Managing Financial Risk, Smithson & Smith

Chapter 19

The Impact of Risk Management

by: Mark Glitto

From Chapter 4, three reasons to Hedge:

• Reduce Tax Liability

We expect to see this used by firms facing convex tax function and which have more tax credits or greater likelihood of income in the progressive region of the tax function.

• Reduce costs of Financial Distress

Used in firms that have a high probability of default (have more exposure to fixed claims).

• Avoid errors in Investment Decisions

Used in firms that have a structure which encourages conflicts between shareholders and bondholders (debt-holders) i.e. firms which have a high dept to equity ratio.

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" Futures and options are the tail waging the dog. They have also escalated the leverage and volatility of the markets to precipitous, unacceptable levels. "

John Shad, former chairman SEC and CNBC news commentator

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There is no doubt the where we see high volatility we see derivative products. But the question is: Are derivatives the cause of high volatility.... or is high volatility the impetus for the introduction of derivatives. Empirical evidence shows that the introduction of derivatives reduces volatility; thus derivatives are present because they are used to cope with increased volatility, not because they are the result of increased volatility.

The Impact on Price Volatility

Empirical evidence, Table 19-3 p.511

- Derivative markets increase the market liquidity of the underlying.

- Using derivatives is valuable when the spot market is volatile, thus exchanges list the more volatile futures and options.

Example: Witching Hours

• Increased disclosure, exchange publishing imbalances in buy or sell orders.

• Exchange trading restrictions added.

Results: Price discrepancy has narrowed so that simultaneous arbitrage has been abandoned. Have the markets become more efficient? Robert Gordon of Twenty-First Securities said, "The arbitrage opportunities were unbelievable for a few years. The market's gotten much more efficient since then."

The Impact on Adjustment Speed

Derivatives may very well increase the speed of market adjustments. The reason for this is that derivatives especially options increase the incentive to obtain information about the underlying.

The Impact on Bid-Ask Spread

Two components:

1. Reduction in inventory cost

2. Reduction in information disparity among traders

The Impact on Trading Volume

Trading volume on underlying has increased with the introduction of derivatives. The reduction in transaction costs is a contributing factor.

NOTE: The symbiotic relationship between the derivative market and the market for the underlying. Shocks (positive and negative?) in either market are transferred to the other market by arbitragers who are exploiting the price differences.

The Impact on the Individual Underlying's Beta

Damodaran and Suhrabmanyam (1992) when derivatives on individual equities are introduced, the beta for the involved firm declines.

Summary

Derivative markets allow corporations to quickly and cheaply hedge against risk.

Examples

Mortgage Market - Comparative advantages

• At one time a local bank originated a mortgage and serviced the loan throughout the life of the loan. The bank bore all the risks over the term of the loan. Using derivatives, the loans are bundled into CMOs and sold on secondary markets across the country. Now the local bank can focus on its comparative advantage, loan origination. A separate entity will bear the loans risks and a third entity can service the loan. This process lowers mortgage rates and the diversification also helps protect the financial system from large losses.

Oil Company - Specialization

• Derivatives create value by reducing total risk for all market participants. In the past an oil producer would look to hedge its risk to the oil market by diversifying its operations into other areas such as manufacturing or transportation. However the skills required in the other diversified fields may be very different than the skills of successfully producing oil. Empirical evidence suggests conglomerates have a lower return on capital compared to non-diversified competitors. One problem is that the diversified firm may have difficult compromises in the areas of finance, dividend, and human resource policy. With access to a well-functioning oil derivatives market the need to engage in less effective and more costly diversifying measures is eliminated.

Futures - Options - Swaps - Forwards - Default Risk - AIRs

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