Corporate Finance - Giddygiddy.org/appliedfinance/risk.pdfCopyright ©2002 Ian H. Giddy Financial Risk Management 2 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS

Giddy Financial Risk Management /1

Prof. Ian GiddyNew York University

Managing Financial Risk

Copyright ©2002 Ian H. Giddy Financial Risk Management 2

Corporate Finance

CORPORATE FINANCEDECISONS


INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT



Corporate Finance



INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT

INVESTMENT

FINANCINGRISK

MANAGEMENT


What Hedging Instruments?

What Protection Needed?

Volatility & Direction

OTC options,Caps and Floors

Direction

Forwards, Futures, Swaps

Exotics, Hybrids, structured

notes

Complex risksOr arbitrage



A Typical Derivative

l We agree today to pay a certain price for a commodity in the future

T.I.T.I. COMPAQCOMPAQ

T.I.T.I. COMPAQCOMPAQ

What’s the difference?The “cost of carry”

What’s the difference?The “cost of carry”


Commodities: Spot and Forward

n$1584.5

n$1607.0

ALUMINUM PRICEper tonne

3 MONTHS 6 MONTHSSPOT

How can Coke’s canners cap their can costs?



Commodity Prices

Simple model of a commodity futures pricebased on the cost of carry:

Ft = Futures price for delivery tyears from todayS0 = Spot price todayRt = Interest rate for t yearsCt = Non-interest costs of carry.

t 0 t tt

F = S (1 + R + C )


Fear and Backwardation

For some, a barrel of oil in the hand is worthtwo in the bush. This "premium for possession"`factor is called convenience yield:

where CY = Convenience yield,in percent per annum

t 0 t tt

F = S (1 + R + C - CY )



A Typical Forward Exchange Contract

l We agree today to pay a certain price for a currency in the future

SonySony B of AB of A

JPY


Foreign Exchange Quotations

Spot Forward points



Policies and Exchange Rate Regimes

l Exchange rate systems--fixed vs floating

l Managed floatingl EMU-type currency blocsl De facto blocs--the dollar


Hong Kong Dollar

Source: pacific.commerce.ubc.ca/xr



Argentine Peso



Euro




Domestic Policies, Domestic Prices and Interest Rates, and Exchange Rates

Country A Country B

DOMESTIC DOMESTICECONOMIC ECONOMICPOLICIES POLICIES

INFLATION INFLATIONRATE RATE

EXCHANGERATE

INTEREST INTERESTRATE RATE

FORWARDRATE


MacParity

Source: economist.com




Heineken and the Euro

l How was the Dutch company Heineken affected by the fall in the Euro in 1999-2000?

l Look atuThe EurouThe company’s salesuThe company’s

production

Euro

0

0.2

0.4

0.6

0.8

1

1.2

10/1

8/19

99

12/1

8/19

99

2/18

/200

0

4/18

/200

0

6/18

/200

0

8/18

/200

0

10/1

8/20

00

US

$ p

er E

uro






production

Location Fixed Assets Sales

The Netherlands2,341 15% 1,063 15%Rest of Europe 8,874 57% 4,027 57%Western Hemisphere1,972 13% 895 13%Africa 685 4% 311 4%Asia Pacific 1,613 10% 732 10%

1548500% 100% 7,028 100%

Data: 1999 figures, millions of EuroSource: http://www.heinekencorp.nl





production



The Exposure Triangle

TransactionsExposure

TransactionsExposure

TranslationExposure

TranslationExposure

EconomicExposure

EconomicExposure


The Hedging Choices

“Natural”Hedge?

“Natural”Hedge?

Derivatives?Derivatives? Debt?Debt?

or



Domestic and Eurocurrency Rates

CountryOver night Day

Change week Month

One month

Three months

Six months One year

US$ Libor* 1.78875 -0.027 -0.111 0.004 1.9 2.03 2.34 3.0275Euro Libor* 3.23375 0.223 -0.032 0.093 3.35 3.4 3.53875 3.90025» Libor* 4.66938 0.597 0.577 -0.025 4.1325 4.18813 4.39625 4.88063Swiss Fr Libor* 1.6 -0.023 0.183 -0.025 1.65667 1.71667 1.875 2.27833Yen Libor* 0.05 - - - 0.1075 0.105 0.10563 0.11188US$ CDs - - - - 1.86 1.96 2.28 2.24Euro CDs 3.325 0.335 0.085 0.025 3.36 3.425 3.585 3.935

Source: ft.com

ft.com• Markets Home• Bonds• Data Links – Money Rates


What Hedging Instruments?

What Protection Needed?

Volatility & Direction

OTC options,Caps and Floors

Direction

Forwards, Futures, Swaps

Exotics, Hybrids, structured

notes

Complex risksOr arbitrage



Option Hedge

CALLOPTIONON YEN

FORWARDCONTRACT

Petrobras hedging cost of Japanese debt


Option Hedge

Questions about options:nWhen should companies use them?nWhich options?nHow much do they cost? nAre they worth paying for?



Hockey Sticks

CALL PUT

BUY

SELL


View on Direction, Volatility or Both?


Managing Financial Risk:Case Study

Prof. Ian GiddyNew York University


Case Study: Photronics

PHOTOMASKS

US DOLLARS




Photronics is the world's leading and fastestgrowing manufacturer ofphotomasks.Photomasks are high precision quartz plates thatcontain microscopic images of electroniccircuits. A key element and enabling technologyin the manufacture of semiconductors,photomasks are used to transfer circuit patternsonto semiconductor wafers during the fabricationof integrated circuits. They are produced inaccordance with circuit designs provided bycustomers at strategically located manufacturingfacilities in North America, Europe and Asia.


Photronics’ International Business

”The globalization of the semiconductor industry has created significantgrowth opportunities beyondPhotronics' core market in North America.Customers operating manufacturing facilities in Asia and Europe, aswell as North America, are streamlining their equipment and materialsprocurement processes, relying on fewer and more capable suppliers.

“Photronics has made excellent progress in expanding its presencearound the world both by acquisitions and by the construction of newfacilities. During the year, new facilities were quickly brought to fullproduction in Manchester, England, and Austin, Texas, while additionaltechnological capability was installed in Singapore. These advancedcapabilities have elevated our strategic supplier status with manysignificant customers who are now benefiting from our balancedapproach to international expansion and technology investments.

“ In Asia, our Singapore facility is benefiting from our customers'utilization of wafer foundries, reflecting the increasing trend ofsemiconductor manufacturers moving toward a fabless businessmodel. We believe that the number of companies utilizing foundries willincrease as they focus on their core strengths—designingsemiconductors and product marketing. Such a business modeltransfers the risk associated with investing capital in production assets,giving the now "fabless" semiconductor company additional flexibilityduring down cycles, like the one affecting the semiconductor industry today.”

From

199

8 A

nnua

l Rep

ort




l The company and its currency exposurel Income, cash flow and translation

effectsl The economic risks


PhotronicsPhotronics



PhotronicsPhotronics

What hedging policy?


Photronics: Translation Exposure



Translation Policy

The Company's subsidiaries in Europe and Singapore maintain their accounts in theirrespective local currencies. Assets and liabilities of such subs idiaries are translated to

U.S. dollars at year-end exchange rates. Income and expenses are translated at averagerates of exchange prevailing during the year. Foreign currency translation adjustments

are accumulated in a separate component of shareholders' equity. The effects of changes

in exchange rates on foreign currency transactions are included in income.


Economic Exposure

l Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes.uExample: Even though Intel invoices German

customers in marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen.

l The currency of determination is the currency in which most of the competition prices similar products.



Translation vs Economic Exposure

Accounting exposurel Exposure = "Exposed" assets - "exposed"

liabilitiesEconomic exposurel Exposure = How will an unanticipated exchange

rate change affect the cash flows of the firm?uDomestic salesuExportsuDomestic costsu Import costs


Photronics: Economic Exposure

SOLD IN UKINVOICED IN GBP

SOLD IN WORLDWIDE MARKET

DETERMINED BYCOMPETITION

GBP?

USD?

JPY?

PHOTO-MASKS

n A/Rn INVENTORYn PLANT



What Should Photronics Do?

l Hedge, or suffer translation gains & losses?l How can its exposure be gauged?l What does FAS 133 imply for a company like

this?l What tools should be used?


What Kind of Debt? Some Considerations

l Fixed/floating:uHow certain are the cash flows? Are operating profits

linked to interest rates or inflation?

l Currency:uConsider currency of the assets: currency of

denomination vs. currency of location vs. currency of determination.

l Maturity or availability:uAre the assets short term or long term? Should the

firm assume ease of refinancing, or buy an option on access to financing?



A Hedging Roadmap

Motivations for Hedge

Driven by company views

Volatility: options, Direction:

forwards, debt

Market risk remains

Driven by company needs

Company has economic exposure

Company has natural hedge

No need for hedgingForwards, swaps or debt


Contact Info

Ian H. GiddyNYU Stern School of BusinessTel 212-998-0426; Fax [email protected]://giddy.org

Documents

Corporate Finance - Giddygiddy.org/appliedfinance/risk.pdfCopyright ©2002 Ian H. Giddy Financial Risk Management 2 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS