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Summary Investment and Risk Article summaries Master BA UTwente

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Universiteit Twente (UT)

A summary of the articles that were talked about in Investment and Risk management class at the University of Twente, including personal notes, all in English. The articles summarized are: Froot, K, Scharfstein, D. and Stein, J., 1994, A framework for risk management. Giambona, E., Graham, J. R., ...

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Investment and Risk Management
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Article 1: A framework for risk management

GOAL OF RISK MANAGEMENT: ALIGNING THE SUPPLY OF INTERNAL FUNDS WITH THE DEMAND FOR
INVESTMENT FUNDING

Caterpillar and Dresser had big problems, while they could have insulated themselves from energy-
price and exchange-rate risks by using the derivatives markets.

Procter & Gamble’s losses in customized interest-rate derivatives and Metallgesellschaft’s losses in
oil futures are two of the most prominent examples. The important point is not that these companies
lost money in derivatives, but that both companies lost substantial sums of money because they took
positions in derivatives that did not fit well with their corporate strategies.

A company’s risk-management strategy cannot be delegated to the corporate treasurer - let alone to
a hotshot financial engineer, it has to be integrated with its overall corporate strategy.

Risk-management paradigm rests on three basis premises:

1. The key to creating corporate value is making good investments.
2. The key to making good investments is generating enough cash internally to fund those
investments; when companies don’t generate enough cash, they tend to cut investment
more drastically than their competitors do.
3. Cash flow (CF) - so crucial to the investment process - can often be disrupted by movements
in external factors (exchange rates, commodity prices, interest rates), potentially
compromising a company’s ability to invest.

Goal of risk-management program: ensuring that a company has the cash available to make value-
enhancing investments.

Miller and Modigliani: value is created on the left side of the balance sheet when companies make
good investments in f.e. R&D, plant and equipment, or market share, that ultimately increase CF.
How the company pays for this is irrelevant.

Less than 2% of all corporate financing comes from the external equity market. Why? The problem is
that it’s difficult for stock market investors to know the real value of a company’s assets. Companies
will be reluctant to raise funds by selling stock when they think their equity is undervalued. And if
they do issue equity, it will send a strong signal to the stock market that they think their shares are
overvalued (usually falls by 3%). MOST COMPANIES PERCEIVE EQUITY TO BE A COSTLY SOURCE OF
FINANCING AND TEND TO AVOID IT.

Debt is easy to value without precise knowledge of the firm’s assets. No one wants to lend to a
company with a large debt. Companies first rely on retained earnings  debt  then outside equity.

Internally generated cash is a competitive weapon that effectively reduces a firm’s cost of capital and
facilitates investment because financial frictions determine not only how companies finance their
investments, but also whether they are able to undertake those investments in the first place.

1

,Omega
They expect the dollar value of its CF from foreign and domestic operations to be $200 million. If the
dollar appreciates relative to the Japanese yen and the German mark, CF will fall to $100 million. A
dollar depreciation would increase CF to $300 million (scenarios are equally likely).  Don’t hedge.

R&D budget of $200 million  NPV of $90 million, compared with $60 million for R&D budgets of
$100 million and $300 million. They can’t borrow any funds to finance R&D and is reluctant to issue
equity. If dollar depreciates: $100 million loss, if dollar appreciates: $100 million gain. Hedging
program locks in net CF of $200 million - the CF that the company would receive at prevailing
exchange rates. When hedging: Omega is able to add $100 million of R&D, increasing discounted
future CF by $130 million (160 to 290).

As the dollar depreciates, the internal supply of funds - Omega’s CF - increases. The demand is fixed
and independent of the exchange rate. If dollar depreciates, supply exceeds demand and the other
way around. By hedging, the company reduces supply when there is excess supply and increases
supply when there is a shortage. Companies should use risk management to align their internal
supply of funds with their demand for funds.

Oil company
Main risk: oil price changes. When oil price is low, it is less attractive to explore and develop new oil
reserves. Because the supply of funds tends to match the demand for funds, there is less reason to
hedge.
Oil prices: Optimal amount of investment
 low: CF $100 million $150 million
 medium: CF $200 million $200 million
 high: CF $300 million $250 million

2 Key features of derivatives that a company must keep in mind when evaluating which ones to use.
1. CF implications of the instruments. F.e., futures contracts are traded on an exchange and
require a company to mark to market on a daily basis - that is, to put up money to
compensate for any short-term losses. These expenditures can cut into the cash a company
needs to finance current investments. In contrast, the over-the-counter forward contracts -
which are customized transactions arranged with derivatives dealers - don’t have this
drawback because they don’t have to be settled until the contract matures. When a dealer
writes the company a forward, he will charge a premium for the risk that he bears by not
extracting any payments until the contract matures.
2. Linearity or nonlinearity of contracts. Futures and forwards are essentially linear contracts.
Options are nonlinear, and they allow the company to put a floor on its losses without having
to give up the potential for gains.

The decision of which contract to use should be driven by the objective of aligning the demand for
funds with the supply of internal funds. Important is that it makes good sense to stay away from the
most exotic, customized hedging instruments unless there is a very clear investment-side justification
for their use. Dealers make more profit selling cutting-edge instruments, for which competition is less
intense. And each additional dollar of profit, for going to the dealer is a dollar less of value available
to shareholders. So, unless a company can explain why an exotic instrument protects its investment
opportunities better than a vanilla one, better go with vanilla.

2

, Article 2: Corporate Risk Management
Regulatory changes implemented to increase market stability could discourage corporate hedging.
Six areas of risk:
1. Interest rate
2. Foreign exchange rate
3. Commodity
4. Energy
5. Credit
6. Geopolitical

Reasons to hedge:
 Non-Financial: to increase expected CF. Smoothing earnings is a reason to hedge.
 Risk managers: to decrease unexpected losses and shareholders expect the firm to do so
 To increase earnings predictability

Market conditions, accounting rules and regulatory changes can affect corporate hedging.

Hedging decreased due to:
 Restrictions on customized over-the-counter derivatives
 Move to all standardized exchange-traded contracts
 Having to post collateral on OTC instruments (more than traditionally required)
 Regulatory changes that make it more difficult and/or costly to trade derivatives

Respondents only or mostly use OTC instruments to manage IR, FX or CM/EN risk. IR swaps are the
most popular way to manage IR risk, while forward contracts are the preferred financial instruments
to hedge FX risk and CM/EN risk. The most common methods to manage CR are to impose a
minimum CR rating for the counterparties or strict caps on exposure to any single counterparty.

The two most common operational methods to manage FX risk are:
1. Pricing strategies
2. Foreign currency debt

Neoclassical: when taxes and other costs are not happening. No frictions in the market. RM not
relevant. Frictionless work and other market imperfections: firm value doesn’t depend upon hedging.

Credit Rationing: firms hedge to mitigate the effect of CR rationing on investment. Risk management
(RM) reduces the volatility of CF that can be used to fund new investment projects in states where
access to CR is limited. Access to liquidity can function as a substitute for RM in mitigating CR
rationing. Firms are more likely to hedge if they face CR. Use hedging to mitigate the effect of
external factors. Difficulty/insufficient to get the finance they want (loans etc.). Risk management is
used to ensure that they get sufficient financing.

Information Asymmetry: managerial ability unobservable; firm is risk neutral. Managers make
decision in their own benefits, conflict of interest. Hard to monitor. F.e. exchange rate changed >
(without hedging, hard to see) additional profit because of manager or because of another factor
(like agency problem). Good managers will try to isolate their influence (high IA is good). Measure
used for testing this return on assets as a proxy for managerial ability. The concern with ROA and
other archival measures is that they are based on observed outcomes and don’t necessarily reflect
uncertainty about managerial ability. IA is higher for small firms. But Table V suggests the opposite.
IA is lower for public firms, table V suggests the opposite.

3

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