What kind of risk?

1
What kind of risk?

• Anything affecting demand and supply
• Output prices
• Input prices

2
1. What kind of risk?

• Foreign exchange
• Historical NT/US rate (1980-2001)

3
1. What kind of risk?

• Foreign exchange
• Transaction risk (Current and future
  transactions)
• Sales is in US, NT received will change when FX
  changes
• Elasticity is 1
• TeU,T is in NT, U is in US, e is FX rate
• ?T/T?e/e
• Economic risk
• When NT appreciates(from NT42/US1 to 38),
  importers will have a lower cost in NT, domestic
  companies will lose competitive advantages and
  profit will drop

4
1. What kind of risk?

• Interest rates
• Historical 31-90 days Commercial Paper rate in
  Taiwan (198011-20019)

5
2. Factors affecting the extent of risk

• Operating dimension
• Products attributes
• Production method(Operating leverage)
• Financing method(Financial leverage)

6
3. How to deal with risk?

• Take calculated risk
• Try to reduce the probability or the payoff of
  failure
• British Petroleum chooses not to insure
  externally against losses above 10 million.
• Weak competition, high insurance permiums
• Low probability of loss
• Enough capital in the case of loss

7
3. How to deal with risk?

• Reduce risk with operating decision
• Strategic move
• Coca-Cola develop the franchise bottling system
  and reduce the uncertainty from bottlers
  (Teisberg, 1993)
• Microsoft develops browser and bundles with
  Windows95
• Know your markets
• J.P. Morgan's John Miller is strictly a numbers
  guy. Although he often goes to the movies, he
  doesn't read scripts, doesn't care about plots,
  and doesn't worry about which stars have signed
  on -- unless they threaten to bust the budget.
  (Business Week, March 7, 2005)
• He relies instead on a sophisticated financing
  model fueled by data on how more than 300 films
  performed at the box office. It allows him to
  tune out the noise and focus on what really
  counts in a movie's success.
• What business plan its budget size, financial
  partners, release date, genre, distribution
  schedule, prospects in foreign, DVD, and other
  markets.

8
3. How to deal with risk?

• Reduce risk with operating decision
• Monitor
• To combat Hollywood's spendthrift ways, Millers
  loan documents are loaded with covenants,
  covering everything from limiting how much of the
  bank's money a producer can spend on a single
  movie to requiring his O.K. before producers add
  financial partners or foreign distributors.
  Miller insists on quarterly reports to make sure
  producers keep their promises, often sending in
  audit teams to double-check. "He makes you work
  for your money," says Charlie Lyons, CEO of
  Beacon Pictures, which has a 200 million credit
  line with Morgan. "It imposes discipline on you."
• Choose appropriate production technology
• Choose capital intensive technology to reduce the
  impact of exchange rate on labor cost

9
3. How to deal with risk?

• Reduce risk with operating decision
• Reduce risk over time
• To get more information
• Pursuing a project in stages, e.g., test market,
  to collect more information or to wait for
  uncertainty to be resolved
• Staged financing in venture capital
• Invest in flexibility
• For example, buy machines that can use different
  energies

10
3. How to deal with risk?

• Reduce risk with operating decision
• Diversification
• Do RD in different technologies, e.g, GM in
  electric car
• Only large firms can afford to spread risk
• J.P. Morgan's John Miller issues loans for slates
  of films at a studio -- 5 to 15 at a time -- not
  single flicks. He figures 3 of 10 movies will do
  well and one will hit the jackpot, offsetting
  losses from the flops. "If you get up to 15
  films, it's hard to lose money on a slate," says
  Miller. (Business Week, March 7, 2005,
  Multibillion Dollar Baby)
• Matching risk
• Matching the currency for revenue and cost

11
3. How to deal with risk?

• Reduce risk with financial decision
• Risk sharing with claim holders
• Risk sharing with more people
• Syndicated loan
• Many shareholders
• Risk sharing with input provider
• Builder and land owner
• Nissan and Yulon share FX risk
• A Brazilian mining company linked its price of
  electricity to the price of their product

12
3. How to deal with risk?

• Reduce risk with financial decision
• Risk sharing with claim holders
• Risk sharing with bondholders
• In mid 1980, Zambian cotton grower expanded its
  operation using a loan whose interest rate is
  linked to international price of cotton
• A West African gold mining company borrowed gold
  and repaid with gold. Although it is denominated
  in gold, the transaction actually took place in
  dollar equivalent

13
3. How to deal with risk?

• Reduce risk with financial decision
• Risk transfer
• Cost of risk transfer
• British Petroleum choose not to insure externally
  against losses above 10 million
• Insurance
• Used in event type of risk Hurricane, earthquake

14
3. How to deal with risk?

• Reduce risk with financial decision
• Risk transfer
• Financial products
• Used in continuous risk price change
• Sometimes, its used together with a loan
  agreement
• In 1989, the first corporate loan after the
  Mexican default in 1982. It includes a fixed rate
  international loan, a copper sales agreement, and
  a copper swap.
• Sales A promise of future delivery (for the life
  of the loan) of a fixed amount of copper at the
  future spot price. It ensures the repayment of
  the loan.
• Swap Converts the market price into a fixed
  price
• In 1990, the company entered another loan that
  includes a secured loan and a hedging program
  (including a swap)

15
3. How to deal with risk?

• Reduce risk with financial decision
• Matching risk
• Matching the duration of asset and liability

16
4. Hedging with financial instruments

• Futures or Forwards
• Contract
• Current FX rate is NT35(Pc), buyer will purchase
  US1 million with a FX rate PF after one month
• Currency 1972, interest rate 1975

17
4. Hedging with financial instruments

• Futures or Forwards
• Payoff at maturity for buyer

PF
FX at maturity
18
4. Hedging with financial instruments

• Futures or Forwards
• Hedging with futures
• 1-to-1 hedging
• Minimum risk hedgingNumber of futures used for
  each spot position(HR)-?Pc/?PF

19
4. Hedging with financial instruments

• Swap
• Contract
• Currency 1982, interest rate 1982
• Current FX rate is NT35(Pc), buyer will purchase
  US1 million each year for the following 5 years,
  with a FX rate PF
• Equivalent to 5 futures contracts

20
4. Hedging with financial instruments

• Options
• Contract
• Call
• Put
• Currency 1982, interest rate 1982

21
5. Hedging objects

• Asset or liability hedging
• Oil inventory hedging
• Foreign currencies accounts receivable hedging
• Commitment hedging
• Contracts that had signed require the firm to pay
  foreign currencies
• Future transactions hedging
• Hedging or speculation?

22
6. Derivative usage in TaiwanSource Shu,
Pei-Gi, and Hsuan-Chi Chen, 2003, The
Determinants of Derivatives Use Evidence from
Non-Financial Firms in Taiwan, Review of Pacific
Basin Financial Markets and Policies 64
23
6. Derivatives usages

• U.S. and Germany
• Survey in 1995 (U.S) and 1997 (Germany) (Bodnar
  and Gebhardt, 1998)
• 78 of German firms using derivatives compared to
  57 of US firms.
• In both countries, foreign currency derivative
  usage is most common, followed closely by
  interest rate derivatives, with commodity
  derivatives a distant third.