corporate risk This is a topic that many people are looking for. newyorkcityvoices.org is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, newyorkcityvoices.org would like to introduce to you FRM 2015 – Corporate Risk Management Part I (of II). Following along are instructions in the video below:
“Risk management primer. So this reading again. It s a small introduction to how risk risk management. World works.
And there is introduction to various terminologies in this first point discussion. Is advantages and disadvantages of hedging your risk exposure. This particular discussion. Wave divided into two parts the first part discusses.
The theoretical reasons. Why we should not hedge and then it says that even though. These reasons are theoretical. They do not have any practical application then in the second part it discusses.
What are the practical reasons. Why we should not hedge and the practical reasons. Why we should hedge. It is divided into three parts first the theoretical arguments for not hedging.
So the first one is mmm franco modigliani and made on miller. These people came up came up with series of research paper. Which discussed that why dividends dividend decision is irrelevant. Then why capital structural decisions are relevant and in the same fashion.
Why hedging is irrelevant for the valuation of the form. Okay so first argument here is which is a theoretical argument. They assumed perfect capital market. This assumption is similar to kapamas emissions value of a form will remain constant despite attempts to hedge risk exposure.
So here in that paper. They discussed irrespective of whether you hedge or you do not hedge. Valuation of the form will not have any impact on it then william sharp. He came up with similar theory that you can remove unsystematic risk without paying any cost.
Because he assumed that there are no transaction charges. And it s a frictionless market. And therefore. There is no benefit of hedging.
Because unsystematic risk can be eliminated. Without any cost and systematic risks cannot be hedged. So again both of these theories. Argue that there is no benefit of hedging.
Most of those reasons to not to hedge make unrealistic assumption of perfect capital markets. Also they ignore the existence of significant cost of financial distress. And bankruptcy you need to understand the difference of these two first you tell me what would be cost of financial distress. Yes.
Cost of financial distress..
If a company reaches to a stretch where now it is going to file for bankruptcy. Then first thing would be it would have loss of sales. This point you can write down in your notes. Heading would be cause of financial distress.
Say they can be a small theory question structured around it so we need to know the technical difference cost of financial distress first point loss of sales loss of profit. Both of these are opportunity losses and most importantly loss of reputation all these losses and classified under cost of financial distress and bankruptcy cost generally is associated with the legal cost of filing for bankruptcy. Now. See what is to give you a big picture.
What mnm theory. Says first assume there are different versions of the original four theories. But to all of them they assume that there is no concept of tax. So they said that you should think of a firm as a simple pie.
It does not matter what portion of that pie is coming from equity and what portion of that pie is coming from debt. The valuation of the entire pie is going to remain constant and they said that if there are two forms. One is hundred percent equity. The other one is hundred percent debt.
The valuation is going to be same it does not matter how you fund your capital now the difficulty with this is when they said hundred percent dead. What they failed to consider the fact that when a company gets very heavily leveraged. There is a possibility of default because the interest cost is high and if there is a possibility of default then the costs of financial distress. And bankruptcy comes into picture should be good practical perspective valid.
Reasons. Not to hedge. First one firm would be distracted from focusing on the core business. So let us say narendra is helping someone managed forex risk.
And he gets the entrepreneur promoter involved in the forex management. And he gets so involved that he starts doing forex trading and forgets. What was his core business lack of skills and knowledge. This is true with a lot of companies in a special in forex sphere.
Who do large amount of transaction. Where they do not understand how to manage your hedge that risk transactions and compliance. Cost. Now reasons.
Why a form should hedge is a risk exposure lowering the cost of capital can you tell me how is that possible you a coffee bean manufacturing company trying to hedge the cost of beans that is definitely a valid reason for hedging. But it will not reduce the cost of capital. Okay here in this context. How they ask you to think is let us say no not not about the amount let us say you you have estimated that you next year.
Your capex requirement is going to be of two hundred million cap x. Means you want to invest two hundred million into business. Out of this eighty will come from retained earnings that means your internal profits 120 will come to external debt. But the possibility is that next your interest rate will increase.
So when i go into market to borrow this 120 million..
The cost could be higher. But i can enter into a derivative called let s say hypothetically for a and this finna forward rate agreement and this forward rate agreement will lock in the rate at. Which i will be able to borrow money from now reducing your cost of capital reducing volatility of reported earnings. So now i think coffee means example is perfect.
If you are a coffee manufacturing company. If the cost of input keeps on changing. Then maybe you can buy a series of forward contracts. So that the price at which you buy new input is not going to change.
It will reduce volatility of reported earnings makes sense. Improvements potential cost saving over traditional insurance products. Okay. So next.
Part of discussion. Decision on whether to hedge. A particular risk. Role of bo d.
And a process of mapping risk in hedging. Specific risk factors. It is necessary to consider the role of bo d. As well as the process of mapping board.
Should set a forms risk appetite. Using one or more. Following. Tools.
Qualitative statement. Of risk. Whether it should be hedged or unhedged. So one example could be let us say a firm makes a statement that forex forex risk should not be hedged.
Okay. So it s a qualitative statement. Now what kind of forms can afford to do this let us say you are an organization like unilever you have businesses. All over the world let s say unilever.
The parent company in europe has a subsidiary in india. Which is called hindustan unilever. Now the european company has a exposure to depreciation of rupee isn t it because if that happens and valuation of the company will decrease. But then hindustan unilever has assets and liabilities both so if the valuation of the currency increases as it will increase liability will increase if the currency decreases assets will decrease liability will decrease the risk is offsetting each other so you can come up with qualitative statements.
Saying that maybe for a risk is to be remain unhedged. But great risk is to be hedged or vice versa. Then you can come up with a number like var. Our daily bar.
Should not exceed..
Xyz amount or you can come up with stress testing. Scenarios. Ooh beata. Should consider conflict of interest between shareholders.
And bondholders. Tell. Me. What is this correctly see bondholders you can died on this point.
Heading. In the notes would be conflict of interest between shareholders and bondholders conflict of interest between shareholders and bondholders and then right below. That you would say bondholders make an arrow. And say no upside potential.
No upside side with a d. No upside potential make sense for example let us say. There is a company. These are the shareholders of the company.
These are the bondholders bondholders are promised a coupon of 12 per annum. But shareholders do not have a fixed return so what shareholders would think is that if the risk increases let me just okay if the risk increases then our potential returns will increase. But what bondholders will think is even if the risk increases. Our repents of when to remain 12 percent.
And therefore. These bondholders would want all the risk to be hedged. Whereas shareholders would want exposure to certain risks. So that their upside potential of returns will increase.
So as a board of director. Your job is to ensure that you are working in the best interest of both the stakeholders. This point is important maybe you can write down because i saw through any question on this. Bo.
D. Bo. Dee has to work in the interest. Bo d.
Has to walk bo dis board. Of directors. Have has to work in the best interest of both the stakeholders now technically board of directors are representative of equity shareholders. So you would expect them to work towards equity.
But the sentences that they have to work in best interests of both equity as well as bond holders. Next clarification on whether we are trying to hedge. The accounting risk or accounting. Profit or economic profit.
What is this whether we are trying to hatch. Accounting profit or economic profit. What is the difference between the two which is one example of it let us say himanshu is this this is himanshu and himanshu sets up a business so he s currently has got a job let s say is making 25. Million rupees per annum and he quits his job.
He said supper business first terry makes sales of five million cost involved with two million accounting profit is how much 3 million. But how he would think is even though from an accounting. Perspective he has earned 3 that 25. Million is an economic.
Cost it s an opportunity cost so he will say. 25 and his economic profit now is 05. Million. So from a risk management perspective board of directors will have to clearly state that when we are trying to hedge risk are trying to hedge profit.
Which profits are they targeting accounting or economic and recommended is economic profits eeeh clarification on whether we are hedging short term or long term arcana accounting profits again this can be tricky cy let us say you got into an agreement with a client and by the end of year. This is time zero this is time 12. You are expecting to receive ten million from your plans in indian company. Receiving 10 million.
Now. What this company. Did is it entered into a short forward contract short forward contract. Where after 12.
Months it will be entitled to sell those 10 million. Us. Dollars and receive indian rupees. Now the difficulties.
This is the closing of first quarter and today they have to prepare their books of account. Now most of the accounting standards. Including ifrs as well as indian accounting standards. They will require you to calculate what are the mark to market profits or losses on every financial statement preparation date.
So this 10 million is coming to you in 12 months. So it is not recorded. But if you made losses here on this so technically when you are making losses on forward you are actually making profits here is that it because they are working in opposite direction. But the profits are not getting recorded.
But derivatives are requiring you to record those losses and therefore you will have to also decide a strategy that whether you are trying to hedge short term or long term. Accounting profits. I clearly this one sir other points now time horizon possibility of implementing definitive. ” .
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