The economics of hedging

February 2017
[email protected]
 Corporate risks
Yield curve
Interest rate risk
risk Repricing
risk
Exchange rate
Market risk risk
Commodity
price risk

Credit risk

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 Hedging
Revenues  Output price × quantity sold
– Costs  Input price × quantity sold
= Profits  Uncertain profit

 Suppose that revenues are fixed (the selling price is known as of

today, say €100).
 Unit operating cost has the following CDF ( N(€65, €38)):

Outcome: €2 €16 €33 €65 €85 €114 €128

CDF: 5% 10% 20% 50% 70% 90% 95%

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 Hedging
 Unit profit (= cash flow to the company’s shareholders) is
uncertain and has the following CDF:

CF: €98 €84 €67 €35 €15 – €14 – €28

CDF: 5% 10% 20% 50% 70% 90% 95%

1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
4 120 100 80 60 40 20 0 -20 -40
 Hedging
 Expected CF per unit is €35, but there is volatility ( risk):
 If the company could set the unit cost today (at, say, its expected
value, €65), the uncertainty over the future unit profit would
disappear ( hedging).

Unit CF 100
Hedging loss
35
Hedging gain

65 100 Unit cost

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 Hedging and value
 Should a company hedge its future prospects?

Agents (shareholders, managers, stakeholders) are risk averse


Hedging reduces risk

Hedging is beneficial

 A fundamental proposition in finance is that financing and risk

management decisions do not add value in perfects markets.
 This is because investors can hedge their individual portfolios.

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 Hedging and value: financial distress costs
1. Hedging reduces the expected costs of financial distress.

Hedged

Unhedged

X E(CF) CF

• If realized profits are smaller than X, the company goes bankrupt

and bears financial distress costs.

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 Hedging and value: financial distress costs
• Direct bankruptcy costs.
• Legal/administrative costs in bankruptcy and liquidation (court, lawyers,
accountants).
• Direct bankruptcy costs are small (< 1% of overall market value) (Warner,
1977, JF).
• Indirect bankruptcy costs.
• Costs involved with the difficulties of running a business while it is going
through bankruptcy.
• These costs are difficult to quantify, but substantial. Examples:
• missed positive NPV investment opportunities;
• loss of customers that value post-sale services;
• loss of willing suppliers;
• difficulty retaining and recruiting employees;
• forced sales of assets at reduced prices.
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 Hedging and value: financial distress costs
• Suppose that the quantity sold is 1M, and that r = 0%. Revenues
(R) are constant (€100 per unit, hence €100M), and operating
costs are random (unit C  N(€65, €38), hence C  N(€65M,
€38M)).
• The firm has a debt of €15M, and bankruptcy is costly
(bankruptcy costs are €3M).
• The value of the firm (assume just one period) is:

V = PV[E(CF) – E(bankruptcy costs)]

= PV[E(CF)] – PV[E(bankruptcy costs)]

• In the example: V = €35M – €3M  Prob(CF < €15M).

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 Hedging and value: financial distress costs
• Since CF  N(€35M, €38M), Prob(CF < €15M)  30%. Hence:

V = €35M – €0.9M = €34.1M.

• If the firm hedges its operating costs, such that CF  N(€35M,

€0M), then Prob(CF < €15M) = 0, PV(bankruptcy costs) =
€0M, and the value of the firm is equal to V = €35M.

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 Hedging and value: financial distress costs
• Also, PV(bankruptcy costs) are an increasing function of SD(CF):

PV(BC), 1.4
€M 1.2
1
0.8
0.6
0.4
0.2
SD(CF), €
0
0 20 40 60 80 100 120

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 Hedging and value: debt overhang
2. Hedging makes it more likely that future attractive investments
will be made by the firm.
Payoff 1 year hence
Probability Project A Project B
30% €5M €0M
30% €5M €0M
9% €5M €0M
1% €5M €10M

• Both project A and project B require investing €3M today (and the
firm has cash).
• There is a debt outstanding of €5M expiring 1 year hence (the
company is in financial distress).
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 Hedging and value: debt overhang
• Stockholders will prefer project B.
• It is much riskier, and its NPV is negative (= –€3M + PV(€0.1M)).
However, there is a 1% chance that they get something (vs. a 0%
chance for project B).
• Bondholders will prefer project A.
• It is a safe project with a positive NPV (= –€3 + PV(€5M)).

• Hedging makes this situation (debt overhang) less likely (since it

reduces the probability for a company to go into financial
distress).

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 Hedging and value: taxes
3. Hedging can reduce taxes.
Unhedged Hedged
Growth Recession Growth Recession
Probability 50% 50% 50% 50%
Gross profit €M 300 0 150 150
D&A €M 80 80 80 80
Interest expense, €M 20 20 20 20
EBT, €M 200 -100 50 50
Taxes (30%), €M 60 0 15 15
Net income, €M 140 -100 35 35

• Expected net income: €20M for the “unhedged” scenario, €35M

for the “hedged” scenario.
• Tax carryforward/carryback weakens this motivation, but at least in
PV terms it holds anyway.
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 Hedging and value: taxes
• The value of the firm (assume just one period) is:

V = PV[E(CF – taxes)]
= PV[E(CF)] – PV[E(taxes)]

• In the example (assume r = 0%): PV[E(CF – taxes)] = (€140M +

€20M)  50% + (– €100M + €20M)  50% = €40M in the
“unhedged” case, and (€35M + €20M)  100% = €55M in the
“hedged” case.
• Hedging raises the value of the firm by €15M, i.e. the PV of
differential expected taxes.
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 Hedging and value: debt capacity
4. Hedging may increase debt capacity.

• Back to the opening example. Suppose that the quantity sold is

1M, and that r = 5%. Revenues (R) are constant (€100M), and
operating costs are random (C = €75M with prob = 50%, and
€55M with prob = 50%). Hence, CF = €25M with prob = 50%,
and €45M with prob = 50%. The tax rate is 50% and the debt is
risk-free.

• Suppose also that the maximum amount that the firm can borrow
is €25M net of taxes in terms of face value (debt holders are not
willing to risk a haircut in case of default).
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 Hedging and value: debt capacity
• With a 5% interest rate, the firm can borrow today B, where B is
found as:

B + 5%  B + 50%  (€25M – 5%  B) = €25M  B = €12.20M.

The value of the firm is:

V = PV[E(CF – taxes)]

• In the example: PV[E(CF – taxes)] = PV{[(€25M – €0.61M)  (1

– 50%) + €0.61]  50% + [(€45M – €0.61M)  (1 – 50%) +
€0.61M]  50%} = €16.96M.
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 Hedging and value: debt capacity
• If the firm hedges its operating costs such that CF = €35M, then it
can borrow today B, where B is found as:

B + 5%  B + 50%  (€35M – 5%  B) = €35M  B = €17.07M.

The value of the firm is:

V = PV[E(CF – taxes)] = PV(CF – taxes)

• In the example: PV(CF – taxes) = PV[(€35M – €0.85M)  (1 –

50%) + €0.85] = €17.07M.
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 Hedging and value: debt capacity
• In other words, absent expected bankruptcy costs, hedging
creates value because increases debt capacity and the associated
tax shields.
• The value created is €0.11M, equal to the PV of tax shields on the
additional debt (= €4.87M).
• In fact:

PV(4.87  5%  50%) = €0.11M.

• Larger debt capacity may also lead to an increase of the firm’s

value from an asset side view ( investment projects undertaken
if and only if the company can borrow more).
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 Hedging and value: imperfect markets
5. Other reasons for hedging.

• It is less costly for the firm to hedge than for individuals to hedge.
• Nonsystematic risk should be hedged when owners are not well
diversified.
• It reduces agency costs of managerial discretion on the company’s
cash flows.
• It also reduces sources of fluctuation of market value, and hence
helps shareholders to assess the skills of the company’s managers.
• Reducing risk, hedging should also imply a lower risk-adjusted
compensation to managers (e.g., stock options).
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 Derivatives: a primer
 A derivative is an instrument whose value depends on the value of
an underlying variable, e.g.:
 interest rates and bonds;
 common stocks or indexes (e.g., a stock index value);
 foreign exchange rates;
 commodity prices;
 other.
 Thus, the value of a derivative is “derived” from another
primary or underlying variable.

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 Derivatives
 Derivatives play an important role in financial and commodity
markets, allowing market participants to:
 hedge and control risks;
 reflect a view on the future direction of the market (speculating);
 lock in an arbitrage profit.

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 Derivatives

Derivatives

Symmetric positions Asymmetric positions

Forwards Options

Forwards Futures Swaps

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 Global OTC derivatives
Notional, $ bln Mrk value, $ bln
800,000 40,000

700,000 35,000

600,000 30,000

500,000 25,000

400,000 20,000

300,000 15,000

200,000 10,000

100,000 5,000

0 0
H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1 H1
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Market value Notional
Source: Bank for International Settlements

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 Global OTC derivatives
Source: Bank for International Settlements

25
 Global ET derivatives

Source: Bank for International Settlements

26
 Global ET derivatives
Data based on the number of contracts traded and/or cleared at 76 exchanges worldwide

Source: Futures Industry Association, 2016 Annual Global Futures and Options Volume

27
 Global ET derivatives

Source: Futures Industry Association, 2016 Annual Global

Futures and Options Volume

28
 Global ET derivatives

Source: Futures Industry Association, 2016 Annual Global Futures and Options Volume
ICE Futures Singapore began trading in November 2015

29