[MUSIC] Hello. The topic this week is hedging. By hedging we mean the policies or actions that a firm or an investor adopts in order to reduce the impact that different sources of risk may have in its value. During this week you will study cases and examples on how to implement hedges against exposures to commodity prices, exchange rates, and interest rates. As an introduction, I would like to explain here why hedging is valuable to corporations. After decades of practice and academic studies of how firms should hedge we have arrived at a synthesis: A list of guiding principles of how a firm should approach its exposure to risk and to deal with it. We call these principles integrated risk management. These principles elevate the importance of the risk management function. Nowadays, the risk management function is considered as important as investment and financing. Risk management policy is often now discussed at the CEO and the board levels, not only within the firms Treasury. So does a firm need to manage risk? And what do we mean by risk anyway? The reality is that the firm's cash flow is unpredictable. Indeed, the bottom line value of a firm will be different depending on which scenario we finally end up in. And the scenario we obtain will be the result of different combinations of risk factors. What do we mean by risk factors? Consider for example, what would be the best case scenario for a wine producer in any given year. For a wine producer the best case scenario requires the following conditions: That spring temperatures are high, that there's enough spring and summer rain, that there's a strong local demand for wine, that there's a strong foreign demand for wine, that the local currency is weak, okay. Or equivalently that the foreign currency is strong. This would make the firm's exports more valuable. But it also requires that: there are low spring temperatures in foreign wine producing areas. But there's low rainfall in foreign wine producing areas, etc, okay. Any other combination of these factors would produce worse scenarios and presumably make the wine production business less valuable. As another example, many firms nowadays find themselves in a bad earnings scenario because of the combination of high energy prices, as a consequence of oil supply shortages following Russia's invasion of the Ukraine and continued disruptions of the supply chains due to the covid pandemic. Often, most of these factors occurred independently of each other. So what should a firm do about the fact that in reality its fortunes are exposed to many risk factors? So, should a firm try to remove its exposure to risk completely? Does it make sense to make its cash flow perfectly predictable? Is it feasible to do so? Well surprisingly, instruments do exist to remove all risks from certain transactions. The more difficult question is whether the firm may want to do it at all. Intuitively reducing volatility and increasing predictability should be good for a firm and its shareholders, right? this is not always the case. Remember that the firm's shareholders are usually experienced investors who can reduce themselves the volatility of their own portfolio by diversifying their investments. As an example, should the technology firm NVIDIA whose stock has a beta of 2.42, meaning that its stock return is more than twice more volatile than the market portfolio's return. Should this firm do something about its high risk? Not necessarily. An investor could hold NVIDIA shares on one hand, but also an equal measure hold shares on say, the Barrick Gold Corporation, which is a gold miner and whose shares have a beta of 0.04. As a result, the investor's overall portfolio would bear almost the same risk as the market does. Moreover, NVIDIA didn't have to do anything about it. The resulting principle is that the practice of hedging and more generally, risk management must involve a reduction of exposures to risk that shareholders cannot easily do by themselves. Consider next the example of Bombardier, the Canadian manufacturer of, among many things, snowmobiles. Since 1998, this company offers its customers a large rebate of about 2000 Canadian dollars if by the end of the winter, if the total amount of snowfall in Canada is below certain level, then the rebate is executed. At the same time Bombardier buys insurance against having to pay this rebate in case there wasn't enough snow in the winter. Of course, Bombardier shareholders could have insured themselves against weather risk by using weather derivatives just like in the NVIDIA case. But the key here is that by offering a rebate and hedging internally, their sales increased by almost 40%. What do we learn from Bombardier's risk management policies? One lesson is that hedging adds value when it's coordinated with the firm's other policies, in this case, its commercial policy, so as to achieve outcomes that its shareholders could not by themselves, i.e, boosting sales. The case of Bombardier also exemplifies another important consideration: Hedging is not about reducing risk per se, but more importantly about reducing tail-risks. What are tail-risks? Tail risks are the risks that we may end up in a very bad or worst case scenarios. In such scenarios, firms have to incur additional costs, non business related, such as the legal fees to protect itself from creditors, seizure of assets which were posted as collateral, the loss of reputation which could further trigger further drops in sales or the loss of trust from clients and providers, okay. That is value drops sharply when we move into tail events on the downside. Very often risk management adds value by minimizing or eliminating the probability of tail events and their additional costs. Now, what are the sources of risk? Another guiding principle is that different sources of risk need different hedging approaches. To understand why let us first discuss the different sources of risk for a corporation. The most common and best understood source is known as market risk. A firm is exposed to market risk when the value of the firm's assets or its liabilities fluctuates along with market variables such as interest rates, the stock market, foreign exchange rates, or commodity prices. For example, crude oil and its derived fuels, such as jet fuel or heating oil, are all traded in a global market, and their prices fluctuate unpredictably. Since the value of an oil producer depends largely on these prices, oil producers bear a lot of market risk. Luckily, most financial derivatives, such as forward contracts, futures, options, swaps, were created to protect the user against market risk. Another well understood source which pertains to banks, is credit risk. The cash flow and therefore the value of a bank is closely linked to its borrower's ability to repay their credit cards, their loans or mortgages. The risk they may default on the bank is what we call credit risk. Banks will use interest rate swaps or futures to hedge against the market risk in their portfolio. But they will also use options and insurance in the form of credit default swaps to hedge themselves against default or credit risk. A source of risk that has gained importance recently is called operational risk. OpRisk refers to the possibility that the normal process of executing the firm's transactions may be disrupted, thus affecting the firms cash flow. For example, the supply chain disruptions during the Covid lockdowns are a manifestation of OpRisk. Similarly, oil spills or natural disasters caused by or affecting the firm's working environment are also OpRisks. Rogue traders, who execute transactions on behalf of the bank outside their remit are also forms of OpRisk. Hedging operating risk cannot be done with standard derivatives or other market risk instruments. Firm can use custom-tailored insurance contracts. More generally, OpRisk tends to be hedged with an internal infrastructure of constant reporting and complying. Another important source is sovereign risk. If a firm conducts operations internationally, a volatile political situation of the host country implies risks of assets expropriation, debt moratoria, or default by clients. Hedging against sovereign risk can also be achieved with combinations of market instruments, such as credit default insurance and sovereign bonds, but also custom-made insurance. How should a firm construct its hedges? Constructing hedges can be straightforward in some situations, but extremely complex in others. It really depends on the type of exposure. Individual transactions exposed to one single market risk factor can be easily measured and hedged appropriately. For example, consider the exports of Porsche, the German sports car manufacturer in this case to the United States. Suppose Porsche ships 33,000 cars to the US each year, expecting to sell them all by the end of the year and be paid $90,000 per car. While Porsche is quite certain to receive an annual revenue of $2.97 billion. What would be the value of its revenue in euros? Porsche cannot know this when the cars are shipped, but at least Porsche knows how many dollars it will receive and when. This is called a direct transaction exposure. In this case, Porsche is said to be long on the US dollar. If the value of the US dollar in euros goes up, then Porsche's dollars will convert to more euros. But if the value goes down, then Porsche's dollars will convert to fewer euros. All Porsche needs to do is to find an offsetting position. That is, a short position which will convert to more euros when the value of the dollar goes down, and to fewer euros when the value of the dollar goes up. In fact, in this case, what Porsche needs to do is to short the $2.97 billion forward over12 months. Thus, the gains or losses on the long exposure will be perfectly offset by the losses or gains on the short hedge. Guaranteeing Porsche with the same revenue in euros, regardless of what the exchange rate may be. To summarize, transaction exposure to market risk factors, can be hedged tactically one to one using derivatives. Unfortunately, in reality exposures can be much more complex than this one. What can firms do facing such complexity? Consider the case of General Motors, the American car manufacturer. How was General Motors exposed to the exchange rate between the Japanese yen and the US dollar, and how did it deal with it? What is most interesting about this case is that throughout the seventies, eighties and nineties, less than 2% of General motor sales were in the Asia pacific region, okay. With so little business in Japan, why should General Motors have worried about the exchange rate between the Japanese yen and the US dollar? Well, General Motors realised that it was losing market share in the United States to Japanese car manufacturers, as the Japanese yen lost value against the US dollar. So General Motors reasoned, that a weakening yen, meaning that a dollar would convert to more and more yen, would imply the following: First, it would imply higher gross margins to Japanese automakers selling cars in the United States. As a result of that, Japanese automakers could pass along some of this benefit to consumers via price reductions. Japanese automakers would then gain even more market share in the United States, decreasing General Motors unit sales. Therefore, General Motors profits would decrease. In fact General Motors estimated that 20% depreciation in the yen would lead to a loss of $1.5 billion dollars per year. What could General Motors do about this economic exposure, which is not related to specific transactions General Motors has contracted, but to the complex interaction of two competing multinationals? The hedge consisted of several policies, okay. First, General Motors reason that hedging with forwards or with futures was deemed too risky, because quantities to hedge were too uncertain. And depended too much about assumptions of your competitors. Second, General Motors increased the yen component of its cars, by using more and more Japanese parts. Third, they started progressively substituting American for Japanese technology in the construction. Fourth, General Motors started borrowing in yen, thus benefiting from a weaker yen on the liability side of the balance sheet. And finally, General Motors invested directly in Japanese automakers, who were benefited from a weaker yen at the expense of General Motors and other American manufacturers. The main takeaways from the previous two examples are that: Forwards or futures contracts can reduce exposure to one risk factor very effectively and almost entirely. In fact, forwards are free and future contracts not very expensive, but, complex exposures require creative solutions that usually involve the use of insurance and so called natural hedges. Firms can purchase insurance directly from insurers to provide cover against tail events. There is a price to be insured, which is called the premium. For example, most airlines have by now abandoned the use of futures contract to hedge against increases in jet fuel prices. Jet fuel is the key expense to fly airplanes. Airlines realised that future hedges guaranteed a certain price for purchases of jet fuel in the future. But in that case, airlines wouldn't be able to benefit when jet fuel got cheaper. Therefore, the way to benefit from cheaper jet fuel is to hedge only against the scenario of increasing fuel prices. That goal can be achieved by simply buying insurance or more simply buying call options on jet fuel. In other words, call and put options are an alternative to forwards and futures that can simulate the situation in which the firm pays to be insured against only downside tail risks. The so called natural hedges consists of generating assets or liabilities that offset existing exposures. For example, by borrowing in yen, General Motors benefits from cheaper loans when expressed in dollars, as the yen weakens with respect to the US dollar while its sales drop. As another example, Delta Airlines started acquiring oil refineries since 2012 to self supply jet fuel and not have to pay the market price in case it went up. To summarize, as you go into this week and study specific hedging strategies, always bear in mind that there is no solution that applies all the time. In fact, what we have learned after decades of research and good and bad practice can be condensed into the following set of guidelines: Number one, risk management is about the identification and assessment of the collective risks affecting firm value and the implementation of a firm wide strategy to manage those risks. Number two, risk management cannot be delegated. It must be implemented strategically and coordinated at the highest level of management. Number three, risk management is not about forecasting the future scenarios, but about hedging against the worst scenarios. Number four, hedging goes beyond using derivatives or buying insurance. It should also include diversifying the firm's operations across countries, across technologies. Diversifying the financing base using several currencies to borrow in order to match the currencies from the sales side or chasing the exposure to interest rates using the swap market. Sharing risks with clients or suppliers we do business with in the long run also helps. I leave you now to enjoy the week.
