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Your team has just been appointed to advice and oversee the Finance Department of a large international company. Upon arrival, you notice that your predecessor had not really been up-to-date with respect to recent financial innovations. For example, members of the department tell you that he had a general distrust towards any derivative instruments, and therefore never hedged any existing exposures. In addition, he argued that the firm’s cost of capital could be determined through considering how the firm’s returns commove with the S&P 500’s returns.
Among all other issues that need to be dealt with, your priorities are to (1) show the members of the Finance Department how an existing exposure in euros can be hedged with a forward contract, to (2) explain to them why hedging makes economic sense, and to (3) determine the company’s cost of capital in an international setting.

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You are on page 1of 18

International Risk

Strategies

Group 2:

34048413 Zhang Jiayuan

34612513 Psyhos Peter

33976546 Lingling Bao

34051538 Zheng Yulin

33962278 Rao Samuel

Completion Date

13/12/2017

Table of Contents Page Number:

1. Introduction 2

2. Hedging Exposures 2

2.1. Direct Hedge 2

2.2. Currency Mismatch but no Maturity Mismatch 2

2.3. Maturity Mismatch but no Currency Mismatch 4

2.4. Currency Mismatch but no Maturity Mismatch – Hedging with Two

Foreign Currencies 6

3. The value of Hedging 8

3.1. Bankruptcy and Financial Distress Costs 8

3.2. Agency Costs 8

3.3. Tax Incentives from Hedging 9

3.4. Decision Making advantages of Hedging 9

4. Cost of Capital in an Integrated Market 10

4.1. The International CAPM 10

4.1.1. Analysing Cost of Capital using the Currency Factor 11

4.1.2. Analysing Cost of Capital using World Market Returns 13

4.1.3. Analysing Cost of Capital using World Market Returns and the

Currency Factor 15

5. Conclusion 16

6. Bibliography 17

1

1. Introduction

As we look forward to the new year, we must look to also bring our department up to the

modern era of finance. The first step is to change the way that we handle our exposures and

updating our international risk strategy. This report will outline how and why we should be

hedging our exposure and will analyse our cost of capital within our place in an integrated and

international marketplace setting.

2. Hedging Exposures

Direct hedge is when the exposure of cash flows expressed in EUR in HC (ST) and the

European forward contract used to hedge the exposure in terms of HC (Ft,T) is at maturity.

In order to hedge, taking out a European forward sale contract (-ST+Ft,T) to hedge the exposure

in FC EUR (ST) will mitigate the currency risk, which are potential losses incurred when the

client is exposed to the spot market of HC/EUR.

To perform the calculation on finding β units of EUR, there is no need to regress percentage

changes of HC/EUR with itself as the result will be γ=1 thus, β=1. So, hedge ratio= (400,000/1)

*Beta = 400 000 units of EUR. This implies that the client need to hedge 400,000 units of EUR.

Currency mismatch with no maturity mismatch takes place when the exposure of cash flows

expressed in EUR in HC (ST) and the FC1 currency used to hedge the exposure is at maturity.

The difference between the first situation in above and now is that there is no available

European forward contract to hedge with. If the exposure is left unhedged, the client may incur

potential losses if EUR depreciates in the spot market.

The implication of currency mismatch would mean that we need to regress percentage changes

of HC/EUR with percentage changes HC/FC1 to find γ and hence finding β to find the number

of units of FC1 to be hedged.

2

Model Summary

Model R R Square Adjusted R Square Estimate

a. Predictors: (Constant), H

Coefficientsa

Unstandardized Standardized

Coefficients Coefficients

a. Dependent Variable: E

Table 1 Regression Results

H = hedging instrument using HC/FC1, expressed in percentage change

Beta = 0.052*0.724559 =0.038

Hedge Ratio = (400,000/1) *0.038 = 15 200 units of FC1

Hedging strategy

The adjusted r2 value shows a weak positive correlation which may suggest there might be a

better instrument to hedge the exposure of EUR other than hedging the exposure using another

currency FC1. If, however, the firm decides to hedge with this instrument, the firm can hedge

successfully as t test is 4.082 and is statistically significant as t test p value is 0.000. The firm

would need to hedge 15 200 units of FC1 in the end.

3

2.3. Maturity Mismatch but no Currency Mismatch

This situation happens when the exposure of cash flows expressed in EUR in HC (ST) and the

European forward contract used to hedge the exposure in terms of HC (Ft,T) is at not at maturity

as the exposure is on 30/06/2018 and the forward contract matures on 21/12/2018.

To hedge, we must firstly make sure that the exposure and the forward contract used to hedge

the exposure is at same maturity. We can do this by constructing a synthetic forward sale to

hedge the exposure using the CIP formula; ST*(1+rt, T/1+rt*, T). For our case, we also need

to change the effective interest rate from 3 months to 6 months when computing the CIP as we

want the forward contract to mature after 6 months on 30/06/2018, where the exposure is at.

Thus, the maturity mismatch problem can be solved. Hedging will mitigate currency risk just

as situation 2.1.

To perform the calculation on finding β number of units of EUR, we need to regress percentage

change of HC/EUR and percentage change of forward rate to find γ thus finding β.

Model Summary

Model R R Square Adjusted R Square Estimate

a. Predictors: (Constant), H1

Coefficientsa

Unstandardized Standardized

Coefficients Coefficients

a. Dependent Variable: E1

4

E1= exposure by HC/EUR, expressed in percentage change

H1 = hedging instrument using forward contract (by computing CIP with interest rate at 6

months), expressed in percentage change

Beta = 0.942*0.992442 =0.935

Hedge Ratio = (400,000/1) *0.935 = 374 000 units of EUR

Hedging strategy

The adjusted r2 value shows a strong positive correlation which suggest taking a forward

contract is the best instrument to hedge the exposure of EUR.

As compared to hedging with another currency FC1. When a firm decides to hedge with this

instrument, the firm can hedge successfully as t test is 65.713 and is statistically significant as

t test p value is 0.000. 374 000 units of EUR is needed to hedge the position of EUR 400 000

which is a big contract but so far, taking the forward contract is the best way to hedge position

at exposure. Hedging will mitigate currency risk just as 2.2.

Hedging by using a synthetic forward contract compared to hedging by using another currency

as above in q2 shows that forward contract is the better instrument to hedge the exposure of

EUR based from the higher r2 shown. However, using a forward contract requires 374 000

units of EUR and when the using FC1 to hedge with only needs 15 200 units of FC1. So, if the

client wants to short lesser units of FC, he would need to display characteristics of being a risk

taker and thus, hedge using FC1. Otherwise, if the client is risk averse, he would hedge with a

synthetic forward contract.

5

2.4. Currency Mismatch but no Maturity Mismatch – Hedging with Two

Foreign Currencies

The implication of currency mismatch and additionally hedging with 2 types of currencies FC1

and FC2 would mean that we need to perform multiple regression with % changes of HC/EUR

against % changes HC/FC1 and HC/FC2 to find γ and hence finding β to find the number of

units of FC1 and FC2 to be hedged with.

To hedge, taking another currency FC1 and FC2 to hedge the exposure of FC EUR (ST) will

mitigate the currency risk, which are potential losses incurred when client is exposed to the

spot market in HC/EUR.

Model Summary

Model R R Square Adjusted R Square Estimate

Coefficientsa

Unstandardized Standardized

Coefficients Coefficients

a. Dependent Variable: E2

Table 3 Regression Results

6

E2 = exposure by HC/EUR, expressed in % change

H2 = hedging instrument using HC/FC1, expressed in % change

H3 = hedging instrument using HC/FC2, expressed in % change

Hedge Ratio = (400,000/1) *0.087 = 34800 units of FC

(14 400 units of FC1 and 20 400 units of FC2)

Hedging strategy

The adjusted r2 value shows a positive correlation which suggest that hedging the exposure

with the combination of 2 different currencies, FC1 and FC2 is relatively a better instrument

to hedge the exposure of EUR as compared to hedging with only 1 currency, HC/FC1. When

firm decides to hedge with this instrument, the firm is better off hedging with FC2 than FC1 as

the t test for hedging with FC2 is higher than the one for FC1. Additionally, the t test p value

of hedging with combination of 2 different currencies, FC1 and FC2 are statistically significant.

However, we can observe that the hedging contract size using FC2 (20400 units of FC2) is

bigger than the one for FC1 (14 400 units of FC1) which may require the firm to buy more

contracts from hedging FC1 compared to FC2. This perhaps is indicating that the firm may

want to find a better combination of currencies to hedge the exposure with lesser number of

contracts.

7

3. The Value of Hedging

In the real world, the purchasing power parity does not hold which causes the currency

exchange risk for companies. So, companies usually use future contracts to hedge with the risk.

The hedging operation can add value to the firm because it assumes that the cash flow generate

from hedging has positive effect on other cash flows that relates to the firm’s existing or future

business (Sercu, 2009). There are some arguments that arise from the interaction between

hedging and other cash flows.

Smith and Stulze (1985) state that corporate hedging reduces probability of bankruptcy and

costs of financial distress. When a firm’s income cannot cover its expenses, it is regarded to be

in financial distress. If the firm cannot deal with the situation, it may lead to bankruptcy and

the firm get into insolvency liquidation or reorganization. According to the analysis of Aretz

et al (2007), the costs incurred during the process of bankruptcy should be regarded as direct

cost, and indirect cost is incurred as soon as the probability of bankruptcy arises, such as

employee compensation. An example from Aretz et al (2007) is, a firm with a 60% default risk

for its obligations. If the firm decides to hedge its cash flow, the default risk decrease to 20%.

Thus, the indirect costs of financial distress and direct costs of bankruptcy decrease because of

the probability of bankruptcy decrease.

Hedging reduces agency costs which arise from the conflicts of interest between managers,

shareholders and bondholders. Sercu (2009) illustrates that for managers and shareholders, the

salary of managers is dependent on the performance of the firm, which causes them to hedge

personally to limit their risk of human wealth. However, when human wealth increase, it causes

a maturity mismatch between the short-term hedge and long-term exposure. Thus, this leads to

liquidity problem and ultimately to personal insolvency. To avoid this problem, managers

prefer to firm hedge. If the firm does not hedge, managers may ask for higher wages to

compensate for risk or reject risky but positive NPV projects to protect their interests. It is a

mutually beneficial deal for shareholders and managers that the firm hedges away its exposure.

8

3.3. Tax Incentives from Hedging

Corporate Risk Management can utilise hedging strategies to reduce fluctuations in pre-tax

income thereby lowering the tax burden, if income is fits a convex tax schedule. In a report by

Graham, J.R. and Rogers, D.A., (2002), out of 80,000 COMPUSTAT firm-year observations,

50% of cases have convex tax functions. Tax gains from hedging are automatic, as all firms

pay tax.

The graph below shows the incurrence of higher expected tax burdens if pre-tax income is

volatile. Pre-tax income is marked 𝑃𝑇𝐼1 and 𝑃𝑇𝐼2 . 𝑃𝑇𝐼3 marks tax payable for a given taxable

income. The highlighted area signifies the reduction in expected taxes when hedging is utilised

(Aretz, K., Bartram, S.M. and Dufey, G., 2007).

The tax rate is 20% for the first $50million, and 40% for anything above. If earnings are $40

million in year one and $60million in year two, tax payable is $8million for year

one(20%*$40million) and $14million for year two(20%*$50million), resulting in an average

tax burden of $11 million(($8million+$14million)/2)

However, if taxes are fixed at $50million, with the remaining $10million spent on corporate

hedging, the average tax burden is $10million(20%*$50million). Resulting in an average tax

burden saving of $1million ($11million-$10million)

(Aretz, K., Bartram, S.M. and Dufey, G., 2007).

The firm can hedge to obtain information on the operational profitability of a division(s) of a

multidivisional company. If each division hedges their cash flows, the firm can obtain division

operating profitability without the noise created by unforeseen exchange rate changes (Sercu,

P., 2008).

Since noise has been removed, the effects of financial decisions made by management are made

clearer to shareholders of the company, if the firm is performing well. Using hedging strategies

to prove positive operational performance has a more direct valuation by the rest of the market

(Sercu, P., 2008).

9

4. Cost of Capital in an Integrated Market

The CAPM originally used by the company only was concerned with the cost of capital related

to the firm’s return corresponding with the S&P 500’s return. This CAPM model uses the

assumption that all investors can expect the same return from their investment. This is

unrealistic in an integrated market. We must, therefore, apply the expanded international

CAPM model instead. The international CAPM accounts for correlative movements between

past stock returns and the world market returns, represented in beta, combined with accounting

for the currency exchange deviations for international investors, represented in gamma. Below,

we will further analyse the value of the international CAPM as a forecasting tool for future

stock returns.

CAPM calculated for each company in an integrated market is shown as the formula below.

∗

𝐸(𝑟𝑗 − 𝑟0 ) = 𝛼 + 𝛽𝑗,𝑤,𝑎𝑙𝑙 𝑠 𝐸(𝑟𝑊 − 𝑟0 ) + ∑𝑁

𝐾=1 𝛾𝑗,𝑠𝑘 ;𝑤 𝑜𝑡ℎ𝑒𝑟 𝑠 𝐸(𝑆𝑘 + 𝑟0,𝑘 − 𝑟0 )

10

As assumed, all changes in the risk-free rate are equal to zero. We find that the adjusted R2 for

most companies is greater than 0.5, indicating a strong positive correlation between the excess

return and the analysed variables of beta and gamma. A positive beta value in the table denotes

that the firm’s movement has a positive relationship with changes in world market returns.

Gamma denotes how the excess return are affected by the changes of the exchange rate, in the

table above.

Average Cost of Capital Average Stock Return

0.05% 8.92%

0.05% 8.10%

0.03% 1.32%

0.00% 1.91%

0.05% 6.92%

0.01% 3.28%

0.04% 4.78%

0.01% 2.90%

0.07% 8.83%

-0.01% 0.72%

0.01% 2.09%

0.08% 9.36%

0.05% 5.13%

0.03% 6.66%

0.01% 0.41%

0.05% 6.09%

0.04% 4.18%

0.02% 7.23%

0.03% 2.77%

0.03% 4.91%

0.01% 1.56%

0.01% 1.05%

0.01% 1.94%

0.01% 2.22%

0.05% 7.93%

Table 5.1 Average Cost of Capital against Average Stock Return (Currency Risk Factor)

11

Graph 2 Average Cost of Capital against Average Stock Return (Currency Risk Factor)

From the first scatterplot and figures, the cost of capital holds a small value when only

considering gamma, the coefficient of the currency factor and its expected value, represented

by the γ𝐸(𝑆). The data still shows a positive relationship between the stock return and cost of

capital, but fails to explain the entire picture.

12

4.1.2. Analysing Cost of Capital using World Market Returns

7.61% 8.92%

6.75% 8.10%

1.32% 1.32%

1.69% 1.91%

5.79% 6.92%

2.53% 3.28%

3.76% 4.78%

2.08% 2.90%

7.42% 8.83%

0.48% 0.72%

1.97% 2.09%

7.12% 9.36%

3.90% 5.13%

5.79% 6.66%

0.57% 0.41%

5.21% 6.09%

3.67% 4.18%

5.95% 7.23%

2.59% 2.77%

4.03% 4.91%

1.86% 1.56%

0.91% 1.05%

1.10% 1.94%

2.03% 2.22%

6.75% 7.93%

Table 5.2 Average Cost of Capital against Average Stock Return (World Market Rate Factor)

13

Graph 3 Average Cost of Capital against Average Stock Return (World Market Rate Factor)

In this scenario, only the world market rate factor is included in the analysis. The data shows

that the beta of the company compared to the world market is a more accurate measure across

all 25 companies. More importantly, there is a stronger linear relationship between the world

market risk factor and the average stock returns than the currency risk alone. This is shown

visibly with the data points being a tighter fit to the regression line, indicating higher accuracy.

14

4.1.3. Analysing Cost of Capital using World Market Returns and the

Currency Factor

8.97% 8.92%

8.10% 8.10%

1.34% 1.32%

1.89% 1.91%

6.94% 6.92%

3.24% 3.28%

4.80% 4.78%

2.89% 2.90%

8.79% 8.83%

0.67% 0.72%

2.08% 2.09%

9.40% 9.36%

5.15% 5.13%

6.62% 6.66%

0.38% 0.41%

6.06% 6.09%

4.21% 4.18%

7.27% 7.23%

2.82% 2.77%

4.87% 4.91%

1.57% 1.56%

1.01% 1.05%

1.91% 1.94%

2.24% 2.22%

7.90% 7.93%

Table 5.3 Average Cost of Capital against Average Stock Return (World Market Returns and

the Currency Factor)

15

Graph 4 Average Cost of Capital against Average Stock Return (World Market Returns and

the Currency Factor)

With the full model applied, both regression coefficients of the international CAPM model are included

in the analysis. Similarity between average stock returns and its predictor, cost of capital, demonstrates

the accuracy that international CAPM has value in forecasting the average stock return. This is further

shown in the scatterplot where all the points lay near the regression line between stock returns and the

cost of capital. The proximity of the points to the regression line indicates that the cost of capital can be

used as an accurate forecasting tool for predicting the average stock return of a firm in an integrated

and international marketplace.

5. Conclusion

After the analysis of the company’s data, we identified how to hedge in different situations and

why hedging creates firm value. We have also shown that through hedging, the company

receives benefits in multiple forms. Finally, we provided evidence as to why international

CAPM provides a more accurate measurement than our previous single market method.

16

6. Bibliography

Aretz, K., Bartram, S.M. and Dufey, G., 2007. Why hedge? Rationales for corporate hedging

and value implications. The Journal of Risk Finance, 8(5), p.439-442

Graham, J.R. and Rogers, D.A., 2002. Do firms hedge in response to tax incentives?. The

Journal of finance, 57(2), pp.815-839.

Sercu, P., 2008. International finance: Putting theory into practice. Katholieke Universiteit

Leuven. pp.400-406

Smith, C., & Stulz, R.,1985. The Determinants of Firms' Hedging Policies. The Journal of

Financial and Quantitative Analysis,20(4), pp.391-405

17

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