International Financial Markets Prices and Policies. Why Measure and Manage Financial Exposure?

Transcription

1 International Financial Markets Prices and Policies Second Edition 2001 Richard M. Levich 16A Measuring and Managing the Risk in International Financial Positions Chap 16A, p. 1 Why Measure and Manage Financial Exposure? ❿ Disaster stories have hit corporations, financial firms, and public agencies (Box 1.1) ❿ Financial swings routinely impact the firm's income and balance sheet (Tables 1.1-2) ❿ Companies will "manage what they measure" Firms will pay attention to what they know will be disclosed and counted. "Due diligence" motive for exposure management vs. value maximization Chap 16A, p. 2 1

2 The Case Against Hedging (1 of 3) ❿ The classical theory of finance (Modigliani- Miller) predicts that when there are no taxes, no transaction costs, and the investment activities of the firm are fixed then, the financial policies of the firm are irrelevant. The firm should not use valuable resources to hedge financial or operating risks, because the shareholder can do this for himself. ❿ Implications of M-M Theory The market DOES NOT reward a firm (by giving it a lower required return on equity or a higher market value) when the firm devotes resources to eliminating its diversifiable risks. Chap 16A, p. 3 The Case Against Hedging (2 of 3) ❿ Logic of the M-M Theory The value of the firm comes from its assets, not how they are financed Investors can diversify away the risks (both operating and currency risks) of an individual firm by holding a portfolio of investments Investors can eliminate any unwanted currency risk by using forward currency contracts Global investors may actually desire a currency mix in their portfolios, especially when their consumption baskets are international, or if capital market barriers constrain their ability to obtain securities in particular currencies Investors could actually penalize firms that engage in discretionary hedging that results in losses or increased exposure to risk Chap 16A, p. 4 2

3 The Case Against Hedging (3 of 3) ❿ Illustration of the Case Against Hedging Consider a large Swiss multinational firm such as Nestle or Ciba-Geigy. Investors may buy shares in these firms not to obtain cash flows in Swiss francs, but rather to own a stream of cash flows coming from around the world. Assuming that the treasurer could identify his true exposure, if the treasurer were to hedge these cash flows into Swiss francs, the investor would then need to unhedge to re-gain his desired position. In this case, hedging is a disservice to the investor Chap 16A, p. 5 The Case Favoring Hedging (1 of 2) ❿ When exceptions to the classical theory of finance are taken into account, then valid, rational reasons for hedging can be made. ❿ Costs associated with financial distress The firm may face extra costs associated with exposure to FX and interest rate risk. If so, hedging could be cost-effective. (benefits exceed costs) the cost of breaking a loan covenant the cost of suppliers refusing to supply us because of trade credit fears the costs of entering bankruptcy, and re-starting the firm after bankruptcy, such as Legal and administrative costs of the bankruptcy process Lost sales Lost investment opportunities Loss of key personnel to competitors Chap 16A, p. 6 3

4 The Case Favoring Hedging (2 of 2) ❿ When the costs of financial distress are reduced by hedging The firm's debt capacity may increase, resulting in greater investment opportunities And, if the probability of a bankruptcy or default is lower, the firm may improve its debt rating and lower its cost of funds ❿ Taxes and hedging The value of expected losses (from tax savings) may not be as great as the value of expected gains, if the tax system does not allow unlimited carryforwards of losses. After-tax value of smooth income > volatile income Chap 16A, p. 7 Just to clarify. ❿ Debt holders should prefer hedging and equity holders should not (Box 16.1) Debt holders want secure income stream, they have no upside to gain Equity holders value volatility and the chance for an upside gain (like an option) and they can diversify risks across various equity positions ❿ Puzzle is to figure out why equity holders would prefer a stabilized income stream Why would the relatively stable income stream (Figure 16.5) be more valuable than the more volatile one without hedging? Chap 16A, p. 8 4

5 Characteristics of firms that may benefit from hedging financial and operating exposure ❿ Firms who produce products: that require after-sale servicing (automobiles, computer, electrical equipment) whose quality is difficult to determine in advance (pharmaceuticals) with high switching costs (computer systems, airplanes, capital equipment) ❿ Firms with high growth opportunities, that need a steady stream of retained earnings (rather than external capital) to keep growing. ❿ Firms that rely on key individuals (scientists, programmers, engineers, traders, managers, etc.) who are mobile to other competing firms ❿ Firms that have large tax deductions (and need a steady income stream to obtain the full benefit of these tax write-offs) Chap 16A, p. 9 Defining Financial and Operating Exposure (1 of 2) ❿ Financial Exposure Represents the sensitivity of the economic value of the firm to changes in financial market conditions. ❿ We can identify various specific financial risks: (a) Currency (FX) risk (b) Inflation risk (c) Interest rate risk (d) Commodity price risk The above are more than just a list ❿ As we will stress later, these risks are important whether they impact (a) Our firm (b) Our customers (c) Our suppliers (d) Our competitors Chap 16A, p. 10 5

6 Defining Financial and Operating Exposure (2 of 2) ❿ Operating Exposure Represents the sensitivity of the firm s cash flows and economic value to changes in business or operating conditions. In general, we think of business or operating risk as encompassing a broad range of situations including: New firms entering the industry New products, production processes, or product improvements Environmental risks: fire, weather, accidents, catastrophic events Regulatory risks Chap 16A, p. 11 Summary on Hedging and Exposure Concepts ❿ The classic M+M model has no role for hedging. Costs of financial distress and taxes provide a rationale. ❿ Certain types of firms are likely to face greater exposure and greater benefits from hedging. ❿ Two types of exposure: Financial + Operating ❿ Two types of managerial responses: financial and operating hedges Chap 16A, p. 12 6