylized Valuation Model:

where, where, INVINVtt = Capital Expenditures, = Capital Expenditures,OtherOthertt = Change in Net Working Capital. = Change in Net Working Capital.

Total Firm Value and Shareholder Value (SHV)Total Firm Value and Shareholder Value (SHV) are are only affected by changes in only affected by changes in MRTMRT ( (MMagnitude, agnitude, RRiskiness, iskiness, and and TTiming of cash flows).iming of cash flows).

tttttt

t

t tTotal OtherINVDEPEBIATFCF

R

FCFV

where,)1(

0

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Ways to Measure the Impact of Risk Ways to Measure the Impact of Risk Management on Firm ValueManagement on Firm Value

ThreeThree key measures: key measures: RAROCRAROC – Risk-adjusted return on capital = – Risk-adjusted return on capital =

Risk-adjusted Dollar Return / Economic Capital Risk-adjusted Dollar Return / Economic Capital at Riskat Risk

EVAEVATMTM / SVA / SVA – Economic Value Added = – Economic Value Added = Annual Dollar Return – (Hurdle rate * Economic Capital)Annual Dollar Return – (Hurdle rate * Economic Capital)

Shareholder Value Added = Shareholder Value Added = Economic Capital * [ {(ROA – g) / (Hurdle rate – g)} - Economic Capital * [ {(ROA – g) / (Hurdle rate – g)} -

1 ]1 ]

Value-at-Risk (VaR)Value-at-Risk (VaR) – VaR can be computed several ways. – VaR can be computed several ways. One “quick and dirty” way is:One “quick and dirty” way is:VaR = 2.33 * Standard Deviation of Percentage Return * VaR = 2.33 * Standard Deviation of Percentage Return * Economic Capital Economic Capital

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MVAMVA and the Four Value Drivers and the Four Value Drivers

Market Value AddedMarket Value Added (MVA) is (MVA) is determined by determined by fourfour drivers: drivers: Sales growth (Sales growth (gg)) Operating profitability (Operating profitability (OP OP = NOPAT / Sales)= NOPAT / Sales) Capital requirements Capital requirements

((CR CR = Operating capital / Sales)= Operating capital / Sales) Weighted average cost of capital (Weighted average cost of capital (WACCWACC))

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MVA for a MVA for a ConstantConstant Growth Firm Growth Firm

MVAt =

┌│└

OP – WACC CR((1+g))

┐│┘

Salest(1 + g)

WACC - g

┐│┘

┌│└

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Discounted Cash Flow Valuation and Discounted Cash Flow Valuation and Value-Based ManagementValue-Based Management

Link to DCF Valuation Excel file:Link to DCF Valuation Excel file:

FM 12 Ch 15 Mini Case.xls (Brigham & Ehrhardt file) (Brigham & Ehrhardt file)

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Risk Profiles and the Fundamental Risk Profiles and the Fundamental Building Blocks of Risk ManagementBuilding Blocks of Risk Management

A A Risk ProfileRisk Profile is a simple 2-D graph of the is a simple 2-D graph of the change in firm value (change in firm value (VV) versus the ) versus the unexpected change in a financial price (unexpected change in a financial price (PP).).

Thus, Thus, VV = V due to = V due to PP minusminus V V beforebefore PP..

And, And, PP = P = P minusminus expectedexpected P. P.

Building BlocksBuilding Blocks are are payoff profilespayoff profiles of of derivative and hybrid securities (derivative and hybrid securities (SixSix key key profiles can form profiles can form allall others) others)

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The The Payoff ProfilesPayoff Profiles of Building of Building Blocks are linear or non-linear...Blocks are linear or non-linear...

Forwards, Futures, and SwapsForwards, Futures, and Swaps have have twotwo linearlinear payoff profiles (payoff profiles (UpwardUpward sloping for long positions sloping for long positions and and downwarddownward sloping for sloping for shortshort positions). positions).

Options Options have have fourfour non-linearnon-linear payoff profiles: payoff profiles: CallsCalls – two profiles (one for long and one for short – two profiles (one for long and one for short

positions)positions) PutsPuts – two profiles (one for long and one for short – two profiles (one for long and one for short

positions) positions)

Can create a Can create a payoff profilepayoff profile for for anyany hedging hedging strategy or hybrid security using the above strategy or hybrid security using the above sixsix profiles in a simple profiles in a simple Spreadsheet File..

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Three Examples of Payoff Three Examples of Payoff Profiles in your Profiles in your PersonalPersonal Life Life

What are the What are the “Payoff Profiles”“Payoff Profiles” for these items? for these items?

Bonus CompensationBonus Compensation (e.g., in addition to your base salary)(e.g., in addition to your base salary)

Car InsuranceCar Insurance (e.g., the payoff when you have an accident) (e.g., the payoff when you have an accident)

Housing PricesHousing Prices (e.g., change in the value of your home) (e.g., change in the value of your home)

Try to Try to solve these on your ownsolve these on your own (see (see Solutions here). here).

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A Brief Overview of the Relevant A Brief Overview of the Relevant Securities: Forward ContractsSecurities: Forward Contracts

Forward ContractsForward Contracts – – ObligatesObligates its owner to buy (if its owner to buy (if in a “long” position) or sell (if in a “short” position) a in a “long” position) or sell (if in a “short” position) a given asset on a specified given asset on a specified datedate at a specified at a specified priceprice (the “forward price”) at the (the “forward price”) at the originationorigination of the of the contract.contract.

Two Key Features:Two Key Features: Credit risk is two-sided (i.e., both buyer and seller of the Credit risk is two-sided (i.e., both buyer and seller of the

forward can default on the deal).forward can default on the deal). No money is exchanged until the forward’s maturity date. No money is exchanged until the forward’s maturity date.

The above features increase default risk and restricts The above features increase default risk and restricts the availability and liquidity of these contracts.the availability and liquidity of these contracts.

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A Brief Overview of the Relevant A Brief Overview of the Relevant Securities: Futures ContractsSecurities: Futures Contracts

Futures ContractsFutures Contracts – Similar to Forwards. – Similar to Forwards. ObligatesObligates its owner to buy (if in a “long” position) or its owner to buy (if in a “long” position) or sell (if in a “short” position) a given asset on a sell (if in a “short” position) a given asset on a specified specified datedate at a specified at a specified priceprice (the “futures (the “futures price”) at the price”) at the originationorigination of the contract. of the contract.

Key Features:Key Features: Credit risk is two-sided but is reduced substantially because Credit risk is two-sided but is reduced substantially because

of two mechanisms: of two mechanisms: 1) 1) marking-to-marketmarking-to-market (daily settling up of the account), and (daily settling up of the account), and 2) 2) margin requirementsmargin requirements (i.e., a good-faith deposit). (i.e., a good-faith deposit).

Standardized contractStandardized contract specifies exact details of term, asset, specifies exact details of term, asset, contract size, delivery procedures, place of trading, etc.contract size, delivery procedures, place of trading, etc.

ClearinghouseClearinghouse reduces transaction costs and de-couples reduces transaction costs and de-couples buyer from seller by providing anonymity. buyer from seller by providing anonymity.

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A Brief Overview of the Relevant A Brief Overview of the Relevant Securities: SwapsSecurities: Swaps

SwapsSwaps – – ObligatesObligates two parties to exchange some two parties to exchange some specified specified cash flowscash flows at specified at specified intervalsintervals over a over a specified specified time periodtime period. Like futures contracts, swaps . Like futures contracts, swaps can be viewed as can be viewed as a portfolio of forward contractsa portfolio of forward contracts..

Key Features:Key Features: Credit risk is two-sided but a swap is Credit risk is two-sided but a swap is less riskyless risky than a forward than a forward

(and (and moremore risky than futures) because a swap reduces the risky than futures) because a swap reduces the “performance period” (the time interval between cash “performance period” (the time interval between cash payments) but does payments) but does notnot require posting a margin. require posting a margin.

Swaps can be tailored exactly to customer needs and can be Swaps can be tailored exactly to customer needs and can be arranged for longer time periods than futures and forwards arranged for longer time periods than futures and forwards (e.g., 1-5 years vs. 1-2 years for forwards/futures).(e.g., 1-5 years vs. 1-2 years for forwards/futures).

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A Brief Overview of the Relevant A Brief Overview of the Relevant Securities: Option ContractsSecurities: Option Contracts

OptionsOptions – Grants its – Grants its ownerowner the the rightright, but , but notnot the the obligation, to buy (if purchasing a “call” option) or sell (if obligation, to buy (if purchasing a “call” option) or sell (if purchasing a “put” option) a given asset on a specified purchasing a “put” option) a given asset on a specified datedate at a specified at a specified priceprice (the “strike price”) at the (the “strike price”) at the originationorigination of the contract. of the contract.

Key Features:Key Features: Calls allow you to bet on Calls allow you to bet on increasesincreases in the asset’s value. in the asset’s value. Puts allow you to bet on Puts allow you to bet on decreasesdecreases in the asset’s value. in the asset’s value. The option buyer pays a The option buyer pays a premiumpremium to acquire the option. to acquire the option. The seller of the option The seller of the option doesdoes have an obligation to buy/sell the have an obligation to buy/sell the

asset. Much riskier than buying the option.asset. Much riskier than buying the option. Options can be: “in-the-money”, “at-the-money”, and “out-of-the-Options can be: “in-the-money”, “at-the-money”, and “out-of-the-

money”.money”. An option is An option is a portfolio of a portfolio of forwardforward contract and a contract and a riskless bondriskless bond. .

Also, can create forwards from options! Also, can create forwards from options!

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Three Fundamental Ways Three Fundamental Ways to Manage Riskto Manage Risk

The The “ART”“ART” of Risk Management: of Risk Management:

AAcceptccept the risk (e.g., self-insure) the risk (e.g., self-insure)

RRemoveemove the risk (divest, diversify) the risk (divest, diversify)

TTransferransfer the risk (hedging, insurance) the risk (hedging, insurance)