The Nature of Risk Management

1
The Nature of Risk Management

• Alicia Garcia

2
What is it?

• A potential gain or loss that occurs as a result
  of an exchange rate change.

3
Should Firms Manage Risk?

• They consider any use of risk management tools,
  such as forwards, futures and options, as
  speculative. Or they argue that such financial
  manipulations lie outside the firm's field of
  expertise.
• They claim that exposure cannot be measured. They
  are right -- currency exposure is complex and can
  seldom be gauged with precision.

4
Managing Firms Economic Value

• Reduces volatility of firms value by reducing
  volatility of income and return on assets without
  altering firms expected value
• Creates value because firms expected value is
  higher in the presence of a risk management
  strategy

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Financial Distress

• Risk worth managing is that which may have
  material impact on the value of the firms
  periodic cash flows
• Large, highly diversified firms may not be at
  much risk from risk exposure
• Small, poorly diversified firms are at greater
  risk because more transactions are large

6
Risk Aversion
Loss Aversion

• Requires corporations give up the chance for
  upside foreign exchange gains to protect
  themselves from possible downside foreign
  exchange losses
• Hedging with options

• Recognizes risk is concern because of the
  downside losses rather than the upside gains
• Fear of Bankruptcy

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Three Preliminary Questions

• What exchange risk does the firm face, and what
  methods are available to measure currency
  exposure?
• What hedging or exchange risk management strategy
  should the firm employ?
• Which of the various tools and techniques of the
  foreign exchange market should be employed debt
  and assets forwards and futures and options

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Forward/Futures

• Require future performance, and sometimes one
  party is unable to perform on the contract. When
  that happens, the hedge disappears, sometimes at
  great cost to the hedger. Most big companies use
  forwards futures tend to be used whenever credit
  risk may be a problem.

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Debt as a Hedge

•  Debt -- borrowing in the currency to which the
  firm is exposed or investing in interest-bearing
  assets to offset a foreign currency payment -- is
  a widely used hedging tool that serves much the
  same purpose as forward contracts.

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Debt Example

• Money Market Hedge
• Fredericks sold Canadian dollars forwards.
  Alternatively she could have used the
  Eurocurrency market to achieve the same
  objective. She would borrow Canadian dollars,
  then exchange them into francs in the spot
  market, and hold them in a US dollar deposit for
  two months. When payment in Canadian dollars was
  received from the customer, she would use the
  proceeds to pay down the Canadian dollar debt.
•  The cost of the money market hedge is the
  difference between the Canadian dollar interest
  rate paid and the US dollar interest rate earned.

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Elimination of Downside Losses

• Options
• As loss aversion
• Managers have incentive to undertake profitable
  projects when allowed to hedge using options

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Last Thought

• Risk management adds value because it helps
  ensure that a corporation has sufficient internal
  funds available to take advantage of profitable
  investment opportunities. Risk management helps
  the firm avoid short-run and intermediate-run
  capital constraints to survive in the long run

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• Questions??

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Ex. 1 Hedging practice at GE

• Use a portfolio approach (50 forward, 25
  option, and 25 spot)
• Keep its individual business units well-educated
  about risk management
• Encourage them to bill in premium currencies like
  Japanese yen and receive invoices in discount
  currencies such as Italian lira

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Ex. 2 Hedging practice at Baxter Int.

• Educate a wide range of people within the company
  in the proper use of risk management tools
• Make many of its risk-management decisions by
  consensus (as an effective check-and-balance
  system)
• Try to interact and share information with
  several investment banks correctly

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Elimination of downside losses

• Managers and shareholders
• ? Not worried about impacts of foreign exchange
  gain, but exchange losses
• ?
• Options are best justified as hedging tools.
• Because of asymmetric pay-off structure
• Because of no possibility for loss beyond the
  amount of the premium paid
• Because of costs to symmetric hedges like
  forwards, money markets, and futures

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Does risk management create value ?

• If marketing resources are allocated where
  currencies are overvalued and are taken away from
  locations where currencies are undervalued
• If production is increased where currencies are
  undervalued and is decreased where currencies are
  overvalued
• ?
• The firm as a whole is more profitable.
• ?
• Risk management may indeed create value as
  well as
• reduce the variability of firm
  value.