Corporate Finance Ⅱ:

Financing Investments and Managing Risk

Professor Heitor Almeida and Stefan Zeume
Module 3: Risk Management

Table of Contents
Module 3: Risk Management .................................................................................................. 1
Lesson 1-0: Module 3 Objectives and Overview ................................................................................ 2
Lesson 1-0.1: Objectives and Overview ............................................................................................................... 2

Lesson 1-1: Good and Bad Reasons to Hedge .................................................................................... 6

Lesson 1-1.1. Good and Bad Reasons to Hedge................................................................................................... 6

Lesson 1-2: Forward Contract ......................................................................................................... 19

Lesson 1-2.1. Forward Contract ......................................................................................................................... 19

Lesson 1-3: Futures Contracts ......................................................................................................... 27

Lesson 1-3.1. Futures Contracts......................................................................................................................... 27

Lesson 1-4: Hedge Ratios and Imperfect Hedging ........................................................................... 37

Lesson 1-4.1. Hedge Ratios and Imperfect Hedging .......................................................................................... 37

Lesson 1-5: Liquidity as a Substitute for Hedging ............................................................................ 47

Lesson 1-5.1. Liquidity as a Substitute for Hedging ........................................................................................... 47

Lesson 1-6: Bilateral Contracts ....................................................................................................... 62

Lesson 1-6.1. Bilateral Contracts ....................................................................................................................... 62

Lesson 1-7: Operational Hedging .................................................................................................... 70

Lesson 1-7.1. Operational Hedging .................................................................................................................... 70

Lesson 1-8: Currency Risk and the Cost of Capital ........................................................................... 81

Lesson 1-8.1. Currency Risk and the Cost of Capital .......................................................................................... 81

Lesson 1-9: Adjusting the Cost of Capital for International Projects ................................................ 96
Lesson 1-9.1. Adjusting the Cost of Capital for International Projects .............................................................. 96

Lesson 1-10: Review and Graded Activities ................................................................................... 110

Lesson 1-10.1. Module 3 Review ..................................................................................................................... 110

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-0: Module 3 Objectives and Overview

Lesson 1-0.1: Objectives and Overview

This module is about managing risk. Companies can use financial instruments such as
futures, forwards, options to reduce or reallocate risks to other parties. What we're going
to talk about in this module is how they can use these traded contracts to reallocate risk
in a way that increases shareholder value. We're going to talk about that, but we're also
going to talk about other mechanisms that companies can use to reallocate risk when
they cannot use traded contracts. A key idea that we're going to learn is that companies
can in some cases use alternative mechanisms such as liquidity, supply contracts and
operational hedges to achieve the same goals that they would achieve with a traded
contract like futures.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

The idea of reducing or reallocating risk is what we call hedging. It's a major component
of modern financial management. CFOs spend a lot of their time thinking about risk
management, hedging, how to reduce risk, how to reallocate risk. So, this is a key
component of a modern corporate finance course.

In terms of specific topics, we are going to talk about how to identify right and wrong

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
reasons to hedge. What are the reasons that truly increase shareholder value and what
are the ways that companies can in fact destroy shareholder value? By using futures,
for example, in the wrong way. So, we're going to talk about that. And then, like I said,
we're going to discuss how to use these specific contracts to hedge risks. In particular,
we are going to talk about this idea of speculation. Right, when you think about
derivatives such as forwards, futures contract, this might bring to mind this idea of
speculation. Companies can also use these securities to speculate, and we're going to
learn how to distinguish hedging from speculation, right? And how to think about
hedging in a way that increases shareholder value.

We will also learn what to do when target risk cannot be eliminated using derivatives.
For example, using liquidity management as a substitute or bilateral contracts or
operational head.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

All of these possibilities are available for companies to mitigate risks such as currency
risks, for example, when futures and forwards cannot be used. Finally, we're going to
talk about currency risk more deeply. We're going to think about how hedged and
unhedged currency risks may affect the company's cost of capital. This is an important
topic because it will help determine how companies should adjust their cost of capital
when investing in international projects. In a globalized world, it is increasingly important
to be able to think about how globalization, how international projects. How
multinationals should adjust their cost of capital to address foreign risks such as
currency risks and other risks.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-1: Good and Bad Reasons to Hedge

Lesson 1-1.1. Good and Bad Reasons to Hedge

The first question we need to talk about is why hedge? Why do this at all? We're going
to talk about good reasons and bad reasons to hedge.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Let's start with the bad reasons. The way I'm going to do this is just propose a few
arguments. Some of them might actually make sense when you think of them, but if you
take more time to really think about it and use your financial knowledge, you're going to
see that the arguments don't make sense. Let me start with this one. Suppose your
company is in a cyclical business or your profits are very volatile, the company is then
thinking about using derivatives to smooth out fluctuations in profits. Low-risk is good.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

What's wrong with this argument? It's wrong because reducing volatility is not going to
increase shareholder value, why? Because shareholders can do this on their own. If
they hold stock of your company, shareholders can diversify risks by buying stock in
another company. If shareholders can do it on their own, the company has no business
to be reducing volatility, in fact, taking risk is the reason why companies exist.
Companies are not going to create value if they don't take risk. No risk, no return.
Reducing risks cannot be the goal of a company. So, reducing volatility is not the right
reason to hedge. We're going to need a little bit more sophisticated arguments to
understand why companies hedge.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Before we get there, let's talk about a few other motivations that are wrong. For
example, suppose your company uses steel as an input. You might think you know a lot
about the steel market, so you think that you're confident that steel prices are going to
continue to go down. Well, what you're proposing is that your company should go to a
futures exchange in short steel. Short means sell, basically.

So, you sell steel now, the price goes down, you make money. You're making money, it

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
seems good. What's wrong? It's wrong because this is speculation, it's not hedging.
Companies should try to produce value from the products that they make. So, if you're
using steel as an input, what you want to do is you want to sell your product at a high
price, you want to make a good product. You should not be betting on the steel market.
If the company's CFO wants to do that, my proposal is that the CFO should move to
Wall Street. That's the picture here, if you want to take risk move to an investment bank.
That's where you can trade, try to make profits out of things like steel futures. A
company is not the right place to do that.

What are the good reasons to hedge? There are three reasons we're going to talk about
here. The first one is to be able to choose which risks the company wants to take, the
second one is eliminating risks outside of the company's control, which is related but a
little bit different. The third one is to reduce the risk of financial distress. These are all
valid reasons that corporate finance theory has proposed, and that make sense both in
theory and in practice.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

First one, suppose for example, that you work for a US company that wants to open a
new branch in India. It doesn't matter what the product is. Let's say that there is a lot of
demand for the product in India, so you want to sell there. However, selling in India
means that you're going to be exposed to exchange rate risk. You're going to sell in
Indian currency, your shareholders are in the US, so now you're going to have currency
risk, if the value of the Indian currency changes that might change your profits.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

The CFO of this company might want to reduce exposure to the Indian currency by
hedging currency risk. Think about what the company is doing. The company is
choosing the exposure, it's not that you want to reduce risk, probably going to India is a
very risky business. You're taking a lot of risk, but you're choosing which risk to take.
You want the exposure to the Indian market, you want to sell in India, you don't
necessarily want exposure to Indian currency. So, you can go to the futures market and
eliminate that particular risk, while at the same time maintain your exposure to the
Indian market. That's what we mean by choosing risks. That is a very powerful, valid,
practical reason to hedge.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Remember that, choosing risks. A company may also want to eliminate risks that are
outside of the company's control. Let me give you an example. Suppose we have an
airline. The airline profits are going to be sensitive to oil prices. What the airline CFO is
proposing is that they should engage in a hedging strategy because they would like
their profits to better reflect the number of tickets that the airline sells, how much the
customers like the airline, they don't want the profits to reflect variation in oil prices. It's
a risk outside of the company's control that can be very valuable for example, for
executive compensation. We know that the CFOs even, are paid depending on bonuses
and stock, so CEO compensation is going to go up if the company is doing well, but if
an airline is doing well because the oil price went down, maybe we shouldn't pay more
to the CFO. The CFO should just make money if the airline sells more tickets, but the
CFO compensation should not really be tied to oil prices. Again, using the futures
market or another hedging tool may be a way to eliminate this particular risk. You still
have risk because you are exposed to the tickets, so your profits are going to depend
on how many tickets you sell, but they are no longer going to depend on oil prices.
Good reason to hedge.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Finally, let's go back to the notion of financial distress that we talked about in module 1
of Corporate Finance 2. Suppose now your airline is highly levered. That actually
happens fairly commonly. Airlines have gone bankrupt a few times already, even the big
ones like American Airlines. Profits are decreasing, your airline is highly levered. Now
the idea is, the airline is going to hedge oil prices to avoid becoming financially
distressed. If oil prices increase further, your profits are going to go down, you're going
to get closer to financial distress. We learned that financial distress reduces value, that's
what we learned in module 1.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Let's think about that. Let's think about these two scenarios here, so low profits, high
profits. Essentially this depends on oil prices. If the oil prices are high, then you're going
to have low profits, if oil prices are low, you're going to have high profits. Suppose the
airline has no debt, should it hedge oil prices? That's the question I have for you. You
have no debt. So, you're not highly levered, you have no debt, should you hedge oil
prices or not?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

The answer is that in this case, not necessarily. As we mentioned before, the volatility of
profits is going to decrease, but maybe shareholders don't care. They could do it on
their own by buying stocks that are not sensitive to oil price or maybe shareholders can
buy a stock that goes up if the oil price goes up. They can buy stock on an oil company.
Maybe the company could do it so that profits don't reflect oil prices, as we mentioned, it
might be because of executive compensation.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

But suppose now that the airline is highly levered, that's going to completely change the
picture, because now if oil prices are high, in the situation where oil prices are high, your
profits are low, what may happen is that the airline may not be able to repay the debt.
That's what we're talking about here.

This situation, high oil prices, low profits, what might happen is you might become
financially distressed if the oil price increases and that debt increase causes financial

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
distress. This is again going to be a good reason to hedge oil price risk. Even if you're
not concerned about executive compensation, you may want to eliminate volatility when
you're getting closer to financial distress.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-2: Forward Contract

Lesson 1-2.1. Forward Contract

Let's talk about how companies can use traded securities to hedge. In some cases,
there are going to be securities that trade in financial markets, or that are traded over
the counter that are going to allow companies to hedge. We're thinking of futures and
forwards mostly. Those are the main securities, the main derivatives that companies
use for hedging in the real world. They are available, for example, for risks such as
currency risk, commodity risk, and interest rates. Let's talk about a forward. That's the
first contract we're going to talk about.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

A forward contract is an obligation to exchange an asset at a future date, but at the pre-
specified price. So, the idea is you fix the price today, and then you agree to exchange
the asset in the future. So, for example, you can be written on currency, you might
agree with your counter party to exchange dollars for pounds in six months, right? What
you do today is you write a contract, you don't have to exchange any cash today, there's
no cash exchanged today. When the maturity comes, the two counterparties have to
settle the contract. You call your counterparty and say look, we have to close the deal.
I'll give you x, you give me y, we're done. Very simple right?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Let me give you some data and then talk about a specific example. Suppose we are on
December 30, 2014. You'll see later why I chose this particular date. We have data here
from the Financial Times. The Financial Times used to be used for forward data. I think
it is likely not there anymore, but you have the snap shot here. So here you have, in the
first column you have the current exchange rates that were current at that time in
December 30, 2014. Then you start to see the forwards, this table shows you one
month forward, three-month forward contracts and 12-month, one year forward
contracts that companies can buy from a counter party in the market. And it also gives
you the specific values that people can trade this for. It's not just companies, right?
Financial institutions, anybody in principle could access this market.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Okay, so let me give you a specific example that I'm pulling out from this table and you
can check the data to make sure that this is right. Suppose that it is December 14, and
we need to make a payment of 200 million roubles to a Russian supplier in December
2015. Right? So, we have to make this pre-specified payment. We know it's 200 million
roubles, but the payment is in roubles, right? That means the US company is going to
face some currency risks.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

The specific risk is that the rouble may appreciate against the dollar. If the rouble
appreciates, right, that means that the value of the payment in dollars is going to go up.
The US company's going to have to spend more dollars to buy roubles. You could
choose not to bear this risk, right? That's one possibility. But if, and if you want to do
that, you can eliminate this risk using currency forwards. It's pretty straightforward to do
this, looking at the data that I just gave you.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

We know that a one year forward contract for roubles was worth 64.885 roubles at that
time. Okay, so what the company would do is it would buy a forward contract today.
Right, so you would write the contract it's a piece of paper. Okay? For delivery of 200
million roubles in one year, you would agree with the bank. In one year, the bank would
give you 200 million roubles and you would fix the price at 64.885. The price is fixed in
one year, right, essentially what the US company will do is pay a certain amount of
dollars which we can actually calculate here is $3.082 million.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

In exchange for that, the bank will give you 200 million roubles, right? So, and that
transaction will happen, irrespective of the future exchange rate. No matter what
happens to the rouble, you are going to transact at that specific exchange rate. So
essentially what you are doing is you're locking in the payment, right? Now the US
company knows that you're going to pay $3.08 million. It doesn't matter what happens
to the rouble any more. That's the beauty of hedging, right? You have eliminated
currency risk. Right?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Forwards are beautiful, but what's the problem? Right? The problem is that the forward
is going to have some settlement risk. Think about this, right? So, it's essentially a piece
of paper. There is no cash exchanged today. There is no guarantee, right? It's just a
promise. This is really a promise. It's just a promise that the two counter parties make.
So, the forward contract is only going to work if both parties are reliable, okay? If there
is a lot of settlement risk, if one of the parties might default on the contract, then the
forward contract is become less reliable. The forward contract is going to become less
attractive for the company because the bank, for example, may not be relied upon to
give you the 200 million roubles. We'll talk about next what companies can do in that
case.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-3: Futures Contracts

Lesson 1-3.1. Futures Contracts

Now we're going to talk about futures. The main difference between futures and
forwards is that futures are traded in an exchange. We are moving the derivative
contract to an exchange. If you look at this picture here, you'll see that George Bush,
our former president, is actually there. Of course, he is not a trader. He was just visiting
the Chicago Board of Trade that day, so it's kind of a fun picture to start this lesson.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

So, what's the futures contract? The main motivation of a futures contract is to solve the
settlement risk problem that we just talked about. It's going to achieve the same thing as
a forward in a way that it mitigates or almost completely eliminates the settlement risk.
How will it do that? First of all, it's going to be a standardized contract. It's no longer a
contract, a piece of paper that you write with a counterpart. It's going to be a
standardized contract that trades in an exchange, right? This is going to trade on a
futures exchange. So, the futures' exchange is going to be responsible to honor the
contract. If one of the parties default, the futures' exchange is now responsible for it,
okay? In order to protect itself what the exchange does is to open a margin account. So,
in order for you to buy or sell a futures contract in an exchange, what you're basically
going to have to do is to deposit some cash. We're going to give an example later
exactly how the margin account works, but the idea is that if you want to hedge using
futures, you have to give some cash to the exchange and put it in a margin account.
The money belongs to you, but it's going to be with the exchange until the contract
expires. And then the exchange is going to assume the settlement risk.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Here is some data on futures. These are futures on British Pound, okay? This data now
comes from September 2016. So, it's a little bit more recent than the other data that I
gave you. And you see that there are futures contract that allow you to buy and sell
British Pounds for all of these dates. There are probably even more futures contracts
but let's talk about at least this one. So, you could buy a future for December 16, March
17, June 17, September 17, again at a specific price. The settle column there gives you
what are the current prices at which you can buy and sell pounds in the futures
exchange.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

So how would a company use this market to hedge? Okay. Suppose it's now October,
2016, and now we have a US company that expects to receive a payment of one million
pounds in approximately one year, September, '17. Okay? So, our previous example
the US company was making a payment in rubles, now you're going to receive a
payment of 1 million pounds.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
How can the US company eliminate this currency risk? Now we have the opposite
position, right? So, you're long on pounds because you're going to receive pounds. So,
if you are going to trade a future to eliminate that risk what you need to do is you need
to sell pounds. The word that we use in finance is actually a short, okay? Because you
don't need to have the pounds today, right? You need zero pounds to do this today,
you're going to write a contract. In one year, you're going to have to come up with the
pounds to close the contract, okay? So that is why we call this shorting. It's selling
without necessarily having the asset. Each future as you look at that data, each future
corresponds to 62,500 pounds. So, if you do the math what the US company would
need to do is to short 16 of these contracts, all right? And as we mentioned before, to
enter this position, the CME, the Chicago Mercantile Exchange, let's say that's where
you're writing this contract. The CME is going to require a cash deposit from the US
company. So literally what you need to do is you need to open an account with the
CME, let's say it's $100,000. So, the margin account will be 10% of the position. Doesn't
have to be just for our purposes here, okay?

So, the current futures price, if you look at that data, is $1.2373 per pound. All right, so
that's the amount that you can buy and sell pounds in one year, okay? So that's
essentially going to be the price of the futures contract. Let's try to understand what
happens now. Suppose that we are one month away, okay? Now it's November 2016,
and the futures price has gone up to $1.3 per pound. So, the pound appreciated, right?
That's going to change the futures price as well, so now it's $1.3 per pound. How is that
going to affect the futures position that the company holds. Let's figure that out.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Okay? What happened is that, remember, you sold pounds, you short pounds, so the
US company is going to lose money in the futures position, right? You have a loss, we
can actually calculate the loss here, right? It's 1.3 minus the 1.2373 that you started with
times the amount that you invested. That means you are going to lose $62,700. What
the CME would do is, to deduct this amount from your margin account. So now instead
of $100,000 the US company only has $38,300 in the margin account plus what we call
accrued interest. The CME will pay you interest on your margin account. It's like a bank
account. Just think of it as a bank account, okay?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Here comes a crucial question. I really want you to think about this and try to answer.
That's a very important point in this module three that's coming up right now. Okay. The
US company lost money, right? You lost money in the futures position. Should we fire
the CFO? Does that mean that the CFO made a mistake by shorting the futures
contract?

The answer is no, no. Remember, the goal of hedging is to eliminate risk. The goal of

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
hedging is not to bet on what's going to happen to the pound. That's actually the risk
you don't want to take, right? So, no matter what happens to the pound, the company is
going to be okay, right? Why am I saying that although you lost money? How can you
be okay? Well, remember, right? You have your London pounds as well because you
have that payment of 1 million pounds. The value of that payment went up.

And we can actually figure out that the value of the payment should have gone up by
exactly the same amount, right? You have the loss of 62,700 but your payment, right?
Now essentially you expect the pound to be at 1.3 now, right? When you receive the
money, the futures went up. The future should be a very good predictor of the future
exchange rate, right? So that means you made a gain. You made an equivalent gain,
right? What's your net gain? 0, that's what hedging means. When you hedge, you want
to see a 0. Okay, that's the goal. The goal is to eliminate, right? We want to eliminate
risk. Eliminate risk means zero. Whatever happens to the currency, you have a zero-net
gain. Very important point, and make sure you understand that, okay?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Let me revert it. Let's say that now the CFO thinks that the UK pound will continue to
appreciate. Okay, so because of this, instead of shorting, the CFO is suggesting that the
company buys the pound, instead of shorting. Right?

Is the CFO, right? The answer is no. The opinion of the CFO doesn't matter at all.
In fact, no one can perfectly predict what's going to happen to exchange rates. It's not
the CFO's job. The CFO is the chief financial officer of a company that wants to

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
eliminate, if it wants to eliminate currency risk, maybe it doesn't. But for sure, the CFO
has no business taking a long position in the pounds just because the CFO thinks the
pound is going to appreciate, okay? That is exactly an example of speculation, which is
the opposite of hedging, it's what companies should not do. Remember this, if you want
to speculate go to Wall Street, do not speculate with company's money.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-4: Hedge Ratios and Imperfect Hedging

Lesson 1-4.1. Hedge Ratios and Imperfect Hedging

The idea of hedging then is to neutralize the effect of a particular exposure. What you're
searching for is this zero-net gain, but what we're going to learn now is that the zero net
gain may be an elusive call. Companies may not be able to always achieve a zero-net
gain. In many cases, hedging will be imperfect.

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

Let me give you an example. Suppose we have a company that is planning to issue
commercial paper, we learned what commercial paper is. It's a source of short-term
financing that the large real-world companies use in practice. Suppose we have this
company, it's planning to issue commercial paper, but you don't have to issue it now.
You have to issue it three months from now. The amount is 100 million. The current
commercial pay per rate is 3%. What the CFO wants to do is to lock in the 3%. You
don't want to be exposed to interest rate risk. How can you do that?

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 Corporate Finance Ⅱ:
Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

What you need to do is you have to enter an interest rate futures contract. You have to
find the contract that will give you a payoff, that neutralizes the effect of an increasing
interest rate.

Which contracts are available in this case, what the CFO will find in financial markets
are either LIBOR or a US treasury bill futures contracts. In particular, there is not going
to be a futures market for the commercial paper issued by this particular corporation. In

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Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
fact, as far as I know, there is no futures market written in commercial paper in general.
Interest rate futures are always based on a very broad complex, such us LIBOR or US
T-bills. What this means is that in this case, hedging using futures is going to be
imperfect. It's going to be more difficult to achieved the zero-net gain.

Let's talk about what the company should do in practice. So, suppose that in this case,
we are concerned that interest rates will go up. That's our example. Remember from
bond valuation theory, we also talked about that in corporate finance one. There is a
negative relationship between prices and interest rates. So, if interest rate goes up, that
means the price of your debt security is going down. Given this, should the CFO buy or
sell an interest rate futures contract? Remember, you're looking for a neutralization.
You're looking for a zero-net gain. Think about that.

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Professor Heitor Almeida and Stefan Zeume

The answer is that you need to short the contract, you need to sell. You're looking for a
position that is going to give your profit if interest rate goes up. If interest rate goes up,
prices go down, the future prices going to decrease. Meaning that the company who
profit from the position and meaning that this futures profit is going to compensate for
higher interest rates. If we have the data, we could work out an example, but we don't
really need to. I think you already understand how these work.

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Professor Heitor Almeida and Stefan Zeume

Here is what I want to talk about. It's this idea of hedge ratio, because now we're having
perfect hedging. We can buy LIBOR futures or T-bill futures, but we can't buy
commercial paper futures. So, suppose that the CFO expects LIBOR, for example, to go
up by 1%. And in that case, the CFO expects the commercial paper rate to go up by
1.5%. So, your expectation is that for every percentage movement in the LIBOR, the
company's commercial paper rate moves by 1.5%.

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Professor Heitor Almeida and Stefan Zeume

How can you adjust your future position to take your expectation into account? It's easy.
What you need to do is you need to take a larger position on LIBOR future to
compensate for the spread. It's a larger move, your commercial paper moves by more,
so you're going to have to open a larger position in LIBOR futures to get the right gain,
to achieve the zero net gain if you can. That's what we call a hedge ratio. In financial
jargon, the hedge ration is the number of units of the future contracts that you have to
hedge, that you have to buy in order to hedge one unit of the underlying risk. In this
case, it's 1.5%.

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Professor Heitor Almeida and Stefan Zeume

Does that solve the company problem? So, you would go in short $150 million, but is
that going to solve your problem? Does that eliminate the interest rate risk?

The answer is no, unfortunately, because the problem is the hedge ratio is going to be
based on the forecast. You are essentially trying to guess what will happen to Y. Y, in
this case is commercial paper if X happens. What happens to commercial paper rates if
the LIBOR changes by 1%? You have to estimate that number, you have to forecast

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Professor Heitor Almeida and Stefan Zeume
that number. In the real world, the spread between LIBOR and commercial paper is
going to be very difficult to precisely forecast.

In fact, let me just give you some data here from the real world. That's the data that
shows how commercial paper spreads, it's measured relative to T-bills here. So, this
shows how commercial paper T-bill spreads fluctuate over time. In normal periods, this
spread can be fairly low like 20 basis points. That's what it's showing here. But in stress
periods like in during 2008, during the financial crisis, that spread went up a lot. So
that's what you're seeing here is that there is very market, very, very strong fluctuations
in the commercial paper could be T-bill spread over time. So that's going to make it very
difficult for us here to precisely forecast what's going to be that spread, if you're looking
now in two months or six months.

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Professor Heitor Almeida and Stefan Zeume

So, that's the problem. What can we do about it? Imperfect hedging is going to be a
feature of the real world. Unfortunately, in the real world, achieving the zero net gain is
in most cases, not going to be possible. Fortunately, companies have other tools that
they can use to improve their hedging ability when futures and forwards cannot give you
a good hedge. That's what we're going to talk about next. Liquidity management,
operational hedging and bilateral contracts may also help.

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Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume
Lesson 1-5: Liquidity as a Substitute for Hedging

Lesson 1-5.1. Liquidity as a Substitute for Hedging

Let's talk about these alternatives and we're going to start with the previous example. In
fact, that previous example has an almost trivial solution. Let me remind you what we're
talking about. We're having this company that expects to borrow in 3 months. The
current rate is 3%. And the company is concerned about the risk that interest rates will
go up, right?

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Professor Heitor Almeida and Stefan Zeume

What's the previous solution? You can issue the commercial paper today. Maybe you've
thought about that already, right? Why is the professor talking about this, it seems like
this is what the company should do is borrow today. You are right. That is in fact a good
solution to this problem. What happens is, in this case, you'll pay 3%. No matter what
happens to interest rates. But we're not done. What else does the company need to do
if you are going to really hedge the interest rate risk? There is one more step. Here it is.
The company needs to hold cash. That's why this lecture is about liquidity, okay?

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Professor Heitor Almeida and Stefan Zeume

In order for these alternatives to work, the company's going to have to hold the cash,
right, instead of spending it, because we have a financial planning model in the
background that tells us we're going to need cash in three months. If you borrow today
and spend it, you're going to need to borrow again. The hedging is gone, right? So
that's why it's liquidity that is a substitute for hedging. You need to hold cash if you want
to hedge in the right way.

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Professor Heitor Almeida and Stefan Zeume

And, as we're going to see, that's going to be a general principle we're going to learn in
this lecture. Okay, the company has to hold the cash. And, of course, that is going to
introduce potential risks. You have to invest in a safe asset, right? Because you want to
make sure you're going to have the money. So, you shouldn't be buying risky equity, for
example. The safe asset is likely to produce a low rate of return. You're going to pay a
liquidity premium, right? The interest payment that you receive on your safe asset, it
may be low but it's taxable, so there's going to be a tax deal, right, that you have to take
into account. And finally, I don't want to take for granted that the company will keep the
cash. Once you put the money in the company, the CEO may be tempted to spend the
cash instead of hoarding it. So that may introduce problems as we already discussed it
in this course, cash can burn a hole in the pockets so companies could be tempted to
overspend. All right, we talked about this when we discussed the payout policy for
example, right? Because of all of these problems, hedging with liquidity is also going to
be imperfect.

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Professor Heitor Almeida and Stefan Zeume

Let me give you another example. And this is a really cool one, I think. That's actually
going to show you why I choose December 14 for the Russian example, okay? So, now
we go back to our US company that needs to make that rouble payment, right? It's in
December 15, so it's in one year. And remember that the company's concern is that the
roubles may appreciate relative to the dollar, so the company is proposing to enter a
forward contract at that amount that guarantees a payment of 3.4 whatever, right? In
one year, you got the idea, we did this already.

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Professor Heitor Almeida and Stefan Zeume

Let's think about a situation when the forward was not available, which is totally possible
for smaller countries, right? If you have a payment that is due in a longer time period, or
maybe, because of settlement risk you may not be able to buy a forward contract. So,
what the company can do is to buy roubles in the stock market. You can buy the roubles
today. The same idea as the interest rate example. Instead of buying roubles tomorrow,
you can buy them today. That is also going to eliminate your exchange rate risk, as
we're going to show next, right? If you look at the table that I gave you from the
Financial Times, the current exchange rate is 55.667. That's the current rate at which
you could buy roubles at December 2014. So now let me ask you this question. What
does the US company need to do with the roubles? Think about that.

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Professor Heitor Almeida and Stefan Zeume

It has to invest in a safe asset, but the asset has to be in roubles. If you have roubles
and you changed them back into dollars, when that year comes you're going to have to
buy roubles again, so it didn't work, right? In this case, the hedging position requires you
to hold cash in roubles. I hope you got that answer.

Let's develop that, how would that work? We have to think about what the interest rates

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Professor Heitor Almeida and Stefan Zeume
were. So, at that time, the 1-year interest rate on a Russian government bond was
16.8%, while the rate on a 1-year US T-bill was just 0.2%. T-bill rates has been very low
in the US, as you probably know. So how many roubles does the company need to
buy? That's what this equation is doing here for you. You need 200 roubles in one year,
right? So, if you invest at 16.8%, that means you're going to buy 171.244 million
roubles, right? So, you don't have to quite buy 200 because you can invest in roubles
and you're going to earn the interest, right? So that's the amount, a simple discounting
problem.

So, that money turns into 200 million roubles in one year. Right, how much does that
take to buy that today given the current exchange rate, which is here? That's going to
take you 3.076 million dollars. So, it's approximately 3 million dollars, right? If the
company does this transaction, think about this, your hedged against exchange rate
risk. You changed dollars into roubles today. You hold the roubles, right? In one year,
you can use the roubles to make the payment. You're done. Again, liquidity substitutes
for hedging, right?

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Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

There are a few things here that you may be worried about. The first one is not a
problem, all right? The amounts are different. So now we are spending 3.076 today
instead of 3.082 tomorrow, as we were doing before with the forward contract, right?
3.082 is the amount you're spending if you're hedging the risk with the forward contract.
Is this the same amount? The answer is yes, because if you had invested the 3.076
today in a treasury bill, you would get exactly 3.082 tomorrow, okay? So, that's how I
put the numbers actually.

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Professor Heitor Almeida and Stefan Zeume

What I used here is the notion of interest rate parity. I actually assumed that the interest
rates where such that interest rate parity exactly worked. Essentially what the interest
rate parity means is that the relationship between the futures and the spot rate has to be
the same as the relationship between the interest rates on two different currencies. All
right, this is not really a topic of corporate finance, but I want to mention it here just to
clarify this example, and the idea is that investors should be indifferent between
investing in dollars or investing in roubles. If investors are perfectly indifferent, then
interest rate parity should work.

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Professor Heitor Almeida and Stefan Zeume

The problem is, of course, the real world is always more complicated than our example,
right? The actual one-year Russian government bond rate was not 16.8%. I made up
that number, I was cheating, okay? The actual rate was 15.6 in December 14. So, in
order to have 200 million roubles in one year, the US company would actually have to
spend more money. It would have to spend a little bit more money, which then, if you do
the math, that would be equivalent to $3.109 million, which is actually going to be more
than what you would have spent with the forward contract. So, hedging with liquidity is
going to have this cost, okay?

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Professor Heitor Almeida and Stefan Zeume

That's not the end of it. Now comes, actually, the most interesting discussion. That's
why I have the picture of the Russian government there, right? Let’s think about what
was happening in Russia at the end of 2014. Why was the Russian one-year rate, 17%
is extremely high, right? For a one-year government bond rate. What was going on?

What was happening is that Russia was in the middle of a currency crisis. On

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Professor Heitor Almeida and Stefan Zeume
December 15th of 2014, as this actually comes from an article from The Economist, the
currency lost 10% of its value in one day. It had already lost 40% on that year, so what
the central bank did is increase the interest rates sharply to try to calm the market. But
there was desperation according to the economists, okay?

So, we are in the middle of a crisis and my hedging strategy seems very smart, but what
I'm proposing is that the US company is going to invest in Russia. What's the problem?
The problem is that Russian bonds were probably not risk free at the end of 2014, right?
The US company maybe eliminates currency risk by doing that, but now you're exposed
to significant credit risk. You have Russian bonds. Russian bonds at that time were a
very risky security, probably have a low credit rating. We talked about credit ratings
already, right? So that is going to create significant credit risk. Currency risk turns into
credit risk. So, again, that's another problem of trying to use liquidity to hedge, you may
not have the right asset, the safe asset that you need to get a perfect hedging strategy.
Now the company needs to think about, is it really worthwhile hedging using Russian
bonds or not? And the answer is not obvious, right?

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Professor Heitor Almeida and Stefan Zeume

So that's the summary. Liquidity is always a possible alternative. It's always an

alternative. Theoretically, at least, you can always think about a liquidity alternative, but
you also have to consider the cost, okay? Liquidity will typically come with additional
costs and risks. There is going to be a cost of carrying cash, there may be interest
payments that are taxable. Interest parity may not hold if this is currency risk. And
finally, as we discussed, you may introduce some credit risk in your strategy, which you
have to think about to make sure that it's really worth using liquidity to hedge, okay?

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Financing Investments and Managing Risk
Professor Heitor Almeida and Stefan Zeume

The bottom line, it's always difficult to give overall conclusions, but I think here the
picture is pretty clear. The bottom line is that if a derivative is available, my guess is that
it will probably be safer and cheaper, think about the Russia example. You could go in
the forward market with an international bank that is a fairly reliable counter party and
write a forward contract. You're not going to have to hold Russian bonds, etc., right? So
that might be safer. It may be also be cheaper, because you don't have the other cost of
holding liquidity. But in some cases, a derivative is not available. That's the commercial
paper example, right? In that case, the best we could do is to have an imperfect hedge.
And it seems very straightforward to borrow today instead of waiting for tomorrow. So,
in that case, liquidity may be a better tool. So, I want you to always think about liquidity,
but remember that if the derivative is available, it might actually be the way to go.

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Professor Heitor Almeida and Stefan Zeume
Lesson 1-6: Bilateral Contracts

Lesson 1-6.1. Bilateral Contracts

We're now going to talk about an alternative that companies have when they want to
hedge input price risk. The right hedging strategy depends on the particular risk that you
want to hedge. We already learned that when we're talking about the currency risk
example and the interest rate example. All right? So, now we're going to talk about
another risk which is input price. So, let's think about a company that makes engines
and the engines use steel. So, this company for whatever reason wants to hedge the
fluctuations in the price of steel. Perhaps, it doesn't want the compensation of its
executives to depend on the price of steel so, it wants to eliminate the impact of
fluctuation in steel prices on the bottom line. I got some data in October 2016 when I
was preparing these notes, the price of steel coil was $497/ton, okay? What the
company could also do at that time is to go to the Chicago Exchange or to the London
Derivatives Exchange, to buy a futures contract on steel coils. And we have the July '18
futures price at that time was $532/ton.

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Professor Heitor Almeida and Stefan Zeume

Here is a picture of a steel coil if you don't know what a steel coil is. That's the basic
way that steel trades in financial markets and in the real world, right? So that's the
picture.

And here is the key idea. Rather than opening a futures position, the company has
another alternative. We choose to write a bilateral contract with the supplier of this deal.
This is going to be similar to a forward contract but it's also different because this
corporate involves a real input. The contract again is a piece of paper just like a forward.

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Professor Heitor Almeida and Stefan Zeume
The contract is going to specify quantity and price for a certain period in the future. So,
for example, you can write this contract saying that you're going to buy 10,000 tons of
silver, for example, in July 2018. When that time comes, your supplier has to provide
this to you, and you can also guarantee the price. You can predetermine the price in the
contract. When companies do that, we call that a purchase obligation. This name comes
from the fact that the company that writes a purchase obligation is obliged to buy the
steel when July 2018 comes. And it's also true that the supplier of steel has to fulfill the
contract, right? Otherwise, there are legal consequences.

Okay so, what's the difference right. So, now we have the future contracting the
exchange, we have the purchase obligation. What are the differences between the
purchase obligation and a futures contract?
The first difference is that the purchase obligation price is not going to be a market
price, right. It's that contractual price which is subject to negotiation, so you're going to
have to call your supplier, and negotiate the contract, what price are you going to put
down in paper?
The purchase obligation does not require a buyer though to set up the margin account.
Remember, the bounced example that we talked about earlier in this lecture to open the
futures positioning in Chicago, our US company had to set up a margin account with the
exchange. The purchase obligation is like a forward, there is no cash exchanged today,
it's just a piece of paper.
Finally, the purchase obligation is going to be subject to settlement risk. because again,
now we're back to a bilateral contract, right? Before, we had the forward that was
between a company and a bank. Now we have two companies. If one of the companies
doesn't fulfill its obligation, the purchase obligation is useless, right? So again, we're
going to have settlement risk.

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Professor Heitor Almeida and Stefan Zeume

What does this mean? In terms of negotiation, the problems that companies face is that
the PO price might actually turn out to be higher than the future price, right. Your
supplier may have a lot of bargaining power. You may be the only player in the industry.
For example, the industry may be concentrated. Your supplier may be able to extract a
high price. Second issue is though is that the PO can be used for financial reason,
Right? You might have a situation when a firm is in cash constrained, if you want to go
to Chicago to open a future account, you have to deposit some cash, right? The
company may not afford to do that. You may be better for a company that is very
financially constrain to enter the zero-cost purchase obligation if you want to hedge your
input prices. And finally, because of settlement risk, that something we have to take into
account, right? Your supplier may default on the contract and that has to be part of the
consideration revenue.

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Professor Heitor Almeida and Stefan Zeume

However, the main reason why I'm talking about purchase obligations is not necessarily
because of steel now. I mean, now companies can go in the futures market and buy
steel coil futures. They definitely have that alternative. But there are many cases in
which the futures contract is not going to be available. Right? For example, a company
may need the specific version of steel, right? The steel coil is a generic contract, right.
But maybe you want a specific kind of steel. You want the steel to be transformed in a
specific way. Right? Or maybe you need another commodity that is different from steel.
And that's not trade in a future exchange and there many examples. There are only a
certain number of commodities that you can trade in a future exchange. Many other
wants are not trade it. For example, even this generic version of steel futures that we're
talking about here, now they are available. But they were not available prior to 2008. So,
there was a time when companies could not use steel futures to hedge. Okay?

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Professor Heitor Almeida and Stefan Zeume

And now we're going to bring back our researcher. I actually wrote a recent paper on
purchase obligations, that looks at what happens in a time when companies cannot use
futures, what happens to the demand for purchase obligations.

How do companies trade off futures and purchase obligations, that's the paper that is
summarized here with Michael Walters. What we show is that one reason why
companies switch from futures into POs is when they become financially distressed.

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Professor Heitor Almeida and Stefan Zeume
Remember the margin account example, right? One problem with having a futures
position is that it requires a cash deposit. So, when companies become financially
distressed, it may become too expensive for them to have a future position. They switch
into POs. And then the other we did is we followed up on this idea that there was this
big change in the market in 2008. For companies that heavy users of steel, right. They
hedging opportunities changed a lot right at the time of 2008, because before that they
could not futures. After that, they could. So, what we're showing in our paper is that,
there was a very strong substitution from POs into futures right after 2008 for the right
companies. You can actually measure in the data which companies are heavy users of
steel and which companies are not.

What we show in our paper, summarized here in this graph. The blue line is for firms
that have users of steel, and you can see that right after 2008, these companies
significantly decreased their usage of purchase obligations, while companies that didn't
had smaller steel exposure actually ended up increasing their usage of purchase
obligations. What this shows is that companies do substitute futures for forwards. Future
for purchase obligations when futures become available in the market. Right?
inappropriate in a specific scenario.

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Professor Heitor Almeida and Stefan Zeume

So, the bottom line, I hope that this idea is sinking in, right. The word hedging usually
brings to mind a futures contract that trades on an exchange, that's probably what
you're thinking about when we started the lecture. That's definitely an important
alternative, but in practice companies are often going to use alternatives, too. Such as
POs, such as liquidity, either because futures may not be available, or because the
future may be as our PO paper shows, for some companies, futures are not appropriate
because their cash constraints are too strong. They have to go to POs instead of
futures. And there are other examples of that in that real world. So, it's very important to
think of hedging more more broadly not only be derivatives but also these alternative
tools.

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Professor Heitor Almeida and Stefan Zeume
Lesson 1-7: Operational Hedging

Lesson 1-7.1. Operational Hedging

Let's talk now about operational hedging, which is another option that companies have
to manage risks when futures may not be available. The idea is that companies can
hedge risks by changing their operations. Let me give you a specific example of a
Japanese company, Honda. It makes cars. And about 50% of its car sales happen in
the US.

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So, let's talk about Honda. Unfortunately, that's not the Honda car you can buy in the
market. But there are others you could buy, right? But we are thinking about the
prospective from the point of view of Honda, right?

It's a Japanese company, 50% of its car sales are in the US. What is the specific
currency risk that Honda faces? So, I want you to think about that. What is the risk that
Honda faces by selling cars in the US and producing cars in Japan?

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The risk is that Honda's costs are going to be in Japanese yen if it produces cars in
Japan. Then you're going to spend money in yen and you're selling dollars, so if the
dollar deprecates relative to the yen Honda's profitability is going to decrease.
Irrespective of how many cars it sells. So even if people love Honda cars, Honda's profit
is going to depend on currency risk, right? It depends on what happens to the yen dollar
exchange rate. And maybe Honda doesn't care but maybe Honda wants to eliminate
that risk, right? If the company wants to mitigate or eliminate the currency risk, how
could it do it? That's what we're going to think about in this lecture.

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First option, of course, is futures. You can definitely buy and sell future or forwards even
on yen dollars, right? What is the position that Honda needs to take? Honda, in this
case, needs to short dollars. Again, remember what you're looking for is the zero net
gain right? So, Honda needs to make money if the dollar depreciates. The way to make
money with dollar depreciation in the futures market is by selling dollars. You ought to
be short on dollars, right? But now the problem is you don't know exactly what's the size
of the position, right? This is a bit more complicated than our, the examples we had
before. Those examples we had a specific amount, $200 million for example. Now, the
amount of hedging that Honda needs depends on how much it expects to sell in the US,
so there's going to be some imperfection.

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Professor Heitor Almeida and Stefan Zeume

Let's think now about liquidity. That's another tool that we talked about and I'm going to
ask you another question this time just because I really want you to get to think about it,
instead of just hearing me talk, okay? So, liquidity, right? That means that Honda is
going to borrow money in one currency and invest in another currency. Very similar to
the Russian example, right? I want you to think about, what is the position that Honda
will need to take in this case?

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Professor Heitor Almeida and Stefan Zeume

The position is that Honda has to be short dollars. Again, right, what you want is you
want to make money if the dollar depreciates. The way to do that using debt and cash is
going to be to borrow money in US dollars, and then invest in yen. You have to invest in
yen for the hedging to work, because if you do that and the dollar depreciates relative to
the yen, the company is going to make money in this trade. The value of dollar
denominated debt decreases, meaning that Honda is going to have additional profit
from having engaging these transactions. This will again mediate what might happen to
the exchange rate, how the exchange rate may affect the profits coming from car sales
in the US.

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The other possibility for Honda is to do what we call operational hedging which is
definitely a very important and realistic alternative for companies in the real world,
especially large companies. Right, what Honda can do is to move production to the US,
right? The big problem is that if the dollar yen exchange rate changes, right, the
company's profit is going to change together with the exchange rate, right? But if costs
and revenues are both in dollars, right? If your costs are in dollars and your revenues
are also in dollars. So now the company's going to have what we call a natural hedge.
For example, if the dollar depreciates your revenues go down, but your costs also go
down in the end, right? So, the company is naturally hedged, not natural in this case, it
involves the decision of the company. So, the word natural may be a little funny. The
company has to make the voluntary decision to move production to the US. After you do
that, you're going to be naturally hedged.

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So, let's gather evidence. This is not a paper. I just went out and looked at the financial
reports for Honda trying to figure out what does Honda actually do to manage its
currency rates. So, from the annual report, companies have to report in their 10-Ks, in
their annual report to investors. They have to tell investors if they are using derivatives
for hedging purposes. And what Honda says is that they do not hold any derivatives
designated as hedges for the years of 2014, 15, and 16. So they don't actually use the
futures market to hedge in this case. Might seem surprising, right? What are they
doing?

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Other thing we can do is to look at the debt structure. That was one of the topics of our
module two. We didn't look at foreign borrowing, but we looked at other aspects like
banks and bonds, commercial paper, etc. right? You can also get data on the currency
that accompanies debt security is. That's what is in this table here. That's from Honda
from the June 30th 2016 financial statement. What you see is that Honda does have US
dollar denominated debt right? So, there is a fairly large issuance here, it's 1 billion yen,
right, of a US dollar medium term bond, okay? So, at a 2.5% interest rate, so Honda is
borrowing dollars. And it's probably holding some cash in the end as well but the
evidence suggests that Honda is in fact using the debt markets to hedge its currency's
rate. Right, that's exactly what Honda should be doing. It should have some dollar
denominated there.

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Finally, let's look at the operational data. Again, there is a lot of data these days about
companies we can try to use to figure out what they're doing in practice. This is Honda.
As I said, a huge fraction of Honda's sales comes from North Americas. So here you
have revenues right, for example in 2015, approximately half of Honda's revenues came
from the US market. Yeah, it's mostly Japan and US market but also other countries in
Asia, right? That comprises most of the sales of Honda. Right, so it's $7 billion. Well,
this is yen. So, I'm not going to try to guess the currency here. But you can see its half
of the total revenues, okay? But look assets, these tells us in which country has Honda
located its assets, its investments, intangible capital for example and what you see is
that there is significant amount of assets in the US as well right? It's not perfect
evidence, this is not cost, right? It's assets but this data does suggest that Honda
moved some of its operations to the US as well, right? And it moved some operations to
Asia, right? Similarly, it has a period or significant amount of sales in other Asian
countries. It moves some of the operations to Asia as well, right? We know, in fact, we
didn't have to get this data. We know that Honda produces cars in the US, right? There
are plants around the US.

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So that's the summary for the case of Honda. The company actually decides not to use
currency derivatives. Why? Maybe because the Honda has a natural hedge. Currency
risk may not be that much of a problem for Honda, because since it produces cars in the
US It is less concerned with the possibility that the US dollar may depreciate. And in
addition, it has debt in dollars. Having borrowed in dollars also going to have a hedging
role for Honda if the dollar depreciates that debt is going to decrease in value so Honda
makes money in the end. So real world companies go beyond derivatives. They use
other alternatives even when derivatives are available. That's what Honda's example is
showing.

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Lesson 1-8: Currency Risk and the Cost of Capital

Lesson 1-8.1. Currency Risk and the Cost of Capital

Let's go back now to a topic that we talked about in corporate finance one, which is a
company's cost of capital. We've been talking about this notion of currency risk, right?
For example, let's go back to Honda. Honda is a Japanese company that is also
investing in the US. How should Honda adjust its hurdle rate, its cost of capital, when it's
evaluating whether to open a new plant in the US or not. Good question, right? What
about the plant in Africa? What if Honda decides to produce in Africa? To take
advantage of cheap African labor for example, right? That hasn't happened yet, but
maybe it will, right? How should Honda adjust its cost of capital? That's the question
we're going to talk about in this topic, in this lecture.

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Let's start with numerical example. So now we have a financial manager of a US

company that identified an investment in the UK and this investment requires you to
invest a 100 million pounds today and it's going to give you 110 million pounds in one
year. This investment has similar business risk as the US business. It's just like your US
business, except that you're moving it to the UK. Think of it this way, the cost of capital
for the US company, you estimated it for domestic projects, it's 8%. The question is
what is the net present value of this project? You are investing in the UK you are US
company, you have the US company's cost of capital. How should you compute the
NPV of this project?

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What the company may want to do is to express the cash flows in dollars. Instead of
thinking in pounds, can we think in dollars? And the answer is yes, right? What the
company can do is to use the futures market. You're going to receive the 110 million
pounds in one year, so what the company needs to do is to sell pounds, right? You go
to the futures market, you short pounds, 110 million at the current future rate which we
figure out already in our lecture, right now when I was preparing this lecture the future
rate was 1.2373. Let me also give you the current exchange rate of dollar pound is
1.2173 and we're going to use those two numbers, right?

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Let me create a timeline here then I'm going to ask you a question. So here we have all
the actions that this company's taking, right? You'll have to go to the future's market,
right? But you are also buying pounds to investing in the UK project, so you're buying a
100 million pounds at the current exchange rate, right? You're investing this money in
the UK and then you're opening the futures position. When next year comes, you're
going to receive 110 million pounds, because that's your investment, right? And you can
use those pounds to close your future position, you're going to go to the futures
exchange and close that position, right? What it means is that, what you're going to
receive is exactly the amount that was written in the future of contract. The future's
exchange is going to give you $136.1 million in exchange for that, right? So now you
know that you invested $121.73 million today and you receive $136.1 million in one
year. Now let me ask you a question, now comes the question, what is the right
discount rate for this project? And remember the discount rates for US projects is 8%.
What should the company discount cash flow then?

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The answer is that it's the same discount rate. Let me do the math first just to clear get
that out of the way and then I'll talk about why, right? So essentially what I'm going to do
is we are going to discount the dollar cash flows, right?. So first we are changing the
cash flows to dollars. And remember, to do this we have to use the future's market,
right? We essentially use the future's market to eliminate currency risk. Once you've
done that, you can discount the cash flows at the same discount rate. So, the NPV if
you do the math by now it should be trivia for you is $4.29 million.

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Let's talk about why, why are we discounting at the same rate? Let's think about two
questions, what happens to the project if the exchange rate goes to 1.05? It is just an
example, whatever number I put here, the answer is nothing. The company is hedged,
right? You are going to make or lose money in the future's positions. You are going to
make money or lose money in the same way in the project, right? You have achieved
the zero net gain that we always talking about. Okay, nothing happens to the company,
the company is fully hedged. What happens to the project if the cash flow is 100 million
instead of 110? Well, unfortunately now you're going to have a negative NPV, right?
You are not able to eliminate the business risk. Yes, you have business risk. What you
don't have any more is the currency risk. The currency risk is gone. Your profits no
longer depend on currency. They only depend on whether your project is successful or
not.

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That's why we should discount at 8%. The project has no currency risk left. It only has
business risk. All the risk comes from the business, right? The general principle here is
that, if a currency risk is fully hedged, the cost of capital for foreign projects should be
the same as the cost of capital for domestic projects. The fact that you're investing in a
foreign country, does not mean you should use a different cost of capital. As long as the
business risk is the same of course, right? The reason we can use 8% in this case is
because we assumed that the business risk was exactly the same. That may not be the
case. You have to find the right discount rate for each business. That's a topic we talked
about a lot in corporate finals one. Once you've done that, if you had currency risk,
you're done, you don't have to worry about it anymore.

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The world would be beautiful, right, if that was the end of it. But of course, the problem
as we've been talking about in this lecture, is that hedging is not trivial. You want to
achieve that zero-net gain, but in many cases, you’re not going to be able to do it.
Hedging is going to be perfect for many reasons, right? And it's very important for us to
think about what happens to the cost of capital when hedging is imperfect. How does
unhedged currency risk affect the company's cost of capital? So, this is one of the big
questions in modern finance and I don't think we have a clear answer yet, but there are
some important principles and ideas that I wanted to discuss with you, so you have a
better handling of this question in the real world. It is a difficult question. It doesn't have
an easy answer.

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Let's start with Honda, right? As we discussed it, Honda has dollar currency risk, right,
because it sells cars in the US. And Honda may be perfectly hedged, we don't know that
exactly, but let's say that are in perfect hedging despite the operational hedging and
despite the dollar of the nominated debt, right? There might be some residual of
currency risk. How would that affect Honda's cost of capital? We are going to have to go
back to Corporate Finance I, and remember this very important idea that, what matters
for a company's cost of capital is what we think of as systematic risk. It's measured by
the Beta, right? The Beta is going to tell you how the company's value is going to
fluctuate with fluctuations in the market. So, if you want to think about currency risk, we
have to think in terms of Beta. We have to try to answer this question, how does
currency risk change Honda's Beta, right?

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Would the US currency risk necessarily increase Honda's Beta? That is what you might
be what you are thinking, there is more risk Beta should be higher. That's actually not
obvious as we are going to learn now. Beta depends on market risk, right? So, it is
going to depend on whether the cash flows and stock returns become more cyclical or
not, right? Once you invest in a foreign country. If they do, then Beta and the cost of
capital should go up. If they don't, then maybe you're going to have a lower Beta. It
might be safer, okay?

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So, this is the framework that I propose, for us to think about this. It's a very simple
framework where we're trying to divide. And what I tried to do here is similar to the
example we've been talking about, dividing risks into business risks and currency risks.
Every investment is going to have at least these two, right? So, there is the business
risk, which is that you might sell more cars, or you might sell less cars. And if you think
about Honda for example, this risk should be highly correlated across US and Japan,
right? If there is a boom in the world economy, right you're going to sell more cars in
US, you're going to sell more cars in Japan as well. It might make sense to assume that
business risk is very similar no matter whether you're selling cars in US or whether
you're selling cars in Japan. Down, down, up, up. What about currency risk, though?
That's a whole new ball game, right? Now we have to think about how does the
exchange rate yen to dollar moves when there is a boom in stock markets, right? When
there is a boom in the world economy, what's going to happen to that exchange rate?
By the same token, what's going to happen when there is a recession, what's the
currency Beta, right?

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And then the answer is that whether Beta increases or decreases is going to depend on
the correlation between the exchange rate risk and the market risk, right? We have to
try to gather some data to think about whether the US dollar relative to the yen, whether
it tends to gain or lose value when there is an economic downturn.

So here is the graph that shows you the data. What you see in this graph is the US to
yen exchange rate, that's the blue line. And then on the red line, what I plotted is the

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return on the S&P 500. So that's how the market is doing, right? So, the blue lines show
the exchange rate, the way to interpret this is that if the blue line goes up, that means
the US dollar is appreciating, because the US dollar is buying more yen. So, what you
see earlier in the data in the early 2000s is that the US dollar was appreciating, right?
At the same time, when the stock market was going down there was the crash of the
internet bubble. So that would suggest that there is a negative correlation. However, if
you look more recently for example in the recent financial crisis in 2008 what was
happening is it was that the stock market is going down, but at that point the US dollar
was depreciating relative to the yen. More recently, the US dollar has been appreciating
together with the stock market, so now it looks like there is a positive correlation, right?

But if you go to the very end, I'm not sure you can see, but in the very end of the picture,
you will see that, again, we seem to have a negative correlation. The US dollar is,
again, depreciating, but the stock market is going up, right?

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So really the answer we got is that it's not clear how the yen to dollar exchange rate
moves with the market, right? So, what we make of the currency beta? An answer that
you see here is we might as well assume that the currency beta is zero. Right, there is
no systematic relationship between the US/yen exchange rate and how the stock
market is doing, right? In addition, if we assume that business risk in Japan is the same
as business risk in the US, it might make sense for Honda in our case to end up using
the same cost of capital. Even if there is unhedged currency risk, right under these two
assumptions the unhedged currency risk would not affect the cost of capital. So that's
the summary here, right?

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In this case unhedged currency risk doesn't seem to be having a big impact on the cost
of capital simply because the currency risk seems to be uncorrelated with market risk.

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Lesson 1-9: Adjusting the Cost of Capital for International Projects

Lesson 1-9.1. Adjusting the Cost of Capital for International Projects

We just talked about Japan, right. We talked about how currency risk changes the cost
of capital for a Japanese company investing in the US. Let's talk about a different
example now, which you might be thinking about. What about an emerging market,
right? So here you have Brazil where I'm from, right? Suppose we have a situation now
where a US company is considering an investment in Brazil, all right?

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Let's say that this investment has a similar business risk as the US business. So, for
example, it may be a technology company that is expanding into the Brazilian market,
selling the product in the Brazilian market, all right? And suppose that there is some
unhedged currency risk, of course, what this company should be trying to do if it's
concern with the currency risk is to find ways to hedge. But as we discuss it in the
Russian example, when you investing an emerging market, it might be more difficult to
fully hedge the currency risk. Because the futures market might be underdeveloped,
and holding equity is costly, and so and so forth, right? So, suppose there is someone
hedge a currency risk, what would be the cost of capital for the Brazilian project? And
here is the benchmark. The benchmark is again, cost of capital of 8% for the US, using
our model that roughly corresponds to a beta of one, right. It's a risk-free rate of 3%, a
risk premium of five so this is a US project that has a beta of one. What will be the cost
of capital for the Brazilian project?

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This framework that we talked about is always works, at least that we know, that we can
think about business risks and currency risks and those are going to be the two risks
that are going to affect the beta. And again, remember, the crucial thing is to think about
how the business risk and the currency risk depend on the overall stock market, right? If
there is a boom in the stock market, right, in the US, what's going to be happening to
profits of Brazilian investments? If there is a recession, if there is a decrease in the US
stock market, what's going to be happening to the Brazilian profits? Of course, Since
our US business has a beta of one, we know that the US business is going to be
cyclical. Profits are going to be going up and down with the stock market. And then we
have the currency, right? What's going to be happening to the emerging market
currency as a function of the stock market, right? So, think about the intuition first,
before we show the data or numbers, right? What our intuition would suggest, I think, is
that investing in emerging markets should be riskier, right? So, what our models should
tell us is that it's risky to invest in emerging markets, so our beta should go up. Your
cost of capital should go up, right?

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That would be true, of course, if the first condition is that investing in emerging market
has to be more cyclical, right? So, if the stock market is doing well in the US, then the
stock market in Brazil is going to be doing even higher. Brazilian profits are going to be
even more cyclical than US profits, okay? And that is usually the case even though
we're going to talk about a problem at the end.

And then we have the currency risk, right? So, what happens to emerging market

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currencies? And what is going to be clear? If you look at data, is that usually what
happens is that emerging market currency stand to depreciate in bad time, right? So, if
you're investing in Brazil, you're making profits in Brazil. There's a recession that the
emerging market currency is going to depreciate, right? So, what's going to happen is
the profits of your company here in the bad state are going to become even lower,
right? So, the currency risk is going to increase the beta for the US company investing
in Brazil. Okay?

So, let me show you an example using the Brazilian data. Here what you have, is the
blue line is the amount of dollars that the Brazilian Real buys, right? So, if the blue line
goes down that means that the Brazilian currency is depreciating. The red line again
shows the US stock market. And look, and the picture now is very different from the
Japanese picture, right? What you see is the blue line is almost perfectly tracking the
red line. Every time the US market goes down, the Brazilian currency depreciates
relative to the dollar. Every time the US market goes up, the Brazilian currency
appreciates relative to the dollar. So that is really what that data are telling us.

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So, if you think about cross-border investments in emerging markets, what we saw is
that the business beta will probably be greater than one, right? Because emerging
market profits are more cyclical, and the currency beta is now positive, right? Because
the emerging market currency is depreciating in bad times. What these effects would to
do is they would make the US investment in Brazil risky, right? So, they would match
out intuition perfectly. These effects should increase the cost of capital for the US
company investing in Brazil, so the Brazil beta should be greater than the US beta.

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One way you can capture this in the capital asset pricing model is by adjusting the
CAPM. So, we call this the adjusted CAPM which is sort of a long formula, right? So,
what is the Brazil beta for the US company would be the US beta, which in this case is
one times the beta of the Brazilian market relative to the US market. If the emerged
market is more cyclical in this currency beta is positive as we sought, then what will
happen is that, the Brazil beta will be higher, right? And the CAPM will get the right
intuition, right? That we started with, the emerging market investment should be risky.

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Great, the problem is I tricked you So I stopped the data in 2010. Let's see what
happens, if I moved, if we look at the Brazilian data in the last five years. So, clearly
what you see in this picture now is that there is the Brazilian currency is no longer
moving together with the US stock market. It's moving in an opposite direction. In the
last five years, the US market has done well as we know, right, we are in 2016. The last
five years have been good for the US stock market. But the Brazilian currency has been
depreciating. If you’re looking at the business data you get a similar picture. The
Brazilian stock market has been doing poorly, even though the U.S market has been
doing great, right? So now if we think about our model, what happens is that the five-
year data. And remember, to compute data we usually have five years of data, so the
model might suggest. That the business beta is negative and the currency beta is
negative, so it seems that Brazil has suddenly become safer.

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So, here's a question for you. Has Brazil really become safer in the last five years or
not? And the answer is that there is a big crisis in Brazil, right? It doesn't seem Brazil is
a very safe place right now. There was a political crisis, the President was impeached,
right?

So, we would probably be making a mistake if we had assumed that Brazil suddenly
became safer, right? The low returns are due to the political crisis in the country, that

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creates the problem for international finance, the theory tells us that data should do the
job for us but data is really failing this case.

What people have done in practice is to try to make adjustments to this CAPM model
that we just talked about. And the model that is most commonly used in practice is what
is called in the industry the Goldman model. As I have a picture of Goldman Sachs
headquarters here for you. It's called the Goldman model because it was invented at
Goldman Sachs when people were initially thinking about how to adjust cost of capital
for international project.

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This is how the Goldman model works. What you do is, you adjust the CAPM by adding
what we called the sovereign risk premium, that comes from the bond market. It's the
spread between the Brazilian sovereign bond and the US risk-free rate. So, the
Brazilian sovereign bond is the bond issued by the Brazilian government to borrow
money in international markets. It's denominated in dollars, so it's in the same currency,
right? That spread in the data, that spread is going to reflect specific risks about Brazil.
So currently for example this is a time when the Brazilian sovereign risk is probably
quite high, what's happening in the market is the long-term Brazilian bond denominated
in dollars in October 2016 was the yields 6%. So, there is a 3% risk premium, if you
compared with the 3% risk free rate. If you invest in Brazil, all right.

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So, how would we use that in the model? Essentially, we have the Sovereign premium
to the cost of equity, or another way to implement this is to rather than use the risk-free
rate to use the yield on Brazilian long-term sovereign bond instead of the US treasury
yield on our CAPM formula. So that's what you have here. So, we would essentially be
using 6% instead of 3% for our risk-free rate and the beta, you can use the same beta
that we talked about before is the adjusted beta, where you would multiply the US beta
that reflects the business times the beta of the Brazilian market relative to the US
market. If you are wondering probably clear given out discussion for a fact. The market
risk premium we are using is the same one that we use in Corporate's Finance 1
Module 4, right? In this course we are using 5%, but some practitioner uses different
market risk premium as we discussed in Corporate Finance 1, you can go back and
review it if you want.

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So how would we implement this? The cost of equity for the company then, for our US
company investing in Brazil would be 6%, right? That's the big change. That's really
what the goal of my model is doing plus this beta. So, even if the beta is low, right?
Even let's say you get a beta of 0.7, which is counter intuitive, right? That's going to be
compensated by the sovereign risk premium. So, in this case, you would get a cost of
equity of 9.5% instead of lower than 8%. So, then a model is again consistent with our
intuition.

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But here's the problem, the Goldman model is a practitioner model, it's really not backed
by finance theory. The CAPM, the nice thing about the CAPM if you through an
investment course, is that the CAPM can really be justified using theory examples, it is a
very strong a model from the theoretical point of view. Whereas, the Goldman model is
what we call ad-hoc adjustment, okay? The best argument we have for the model is that
other people use it. So, that's why I'm teaching you this model hopefully though, the
research would show us how to make this adjustment in the more solid, the more
theoretical way, okay? There is also some evidence that the sovereign risk premium
captures the right risk because the sovereign risk premium predicts high sovereign
returns. And people are trying to follow up on this idea to try to find the version of the
Goldman model that can be justified by theory and beta. Maybe in a future class we'll be
able to talk about them.

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Lesson 1-10: Review and Graded Activities

Lesson 1-10.1. Module 3 Review

This module was about risk management. And we started by identifying right and wrong
reasons for hedging risks. So, remember, hedging is not about reducing risk. Hedging is
about choosing which risks to take. That's the key idea we talked about in this module.
We also talked about how companies can use forwards and futures to hedge specific
risks that they want to eliminate. We talked about specific positions that companies
have to take, which direction. And in particular, we emphasized that it's very important
to distinguish hedging from speculation. Speculation is the wrong way to go to a futures
market. It's the wrong reason to go to a futures market.

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And then we talked about what can we do when the target risks cannot be eliminated
using derivatives? There might be imperfect hedging, futures contracts may not trade,
so we talked about substitutes such as liquidity management. Companies can use cash
and appropriate borrowing positions in order to substitute for derivatives hedging. We
talked about which specific transactions do you want to enter? How to borrow in the
foreign currency, for example. Which cash to hold, right? We were very specific about
this. This is a very important idea for hedging, is that liquidity is a substitute for hedging.
Then we talked about bilateral contracts. Which is a very useful form of hedging for
when the risk that you're concerned about is related to prices of important input.

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And at the end we talked about a currency risk. And one issue we emphasized is that
companies can change operations to hedge risks, such as currency risk, specifically.
We talked about operational hedging in Honda, for example, moving production to the
U.S. is a way to address currency risk. This point is broader though. Company
operational hedging can be used as a substitute for futures and forwards as well. It's
another way that companies can eliminate, mitigate specific risks. And then at the very
end, we talked about the relationship between currency risks and costs of capital. Both
for the cases when the currency risk is fully hedged, in that case there is no effect on
the cost of capital. And then, when the currency risk is unhedged, we talked about the
difficulty, actually, of adjusting the cost of capital for international projects when
currency risk is unhedged. We've talked about models that practitioners used. But this is
really an area where I think our finest researchers and practitioners have to learn more
in order to improve our knowledge of how to adjust the cost of capital for international
projects.

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