Transcript ENTERPRISE RISK MANAGEMENT

ENERGY
INSURANCE
MUTUAL
19th ANNUAL
RISK MANAGERS
INFORMATION MEETING
The Westin Innisbrook Golf Resort
Tarpon Springs, Florida
February 27 - March 1, 2005
Neil
Doherty
Frederick H. Ecker
Professor of Insurance and
Risk Management at the
Wharton School
DOCUMENT HOW VOLATILITY AFFECTS
COPORATE VALUE
1. Risk increases costs of financial distress
(a). Ex ante: the prospect of distress can lead to conflicts of interest and
dysfunction decision making
(b). Ex post: distress involves transaction costs, loss of business
opportunities, increased cost of funding, etc
2. Volatile cash flows prejudice financing of new investments
Most firms prefer to fund with cheaper internal cash
Shocks to earnings can deprive firm of
3. Risk introduces noise into accounting and economic numbers. Lack of
transparency makes monitoring and valuation difficulties
Each reason might call for different risk management strategy
RISK INCREASES COSTS OF FINANCIAL DISTRESS
 Costs of insolvency
- Legal cost
- Regulatory costs
- Liquidation costs
Probability
 Solutions
- Reduce risk
(hedge insurance)
- Lower leverage
- Structured debt –
forgivable or reverse
convertible debt
- Contingent equity capital
Debt
Firm
Value
RISK INCREASES COSTS OF FINANCIAL DISTRESS
STRUCTURED DEBT TO REDUCE CREDIT RISK
(FROM CULP JACF)
FIRM VALUE
Modigliani and Miller
FIRM VALUE
D/E
D/E
D/E
RISK INCREASES COSTS OF FINANCIAL DISTRESS
LOWER LEVERAGE LOWERS NEED FOR HEDGES
 Many studies (Dionne; Doherty&Klefner/etc) confirm that firms
with lower leverage tend to hedge less
 After-event studies (Pretty; Doherty-LammTennant-Starks; GronWinton; etc.) : show that firms with lower leverage recover more
quickly.
 However, these studies show that leverage is only a problem
when firm value falls
 This points to the value of structured debt as a risk management
tool. Lowering of firm value triggers derivative which un-levers
the firm.
- Forgivable debt
- Reverse convertible
- Warrants
- Contingent equity
RISK INCREASES COSTS OF FINANCIAL DISTRESS
STRUCTURED DEBT TO REDUCE CREDIT RISK
(FROM CULP JACF)
 Sonatrach – Algerian state owned oil producer
 Problem – Servicing Floating Debt – High Credit Risk – High
Interest Charges. The particular credit risk problem is that they may
not be able to meet high interest charges when oil revenues fall.
 Solution – Issue “Inverse Oil Indexed Bonds” – Raised Credit
Quality And Lowered Cost Of Debt. Sonatrach wrote a 2 year call
on oil with a strike of $23. Thus they would have to make payment
if oil prices rose above the strike. In turn the counterparty (Chase)
wrote a spread on oil prices (i.e., wrote a call and put) to the
creditors who bought Sonatrach’s debt. Thus the investors had a
long position in volatility.
- Lowers cost of debt to LIBOR plus 100 basis points
- Sonatrach yields some upside on oil to counter party
- Investors accept long puts and calls – willing to accept this play on oil
prices
SONATRACH
Credit risk if oil prices fall
Floating rate notes
@ LIBOR+1
Writes 2 year call on
oil – strike $23
INVESTORSSYNDICATED
BANKS
Writes 7 year call on
oil – strike $22
Writes 7 year put on
oil – strike $16
COUNTERPARTY
RISK INCREASES COSTS OF FINANCIAL DISTRESS
REVERSE CONVERTIBLE DEBT
 Convertible debt but conversion option held by firm
 Exercised when firm value falls
 Advantages
- Anticipates workouts in which debt replaced with equity
- Avoids bankruptcy costs (which would fall on creditors)
- More closely aligns incentives of creditors and shareholders
- Shareholders now have more stake in downside
- Managers more averse to risky projects (no default option)
- This will benefit creditors
 User ING.
 Form more common in Europe
FUNDING POST-LOSS INVESTMENTS
 Graph shows the ranking
of seven projects
- With low cost internal funding
- With high cost external funding
20
15
 With internal funding all
seven projects have
positive NPV
10
- Total value created = 97
0
 With external funding
projects 1-4 have
positive NPV
- Total value created = 35
Internal
funding
external
funding
5
-5
-10
1 2 3 4 5 6 7
FUNDING POST-LOSS INVESTMENTS
(CONTINUED) MERCK
 Merck was one of the first users of this RM strategy
 Research based Pharmaceutical company
- Investment in R&D
- Bringing new drugs through clinical trials and then to market
- Predictable (?) investment budget
 Problem – large exposure to FX risk. Worried that sudden FX
loss would deplete earnings. Thus Merck would lose cheap
funding for R&D, etc., and would have to cut back on new
investment
 Solution – hedge R&D risk to protect cheap funding
- Note transaction costs of FX hedge fairly low
- Would this strategy be as attractive for product liability risk where
insurance transaction costs are high?
FUNDING POST-LOSS INVESTMENTS:
SOLUTIONS
 Hedging
- Secures cheap internal funding source; example see Merck
 Contingent equity
- Example 1. Insurance firm fearing catastrophe loss sell put option
on their own stock to counterparty. Provides cheap post-loss
capitalization. CATEPUTS
- Example 2. Cephalon drug company is taking drug through
clinical trials. If FDA approval, it will need source of funding to
develop the drug. Buys call options on its own stock.
- Example 3. Michelin keeps high level of capital as war-chest for
acquisitions. The cost of this capital is high and it can become a
target. Solution contingent equity
FUNDING POST-LOSS INVESTMENTS: A
RELATED ISSUE
 Apache oil (member of EIM)
 Problem is that is creates value through acquisitions that
are well priced and it has comparative advantage
 Hedging oil price risk allows it to lock in profit from
acquisition which it gives a comparative advantage in the
bidding process
 Hedge oil price risk with zero cost collar
 Also controls leverage to maintain financial flexibility so
that it can fund acquisitions as they arise
 Candidate for contingent equity?
RISK MANAGEMENT AS SIGNAL
 Risk management changes performance of a firm.
 Managed numbers can convey more, or less information
 Examples where signaling is important
- Outside investors rely on accounting numbers to value the firm. Do
“hedged” numbers convey more or less information
- The profit or share price of a firm depends both on factors under the
control of the managers and factors outside their control
- Managers of an oil company can control the rate of extraction but
not the oil price.
- If the firm hedges the factors outside the managers control, then the
remaining profit provides a better monitor of managerial
performance.
- Notice firm may be able to achieve the same goal by paying
executives with indexed options
RISK MANAGEMENT AS SIGNAL
CAN WE USE HEDGING MAKE EARNINGS MORE
TRANSPARENT INDICATORS OF VALUE?
Earnings = Base + Signal + Noise
Signal persists but noise transient
Investor cannot separate noise from signal.
How does investor forecast next period earnings?
Bt + (St + Nt)
earnings @t
(Bt + St)
earnings @t+1
+ (St+1 + Nt+1)
(Bt + St + St+1) + (St+2 + Nt+2)
earnings @t+2
NOISE HEDGING : FORECASTING EARNINGS
FORECASTING WITHOUT NOISE
Bt + St
earnings @t
(Bt + St) + St+1
earnings @t+1
RED LINE = EARNINGS
BLUE LINE = EARNINGS W/O
NOISE
Time
t
(Bt + St + St+1) + St+2
earnings @t+2
t+1
RISK MANAGEMENT AS SIGNAL
 If purged of noise, then earnings become more
transparent signals of underlying value
 Some evidence shows that when firms hedge, the
responsiveness of the stock price to earnings
surprises increases
 This leads to the interesting possibility that
- Increased transparency can INCREASE the volatility of the
stock price
- If so, then stock options convey option to make earnings
more transparent by encouraging managers to hedge noise
WHERE IS THIS ALL LEADING?
 ERM starts with fundamentals
- How does risk impact firm value?
- How can management of risk preserve value?
 Three broad themes developed here
- Risk affect the costs of financial distress
- Risk can impede funding of investments
- Risk affect the information conveyed to stakeholders
 There may not be one unified risk management
strategy that hits all these points
 But it does suggest framework for ERM strategy
BLENDING COST-OF-RISK THEORIES
AND TRANSPARENCY THEORY
Leverage & Contingent
Capital
Contingent
Mitigation
Hedging
Leverage.
Signaling &
Transparency
Bankruptcy
Noise / Non Core Yes
Signal / Core
Yes
Yes
Yes
Disturbs
Investment
Decisions
Yes
Yes
Yes
Post Event
Financing
Yes
Yes
Yes
Costs
No