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Corporate Financial Policy

Semester A 2012-13City University of Hong Kong

AC4331 Topic 8 & 9

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Topic 8&9

.

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1-2

Introduction to Financial Management

Free Cash Flow

Financial Planning and Forecasting

Financial Assets and Time Value of Money

Risk and Return Bond and Stock Valuation

Cost of Capital

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Treasury and Valuation

Enterprise Risk Management Dividends and Share Repurchase

Merger and Acquisitions

Working Capital Management

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Extra Ref:Smart,Chapter 20 (pg. 670-675) Managing Financial, Economic andPolitic RiskEugene and Brigham 12E, Chapter 23, (pg. 834-837) - Corporate Risk

Management

Topic 8 & 9:Treasury and Valuation

Enterprise Risk Management

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Chapter 18

Motives for Risk Management

Fundamentals of RiskManagement

Derivative Securities

Using Derivatives

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Motives for risk management

5

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Diversified shareholders may already behedged against various types of risk.

Reducing volatility increases firm value only

if it leads to higher expected cash flowsand/or a reduced WACC.

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Reduced volatility reduces bankruptcy risk, whichenables the firm to increase its debt capacity.

By reducing the need for external equity, firmscan maintain their optimal capital budget.

Reduced volatility helps avoid financial distresscosts.

Managers have a comparative advantage inhedging certain types of risk.

Reduced volatility reduces the costs ofborrowing.

Reduced volatility reduces the higher taxes that

result from fluctuating earnings. 18-7

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Fundamentals for risk management

8

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Corporate risk management relates to themanagement of unpredictable events thatwould have adverse consequences for the

firm. All firms face risks, but the lower those risks

can be made, the more valuable the firm,other things held constant. Of course, risk

reduction has a cost.

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Speculative risks: offer the chance of a gainas well as a loss.

Pure risks: offer only the prospect of a loss.

Demand risks: risks associated with thedemand for a firms products or services.

Input risks: risks associated with a firmsinput costs.

Financial risks: result from financialtransactions.

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Property risks: risks associated with loss of afirms productive assets.

Personnel risk: result from human actions.

Environmental risk: risk associated withpolluting the environment.

Liability risks: connected with product,service, or employee liability.

Insurable risks: risks that typically can becovered by insurance.

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Financial risk exposure refers to the risk

inherent in the financial markets due toprice fluctuations.

Example: A firm holds a portfolio ofbonds, interest rates rise, and the value

of the bonds falls.

What is a financial risk exposure?*

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Financial market movement Effect on Business

Interest Rates Rise Working capital costs increases

Interest costs of floating rate borrowingincrease

Yields on floating rate investmentsincreases

Interest Rates Fall Working capital costs decreases

Interest costs of floating rate borrowingdecrease

Existing fixed rate borrowing relativelymore expensive than variable rateborrowing until renegotiated

Yields on floating rate investments fall

Value of domestic currency fallsExposure to foreign currencies has greaterimpact

Cost of imported goods increases

Value of domestic currency rises Products become less competitive on worldmarket

Value of foreign earnings fall

Value of overseas investments andproperty falls

QP Manual Module B Section 14 2008 a e 4

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Financial market movement Effect on Business

Commodity Prices Rise Working capital costs increases

Commodity Prices Fall Working capital costs decreases

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Step 1. Identify the risks faced by the firm.

Step 2. Measure the potential impact of theidentified risks.

Step 3. Decide how each relevant riskshould be dealt with.

Managing Financial Risk*

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Step 1: The Risk Profile A plot showing the relationship between

changes in the price of some goods,services, or rate and changes in the value

of the firm. Step: Measure the Risk and Reducing RiskExposure Reduce the risk to bearer level and

thereby flatten out the risk profile

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Risk Size of cost of the risk event

Low High

Low Retention Transfer

High LossControl Avoidance

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Insurance Transfer - Transfer risk to aninsurance company by paying periodicpremiums.

Non-insurance Transfer - Transfer functionswhich produce risk to third parties. Itincludes hedging price risk (eg. Interest

rate, foreign exchange and commodityprices) purchase derivatives contracts toreduce input and financial risks.

Approaches thatcompanies can take to minimize

or reduce risk exposures**

(More...)

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Retention - Take actions to reduce theprobability of occurrence of adverseevents (active vs passive)

Loss Control - Take actions to reduce

the magnitude of the loss associatedwith adverse events.

Avoidance - avoid the activities thatgive rise to risk.

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Prior to undertaking interest rate riskmanagement, the treasurer must:

1) identify and measure the interestexposure

2) seek Board approval for the policy

Types: 100% hedging, selectivehedging, no hedging

3) Authority and parameters must begiven

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(a) Forward rate agreements

(b) Financial futures

(c) Options (interest rate caps, interest ratecollars)

(d) Swaps

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A forward agreement is an obligation to buyor sell a given asset on a specified date at a

price specified at the transaction date of the

contract

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Expect increase in interest rate Buy the forward rate at agreed rate to lock in

the current interest rate

Profit = Market interest rate at the settlementdate - Agreed rate

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A future contract is an obligation to make(seller) or take (buyer) delivery of a specifiedquantity and quality of an underlying asset ata specified future date and at a price agreed

when the contract originates Tool: Hang Seng Index Futures

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Contract size: HK$50* index

Minimum price fluctuation: One index point ($50)

Last trading day:

The bus day preceeding the last business day of themonth

Delivery method: Cash settlement

Initial margin (Variable): $50,000

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Bet on the market will become bearish Take a short position in HS futures contract

Close out the position by buying HS futurescontract

Profit = no. of contracts* $50 * ( the index atthe date you short - the index at maturity)

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Bet on the market will become bearish (fall) (yesterdayclosing: 17,097)

Expects market to fall may on 1 Sept sell, saythree, Oct. H S futures at 17,097; (deposit:3*50,000=150,000)

Take a short position in HS futures contract

Close out the position by buyingHSI futures contracton Oct 30 at 16,900 (if index is 16,900 on Oct 30)

Profit = 3* $50 * (17,097-16,900)[ the index at thedate you short - the index at maturity] = $29,550 lesscommission and also receives deposit of 150,000

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Bet on the market will become bullish (rise) (yesterday

closing: 17,097)

Expects market to rise may on 1 Sept___, saythree, Oct. H S I futures at 17,097; (deposit:3*50,000=150,000)

Take a position in HS futures contract

On Oct 30, forced to close out the position by ______ HSfutures contract on Oct 30 at 16,900 (if index is16,900 on Oct 30)

Loss = 3* $50 * (17097-16900)[ the index at the dateyou short - the index at maturity] = _____ lesscommission

May need to pay variation margin if wishes to avoid

being closed out

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Bet on the market will become bullish (rise)

(yesterday closing: 17,097) Expects market to rise may on 1 Sept buy,

say three, Oct. H S I futures at 17,097;(deposit: 3*50,000=150,000)

Take a long position in HS futures contract On Oct 30, forced to close out the position by selling

HS futures contract on Oct 30 at 16,900 (if index is16,900 on Oct 30)

Loss = 3* $50 * (17097-16900)[ the index at thedate you short - the index at maturity] = 29,550 lesscommission

May need to pay variation margin if wishes to avoid

being closed out

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It allows for speculation on interest ratemovements or for hedging by borrowers andinvestors with actual or intended physicalpositions in HIBOR based (or similar)

products.

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Bet the interest rate will rise Sell the 3-month HIBOR future contract

Close out the position by selling the contract

If HIBOR increase then the borrowerloseson the physical market butwinson thefutures market

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Futurescontract

Forward contract

Form of

contract

Standardised Customized

Tradingmarket

Have activesecondarymarket

Over the counter

Settlement Market tomarket daily

Settlement date

Margin Yes No

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An option is a right but not an obligation to

buy (call) or sell (put) a specified asset at

the exercise price on or before the expiry

date

To reduce or minimize interest rate risk

Tools: Interest rate caps, interest rate

collars

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For floating-rate borrowers, they can hedgeagainst interest rate risk by buying aninterest rate put option from the lender

This guarantees that the interest rate willnot exceed the cap rate (exercise price) forthe life of the option.

Buyer is buying insurance against an

unfavourable interest rate movement

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A borrower can buy a put and simultaneouslysell a call option, at a lower rate of interest

A collar provides the same protection as acap but the potential benefit of a fall in rates

is limited by the call option

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A swap is an obligation between two

counter-parties to exchange future

specified cash flows on specified dates

Rationale: it derives from arbitrageopportunities that arise as a result of

different perceptions of risk and credit

standing held by different markets.

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You want to borrow fixed rate loan but youhave comparative advantage in borrowingfloating rate loan. Through financialintermediaries, another counterparty is

introduced. Every period, you give a fixed interest to and

received floating interest from yourcounterparty.

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interest rate swap does not involve anexchange of the principal amount and is not aform of borrowing

It is a means of reducing perceived interest

rate risk by switching from fixed to floatingrate or vice-versa

It reduces the cost of borrowed funds

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Hedging: Generally conducted where aprice change could negatively affect afirms profits.

Long hedge: Involves the purchase of a

futures contract to guard against aprice increase.

Short hedge: Involves the sale of afutures contract to protect against a

price decline in commodities orfinancial securities.

(More...)

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Types of exposure: i) transaction - fluctuation arise out of

the need to buy or sell at uncertainprices in near future (short run) Ii) translation fluctuations due to

currency translation

Iii) economic permanent changes inprices or other economic fundamentals(long term)

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Types of foreign exchange risk

(a) Transaction Risk

- where there is a possibility for a movement in the rate of exchange

between the initiation and completion of a transaction.

- (importers and exporters)

(b) Translation Risk

- arises from the translation into domestic currency of a companys

foreign subsidiary or branch operations in order to prepare group accounts in thedomestic currency. There is no immediate cash effect and FX gains and losses maynever be realised. Foreign currency translation gain or loss is dependent upon thetranslation method used.

(c) Economic Risk

- arises from the structure of the business, the structure and operating currencies ofcompetitors and the manner in which costs, prices and profits respond to exchange

rate movements.

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Who are subject to foreign exchange risk? Businesses which have net assets or net

liabilities denominated in foreign currencies,which are subject to exchange rate

movements against domestic currency, haveforeign exchange risk

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Important issues to address:

How foreign exchangemarkets operate

Why exchange rates fluctuateHow to protect against

exchange risk

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Hedging i) internal/external

ii) natural/transactional

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I. Natural Hedging Methods that a company can adopt within its

own company to reduce its exposure to foreignexchange risk

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Examples:

An exporter with cash inflows and/or assets denominated in a foreigncurrency may hedge, by borrowing in that currency.

Early settlement on foreign currency trade receivables or payablesmay be feasible especially if a discount can be negotiated.

Hedge intra-group receivables and payables through settlementprocedures .

b) Foreign Exchange Risk

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Methods of natural hedging:1. pricing sales in the local currency2. offsetting payment of imports and

exports in same foreign currency3. bilateral netting of accounts betweenaffiliate companies4. intercompany forward contracts where

a holding company or central treasuryacts as a banker to subsidiaries.

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II. Transactional hedging techniquesGenerally use a financial productto transfer the risk to a financialintermediary

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Forward ContractsTo buy or sell foreign currencies for futuresettlement at a price determined today.

Foreign Currency futuresA currency futures contract represents an

obligation to make or take delivery of a specifiedquantity of a foreign currency at a specified futuredate at a price agreed/when the contractoriginates.Foreign currency futures perform the samefunction as forward contracts in that they allow

hedgers to lock into an exchange rate today, bybuying or selling a futures contract, for settlementat some future point in time.

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Foreign Exchange Risk

Hedging TechniquesForeign Currency OptionsThe buyer of a currency call (put) option has the right to buy (sell) apredetermined amount of one currency in exchange for a predetermined amount

of another currency on (or before) a predetermined date. Currency options on anOver the Counter basis can be tailored to the option buyers specific needs withrespect to amount, exercise price and expiration date.

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Other Methods: Foreign exchange swaps

Short term investment and borrowing combinations

Foreign currency accounts

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1. A firm that needs to borrow long-term inthe future has a long position in bonds. Wealthwould decrease in response to a decrease inbond price (or increase in interest rates).

Interest rate exposure can be hedged withinterest rate futures and swaps. 2. A firm is long in the goods it sells, and short

in the goods it buys. These exposures can bemanaged with futures and forward contracts.

3. A domestic firm which sells in foreigncurrencies has a long position in them. The riskof devaluation can be offset by forwardcontracts, or by acquiring liabilities in theforeign currency.

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Derivatives: Security whose value stemsor is derived from the value of other assets.

Options, futures, forward contracts and swapscan be used to manage financial riskexposures.

Uses of Derivatives

(More...)

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Options: Options can be used to hedgevarious financial exposure such as exchangerisk and interest rate risk.

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Futures: Contracts which call for thepurchase or sale of a financial (or real) assetat some future date, but at a pricedetermined today. Futures (and otherderivatives) can be used either as highly

leveraged speculations or to hedge andthus reduce risk.

A futures contract is a legally bindingcommitment to make or take delivery of a

given quantity of a given asset at a giventime in the future.

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Hedging: Generally conducted where aprice change could negatively affect afirms profits.

Long hedge: Involves the purchase of a

futures contract to guard against aprice increase.

Short hedge: Involves the sale of afutures contract to protect against a

price decline in commodities orfinancial securities.

(More...)

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Forward contract: one party agrees to buy acommodity at a specific price on a futuredate and the counterparty agrees to makethe sale. There is physical delivery of thecommodity.

Futures contract: standardized, exchange-traded contracts in which physical delivery of

the underlying asset does not actually occur. Commodity futures

Financial futures

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The purchase of a commodity futures

contract will allow a firm to make afuture purchase of the input at todaysprice, even if the market price on theitem has risen substantially in the

interim.

How can commodity futures markets

be used to reduce input price risk?

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A forward contract is a contract made todayfor the delivery of an asset in the future. The buyer of the future contract agrees to

pay a specified amount at a specified datein the future in order to receive a given

asset at the exercise price. If at maturity: Actual price > Exercise priceProfit Actual price < Exercise priceLoss

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1. Futures are marked to market daily. The dailygain or loss from holding a futures contract istransferred between traders each day.

2. Margins must be posted on futures contracts.

3. Forward contracts tend to be customized,where futures contracts are standardized so thatthey can be widely traded on exchanges.

4. Futures contracts often have active secondarymarkets, forward contracts do not.

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A producer or user of commodity can lock in the transactionprice through a forward or futures contract. This reducesuncertainty about future revenues or expenses.

A producer (farmer) is long in the crop to be sold at a futuredate.

A user (a food processing firm) is short in the commodity

used in future production. The basic idea is to balance a natural long (or short) positionwith an offsetting short (or long) position, in order to reducerisk and have profitability determined by operating activities.

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Hedging is usually used when a price changecould negatively affect a firms profits. Long hedge: involves the purchase of a futures

contract to guard against a price increase.

Short hedge: involves the sale of a futures contractto protect against a price decline.

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The purchase of a commodity futurescontract will allow a firm to make a futurepurchase of the input at todays price, even ifthe market price on the item has risen

substantially in the interim.

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Example: In Jan, a manufacturer of silverproducts plans to buy 20,000 ounces ofsilver in Jun to fill a contract based on a

silver price of $2.5/oz. In Jan., cash silver price is $2.5/oz and July

silver futures are trading at $2.9/oz. Heestablishes a hedge.

On 15 Jun, the manufacturer purchases

silver in the cash market at $3.1/oz andsells his future position at $3.2/oz.

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1. He originally has a short position insilver so he buys futures and takes a long

hedge position.

Hedging example:Manufacturer

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2. Net purchase price of silver:

Per oz Total

Cash price in June $3.1 $62,000Less: Gain in futures ($3.2-$2.9) $0.3 $ 6,000

Net purchase price $2.8 $56,000

Hedging example

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The exchange of cash payment obligationsbetween two parties, usually because eachparty prefers the terms of the others debtcontract. Fixed-for-floating

Floating-for-fixed

Swaps can reduce each partys financial risk.

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1. A firm that needs to borrow long-term inthe future has a long position in bonds. Wealthwould decrease in response to a decrease inbond price (or increase in interest rates).

Interest rate exposure can be hedged withinterest rate futures and swaps. 2. A firm is long in the goods it sells, and short

in the goods it buys. These exposures can bemanaged with futures and forward contracts.

3. A domestic firm which sells in foreigncurrencies has a long position in them. The riskof devaluation can be offset by forwardcontracts, or by acquiring liabilities in theforeign currency.

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1.Identify the risks faced by the firm.2.Measure the potential impact of the identified

risks.

3.Decide how each relevant risk should behandled.

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Derivative Securities more on options

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A contract that gives its holder the right,but not the obligation, to buy (or sell) anasset at some predetermined price withina specified period of time.

Its important to remember: It does not obligate its owner to take action.

It merely gives the owner the right to buy orsell an asset.

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Call option: an option to buy a specifiednumber of shares of a security within somefuture period.

Put option: an option to sell a specifiednumber of shares of a security within somefuture period.

Exercise (or strike) price: the price stated in

the option contract at which the security canbe bought or sold.

Option price: option contracts market price.

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Expiration date: the date the optionmatures.

Exercise value: the value of an option if itwere exercised today (Current stock price Strike price).

Covered option: an option written againststock held in an investors portfolio.

Naked (uncovered) option: an optionwritten without the stock to back it up.

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In-the-money call: a call option whoseexercise price is less than the current price ofthe underlying stock.

Out-of-the-money call: a call option whoseexercise price exceeds the current stockprice.

Long-term Equity AnticiPation Securities

(LEAPS): similar to normal options, but theyare longer-term options with maturities of upto 2 years.

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A call option with an exercise price of $25,has the following values at these prices:

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Stock Price Call Option Price

$25 $ 3.00

30 7.50

35 12.00

40 16.5045 21.00

50 25.50

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StockPrice

StrikePrice

ExerciseValue

OptionPrice

OptionPremium

$25.00 $25.00 $0.00 3.00 3.0030.00 25.00 5.00 7.50 2.50

35.00 25.00 10.00 12.00 2.00

40.00 25.00 15.00 16.50 1.50

45.00 25.00 20.00 21.00 1.00

50.00 25.00 25.00 25.50 0.50

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The premium of the option price over theexercise value declines as the stock priceincreases.

This is due to the declining degree ofleverage provided by options as theunderlying stock price increases, and thegreater loss potential of options at higheroption prices.

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5 10 15 20 25 30 35 40 4550StockPrice

OptionValue30

25

20

15

10

5

Market price

Exercise value

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Data: P = $15; X = $15; t = 0.5; rRF = 6%

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Ending

StockPrice StrikePrice

Call

OptionValue

$10 $15 $0

$20 $15 $5

Range $10 $5

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Step 1: Calculate the value of the portfolio atthe end of 6 months. (If the option isin-the-money, it will be sold.)

18-80

EndingStockPrice 0.5

EndingStockValue +

EndingOptionValue =

Valueof

Portfolio

$10 0.5 $5 + $0 = $5

$20 0.5 $10 + -$5 = $5

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Step 2: Calculate the PV of the risklessportfolio today.

18-81

86.4$PV

0296.1

5$PV

)r(1

valueportfolioFuture

PV tRF

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Step 3: Calculate the cost of the stock in theportfolio.

Step 4: Calculate the market value of theoption.

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$7.50

$150.5

priceStockportfolioinstockof%portfolioinstockofCost

64.2$

86.4$50.7$

portfolioofPVstockofCostoptionofPrice

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As Factor Increases Option Value

Current stock price Increases

Exercise price Decreases

Time to expiration IncreasesRisk-free rate Increases

Stock return volatility Increases

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As Factor Increases Option Value

Current stock price Decreases

Exercise price Increases

Time to expiration IncreasesRisk-free rate Decreases

Stock return volatility Increases

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1. Self-study: Read Pg 588-589. Find outhow firms manage risk in practice.

2. Reading: Find out how to use derivates toreduce risk. Read Eugene pg 587 and find

out the use and misuse of derivatives 3. Do the following assignment at home:

Self-test problems listed on Eugene textbookpage 587

Challenge problem: Try Eugene TextbookP18-8

* Note: Black and Scholes Model is not