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FM212 Solutions to Class Exercises Lent Term 2009/10

Solutions to Class Exercise 10

1.
Hedging & MM
Modigliani and Miller would say that both financing and risk management are irrelevant
in perfect capital markets because any changes in capital structure and firm risk that can
be created by the firm’s management can also be created in the capital markets by
individual investors. In perfect capital markets, management can not increase firm value
by adjusting capital structure and firm risk because individual investors can accomplish
these adjustments on their own. The assumptions for MM capital structure irrelevance
would also apply to risk management irrelevance, and are
1. No transactions costs
2. No Taxes
3. No Bankruptcy costs
4. Investment is held constant
5. Efficient capital markets (no asymmetric information)
6. Managers maximize shareholders' wealth
If market imperfections exist, it may be beneficial to the firm and its stockholders if the
firm hedges the firm’s risks. A large firm can hedge many of its risks with much greater
cost effectiveness than could an individual shareholder. For example, hedges in the
commodity futures markets and in foreign currency futures can be accomplished at much
lower cost by the firm than by individual shareholders.
2.
Risks and Insurance
Insurance companies have advantages/disadvantages in bearing risk 
Advantages in bearing risk
– Skills in estimating probabilities
– Skills in identifying risk-reduction techniques
– Diversified risk-pool 
Disadvantages in bearing risk
– Administrative costs
– Adverse selection/moral hazard
– Risk pool may have correlated risks
• AIG offered credit risk insurance
Insurance company expertise can be beneficial to large businesses because the insurance
company’s experience allows the insurance company to correctly price insurance
coverage for routine risks and to provide advice on how to minimize the risk of loss.
Insurance company experience and the very competitive nature of the insurance industry
result in correct pricing of routine risks. In addition, the insurance company is able to
pool risks and thereby minimize the cost of insurance.
With insurance a firm pays a fixed amount (the insurance premium) in exchange for the
insurance company paying the variable cash flow (the loss) instead of the firm. This
exchanges a random cash-flow for a fixed one
– Insurance is against (mostly idiosyncratic) risk
– The insurance company diversifies much of the risk internally by selling many
policies

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However. The disadvantage is that. however. Effectively. 4. an investor will still be hedged by selling futures and borrowing.’ 2 . Speculators and Hedgers If futures are underpriced. large companies self-insure against small potential losses. 3. This arbitrage is known as ‘cash-and-carry. he not only needs to know that they are fairly priced now but also that they will be fairly priced when he buys them back in six months. Rarely does it pay for a company to insure against all risks. for example. has concluded that insurance industry pricing of coverage for large potential losses is not efficient because of the industry’s lack of experience with such losses. earthquakes – The remaining risk is passed to shareholders through the securities market. speculators can make arbitrage profits by selling futures. rather than insurance companies.FM212 Solutions to Class Exercises Lent Term 2009/10 – But beware of correlated risks: weather. he will not be fully hedged. The stock market can be an efficient risk-absorber for these large but diversifiable risks. In which case above some losses. this means that BP uses the stock market. BP has chosen to self insure against these large potential losses. Basis risk is the risk of whether the catastrophe bond will be triggered or not. If. If there is uncertainty about the fairness of the repurchase price. if six-month futures are overpriced. In other words. If the payments are reduced based on claims against the entire industry. as its vehicle for insuring against large losses. Speculators like mis-priced futures. borrowing and buying the spot asset. but he will make a known loss (the amount of the underpricing). knowing this. BP. Consequently. Basis risk will be highest in the first case due to the larger firm specific risk. large losses result in reductions in the value of BP’s stock. where the security holders diversify the risk. For example. an on-going and viable insurance market may be assured but some firms may under-commit and yet still enjoy the benefits of lower payments. further losses are co-insured with the bondholder. the insurance company may over-commit in this area in order to gain additional premiums. for example. If payments are reduced when claims against one issuer exceed a specified amount. he hedges by selling seven-month futures. and some degree of on-going viability is ensured in the event of a catastrophe. Typically. Catastrophe Bonds Swiss Re issues CAT bonds in which the interest payments to the bondholder are reduced if Swiss Re has had a lots of claims against it. the issuer is co-insured above some level.