Welcome to the course Financial Risk Management Alexei

Welcome to the course Financial Risk Management Alexei Goriaev agoriaev@gmail. com

Why do we need risk management? q Many cases of big losses and failures – E. g. , the global financial crisis of 2008 – …and the subsequent European government debt crisis q …due to mismanagement of risks? 2 q Regulators – SOX (2002): corporate governance requirements – Basel III (2010): tighter restrictions on banks q The exchanges – Listing requirements q Credit rating agencies – Using more sophisticated methods to evaluate the firm’s risks q Stock analysts and investors – Increasingly sensitive to earnings volatility and unfavorable deviations from earnings targets

What is this course about? q Objectives: – Tools to measure and manage risk – Philosophy: critical attitude necessary for conscious decision-making q Knowledge – Skills – Attitude – …gained through self-study and inclass discussions q How? – Discussing famous cases – Analyzing real data – Forming unified approach 3

Administration q Books: – – Круи, Галай, Марк, Основы риск-менеджмента Hull, Risk Management & Financial Institutions Hull, Options, Futures, & Other Derivatives Fraser, Simkins (Eds. ), Enterprise Risk Management: Today's Leading Research and Best Practices for Tomorrow's Executives q Cases: – American Barrick, LTCM, JP Morgan Chase, Hydro One, … q Grades: – – 4 Two home assignments: 20% (individual) Two cases: 20% (in groups of 4 -5 students) Final exam: 60% (closed-book) Class participation (up to 5% bonus points)

What is the main goal of risk management? Possible answers: 1. Increasing profit for the company 2. Reducing risk 3. Control by shareholders 4. Satisfying regulators’ requirements 5. Reducing volatility of earnings 6. Preventing bankruptcy 7. Something else: ___________ 5

What is risk management q Risk management is the practice of creating economic value in a firm by managing exposure to risk. q Risk management requires identifying its sources, measuring it, and plans to address them. 6

How can a company create value (raise its capitalization)? q Left-hand side of the balance: choosing investment projects – Discounted cash flows from the project must exceed initial investment q Right-hand side of the balance: choosing the sources of financing – Capital structure: Equity vs. Debt NPV = -I 0 + t. CFt/(1+r)t > 0 How does risk management change the picture? 7

There is no place for risk management in the ideal world q Modigliani-Miller theorem: capital structure (debt vs. equity) does not matter for the company’s value q …assuming – No taxes – No bankruptcy costs – No information asymmetry • …between managers and different investors – Market efficiency • Prices reflect all relevant information about the firm q Investors can reduce risk on their own by hedging or diversifying their portfolios 8

How risk management contributes to the company’s value in the real world q Reduce the costs of bankruptcy – Try to avoid situation when the company comes close to default losing its reputation and clients q Better use of depreciation and interest tax shields – The company avoids annual losses, when tax shield is underutilized q Make external funding cheaper – Lower beta for equity – Achieve a higher credit rating – Show transparent risk profile to investors q Protect from market inefficiencies – Ensure long-term funding to make sure that the company does not abstain from profitable projects during the crisis 9

Risk management is a double-edged (s)word q The chinese pictogram “risk” consists of two parts: – Danger – Opportunity q This is the essence of risk management! – Defend from the danger – Take on the opportunities! 10

Example: Bombardier q What is the main risk for buyers of snowmobiles? – That they will rarely use it… q 1998: Bombardier implemented a new marketing strategy to sell snowmobiles in the US – If the total snowfall in the winter does not exceed a certain level, then the company will return $1, 000 to the buyer q Hedging implied risk: via weather derivative – Bombardier bought an option, which paid a certain amount to the company in case of little snowfall q Sales growth of 38% more than compensated the cost of this option! 11

What are benefits of risk management for the company? q Shareholder wealth maximization under market frictions – Financial distress costs / taxes / external financing costs q Reducing earnings volatility – Becoming more predictable for outside investors q Improving decision making – Awareness of risks allows the company make better decisions q Managerial incentives – Improving performance evaluation and compensation structure – Promoting job and financial security 12

How to identify risks of a company? 13

Risk identification q Do you agree with the statement: “All risks are equally important for the company” q How many risks can the company focus on? q How to identify risks that are more important for the company? q How to measure the importance of risks? 14

Пример: q Аэрофлот – лидер российского рынка авиаперевозок q Стратегия: формирование глобального сетевого игрока с центральным хабом в Москве и – 2012: 18 млн пассажиров (37% рос. рынка) региональными центрами в Северном, Южном и – Рейсы в 118 пунктов 51 страны (по России - 31 пункт) Дальневосточном федеральных – 131 самолет, средний возраст: 5, 2 округах России лет q q Выручка: 178 млрд руб. Прибыль: 5 млрд руб. Кредитный рейтинг: BB+ (Fitch) В Группу Аэрофлот входят еще 5 региональных авиакомпаний q 51, 17% акций ОАО «Аэрофлот» принадлежит государству – Компания входит в Перечень стратегических предприятий 15 – Приоритет: развитие внутреннего рынка, присутствие в Сибири и на Дальнем Востоке. q К 2025 году предусмотрено вхождение в число 20 крупнейших глобальных игроков рынка авиаперевозок по объему пассажиропотока и выручке. – 70 млн пассажиров, $32 млрд в год

Риски Аэрофлота q Отраслевой риск: падение спроса на авиаперевозки q Риск рыночной конкуренции: снижение доли на рынке q Операционный риск: аварии, задержки рейсов q Кредитный риск: невыполнение обязательств со стороны контрагентов q Товарный риск: повышение цен на топливо q Политический риск: изменение регулирования q Региональные риски: события в странах назначения q Репутационный риск 16

Ключевые риски стратегии Аэрофлота согласно компании Oliver Wyman q Инфраструктура «Шереметьева» – Перегруженность аэропорта – Ограничения по количеству взлетовпосадок (38 в час против 90 у «Домодедова» ) • При имеющейся инфраструктуре «Шереме тьево» может обслужить максимум 35 млн человек в год, а в 2025 г. группа «Аэрофлот» хочет перевезти более 70 млн человек 17 q Госрегулирование – Например, дефицит летного персонала в России запрещено восполнять за счет иностранцев – С 2014 г. авиакомпания может прекратить получать роялти ($200 -300 млн в год) – После либерализации авиасообщения с Европой конкуренты могут потеснить Аэрофлот на самых рентабельных маршрутах

General classification: Financial risks Market risks q Interest rate risk – At which rate will the firm attract funding? – Risk-free rate + Risk premium q Currency risk – Exporters benefit from devaluation of the national currency, whereas importers lose from it q Commodity risk – A company benefits from its output becoming more expensive and loses from growing input prices q Equity risk – If the firm holds financial assets, it will lose from their price decline 18 q Credit risk – If the counterparty does not fulfill its contract obligations q (Funding) liquidity risk – Cash and other liquid assets may not be enough to pay on current liabilities q Operational risk – Unexpected losses due to technology, personnel, etc.

Other risks q Social risk q Corporate governance q Political risk q Legal risk q Environmental risk q Strategic risk 19

How to manage risk? My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year; Therefore, my merchandise makes me not sad. W. Shakespeare, ‘Merchant of Venice’ 20

Diversification q Spreading out investments to reduce risks q Application: asset management – Talmud: split your assets into thirds: - business (buying and selling things) - liquid assets (e. g. gold coins) - land (real estate) – Regional / industry diversification q Does diversification pay off as a business strategy? – Conglomerate discount: 13 -15% relative to single-segment competitors – Value loss related to overinvestment and cross subsidization – Conglomerate stock may not set up appropriate payoff for risk taking Can you diversify away all risks? 21

Insurance q Transfer of the risk of a loss, from the insured (policyholder) to the insurer, in exchange for a premium – A guaranteed and known small loss - to prevent a large loss. q Typical characteristics of commercially insurable risks: – A large number of homogeneous exposure units. Then insurer can benefit from the law of large numbers. – Definite Loss: taking place at a known time/place, from a known cause. – Accidental Loss: should be outside the control of the insured. Which risks cannot be insured? 22

Hedging q Reducing exposure to undesired risk in the main activity by taking opposite position (in another market or instrument) – Natural hedge: in the crisis, both output and input become cheaper – Active hedge: an exporter who suffers from appreciation of the local currency may shift production abroad q Usually, done with derivatives – Financial instruments with payoff tied to the underlying asset • FX/interest rates, stock/commodity prices, weather, … • The market has been growing since 1970 s when FX and interest rates became much more volatile – E. g. , the exporter may fix the future exchange rate via forward or futures or swap 23

Which factors may influence the company’s hedging strategy? q The company’s risk profile and target – In particular, risk attitude q Shareholder objectives/preferences – They may hedge some risks themselves via exchange-traded derivatives q The cost of hedging – Financial intermediaries may charge a high commission q Specifics of hedging instruments – Derivatives are complicated q Actions of competitors – We may win or lose to them due to different exposure to risks 24

Example: oil company q Should an oil company hedge the risk of decline in oil price? – Its shareholders hold a diversified portfolio – …and can hedge themselves via oil futures q Answer: YES if… – Many shareholders do not have access to financial markets – This helps the company to avoid bankruptcy (if the oil price falls below the cost level), – …optimize tax payments – …and lower the cost of financing 25

In-class discussion of the case: risk management in the gold-mining industry 26

How can a gold mining company achieve a comparative advantage? Exploration Mining Sell Gold Acquisition q Product differentiation – In gold industry firms cannot differentiate their end product. q Market position – The industry is very competitive and firms have no price latitude. q Costs of production – Operating efficiency depends on the mine conditions and economies of scale q Risk management? 27

Gold price dynamics 28

To hedge or not to hedge? q Уникальная программа q Homestake не будет хеджирования дает American использовать политику Barrick небывалую хеджирования, чтобы ее финансовую стабильность. акционеры могли в полной Она уберегает нас от мере выигрывать от роста негативного влияния падения цены на золото. В цены на золото, позволяет результате, прибыли нам с большой точностью Homestake гораздо предсказывать денежные волатильнее прибылей потоки, а также, в сочетании с конкурентов. Компания растущим объемом добычи, полагает, что ее акционеры принесет инвесторам извлекут из такой стратегии предсказуемый и растущий максимум пользы в поток прибылей в будущем. долгосрочной перспективе. 29

What were the benefits of Barrick from hedging gold price risk? q The founder’s goal was to create a well run, low cost gold producer with low exposure to commodity price risk. q Hedging reduced the cost of capital. – Hedged goldmine is a pure bet on operating efficiency. q Shareholders may not be able to diversify commodity price risk on their own. q Managers (who were risk averse) also preferred hedging because it made their job less risky. q Hedging ensured access to funds to do strategic acquisitions when gold price is low. – When gold mines were cheap and access to financing was problematic. 30

How should Barrick hedge gold price risk? q How much to hedge? 31 q Which (financial) instruments to use?

How did Barrick hedge gold price risk? q How much to hedge? – 100% of the expected future production for the next 3 years – Around 20% of the production over the next decade 32 q Which (financial) instruments to use? – Gold-linked financing – Derivatives

Gold-linked financing q Gold Trust – Investors received 3% of the mine’s output if gold prices were below $399, rising up to 10% of production when gold price reached $1, 000. – At low gold prices, Barrick’s cash outflow was minimal – If gold prices were high, Barrick would give up an increasingly large stake of its more valuable production. q Bullion loans – Borrowing gold, which is then immediately resold at the market – Repaying the loan in monthly installments (in gold) at 2% annual rate q Gold-indexed notes – Investors receive a certain number of ounces of gold or equivalent amount of cash 33

Forward sales q The forward price of the contract is based on the spot price on the date of the contract plus a premium (contango). – The contango is LIBOR less the gold lease rate. q Potential problems – If gold lease rate rises above the LIBOR rate then forward prices will be in backwardation – If Barrick’s counterparties are not able to borrow gold to facilitate the contract, settlement price may be unfavorable q The goal is to secure price and avoid downside of price drops (at a cost of sacrificing upside). – In 1985, Barrick lost because prices rose after selling forward. 34

How It Works Bullion Bank Central Bank Barrick ABX enters into the forward contract with the Bullion Bank. 35

How It Works Bullion Bank Central Bank Barrick Bullion Bank borrows gold from the Central Bank 36

How It Works Bullion Bank Central Bank Barrick Spot Market Sells the gold in the spot market 37

How It Works Bullion Bank Central Bank Barrick 1% lease rate Interest earned 4% 38

How It Works Bullion Bank Barrick Central Bank At the delivery date Barrick delivers the gold 39

How It Works Bullion Bank Barrick Central Bank Bullion Bank pays Barrick and returns the gold to the Central Bank 40

Options q Long put on gold? – Buying put is costly → finance it by selling call q Collar: long put and short call with zero cost – Protection from gold price drops – …at a cost of sacrificing upside profit opportunities – Gold price exposure in the range between put strike and call strike q Modified strategy: buy put and sell two calls with a lower strike – Gives the company limited upside Note: options are short in duration (2 -5) years relative to AB’s 20 -year production horizon. 41

Spot Deferred Contract (SDC) q SDC is like a forward contract with multiple “rollover” delivery dates over 5 -10 year period – ABX could deliver on specific delivery date or rollover to the next date if it could make more money by selling its gold in the market at the current spot price. q Barrick’s counterparties can opt for early close out of contracts in the event of a material and lasting impact on Barrick’s ability to deliver gold 42

Spot Deferred Contract: Example q At t = 0, Barrick enters into contract to sell either at t = 1, or at t = 2. Spot at t = 0 is $300. At t = 1, if it chooses not to deliver on contracts, it sells on spot market at $500. q The price is set so that “both parties are indifferent between rolling over the contract for another year or closing out the SDC contract and initiating one-year-forward contract. ” q Setting the price (keeping Libor = 6% and gold lease rate = 2% constant). – Forward at t = 1 is then: 500*(1+0. 06 -0. 02) = 520 – Barrick made a loss of $188 by entering into forward [500 – 300*(1+. 06 -. 02)] – This loss has to be carried forward at 6%. – So, new price is 520 – 188*(1. 06) = $320. 72 43

Spot Deferred Contract: Discussion q Is SDC closer to an option or to a forward contract? q Why did Barrick prefer to use SDC rather than forward? This contract was mainly designed by managers, as they did not have to recognize immediate gains/losses for taxes and reporting. 44

Barrick’s risk management policy q Barrick hedged 16. 1 million ounces – 3 years of expected future production q Between 1991 and 2002, Barrick’s hedging program generated additional revenue of $2. 2 bln 45

Barrick’s achievements q Exceptional performance (ex post) – Risk management program allowed to sell gold above market prices – Acquisitions in depressed environment – Able to cut costs due to economies of scale – Massive reserves discovered in newly acquired Goldstrike mine 46 q Was it a good strategy (ex ante)? – Directed to a particular goal – Taking advantage of a particular market imperfection – Non-anticipative (passive)

Next class: market risk q Hand in HA 1 on risk identification 47 q Prepare by reading Mc. Kinsey report on modeling market risk