The assignment for completion is in Word format, the accompanying documents that may be helpful are in the powerpoint document
Business Stats: An Applied Approach Controlling Project (and Firm) Risks Unlike the real options considered last week, in some cases information about future outcomes will only be available after decisions must be made. When this is the case, we can still reduce uncertainty by “hedging” our risk exposures. We do this by establishing conditions which create a second, opposite, payoff to neutralize the original uncertainty. This can be done naturally, or by financial instruments (typically derivatives) that establish prices or payouts ahead of time. Typically, we identify the key drivers of changes in NPV through either simulation or sensitivity analysis and then hedge these risks to insulate firms and projects against undesirable outcomes. Hedging Definitions A long risk exposure is one from which we will profit from an increase in the value of the underlying asset and lose if it decreases. Intuitively, it is an asset we own, or will own, as a result of our position A short exposure is the reverse - we profit from a decline in asset prices and lose if they appreciate. Intuitively, it is an asset we owe either immediately, or will owe at some point in the future (consider what you do when short-selling a stock). Hedging Example A Canadian firm whose expenses are in CAD will receive 1 million USD in 30 days. It is exposed to exchange rate risk which creates uncertainty in the final CAD payoff. The firm has a long exposure to USDs as it will own them (they profit if USD rises by then). This exposure can be hedged by contracting with another party to sell them the 1 million USD in 30 days for a pre-arranged amount of CAD With this second transaction they are now short USDs as well. When combined, these two positions neutralize one another perfectly and there is no uncertainty about how much CAD we will receive in 30 days. When hedging, the amount and timing of exposures need to match! The Cost of Hedging People are generally willing to pay for hedging for one of two reasons: To remove the possibility of catastrophic risk (health insurance as a hedge to your health) To remove uncertainty about an outcome (ordering materials ahead at a pre-established price) Hedging is never free – Even if net cash flows between parties is zero, the deal makers, lawyers, and accountants still get paid. How much people are willing to pay to hedge a risk depends on how averse they are to the “bad” outcome. How much people sell such protection for depends on market competition and on the ease with which a seller can defuse the risk themselves (through diversification, reselling, etc) What CAN be Hedged? Almost any risk can be hedged provided you can find a counter-party. https://ca.finance.yahoo.com/news/10-celebrities-insured-body-parts-210000413.html The question is generally not whether you can hedge, but whether or not it is economical to do so. Simply being uncertain does not qualify a project input for hedging. How valuable or important it is to control a particular source of uncertainty? The best hedges reduce the volatility of NPV the most for the lowest cost. Enterprise Risk If every project hedges its own risks without regard for others, there could be needless (and costly) duplication of effort. For this reason, firms should try to estimate net risk exposures to various sources and consider hedging those. Consider the following examples where 12 transactions worth $355 between international offices of the same firm is reduced to 2 transactions and $55 in exposure through netting (bilateral as well as multilateral) Exposure Netting Example Consider a firm with three foreign offices and the following transactions between them: $10 $35 $40 $30 $20 $25 $60 $40 $10 $30 $20 $30 Exposure Netting Example Multilateral netting can simplify things greatly and significantly reduce the cost of risk control. $15 $40 What SHOULD be Hedged? From the perspective of a portfolio investor however, there are several reason that firms should NOT hedge: If shareholders can manage the exposure themselves, should the firm force them to hedge? Hedging may not reduce the non-diversifiable risk of the firm (Beta) and therefore have no impact on how interacts with the rest of the portfolio. There are a few instances in which a firm should consider hedging: The managers know about an undisclosed risk exposure that shareholders do not The firm may be able to hedge collectively at better prices than the shareholders do individually The firm can reduce the probability of default by hedging The firm faces a progressive tax regime and has volatile earnings that result in “high rate” years. Imagine a firm making an average of $230,000 a year +/- $50,000 when the tax rate step occurs at $250,000. Natural and Meta-Hedging In some of these cases, a natural hedge may exist where operational choices can be made which reduce exposure to uncertainty. It frequently occurs by vertical integration in the supply chain of key materials. They also occur in international finance when capital for a project can be raised in the local currency, allowing firms to net out the revenue exposure with an appropriate cost exposure. Rather than simply accepting that a particular risk exists and that the firm should shield itself from it, some try to negate the risk itself (corporate lobbyists). What aspects of the operating environment create a particular risk and can this aspect of the environment be changed? https://www.researchgate.net/publication/306305464_Insuring_hedged_bets_with_lobbying Financial Hedging Some corporate risks can’t (shouldn’t) be naturally hedged however. http://en.wikipedia.org/wiki/Kidnap_and_ransom_insurance For these situations, a financial contract is created which will generate the desired payoffs and then we buy or sell it in exchange for some pattern of cash flows: Forwards, futures, swaps, options As in production economics, standardization of the tools involved and their pricing has reduced the cost of hedging significantly in the last 50 years. Forward Contracts A forward contract establishes a price today for future delivery. These contracts are bilateral, customized, and not traded. These type of arrangements have been around since at least classical Greece (Sumer even?) They can be specified for almost any future date. No cash changes hands until the contract is settled – it is purely an agreement to transact later at a pre-determined price. This type of “pure promise” obviously carries substantial risks (as Dutch tulip traders found out in February 1637: https://en.wikipedia.org/wiki/Tulip_mania * Futures Contracts A futures contract is the exchange-traded version of a forward contract. Instead of bilateral customization, futures are standardized for all buyers and sellers with fixed delivery dates, quantities, and qualities. Trading via an organized exchanges reduces credit risk (profits and losses are marked to market daily), allows positions to be readily liquidated, and lends itself to centralized reporting of prices and volumes traded. Such contracts cover a number of risk including basic commodities, financial data, and unusual risks like rainfall, power outages, and shipping disruptions. * Swaps A swap contract is effectively a collection of forward contracts due at regular intervals in time. A Canadian firm receiving monthly payment in USD may engage in a regular swap with a counterparty for Canadian currency. A firm could swap a payment based on a fixed interest rate for one based on a floating interest rate These arrangements are generally traded OTC and there is credit risk involved. Banks or specialized swap dealers generally serve as intermediaries. * Options Like other derivative contracts, options involve setting a price today at which a transaction is to be completed in the future. The major difference being that the buyer of the option has is granted the freedom to decide whether or not the contract is completed (“exercising an option”). Those buying options have all the upside but limited downside on a particular exposure. The ability to choose whether or not the transaction is completed provides managers with a powerful tool for risk management Predictably, such flexibility comes at a higher price than if you were forced to complete the transaction regardless of market circumstances. Although many options are exchange traded (with futures-style margin requirements, a central counter-party, etc), they may be created and traded OTC. * Option Markets A major advantage of an exchange traded option is the ability to sell/buy it back to/from the exchange. This allows firms to hedge risks or investors to gain portfolio exposure for time periods other than those ending on option expiration dates. This means we will only have to pay for a hedge during the period we need it. If we have a $1 million USD payable due in 13 days, we can buy (or sell) options to hedge the risk. This locks in today’s price provided we sell (or buy) the options back to the exchange when the payment gets made. There will be a loss related to the cost of buying such “insurance” from someone in the market. Option Terminology Strike Price: The contracted price of the transaction. The amount the option buyer must pay the option seller if they wish to complete the transaction. Payoff: The net proceeds that would be generated by exercising the option if today was the expiration date of the contract. It is the option’s “intrinsic value”. In-the-Money: An option with intrinsic value. (You can have an agreement to sell orange juice to someone at $2.50 while the open market price of orange juice is less than $2.50) Out-of-the-Money: An option with no intrinsic value. (A deal to buy sheep for $1400 while the open market price is $1200) Call Options (Buyer’s Payoff) A call option gives the buyer the right to require the seller (writer) to sell the underlying asset for the agreed upon price (the option’s “strike price”). The option buyer can “call” the asset from the seller The higher the price of the underlying asset is above the strike price, the greater the value in exercising the contract (at least for the buyer…) $70 $20 Sheet1 Asset Price$30$40$50$55$60$70 Call holder payoff$0$0$0$5$10$20 Put Options (Buyer’s Payoff) A put option gives the buyer the right to require the option seller (writer) to buy the underlying asset for the agreed upon strike price. The option buyer can “put” the asset onto the seller This means that the lower the price of the underlying asset is beneath the strike price, the greater the value in exercising the contract. Sheet1 Asset Price$30$40$50$55$60$70 Put holder payoffs$20$10$0$0$0$0 Option Sellers The payoff for option buyers is either zero, or a positive amount. For the sellers, this fate is reversed on a one-to-one basis (zero sum between players). Put option seller’s payoff Asset Price$30$40$50$55$60$70 Writer's Payoff$00$$0-$5-$10-$20 Asset Price$30$40$50$55$60$70 Writer's Payoff$20$10$0$0$0$0 Time Value With a “0 or less” payoff of option sellers, there must be some compensation for their potential losses or there would be no market for options. This compensation is a premium which raises an option’s price over its intrinsic value (IV). This is the “time value” of an option (TV). Option Pricing For the market to clear, the time value of an option must compensate the seller for the risks they face (or at least the seller’s estimates of those risks). Since the seller is providing insurance, they demand