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Role of Derivatives in corporate risk management

Introduction:

Basics of Derivatives:

Derivatives are financial instruments that are mainly used to protect against and manage

risks, very often also serve arbitrage or investment purpose, provide various advantages

compared to securities. Derivatives are various types and can differentiated by how they are

traded, the underlying they refer to, and product type etc.

We will discuss two FTSE100 and one NYS companies who use derivatives for risk

management tool.

Aviva plc is the UK’s largest life and general insurer with strong business in selected

international markets. Aviva plc a FTSE 100 company. The Group uses derivatives to mitigate

risk. The Aviva uses a variety of derivatives financial instruments, including both exchange

traded and over the counter in line with their overall risk management strategy. The

objectives are exposure management for price, foreign current and / or interest rate risk on

existing assets or liabilities, as well as planned or anticipated investment purchases.

In the narration and tables / figures are given for both notional amounts and fair values of

these instruments.

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If we go through the annual accounts1 it shows that Group entered into number of interest

rate swats in order to hedge fluctuations in the fair value part of its portfolio of mortgage

loans and debt securities in the US. The notional value of these interest rate swap is

indicated in the table and these hedges were fully effective during the year. To reduce its

exposure to foreign currency risk, the Group has entered into net investment hedges:

The Group has designed a portion of its euro and US dollars denominated debt as a hedge of

the net investment in its European and American subsidiaries.

1 Aviva plc annual report 2011

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Group also indicates in its report the derivatives not qualifying for hedge accounting, because

certain derivatives either do not qualify for hedge accounting under IAS392or the portion to

hedge account has not been taken.

Diageo Plc is a British company which is on FTSE100, Diageo distils, brews, packages, and

distributor of spirits, beer, wine, and ready to drink beverages. It offers many market leader

brands. The company is founded in 1886 and based in UK.

The Group uses derivatives financial instruments to hedge its exposures to fluctuations in

interest and exchange rates risks. The annual accounts 3shows that derivatives instruments

used by Diageo mainly of currency forward, foreign currency swaps, interest rate swaps and

cross currency interest rate swaps. Diageo uses derivatives to manage the foreign exchange

risk and use hedging ongoing basis, the group hedges a substantial portion of its exposure to

fluctuation in the sterling value of its foreign operations by designating net borrowings held

in foreign currencies and by using foreign spots, forwards, swaps and other financial

derivatives. The board recently revised risk management strategy to manage hedging of

foreign exchange risk arising from net investment in foreign operations.

The Group uses transaction exposure hedging policy to hedge up to eighteen months.

The effective portion of the gain or loss on the hedge is recognised in other comprehensive

income and recycled in to income statement and at the same time as the underlying hedge

transaction affects the income statement. Any ineffectiveness is taken to the income

statement. The Group has an exposure to interest rate risk, arising principally on changes in

US dollars, Euro and sterling interest rates. To manage this risk the Group manages its

proportion of fixed to floating rate borrowings with limits approved by the board, primarily

through issuing fixed and floating rate borrowing and commercial paper, and utilising interest

rate derivatives. Interest rate derivatives aim to minimise the group’s net finance charges

with acceptable year on year volatility. To facilitate operational efficiency and effective

hedging accounting. The majority of Diageo’s existing interest rates derivatives are

designated as hedges and these hedges are expected to be effective. Fair value of these

derivatives is recognised in the income statement, along with any changes in the relevant fair

value of the underlying hedged asset or liability.

Diageo uses derivatives transactions to manage its financial credit risk, Diageo may where

appropriate, enter into certain agreements with such banks counterparties whereby the

parties agree to post collateral for the benefit of the other if the net valuations of the

derivatives are above the pre-determined threshold.

2 International Accounting Standards IAS

3 Annual accounts 2011

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4- HILTON HOTELS HEDGE USING AN INTEREST RATE SWAP

Hilton Hotels (hereafter referred to as Hilton), together with its subsidiaries, is involved with the ownership, management and development of hotels, resorts and timeshare properties and the franchising of lodging properties. During the period of the interest rate swap, Hilton owned and operated 60 hotels, leased and operated 203 hotels, owned an interest in and operated 53 hotels, managed 343 hotels owned by others and franchised 2,242 hotels owned and operated by third parties. Hilton was founded in 1946.

4 Please accept this example as an exceptional case because they have explained derivatives in details, as I was

asked to include all FTS100 companies, as it is not on FTSE100.

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Given our assumption about the initial spot value date of 12/15/2002, the first reset is on 6/15/2002 and subsequent reset dates fall on the December 15 and June 15. To calculate the

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futures hedge rates for all exposures, we use the futures prices of the two futures contracts that immediately follow the hedge value dates. Table 3 shows the hedge value dates, futures contracts chosen, futures prices as of 12/15/2002, the corresponding futures rates, computed futures hedge rates and par yields.

Earnings impact Hilton reported in its 10-K report that the interest rate swap qualifies as a fair-value hedge. In a fair-value hedge, as summarized in Section III, a company uses a derivative to hedge the exposure to changes in the fair value of a recognized asset or liability. In this case, the hedged liability is the issued senior notes that pay a fixed rate of 7.95%. Hilton discloses in its 10-K report: “We have an interest rate swap on certain fixed rate senior notes which qualifies as a fair value hedge. This derivative impacts earnings to the extent of increasing or decreasing actual interest expense on the hedged notes to simulate a floating interest rate. Changes in the fair value of the derivative are offset by an adjustment to the value of the hedged notes." Based on this statement, we can conclude that only the interest expense item on the income statement will be affected by the swap. The entry for another item, net other (loss) gain, will have a value of zero, reflecting the difference between the fair value of the bond and the fair value of the swap. The net income – and as a result, the earnings per share (EPS) – will change with our replication using exchange-traded derivatives, as we start changing the position that Hilton has taken from paying a floating side of a swap to being long a strip of Eurodollar futures. We make the assumption that only the interest expense will change, and we are going to include the mark-to-market of all futures contracts in the interest expense as well.

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Int.Exp.(a) = Int.Exp.(e) + [6M LIBOR + 415bp]*375M, where the last term reflects the effect

of the swap. From here, Int.Exp.(e) = Int.Exp.(a) - [6M LIBOR + 415bp]*375M

Table 6 shows the actual pay and receive rates for the swap.

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Table 6: Interest Rate Swap Pay and Receive Rates

For example, the calculations for 2002 are as follows. The interest expense for that year (Int.Exp.(a)) is 328. From the above table, the average pay rate (Avg.Pay) is 5.50% (6M LIBOR+415bp); therefore, the Int.Exp(e) = 328-5.5%*375 = 307. Now, we are ready to compute the interest expense without any hedge. It will be equal to: Int.Exp (e) + Int.Exp (b) = 307 + 7.95%*375 = 337.

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Table 7 shows the income statement, where the interest expense is substituted with the one

computed above, and the net income and EPS are as a result changed.

HILTON HOTELS INCOME STATEMENT CHANGES FROM 2002 THROUGH 2006

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Table 10 shows a comparison between the actual EPS and the newly computed EPS. Note

that the interest rate swap is the best option in terms of EPS volatility. Next is the futures

hedge, and the worst case is no hedge at all. The OTC interest rate swap helps reduce

volatility in EPS from 0.48 to 0.46 (a 4.2% reduction) or from 0.47 to 0.46 (a 2.1 % reduction)

versus exchange-traded contracts. These are important results showing the benefits of OTC

derivatives as compared to exchange-traded contracts, especially when you consider this is

only one $375 million debt financing transaction for a firm with total long-term debt of

$4,554 million and total assets of $8,348 million in 2002. Larger hedges in OTC markets can

further reduce earnings volatility.

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Due to being on the favourable side of the hedge, Hilton’s cash flow benefited from the MTM

of the ED futures contracts. This is why we see that the average EPS went up; however, the

volatility increased as well.

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Derivatives as corporate risk management tools:

Why firms use derivatives? Are they hedging interest rate risk to reduce expected costs of

financial distress ( Smith and Stulz 1985) to lower the expected tax payment under a convex

tax schedule (Smith and Stulz) to avoid costly external financing by better matching internal

cash flow with financing needs ( Froot, Scharfstein, and Stein 1993)? To reduce the volatility

of executive compensation (DeMarzo and Duffie (1995))? Or firms just use derivatives to

speculate on movements in the interest rates and to manage earrings (Bodnar, Hayt, and

Marston 1998), Faulkender 2005), and Geczy, Minton, and Schrand 2007?

The role of derivatives in corporate risk management, we will analyse several listed firms that

reported the use of variety of derivatives. In the wake of the financial crises, regulatory

proposals were made that would enforce margin requirements on non-cleared derivatives for

market participants. Such regulations would limit the ability of non-financial firms to

effectively manage risk. However, an exemption for non-financial companies was included

within the US Dodd – Frank Act52010 and European Market Infrastructure Regulation (EMIR)

20126 which excuse those firms that use derivatives to hedge commercial risk from

mandatory central clearing rules. Non – systemically important non – financial institutions

will also be exempt from posting margin on non-cleared transactions, according to rules

finalized by the Basel Committee on Banking Supervision and International Organization of

Securities Commissions in September 2013, nonetheless, it is important to note there may be

indirect costs for corporate end-users7

the derivative statistics on the BIS website, including the total notional principal amount

outstanding (np) as December 2012, are as follows:8

5 Dodd – Fran Wall Street Reform and Consumer Protection Act 2010 – www.banking.senate.gov

6 The Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4

th July 2012 on OTC

derivatives, central counterparties (CCPs) and trade repositories (TRs (EMIR) entered into force on 16th

August 2012. 7 As of September 2013, the margin requirements for uncleared trades only apply to financial institutions and

systemically important non-financial entities. Non-financial firms are exempt from clearing if the hedges are used for hedging commercial risk. There may be indirect impact. Under Basel III, dealers are required to hold higher capital for unclear trades, and they also need to apply a credit valuation adjustment (CVA) capital charge. This charge may be high for uncleared, non-collateralized trades. The dealer may also hedge its exposure with another dealer – which would be subject to margin requirements (cleared or uncleared). The dealer may pass part or all of the funding cost, plus the capital charges, back to the non-financial. Under European rules, European banks do not need to apply a CVA charge when trading with a non-financial, but this exemption was not adopted in the US 8 A report by Keybridge Research (2010) provides analysis of the impact on non-financial firms if mandatory

margin requirements were required. This research was done before the new rules were finalized and non-financials were exempted. While these results do not apply now, the findings are insightful, especially if the rules were changed in the future. The key findings are as follows: (1) About 72% of survey participants report that proposed regulations would have a significant impact on their hedging activities. (2) A 3% margin requirement, assuming no exemptions, would require total collateral of $33.1 billion for non-financial, publicly

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1. Interest rate contracts: forward rate agreements, interest rate swaps ($489,703

billion np globally; non-financial firms are $34,731 billion np (7.1%)

2. Foreign exchange contracts: forwards and forex swaps, currency swaps ($67,358

billion np globally; non-financial firms are $9,693 billion np (14.4%)

3. Credit default swaps: single-name instruments, multi-name instruments ($25,069 billion np globally; non-financial firms are $200 billion np (0.8%)

4. Equity-linked contracts: forwards and swaps, options ($6,251 billion np globally; non-financial firms are $755 billion np (12.1%)

5. Commodity contracts: forwards and swaps, options ($2,587 billion np; non-financial firms not available).

Motivations for Hedging -

Researcher has shown that there are important motivations for firms to hedge using

derivatives and that hedging can increase firm value. Smithson and Simkins (2005) provide a

comprehensive review of the literature in this area. Reasons to firms to hedge include to:

Reduce expected taxes (Nance, Smith, and Smithson, 1993 and Graham and Rogers, 2002)

Reduce expected costs of financial distress (Stulz, 1996)

Reduce agency costs (Smith and Stulz, 1985).

Reduce costs associated with under-investment opportunities (Froot, Scharfstein, and Stein,

1993, Gay and Nam 1998, among others.

Studies including Nance, Smith, and Smithson (1993), Dolde (1995) and Geczy, Minton, and

Schrand (1997), and Allayannis and Ofed (1998) have shown that hedging using foreign

derivatives is consistent with shareholder wealth maximization. Other studies have

demonstrated the value of interest rate derivatives. For example, Simkins and Rogers (2000)

traded BRT firms. (3) Non-financial publicly traded BRT firms would likely respond to the imposition of margin requirements on OTC derivatives by reducing capital spending 0.9% to 1.1% (approximately $2 billion to $2.5 billion) and (4) Extending their estimates to S&P 500 companies indicates a reduction in capital spending of $5 billion to $6 billion per year and an estimated loss of 100,000 to 120,000 jobs. See Bank for International Settlements 2013 in the references and http://www.bis.org/statistics/derstats.htm.

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find that firms using interest rate swaps to create synthetic fixed rate financing are more

likely to undergo credit – quality upgrades. This evidence is consistent with the use of

corporate risk management to reduce the probability of financial distress.

Financial distress and corporate risk management is explained in Amiyatosh Purnanandam

(2008)9

A number of studies have directly examined if hedging can increase firm value. Most studies

have shown positive relation between corporate risk management and value of the firm. For

example, Allayannis and Weston (2001) examine the use of foreign currency (FX) derivatives

by large non –financial firms between 1990 and 1995, and find that FX hedging is associated

with 4.8% premium for companies with FX exposure (as measured by foreign sales).

Regarding hedging using commodity derivatives, Carter, Rogers, and Simkins (2005) show

that fuel price hedging by airlines is associated with significantly higher firm values.

A study of oil and gas firms by Jin and Jorion (2005) find that while hedging reduced the firm’s

stock price sensitive to oil and gas prices, it did not appear to increase value.

Academic article and research paper wrote by David J, Richard D. Philips, Stephen D. Smith

(1998)10 in this research paper they have formulated and tested number of hypotheses

regarding insurance participation and volume decisions in derivatives markets.

The results provide a considerable amount of support for the hypothesis that insurances

hedge to maximize value, insurers are motivated to use financial derivatives to reduce the

expected costs of financial distress – the decision to use derivatives is inversely related to the

capital –to-asset ratio for both life and property liability insurers. It has also evident that

insurers use derivatives to hedge asset volatility, liquidity, and exchange rate risks. Life

insurers appear to use derivatives to manage interest rate risk and risk from embedded

options present in their individual life insurance and GIC liabilities

Misconception - Derivatives Caused the Destruction of $75 Billion in Value

The architect of Lehman Brothers’ bankruptcy filing, Harvey Miller, testified that a massive

destruction of value could have been averted if an automatic stay had been in place for

derivatives contracts upon bankruptcy. U.S. Treasury Secretary Timothy Geithner

commented, “The market turmoil following Lehman’s bankruptcy was in part attributable to

9 Purnanandam A 2007. Financial distress and corporate risk management: Theory and evidence, Journal of

Financial Economics 87 (2008)706 - 739 10

J.David Cummins, Richard D. Philips, Stephen D. Smith 1998. Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry, The Wharton Financial Institutions Centre

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uncertainty surrounding the exposure of Lehman’s derivatives counterparties.11” Both are

mistaken.

Under the Bankruptcy Code, creditors of a failed entity are stayed or prohibited from seizing

that entity’s assets. Since 1978, however, Congress has exempted derivatives counterparties

from the automatic stay and permitted the termination of the derivatives contracts. Congress

wanted to prevent a cascade of bankruptcies of financially interconnected entities by

permitting counterparties to terminate derivatives transactions with a bankrupt entity,

thereby preserving liquidity for non-defaulting counterparties and enhancing the financial

system’s stability. In the case of Lehman Brothers, not one of its derivatives counterparties

filed for bankruptcy in the aftermath of its failure. Neither did the derivatives market grind to

a halt after Lehman Brothers’ bankruptcy filing.

When Lehman Brothers filed for bankruptcy, the estate reported that it was a counterparty

to 906,000 derivatives transactions documented under 6,120 ISDA Master Agreements.12

Lehman Brothers’ derivatives portfolio represented roughly 5 percent of derivatives

transactions globally at that time.13 Approximately 80 percent of Lehman Brothers’

derivatives counterparties terminated their transactions within five weeks of bankruptcy.14

The estate was successful, almost immediately post-bankruptcy, in capturing receivables. On

September 14, 2008, LBSF, the primary U.S. derivatives business, had a then-current cash

position of $7 million and within three and a half months, its cash position was $925 million.15

By February 1, 2011, LBSF had $8.79 billion in current cash and investments.16 At present,

LBSF represents about 40 percent of all cash and cash investment positions in the entire

Lehman Brothers estate.17

11

Public Policy Issues Raised by the Report of the Lehman Brothers Bankruptcy Examiner: Hearing before the H. Comm. on Fin. Servs., 111th Cong. 168 (2010) (statement of Timothy Geithner, U.S. Treasury Secretary). 12

Lehman Brothers Holdings Inc. First Creditors Section 341 Meeting, slides 19-20 (Jan. 29, 2009), available at http://www.lehmanbrothersestate.com/LBH/Project/default.aspx#L. Note that the Lehman Brothers Holdings Inc. The State of the Estate, slide 28 (Nov. 18, 2009), reports a slightly different figure of 6,355 contracts. 13

Semiannual Over-The-Counter (OTC) Derivatives Markets Statistics, BANK FOR INTERNATIONAL SETTLEMENT (June 2009), http://www.bis.org/statistics/derstats.htm. 14

Debtors’ Motion for an Order pursuant to Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivatives Contracts, In re Lehman Brothers Holdings Inc., No. 08-13555 (Bankr. S.D.N.Y. Nov. 13, 2008). 15

First Creditors Section 341 Meeting, supra note 4, at slide 16 (reflects figures as of January 2, 2009). 16

Monthly Operating Report February 2011, In re Lehman Brothers Holdings, Inc., No. 08-13555 (Mar. 18, 2011). 17

Lehman Brothers Holdings Inc. The State of the Estate, slide 10 (Sept. 22, 2010), available at http://www.lehmanbrothersestate.cpm/LBH/Project/default.aspx#L.

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Conclusion: An alternative vision for policy makers in the after math of Lehman Brother’s

bankruptcy would have involved greater consideration of how liquidity can become

constrained so quickly, as in the commercial paper and repo markets, and an effort to

mandate the type and amount of collateral provided in these asset classes. More regulations

required to regulated derivatives and self – established risk management system should be in

place. As Georg Santayana so famously remarked,

“Those who do not understand history are doomed to repeat.”

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References: Bank for International Settlements (BIS), 2013, Statistical Release: OTC Derivatives Statistics at End-December 2012, May.

Dolde, W., 1995, “Hedging, Leverage, and Primitive Risk,” Journal of Financial Engineering 4, 187-216. Jin and Jorion, 2006, “Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers,” Journal of Finance, 61, 893-919. Gay, G.D., and J. Nam, 1998, “The Underinvestment Problem and Corporate Derivatives Use,” Financial Management 27 (4), 53-69.

Froot, Kenneth, David Scharfstein, and Jeremy Stein, 1993, “Risk Management: Coordinating Investment and Financing Policies,” The Journal of Finance 48, 1629-1658. Jin and Jorion, 2006, “Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers,” Journal of Finance, 61, 893-919. Géczy, C., B.A. Minton, and C. Schrand, 1997, “Why Firms Use Currency Derivatives,” Journal of Finance 52, 1323-1354. Graham, J.R., and D.A. Rogers, 2002, “Do Firms Hedge in Response to Tax Incentives?” Journal of Finance 57, 815-839. Grinblatt, M., and N. Jegadeesh, 1996, “Relative Pricing of Eurodollar Futures and Forward Contracts,” Journal of Finance 51, 1499-1522. Gupta, A., and M.G. Subrahmanyam, 2000, “An Empirical Examination of the Convexity Bias in the Pricing of Interest Rate Swaps,” Journal of Financial Economics 55, 239-279. Hovakimian, A. and G. Hovakimian, 2009, “Cash Flow Sensitivity of Investment,” European Financial Management, 15 (1), 47-65. Kavussanos M., and I. Visvikis, 2004, “Market Interactions in Returns and Volatilities between Spot and Forward Shipping Freight Markets,” Journal of Banking & Finance 28, 2015–2049. Kawaller, Ira, 1994, “Comparing Eurodollar strips to interest rate swaps,” The Journal of Derivatives 2 (1), pp. 67-79. Kawaller, Ira, 1997, “Tailing Futures Hedges/Tailing Spreads,” The Journal of Derivatives, 5 (2),

62-70.

FMC Corporation, 2012, “The Impact of Dodd-Frank on Customers, Credit, and Job Creators,” Hearing before the Subcommittee on Capital Markets and Government Sponsored

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Enterprises – Committee on Financial Services U.S. House of Representatives, Testimony of Thomas C. Deas, Jr., July 10. Gregory W. Brown, 2000,” Managing foreign exchange risk with derivatives”, Journal of Financial Economics 60 (2001) 401 – 448 Graham, J, Smith C, 1999. Tax incentives to hedge. Journal of Finance 54, 2241 -2262 Dolde, W, 1995. Hedging, leverage, and primitive risk. The Journal of Financial Engineeering4, 187 – 216. Gerald D. Gay, Chen – Miano Lin, Stephan D Smith, 2011”Corporate Derivatives use and the cost of equity”, Journal of Banking and Finance 35 (2011)1491 -1506