Corporate Finance

London School ofBusiness and Finance

Lecture Nine Corporate FinanceRisk Management

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Lecture OutlineInsuranceCommodity Price RiskInterest Rate Risk

Learning Objectives

• Understand the use of insurance to manage financial risk

• Demonstrate how commodity price changes create risk and how to manage that risk

• Show how a nonfinancial firm can still be at risk from fluctuations in interest rates

Insurance

• Insurance is the most common method firms use to reduce risk

• Protects against hazards such as fire, storm damage, vandalism, earthquakes, and other natural and environmental risks

Insurance

• Other common types of insurance include:o Business liability insurance, which covers the costs that

result if some aspect of the business causes harm to a third party or someone else’s property

o Business interruption insurance, which protects the firm against the loss of earnings if the business is interrupted due to fire, accident, or some other insured peril

o Key personnel insurance, which compensates for the loss or unavoidable absence of crucial employees in the firm

Actuarially Fair Insurance Premium• An actuarially fair insurance premium is equal to

the present value of the expected loss:

Example :Insurance Pricing andthe CAPMProblem:

• As the owner of a landmark Chicago skyscraper, you decide to purchase insurance that will pay $1 billion in the event the building is destroyed by terrorists.

• Suppose the likelihood of such a loss is 0.1%, the risk-free interest rate is 4%, and the expected return of the market is 10%.

• If the risk has a beta of zero, what is the actuarially fair insurance premium? What is the premium if the beta of terrorism insurance is –2.5?

Example :Insurance Pricing andthe CAPMSolution:

Plan:• The expected loss is 0.1% $1 billion = $1 million.

Given a risk-free rate of 4% and an expected market return of 10%, we can use the CAPM to compute the rate of return we would use to compute the fair insurance premium under the two scenarios of zero beta and beta of -2.5.

• Once we have the rate of return, we will divide the expected loss (the cash flow) by 1+rate of return as in the above Equation


Execute:• If the risk has a beta of zero, we compute the

insurance premium using the risk-free interest rate: ($1 million)/1.04 = $961,538.

• Given a beta for the loss, L, of –2.5, the required return is: rL = rf + L (rmkt – rf) = 4% – 2.5 (10% – 4%) = –11%

• In this case, the actuarially fair premium is ($1 million)/(1 – 0.11) = $1.124 million.


Evaluate:• Although this premium exceeds the expected

loss, it is a fair price given the negative beta of the risk.

• The insurance pays off exactly when the cash flows from your business operations are likely to be very low.

Example :Insurance Pricing and the CAPMProblem:

• As the owner of the McCarty Oil Pipeline, you decide to purchase insurance that will pay $100 million in the event the pipeline ruptures.

• Suppose the likelihood of such a loss is 0.3%, the risk-free interest rate is 5%, and the expected return of the market is 12%.

• If the risk has a beta of zero, what is the actuarially fair insurance premium?

• What is the premium if the beta of leak insurance is –2.0?

Example :Insurance Pricing and the CAPMSolution:

Plan:• The expected loss is 0.3% $100 million =

$300,000. Given a risk-free rate of 5% and an expected market return of 12%, we can use the CAPM to compute the rate of return we would use to compute the fair insurance premium under the two scenarios of zero beta and beta of -2.0. Once we have the rate of return, we will divide the expected loss (the cash flow) by 1+rate of return as in Eq. (21.1)


Execute:• If the risk has a beta of zero, we compute the

insurance premium using the risk-free interest rate: ($300,000)/1.05 = $285,714.29

• Given a beta for the loss, L, of –2.0, the required return is: rL = rf + L (rmkt – rf) = 5% – 2.0 (12% – 5%) = –9%

• In this case, the actuarially fair premium is ($300,000)/(1 – 0.09) = $329,670.33


Evaluate:• The insurance company charges a premium to cover the

expected cash flow it must pay, but receiving the insurance payment may be worth more than the amount of the payment.

• The insurance payment allows the firm to avoid other costs, so it is possible for the premium to be actuarially fair and for the insurance to still be a positive-NPV investment.

The Value of Insurance• In a perfect capital market, insurance will be priced

so that it has an NPV of zero for both the insurer and the insured.

• But if purchasing insurance has an NPV of zero, what benefit does it have for the firm?

The Value of Insurance• Modigliani and Miller provided us with the answer

to this question: • In a perfect capital market, there is no benefit to

the firm from any financial transaction, including insurance.

• Insurance is a zero-NPV transaction that has no effect on value.

• Although insurance allows the firm to divide its risk in a new way (e.g., the risk of fire is held by insurers, rather than by debt and equity holders), the firm’s total risk—and, therefore, its value—remains unchanged.

The Value of Insurance• Bankruptcy and Financial Distress Costs

o When a firm borrows, it increases its chances of experiencing financial distress.

• Issuance Costso When a firm experiences losses, it may need to

raise cash from outside investors by issuing securities. Issuing securities is an expensive endeavor

Example : Avoiding Distress andIssuance CostsProblem:

• Suppose the risk of an airline accident for a major airline is 1% per year, with a beta of zero.

• If the risk-free rate is 4%, what is the actuarially fair premium for a policy that pays $150 million in the event of a loss?

• What is the NPV of purchasing insurance for an airline that would experience $15 million in financial distress costs and $10 million in issuance costs in the event of a loss if it were uninsured?

Example : Avoiding Distress andIssuance CostsSolution:

Plan:• The expected loss is 1% x $150 million = $1.50

million, but the total value to the airline is $150 million plus an additional $25 million in distress and issuance costs that it can avoid if it has insurance.

• The premium is based solely off of the expected loss, as the PV of the expected loss as in the Eq. above

• Since the beta is zero, the appropriate discount rate is 4%.


Execute:• The actuarially fair premium is $1.50 million/1.04 =

$1.44 million.• The NPV of purchasing the insurance is the

expected benefit, including avoiding the distress and issuance costs, net of the premium: NPV = –1.44 + 1% X (150 + 25)/1.04 = $0.24 million


Evaluate:• The insurance company charges a premium to

cover the expected cash flow it must pay, but receiving the insurance payment may be worth more than the amount of the payment.

• The insurance payment allows the firm to avoid other costs, so it is possible for the premium to be actuarially fair and for the insurance to still be a positive-NPV investment.

Commodity Price Risk• For many firms, changes in the market

prices of the raw materials they use and the goods they produce may be the most important source of risk to their profitability. o Hedging with Vertical Integrationo Hedging with Storageo Hedging with Long Term Contract

Commodity Price Risk• By locking in its fuel costs through long-term supply

contracts, Virgin Atlantic Airlines has kept its earnings stable in the face of fluctuating fuel prices.

• For example, with a long-term contract at a price of $23 per barrel, Virgin would gain by buying at this price if oil prices go above $23 per barrel.

• If oil prices fall below $23 per barrel, Virgin would lose from its commitment to buy at a higher price.

Example :Hedging with Long-Term ContractsProblem:

• Consider a chocolate maker that will need 10,000 tons of cocoa beans next year.

• The current market price of cocoa beans is $2900 per ton. At this price, the firm expects earnings before interest and taxes of $44 million next year.

• What will the firm’s EBIT be if the price of cocoa beans rises to $3500 per ton?

• What will EBIT be if the price of cocoa beans falls to $2600 per ton?

• What will EBIT be in each scenario if the firm enters into a supply contract for cocoa beans for a fixed price of $2950 per ton?

Example :Hedging with Long-Term ContractsSolution:

Plan:• At $2900 per ton, the firm’s EBIT is $4 million. For every

dollar above $2900 per ton, its EBIT will decrease by 10,000 dollars (for 10,000 tons) and similarly will increase by $10,000 for every dollar below $2900 per ton.


Execute:• At $3500 per ton, the firm’s costs will increase by (3500 –

2900) 10,000 = $6 million. Other things equal, EBIT will decline to $44 million – $6 million = $38 million.

• If the price of cocoa beans falls instead to $2600 per ton, EBIT will rise to $44 million – (2600 – 2900) 10,000 = $47 million.

• Alternatively, the firm can avoid this risk by entering into the supply contract that fixes the price in either scenario at $2950 per ton, for an EBIT of $44 million – (2950 – 2900) 10,000 = $43.5 million.


Evaluate:• The firm can completely reduce its risk by entering into the

supply contract. • The cost is accepting lower (by $500,000) profits for certain.

Example : Hedging with Long-Term ContractsProblem:

• Consider a shoe maker that will need 5,000 tons of rubber next year.

• The current market price of rubber is $3500 per ton. At this price, the firm expects earnings before interest and taxes of $10 million next year.

• What will the firm’s EBIT be if the price of rubber rises to $4000 per ton?

• What will EBIT be if the price of rubber falls to $3000 per ton?

• What will EBIT be in each scenario if the firm enters into a supply contract for rubber for a fixed price of $3550 per ton?

Example : Hedging with Long-Term ContractsProblem:

Solution:Plan:• At $3500 per ton, the firm’s EBIT is $10 million. For

every dollar above $3500 per ton, its EBIT will decrease by 5,000 dollars (for 5,000 tons) and similarly will increase by $5,000 for every dollar below $3500 per ton.

Example : Hedging with Long-Term Contracts

Problem:Solution:Execute:• At $4000 per ton, the firm’s costs will increase by (4000 –

3500) 5,000 = $2.5 million. Other things equal, EBIT will decline to $10 million – $2.5 million = $7.5 million.

• If the price of rubber falls instead to $3000 per ton, EBIT will rise to $10 million – (3000 – 3500) 5,000 = $12.5 million.

• Alternatively, the firm can avoid this risk by entering into the supply contract that fixes the price in either scenario at $3550 per ton, for an EBIT of $10 million – (3550 – 3500) 5,000 = $9.75 million.

Example : Hedging with Long-Term Contracts

Problem:Solution:Evaluate:• The firm can completely reduce its risk by entering into the

supply contract. • The cost is accepting lower (by $250,000) profits for certain.

Commodity Price Risk• Hedging with Futures Contracts

o A futures contract is an agreement to trade an asset on some future date, at a price that is locked in today. Futures contracts are traded anonymously on an exchange at a publicly observed market price and are generally very liquid.

o Both the buyer and the seller can get out of the contract at any time by selling it to a third party at the current market price.

Common Mistakes When Hedging Risk• Not accounting for natural hedges

• Exposing the firm to liquidity risk• Mismatching futures contract and risk exposure

Interest Rate Risk• Firms that borrow must pay interest on their debt. • An increase in interest rates raises firms’ borrowing

costs and can reduce their profitability. • In addition, many firms have fixed long-term future

liabilities, such as capital leases or pension fund liabilities.

• A decrease in interest rates raises the present value of these liabilities and can lower the value of the firm.

• Thus, when interest rates are volatile, interest rate risk is a concern for many firms.

Interest Rate Risk• Financial managers need to know the duration—

the sensitivity to interest rate changes—of their assets and liabilities.

• The farther away the cash flow is, the larger the effect of interest rate changes on its present value

Interest Rate Risk• Duration Based Hedging

o Avoid a duration mismatch—when the duration of your liabilities is different from the duration of your assets

• Swap Based Hedgingo An interest rate swap is a contract entered into

with a bank in which the firm and the bank agree to exchange the coupons from two different types of loans.

Example :Using Interest RateSwapsProblem:

• Bolt Industries is facing increased competition and wants to borrow $10 million in cash to protect against future revenue shortfalls.

• Currently, long-term AA rates are 10%. Bolt can borrow at 10.5% given its credit rating.

• The company is expecting interest rates to fall over the next few years, so it would prefer to borrow at short-term rates and refinance after rates drop.

• However, Bolt’s management is afraid that its credit rating may deteriorate as competition intensifies, which may greatly increase the spread the firm must pay on a new loan.

• How can Bolt benefit from declining interest rates without worrying about changes in its credit rating?


Solution:Plan:• Bolt wants to convert its long-term fixed rate into a floating

rate (one that will decline if market interest rates decline). It can do this by entering into a swap where it will receive a fixed rate (which can then be used to pay its fixed long-term obligation) and pay a floating rate. Its net exposure will be the floating rate.


Execute:• Bolt can borrow at the long-term rate of 10.5% and then

enter into a swap in which it receives the long-term AA fixed rate of 10% and pays the short-term rate Its net borrowing cost will then be

Using Interest RateSwapsEvaluate:

• In this way, Bolt locks in its current credit spread of 0.5% but gets the benefit of lower rates as rates decline. The tradeoff is that if rates increase instead, it is worse off.


• Scott Industries is facing increased competition and wants to borrow $7 million in cash to protect against future revenue shortfalls.

• Currently, long-term AA rates are 8%. Bolt can borrow at 9% given its credit rating.

• The company is expecting interest rates to fall over the next few years, so it would prefer to borrow at short-term rates and refinance after rates drop.

• However, Scott’s management is afraid that its credit rating may deteriorate as competition intensifies, which may greatly increase the spread the firm must pay on a new loan.

• How can Bolt benefit from declining interest rates without worrying about changes in its credit rating?

Example :Using Interest RateSwapsSolution:

Plan:• Scott wants to convert its long-term fixed rate into a floating

rate (one that will decline if market interest rates decline). • It can do this by entering into a swap where it will receive a

fixed rate (which can then be used to pay its fixed long-term obligation) and pay a floating rate.

• Its net exposure will be the floating rate.

Example :Using Interest RateSwapsSolution:

Execute:• Scott can borrow at the long-term rate of 9% and then enter

into a swap in which it receives the long-term AA fixed rate of 8% and pays the short-term rate. Its net borrowing cost will then be

Long-Term + Floating Rate – Fixed Rate Received = Net Borrowing CostLoan Rate Dure to Swap from Swap

9% + – 8% = + 1

Example :Using Interest RateSwapsEvaluate:

• In this way, Scott locks in its current credit spread of 1% but gets the benefit of lower rates as rates decline.

• The tradeoff is that if rates increase instead, it is worse off.

Corporate Finance

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