金融工程學(xué)：Why firms should hedge

1、1. Incentives for firms to hedge - Key Theories.Some Basics: Financial hedging to mitigate risksFinancial instruments for risk hedging: Exchange-Traded derivatives: commodity futures, currency futures/options, etc.Over-The-Counter derivatives: currency swaps, weather derivatives.Practical use of fin

2、ancial hedging empirical evidence:Bartran et al. (2009) has surveyed 7,319 nonfinancial firms across 50 countries;They find that over half (60.3%) of the surveyed firms have used financial hedge against their risk exposures.1.1 Why firms should hedge?Why ask this question?The Modigliani-Miller theor

3、em underlies the modern Corporate Finance thoery.In a ideal Modigliani-Miller world, however, firms do not need to hedge. 1.1.1 Understanding the Modigliani-Miller argumentRecap of Key assumptions in Modigliani-MillerNo TaxNo Bankruptcy costNo Agency costNo asymmetric informationThe market is effici

4、entUnder these assumptions, the argument for the claim “l(fā)everage will not affect the firm value” can be used similarly to support the claim “hedging will not increase the firm value”Argument for the ineffectiveness of leverage: If the firm use debt capital, its effect is equivalent to the case that

5、the shareholder raise debt himself, and then inject the borrowed money to the firm. (There is no difference between firm borrowing and shareholder borrowing in Modigliani-Miller)Argument for the ineffectiveness of hedge: If the firm hedges against risk, its effect is equivalent to the case that the

6、shareholder conducts the hedge himself. Moreover, the shareholder can even diversify the firms risk by investing in multiple firms.1.1.2 What is missing in Modigliani-Miller?Firms need to pay taxFirms may go down, and the liquidation of the firm assets is costly.Managers may shirk on their duty, or

7、even divert the firms profit for its own use. Shareholders may drawn on debtholders value by investing in risky assets (the debt-overhang problem)Investors may face a borrowing rate significantly different from the firmAnd so on.DO THESE FACTORS GIVE INCENTIVES FOR FIRMS TO HEDGE?1.1.3 Progressive t

8、ax rate A exampleProfits above 10 million25% tax rateProfits below 10 million 20% tax rate 12 million6 million50% chance 50% chance 9 million100% chance Firm A(Risky)Firm B(Riskless)Expected before-tax profitPossible future profitsExpected taxExpected after-tax profit9 million9 million(12*25%+6*20%)

9、/2=2.1 million 9*20%=1.8 million7.2 million 6.9 million Progressivity in tax rates:Risky versus riskless profits:Think: How can we represent the above tax rate progressivity in Math?Let us draw a simple figure to depict this. Key observations: Tax payable is convex in taxable income, so after-tax profit is concave in before-tax profit1.1.4 Possible hedging incentivesIncentivesMarket Frictionsnot inModigliani & MillerFinancial distress costHigh financing costsBankruptcy costsAg