Question

a) In 1994, one subsidiary of Daimler-Benz, Daimler-Benz Aerospace, had an order book of DM20 billion, of which 80% was fixed in US dollars. In 1995, Daimler-Benz reported losses of DM1.56 billion, the largest in the company’s 109-year history. Briefly explain why Daimler-Benz failed to hedge its position [Hint: In your answer, you should refer to the primary goal of risk management as stated by Stulz (1996, Journal of Applied Corporate Finance)].

Answer 1

In 1995, Daimler-Benz reported first-half losses of DM1.56 billion, the largest in the company’s 109- year history. In its public statements, management attributed the losses to exchange rate losses due to the weakening dollar. One subsidiary of DaimlerBenz, Daimler-Benz Aerospace, had an order book of DM20 billion, of which 80% was fixed in dollars. Because the dollar fell by 14% during this period, Daimler-Benz had to take a provision for losses of DM1.2 billion to cover future losses. Why did Daimler-Benz fail to hedge its expected dollar receivables? The company said that it chose not to hedge because the forecasts it received were too disperse, ranging as they did from DM1.2 to DM1.7 per dollar. Analysts, however, attributed Daimler-Benz’s decision to remain unhedged to its view that the dollar would stay above DM1.55.8 These two brief case studies reinforce the conclusion drawn from the survey evidence. In both of these cases, management’s view of future price movements was an important determinant of how (or whether) risk was managed. Risk management did not mean minimizing risk by putting on a minimum-variance hedge. Rather, it meant choosing to bear certain risks based on a number of different considerations, including the belief that a particular position would allow the firm to earn abnormal returns. Is such a practice consistent with the modern theory of risk management? To answer that question, we first need to review the theory.

A hedging strategy that focuses on the probability of distress is consistent with risk-taking. Remember that with such a strategy, one is concerned about the lower-tail outcomes. Hence, it is perfectly feasible for a company to increase its volatility yet reduce the probability of a bad outcome that would create financial distress. For instance, a strategy that levers up the firm but buys way out of the money put options that pay off if the firm does poorly will increase firm value volatility and, if the puts are bought in appropriate numbers, decrease the probability of financial distress. Focusing on lower tail outcomes is also fully consistent with managing economic exposures. Suppose that we are willing to put an explicit cost on an increase in the probability of distress. In that case, the trade-off for taking a bet for the company becomes simple. The bet increases firm value by its expected profit minus the cost of its impact on the probability of distress. A bet that has a positive expected profit and has no impact on the probability of distress is one that the firm should take since it has a positive net present value. If a bet has a positive expected profit but increases the probability of financial distress, it may not be profitable because the adverse effect of a poor outcome is too costly. However, in this case, it makes sense for the firm to think about how it can reduce the impact of a poor outcome on the probability of distress. Consider the situation where the cash flow of that firm is risky, so that if the bet has a poor outcome and cash flow is low the firm will be in distress. The first question the firm should ask is whether it can reduce cash flow risk. It could be that through a hedging program the firm can reduce cash flow risk substantially, so that an adverse outcome of the bet would not create financial distress. After having implemented its hedging program, the firm would then be able to make the profitable bet. When evaluating the bet, however, the appropriate profit is it’s risk-adjusted expected profit. This riskadjusted expected profit is not the expected gain divided by the capital contributed or the expected profit divided by the standard deviation of the bet. Remember that shareholders could take the same risks as the firm and for that risk would receive some compensation from the capital markets. For instance, there is a lot of evidence that holding currencies of high interest rate countries earns on average an excess return over the risk-free rate. Most likely, this excess return is compensation for risk. It therefore would not make sense to reward a treasury for earning excess returns this way. The treasury takes on risks when it pursues that strategy. Shareholders want to be compensated for these risks. If all of the expected excess return of this strategy is compensation for risk, on average the excess return earned this way is not a profit for the corporation - it is not an “abnormal return” but compensation for taking a risk that would accrue to anybody who takes on that risk. Consequently, the criterion that should be applied when a corporation makes a bet is whether the compensation it expects from making the bet exceeds what shareholders, without any special information, would expect to receive on their own. A bet will increase firm value only if its expected return exceeds the expected return attributed to it by uninformed investors. When devising a compensation scheme for those managers that can make a bet, it is of crucial importance to provide appropriate incentives so that they only take those bets that increase shareholder wealth. It turns out that the data used to compute VAR provides the way to do that. A firm has many different sources of risk. Consequently, when computing VAR, it is common to focus on the most important sources of risk. Suppose that you have n different sources of risk that you use in the computation of VAR. You can then put a market required return for these risks and hence derive an expected return that must be obtained for a given amount of capital at risk to insure that shareholders benefit. Let’s look at a simple example that makes this clear. Suppose that one source of risk is emerging markets risk. The firm takes exposure to this risk. If shareholders can earn a risk premium of 5% p.a. being exposed to that risk, then managers make money for the firm taking on this risk only if they earn more than 5% on average. Hence, managers should not be compensated for earning more than the risk-free rate. They should be compensated for earning more than what the shareholders could earn without their help. This approach does not completely eliminate the problem that the individual has incentives to take risks because of the reasons discussed earlier. However, it has the advantage that it becomes more difficult for a risktaker to make money by making random bets. If a risk-taker simply receives a bonus for making positive gains, he has incentives to take random bets because he gets a fraction of the gains he makes and does not bear the losses. A risk-taker who has to beat the market to make money does not find random bets profitable.

Although well-diversified shareholders may not be concerned about the cash flow variability caused by swings in FX rates or commodity prices, they will become concerned if such variability materially raises the probability of financial distress. In the extreme case, a company with significant amounts of debt could experience a sharp downturn in operating cash flow—caused in part by an unhedged exposure—and be forced to file for bankruptcy. What are the costs of bankruptcy? Most obvious are the payments to lawyers and court costs. But, in addition to these “direct” costs of administration and reorganization, there are some potentially larger “indirect” costs. Companies that wind up in Chapter 11 face considerable interference from the bankruptcy court with their investment and operating decisions. And such interference has the potential to cause significant reductions in the ongoing operating value of the firm.