The increasingly hostile mergers and acquisitions market.

9.      Mergers, acquisitions and the market for corporate control

The increasingly hostile mergers and acquisitions market.

            Nothing wets the appetite of the financial press more than a hostile takeover bid. In 2010 alone, there was more than 260$ billion in hostile takeovers launched, with the trend expected to strengthen in 2011. ⁽¹⁾ With nearly 57 thousand bankruptcy fillings last year, ⁽²⁾ large companies are aggressively pursuing takeover bids in an effort to profit off good value acquisitions given the current economic climate. These bids however are not always welcomed. The merger and acquisition market for publicly traded companies has become increasingly hostile over the past two years, according to a recent report by The Conference Board ⁽³⁾. According to the report, hostile offers accounted for 47% of total mergers and acquisitions in the first two months of 2009, compared with 24% for the whole of 2008, and only 7% in 2004. ⁽⁴⁾ Companies with undervalued stock, have a low debt ratio or have a large cash flow are prone to takeovers.

                        As companies are experiencing short-term liquidity issues, increased pressure to achieve cost savings, investment fatigue from investors, many have done away with structural takeover protections, which have contributed to the increasingly hostile buyout market. One such firm who have recently thrown in the towel after a long battle is Cadburys. In early 2010, they accepted defeat in their battle to resist the 12£ billion takeover from US rival Kraft. ⁽⁵⁾ The hostile takeover bid, which was greeted with huge opposition across England and Ireland, was described as a merger by Kraft and they claimed it would deliver more value than Cadbury could achieve on its own. ⁽⁶⁾

                        As was the case with Cadburys, target companies have every reason to fight off bids. Employees of the target companies often find themselves without a job, as the trusted employees from the acquiring company are retained as the firm views the target company’s employees as new and unknown. Kraft has since shut down Cadbury’s Keynsham plant, despite its pledge to keep it open, resulting in the loss of 400 jobs. ⁽⁷⁾ There are fears of further job losses as the company is moving its production to more tax-efficient countries such as Poland. Furthermore, ownership of Cadbury is likely to move to a holding company in Zurich, a move which will cost Britain 60£ million in tax receipts, enraging worker and government officials alike.

            Although Cadburys attempted to stave off any attempts of a takeover by Kraft, they eventually conceded and are now feeling the effects. Given the increasingly hostile mergers and acquisitions market, many methods of resisting both potential takeovers and an actual hostile takeover bid have been developed and certain companies have succeeded in their attempts to fight off these takeovers.

            Pre-emptive anti-takeover measures include:

1)   

             Poison Pills

With a poison pill, the target company attempts to make its stock less attractive to the acquirer, either by a ‘flip in’ or a ‘flip over’. A ‘flip in’ allows existing shareholders- except the acquirer to buy more shares at a discount, diluting the shares held by the acquirer, thus making them less valuable. This makes the takeover attempt more difficult and expensive. A ‘flip over’ allows stockholders to buy the acquirers shares at a discount price after the merger, thus making the acquisition less attractive. Poison pills are very effective as a defence tactic and are favoured by the board for the leverage they bring to the bargaining table. In 2003, enterprise giant Oracle attempted to acquire rival PeopleSoft through a 5.1$ billion hostile takeover bid. PeopleSoft employed a poison pill which was set to trigger if Oracle bought more than 20% of the company. Finally, after an 18-month battle, PeopleSoft finally voided its poison pill and was acquired by Oracle, but for 10.3$ billion – double Oracle’s initial offer. ⁽⁸⁾

2)      Poison Puts

A poison put is a right, distributed to common stockholders which make some or all of their stock puttable to an acquirer at a very high price. This, like poison pills, increases the cost of a potential takeover and discourages it.

3)      Shark Repellents

This involves a firm amending their corporate charter or bylaws. The amendments will only become active when a takeover attempt is announced or presented to shareholders. It reduces the profitability of the acquisition.

            Active anti-takeover measures include:

1)     

      Golden Parachutes

These are lucrative benefits given to employees of the target firm in the event they lose their jobs after a takeover. Benefits include stock options, bonuses, severance pay etc.

2)      Stand-still agreements

A contract that stalls or stops the process of a hostile takeover by reaching a contractual agreement with a potential acquirer whereby the acquirer agrees not to increase its holdings in the target during a particular time period.

3)      White knight

This occurs when friendly companies bid for a takeover against a hostile acquirer. The Chrysler takeover by Fiat, which saved them from liquidation, is an example of this method.

4)      White Squire

Strategy in which a takeover target places a block of stock in the hands of an investor deemed friendly by the management. This decreases the possibility of a takeover as the suitor must acquire a significantly greater proportion of the remaining shares in order to complete the takeover.

5)      Change in Capital Structure

This involves changing the capital structure of the target company. This can be done in a number of ways; by recapitalization, assuming more debt, issuing more shares or buying back shares. This makes it more difficult and expensive to take over the target company.

            The danger of an unwanted takeover bid can force firms to self-inflict harm in a bid to fend off potential acquirers. As was the case with Cadburys, they are not always successful and eventually give up their control of the firm; however a number of methods are used in an effort to make the acquisition less attractive. The value of worldwide mergers and acquisitions totalled 1.75$ trillion in the first 3 quarters of 2010, an increase of 21% from the same period the previous year. ⁽⁹⁾ 8% of these bids were reported to be hostile, with firms reluctant to sell as the economy starts to improve. Therefore fewer and fewer takeovers are friendly, and with companies looking to expand and profit on good value investments expect there to be further hostile reports in the future.

References:

1)      http://www.miningreview.com/node/18975

2)      http://www.bankruptcyaction.com/USbankstats.htm

3)      http://www.conference-board.org/press/pressdetail.cfm?pressid=4148

4)      http://www.biztimes.com/money/2009/6/30/hostile-takeovers-becoming-more-common

5)      http://www.thisislondon.co.uk/standard/article-23797094-cadbury-family-attacks-pound-12billion-takeover-by-kraft-as-a-horror-story.do

6)      http://www.thefreelibrary.com/Joining+forces+against+Kraft%3B+CADBURY%3A+Show+of+strength+to+oppose...-a0214470697

7)      http://www.dailymail.co.uk/news/article-1335774/Cadburys-Swiss-avoid-British-tax-cost-Treasury-60-million-year.html

8)      http://news.cnet.com/Oracle-buys-PeopleSoft-for-10-billion/2100-1001_3-5488298.html?tag=mncol

Dividend stocks – Why they’re the better investment decision and why firms should pay out.

7. Dividends, Dividend policies and sustainability.

Dividend stocks – Why they’re the better investment decision and why firms should pay out.

            Last month, the dividend yields on American AAA corporations rose above the yield on 30yr Treasury bonds - an unprecedented occurrence. Similarly the dividend yield of the S&P 500 Index is now higher than the 10-year Treasury yield, countering the belief that dividend yields are ‘like watching paint dry’.

Dividends are becoming an increasingly decisive factor in investment decisions and firms would do well to pay out on their stock. Although the percentage of companies who pay dividends has fallen, it still stands at over 70% of S&P 500 companies.

           

            There are arguments for and against dividend policy, with many reputable economists in favour of a no-dividend policy. However no Nobel Prize winner will convince me of this approach. In theory it makes sense for companies to reinvest all of their earning straight back into the business, compounding the growth rate of the firm. In reality however the money is often wasted on failed acquisitions, taking on too much risk and irresponsible investment decisions. The money that should have been in your pocket is being paid to lawyers, middlemen and the government through taxes on new investment projects, which have no relevance to you. The earnings that a company makes should be shared among the owners of the firm, who can then decide whether they want to re-invest of spend THEIR money on themselves. The companies that reward you with these earnings show confidence in their ability to generate future cash flow increases, which may be passed on as dividends. Furthermore companies paying out dividends show shareholders that those earnings are real and not manufactured by accounting techniques, techniques which were commonly used in the loosely regulated financial markets in the years leading up to the crash.

            But what do dividends matter? They are only part of the potential capital gain received if one was to sell a stock for a profit due to increased growth – fuelled by retained earnings. Research has shown ⁽¹⁾ that dividend paying stocks do in fact outperform non dividend paying stocks – well only over the past 35 years as I’m sure some would argue. The study even goes as far to say that those who increase their dividend payment consistently will perform even better! While the late 90’s argument that companies should “reinvest the capital rather than pay it out” was en vogue for a time, there has been little or no proof that this works in practice.  It’s more likely that companies will engage in what Peter Lynch referred to as “Diworseification” – i.e. a dumb acquisition. ⁽²⁾ This leads me to question how a theoretical economic model can be favoured over empirical evidence.

            Clearly, there are strong arguments in favour of dividends; a strong financial image, better performing stocks, added incentive for investors and the fact that highly priced stock (associated with dividend paying firms) will give a company the option of raising a lot of capital through a share issue. However all of this is contingent on actual demand by investors in the stock. What makes shares in a company more desirable than say bonds, gold or earning interest in a deposit account? There are countless reasons to invest your money in a dividend paying stock and I believe they should form the base of any portfolio.

1)     Performance

As the Great Ned Davis Dividend Study has shown, (3) dividends matter. S&P companies that pay dividends have historically provided greater returns over the years. They have steadily grown during bull markets and have managed to reduce losses during recessions – a decisive factor in today’s investment decisions.

2)     Dividends are a big chunk of your profits

Although the S&P’s 500-stock index currently yields 2.02%, (4) dividends have historically accounted for 43% of the US stock market’s long term return. Furthermore dividends tend to be more predictable than share prices.

3)     They can grow

Unlike most bonds, dividends have the potential to increase in the future depending on the company’s fortunes and dividend policy. With most bonds you receive the same interest rate to maturity however with a stock; the interest payments (dividends) you receive can be increased. Over the past 25 years the dividends paid out by companies in the S&P 500 have grown at a compounded rate of 3.2% per year. (5)

4)     Less volatile and stay afloat

Dividend paying stocks are usually less volatile than nonpayers. Volatility can be measured by beta, and a beta of 1 tends to follow the S&P 500 index closely. Over the past 5 years the average beta of dividend-paying US stocks has been .98 while that of nonpayers has been 1.50. Similarly dividend paying stocks generally do better when the stock market tanks, like it did in 2008. Dividend paying stocks lost an average of 39% compared to the 46% fall for nonpayers. The contrast was even starker in 2002 with the falls calculated at 15.8% and 30.3% respectively.

5)     More diverse

A company that does not pay dividends only has 1 channel of profit – capital gains. The addition of dividends diversifies the investment as it has two streams of growth; dividend yield and capital appreciation.

6)     Shareholder friendly

A company that pays out dividends can be seen as one that is shareholder friendly. A great company may not necessarily make a great stock as it could be overvalued in terms of share price or it might not care about creating shareholder value. Companies that pay dividends are looking after the shareholder’s needs.

7)     Company diligence

With less retained earnings, companies will have less money to invest in future projects. This isn’t always a bad thing. New investment decisions will have to be carefully selected, with only investments that are expected to be the most efficient and profitable chosen. Similarly paying a dividend requires a sold cash flow. This means a company has to have its financials in order to know how much it can reasonably pay over the long term.

8)     Simple

Stocks that pay a dividend don’t have to be constantly checked and traded. The cash flow from the dividend is relatively stable (depending on the company) and will not fluctuate in the short term. Dividends also provide stable investments that can be life-long. The dividend every year will increase demand for the stock, thus increasing its price. Holding a stock like this from its youth can provide both a steady cash flow, and an opportunity to make a capital gain at some time in the future by selling the share.

9)     Management projection

The payment of dividends increases the transparency of a firm. Management’s confidence of future earnings or trends can be hinted at by their dividend policy. If they are unsure or pessimistic about the future of the company, dividends are likely to be kept conservative and vice versa.

           

      With investors searching for safe, reliable investments and companies aiming to maintain a good relationship with their investors in the turbulent economic climate, the concept of paying dividends is appealing. As empirical evidence shows, dividend paying stocks do in fact perform better than stock with no dividends which in my opinion is the only reason a company needs to pay out and similarly the only reason an investor needs to include these stocks in their portfolios.

            

References:

1)     http://contraryinvesting.com/stock-market-valuation/great-ned-davis-dividend-study-yes-they-do-matter-big-time/

2)     http://peterlynchnews.com/1426/diversification-without-diworsification-ninemsn/

3)     http://contraryinvesting.com/stock-market-valuation/great-ned-davis-dividend-study-yes-they-do-matter-big-time/

4)     http://www.multpl.com/s-p-500-dividend-yield/

5)     http://www.kiplinger.com/magazine/archives/why-dividends-matter.html

Valuing a company by its capital structure, and why the Modigliani-Miller Model is unconvincing.

(6) Valuing firms again – a cookbook

Valuing a company by its capital structure, and why the Modigliani-Miller Model is unconvincing.

                

                Every firm faces the age old question of how to finance themselves. Whether they are new start-up companies or long established market leaders, CFO’s must decide between debt and equity. Ultimately, they are funded with a mix or borrowed money (debt) and owner’s funds (equity). Differences arise depending on the nature of the firm; for publicly traded companies, debt may take the form of bonds and equity is usually common stock, and in a private business, debt is more likely to be bank loans and owner’s savings represent equity. There is no ‘one size fits all’ in capital structure, and each must find their own ‘optimal level’ of debt to equity, given the objective function of maximising firm value. This is known as the optimal debt ratio and will be different for each firm.

                With firms going out of business by the day- over 1000 Irish firms were declared insolvent in the first 6 months of 2011 ⁽¹⁾, the balance between borrowed money and owner’s equity is more important than ever. What is even more shocking is, despite these figures only 37% of firms have a flexible target when it comes to debt-equity ratios. ⁽²⁾ What does this mean though? Why is having a flexible capital structure target so important, especially in today’s economic climate? Do a firm’s financial leverage decisions affect investor confidence and ultimately the value of the company?  

                Despite the existence of models such as the Modigliani-Miller model, which argues that the value of a firm is not contingent on its capital structure, I believe the debt-equity ratio is in fact a decisive factor when valuing any financial institution. In an attempt justify my argument I will use the shortcomings of the Modigliani-Miller model, presenting what I feel are the 2 major drawbacks which render it ineffective.

                The model states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient markets, a company’s value is unaffected by how it is financed.  It is argued that capital structure merely determines how risk is allocated between bondholders and shareholders. Incorporated in this model are two propositions;

1)      The market value of a firm is independent of its capital structure

2)      The required rate of return on equity increases with financial leverage

I believe the Modigliani-Miller model to be an unrealistic, impractical one which cannot be applied to real markets. There are 2 underlining drawbacks in my opinion, which prevent the model from being relevant.

1)       Unrealistic assumptions

                Economic models are conceptual frameworks that aid in the understanding, description and/or prediction of human behaviour and although they all rely on certain assumptions on which they work, I feel that the assumptions in the Modigliani-Miller model undermine its validity and integrity completely.

Perfect markets are assumed- therefore no single buyer or seller can influence market prices. To me this is absurd, especially considering the current bond market in the Eurozone. The countless efforts by the ECB to stimulate the sovereign bond market by purchasing government debt would have no effect. The entire financial framework on which governments borrow would be undermined were this assumption to be true.

Similarly, perfect knowledge is assumed- investors all know with ‘prefect certainty’ what the future will bring, speculation will cease to exist and trading as we know will stop.

As ‘All players think alike’, there is a principle agent problem. How can controlling shareholders, managers and minority investors be expected to share the same views regarding the governing of a company.

Stock and bond equivalence means investors have no preference for the contractual promise of bonds, as compared to lack of corporate liabilities on equities.

Assuming tax neutrality, there is no tax difference between debt and equity. This means there is no tax on dividends or interest.

As all transactions are free, there are no brokerage fees, dealer spreads or transfer taxes, thus eliminating the need for brokers and stock exchanges.

                Although assumptions are widely seen as necessary for the formation of any economic model, the extent to which the Modigliani-Miller model adjusts economic fundamentals is too great to convince me of its relevance.

2)      Promotes high leverage

                The model, which justifies almost unlimited financial leverage to boost economic and financial activities. This has resulted in increased complexity, lack of transparency and higher risk and uncertainty in those activities. Particularly given the current financial crisis, not only is this model not suitable, I don’t believe any company will want to, let alone be allowed to operate with such a structure.  Modigliani and Miller argue that the capital structure should not affect the choices made by the investors as long as both parties are using the same risk free rate of interest. This promotes the idea that capital structure is irrelevant even when debt is risky, which to me is nonsensical because the substantially higher risk associated with a fully leveraged company must have some effect on how investors value that company. Take for example Kingfisher Airlines, an Indian airline currently facing severe financial problems. With debts of nearly 3$ billion ⁽³⁾, and huge losses over the past 4 quarters, doubt is emerging over the future solvency of the company. As investors have become spooked at the amount of debt associated with the airline, they have been reluctant to buy, causing the share price to collapse. Since January of this year, the share price of Kingfisher has fallen 63% to 25$.

                The very definition of a company’s total value or market capitalization is its share price, so the argument put forward by Modigliani and Miller that a high level of debt will not affect the value of a firm is invalid as it is clear it implicitly does. Investor speculation, confidence and demand for a company’s stock will determine its market value. As is the case with Kingfisher and countless other companies who adopted a highly levered capital approach, the existence of large amounts of debt on a balance sheet will deter potential investors, reducing the demand and ultimately price for the stock.

                The Modigliani-Miller model for all its repute is, in my opinion, flawed. Although a firm’s value does not depend entirely on the capital structure it operates under, I believe it does have some importance. Both the existence of grossly unrealistic assumptions and the share price uncertainty for a highly leveraged firm lead me to dispute the model and its propositions. The capital structure decisions taken by management can lead to changes in the valuation of a company by investors, a problem that has become increasingly common since the advent of the financial crisis.

References:

1)      http://businessetc.thejournal.ie/over-1000-companies-declared-insolvent-in-first-half-of-2011-171428-Jul2011/(

2)      HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? by John Graham and Campbell Harvey, Duke University / Journal of Financial Economics 60 (2001)

3)      http://www.aviationweek.com/aw/generic/story_generic.jsp?channel=awst&id=news/awst/2011/12/05/AW_12_05_2011_p46-397865.xml&headline=Indian%20Airlines%20Struggles%20With%20Deep%20Troubles&next=0

               

               

               

               

                 

Diversification in a recession, Is it effective?

3. What about diversification? How can we deal with risk in assets and what is risk anyhow?

Diversification in a recession, Is it effective?

            When it comes to investing, the most decisive factor is of course the level of risk associated with decision. Although thought of as a negative determinant, the level of risk will ultimately influence the extent of one’s economic returns- positive or negative. Risk; defined as ‘the chance that an investment's actual return will be different than expected’ ⁽¹⁾, has becoming increasingly complex and difficult to manage since the start of the current financial crisis, and investors have employed numerous tactics in an effort to reduce their exposure to risk. Hedging, insuring and diversifying are 3 types of risk management strategies, all of which are effective and necessary especially in the current economic climate.

            There are various different types of risk which can affect investments, divided into two categories, unsystematic (diversifiable) and systematic (non-diversifiable). Diversifiable risk is simply risk that is specific to a particular security or sector. It can be minimised by creating a portfolio with a large number of sound investments, all of which have little influence on the rest of the investments held. Take for example a portfolio of 3 airline stocks AMR, BAY and DAL. This portfolio contains a large amount of risk- risk which can be diversified away by the purchase of unrelated stock. If, for instance, the airline market was affected by a terrorist attack, the share prices for airline stock in general would decrease, therefore decreasing the entire value of the portfolio as all of the investments are related to air travel.

              

           What about now though? If ever markets were under-performing, volatile and incredibly risky, it’d be now. With fears of a double-dip recession and continuing low growth rates, will diversification be enough to offset the huge amount of systematic risk associated with market failure? Can investors protect themselves from personal losses by spreading their investments across a wide range of industries? In my opinion, its downturns like these in which diversification demonstrates its effectiveness and ability to prevent significant losses for investors.

            Volatility is essential for returns. 100€ placed in a company today could earn thousands tomorrow. Riskier investments generally generate greater returns- and greater losses. For the lucky (or smart) few, huge profits can be made on dangerous, risky investments. This however is not universal and most investors like to minimise their risk and ensure against any losses, losses which are ever prevalent during a recession. Some economists have argued that trying to diversify away risk in a recession is both impossible and useless. They believe that the effects of an underperforming market will cause stock indices to plummet, ultimately reducing the value of any portfolio. They see diversification as a futile attempt to reduce inevitable exposure to the market’s failings.

            To me this attitude seems like a losing one, one which surely won’t increase your chance of retaining any sort of value in a portfolio. Booms and busts are part of the economic cycle. The economy will recover, and unfortunately, fall again. But does this mean that there is no one who can weather the storm? Is every business, like every portfolio doomed to periods of financial loss and hardship? The whole concept of diversification is that some of the risk is removed by arranging assets in a manner that not all of them are contingent. Of course, certain industries will be affected, and the sales and share prices of certain companies will fall, but will this necessarily topple your portfolio? Not if you have sufficiently diversified your investments. Many companies have in fact profited from the downturn; either due to the nature of the industry in which they operate, or the fact that their superior positioning has allowed them to benefit from their insolvent competitors.

            Amazon.com is one of these companies. They have seen their revenue increase 38% since the beginning of the recession in 2007. ⁽²⁾ The online retailer has seen sales soar as thrifty consumers opt to search online for the best deals rather than buy from retail outlets. The ‘Wall-Mart of the web’ ⁽³⁾ has shown that its online store is both flexible and effective and with a low cost model, Amazon has enjoyed increased profits in recent years. Its share price has increased by 400% since January 2007, demonstrating its strength in the current market and US analysts at Stifel Nicolaus recently upgraded their shares to a buy rating. ⁽⁴⁾  

          Another company which has thrived despite the recession is the world’s largest retailer Wal-Mart. With its focus on low, ultra-competitive prices, Wal-Mart has become the replacement destination to the higher priced competitors. Net Income has risen in the past 3 years; 13.381$ billion in 2009, 14.37$ billion in 2010 and 16.389$ billion in 2011 ⁽⁵⁾, all while maintaining its philosophy of having the lowest prices around. Similar to Amazon, although not as considerable, Wal-Mart’s share price has risen from around 47$ to just under 60$ ⁽⁶⁾ over the past 4 years, 4 years in which we have experienced the most severe economic downturn in recent times, proving that not all investments are doomed to fail during a recession.

             It is evident that there are a certain few who actually perform better during an economic downturn, with Amazon and Wal-Mart being only 2 examples. Investment in either of these two firms would have seen large returns as their share prices increased proving that there is scope for profit to be made. The diversification of a portfolio will increase your chance of having money in an industry that will grow and prosper, despite the challenges it faces. If anything, during a recession diversification is more inclined to reduce exposure to risk. The increased volatility of the market means there is more scope to reduce risk by diversification, thus making it more effective.

References:

1) http://www.investopedia.com/terms/r/risk.asp#axzz1fDBivMAb

2) http://articles.moneycentral.msn.com/Investing/FindHotStocks/10-retailers-rising-in-the-recession.aspx

3) http://www.brandchannel.com/home/post/2009/09/22/Nimble-Amazon-Thrives-In- Recession.aspx

4) http://www.reuters.com/article/2011/10/03/us-amazon-research-stifel-idUSTRE7922EK20111003

5) http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?symbol=wmt

6) http://uk.finance.yahoo.com/echarts?s=WMT#symbol=wmt;range=5y;compare=;    indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;

External risk management techniques and their importance.

8.    An introduction to risk management tools

External risk management techniques and their importance.

            Risk is a term that is becoming increasingly common over the past few years as we try and deal with the worst financial crisis since WWII. With companies hiring top financial advisors to try and deal with the increasing levels of risk and lower their risk exposure, questions must be asked. Are these efforts necessary and effective and do risk management techniques deserve the importance that is placed upon them?

            Financial institutions encounter fiver general types of risk

  Interest rate risk

2)      Price risk

3)        Prepayment risk

4)       Credit risk

5)      Exchange-rate risk

These risks are unavoidable and cannot be completely eliminated, however with the help of risk management techniques, they can be significantly lowered in an attempt to reduce any considerable loss. There are a number of ways to manage risk; both internally and externally, however I feel that the scope for reducing a company’s exposure to risk internally is small and firm specific, therefore I will focus more on external tools. External risk management techniques are all market based tools in which expectations of future prices, interest rates or foreign exchange rates are used in an attempt to profit off favourable movements. For example an option could be used for a future transaction at a price agreed today. The buyer of the option gains the right-but not the obligation, to buy the good for an agreed price at some point in the future. Consider the price of the asset in question doubled 2 months after the option was bought; the buyer could exercise the right to buy that asset at the pre-arranged price, which would only be half of what the asset is worth if it is bought. If a company expects the price of a asset to rise in the future, they can purchase an option which reduces the risk that they will have to pay the higher future price. This is an example of hedging, which involves taking an offsetting position in a related security. However there is no guarantee that price will rise, so it is possible that the company could lose money on the purchase of the option by not actually exercising it if the prices in fact fall below current prices.

                    There are a number of different techniques similar to buying options that can be used to manage risk; with 2 of the most common and effective given the current volatile markets being forwards contracts and interest rate swaps. Like options, they are external risk management techniques known as derivatives, however interest rate swaps - as the name would suggest hedges the buyer against changes in the interest rate. Forward contracts are very similar to options except unlike an option which gives the buyer the right, not the obligation to buy; these derivatives assert that the asset WILL be bought for a price agreed today. Along with explaining both types of derivatives I will comment on their relevance to today’s markets and use an up-to-date example to help demonstrate how they can be used to manage and reduce risk.

             Forward contracts essentially protect against unfavourable changes in the interest rate. With the extremely volatile and uncertain foreign exchange market seen today, forward contracts are very handy in limiting the risk of sudden jumps in a currency. As we can see from the graph, the exchange rate between euro and dollars has been up-and-down. In fact yesterdays close saw a 1.4% fall in the euro with the exchange rate now at 1=1.2993- the euro’s lowest rate since the 11^th of January this year.⁽¹⁾ 

The growing uncertainty in the foreign exchange market means that companies such as Microsoft have engaged in forward contracts as a form of hedging. With over 9.3$ billion worth of foreign exchange contracts sold in 2011, Microsoft is actively involved in using derivatives to reduce their risk. ⁽²⁾ Their hedged currencies include the euro, Japanese yen, British pound and Canadian dollar. With a large amount of business activities, suppliers and customers internationally, Microsoft must manage their exposure to foreign exchange risk accordingly. For instance, if their New Zealand suppliers Black Diamond Technologies ⁽³⁾ limited charged them 1 million New Zealand dollars for an order at a rate of 1:.7523, this would translate to 752,300 US dollars. If however Microsoft expected the New Zealand dollar to appreciate against the US dollar, they could enter into a forward agreement to lock in the price of 752,300 for that order. Not only does this allow Microsoft to eliminate any risk of a loss due to an appreciation of the NZ dollar, it also provides certainty on the price they will pay. This allows Microsoft to set final prices and continue with production without having to worry about their supply price.

            Microsoft are not unique in using forward contracts to hedge. Many other S&P 500 companies such as AIG, Intel, McDonalds, Coca-Cola, Hewlett-Packard and Procter & Gamble also engage in forward contracts which, given the risky nature or current foreign exchange markets are very attractive and widely used.

            Similarly the use of interest rate swaps can be employed as a risk management technique and can considerably reduce a company’s exposure to changes in the interest rate. Interest rate swaps are cash-settled over-the-counter derivatives under which two counter parties exchange two steams of cash flows.⁽⁴⁾ The most popular interest rate swaps are fixed-floating swaps, whereby cash flows of a fixed-rate loan are exchanged for those of a floating rate. They are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. As we saw earlier, there are advantages to knowing the exact value of future cash flows, as is the case if you receive a fixed interest rate. With a greater certainty of income, companies can engage in more accurate budgeting and cost management techniques. This has become an increasingly necessary attribute for companies over the past few years due to the collapse of global banking systems and the financial crisis.  

            An example of a firm that engages in interest rate swaps is Unilever. Unilever is a British-Dutch multinational company specialising in fast-moving consumer goods. According to their report of directors 2011, Unilever uses interest rate swaps to ‘minimise interest costs and reduce volatility’. ⁽⁵⁾ Their interest rate management approach aims to achieve an appropriate balance between fixed and floating interest rate exposures, offering them the ability to both reduce uncertainty, and take advantage of current interest rates which are at a historic low in both the US and Europe.

            Consider a situation whereby Unilever is borrowing at a variable rate – the LIBOR rate which stands at 2.1%. They want to engage in a swap to allow them to have a fixed rate of borrowing rather than the LIBOR rate which is unknown after the first period. A second counterparty with a fixed interest rate payment of 2.3% will enter into a swap with Unilever. Therefore Unilever will pay interest of 2.3% for all periods i.e. a fixed rate to the counterparty, and the counterparty will pay the LIBOR rate plus 1% to Unilever. The incentive for Unilever is that the interest they pay on their borrowing is fixed, allowing them to budget more accurately. The counterparty will engage in the swap as they have the chance of receiving a higher interest rate than they are paying to Unilever, therefore making a gain. If the LIBOR rate is above 1.3%, they will receive more than 2.3% from Unilever (1.3% + 1%) although they are only paying 2.3% back.

            The use of financial derivatives is a great way to reduce exposure to risk and is commonly used risk management techniques. Given the nature of these external market-based methods, companies have realised the scope these techniques possess in reducing the chance of a loss. The unforgiving current market conditions necessitate that risk managers are extremely careful in the decisions they make and from previous experience derivatives can prove to be very dangerous if not handled properly. However the high level of volatility that causes this risk can provide greater scope to hedge successfully.

References:

(1)    http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html

(2)    http://www.microsoft.com/investor/reports/ar11/financial_review/derivatives.html

(3)    http://www.seek.co.nz/AdvHomes/lynnh/21157372_1.htm.profile

(4)    http://www.riskglossary.com/link/interest_rate_swap.htm

(5)    http://www.unilever.com/images/OutlookandrisksAR10tcm13259508.pdf