FM213 Principles of Finance
Part 2
Lecture 10
Kim Fe Cramer
LSE Finance
Assistant Professor
What Did We Do?
1. What projects should you invest in?
• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options
2. How should you distribute the money you made?
• Lecture 3: Payout Policy
3. How should you raise more money for investments?
• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings
4. Should you agree to a merger?
• Lecture 9: Mergers, corporate governance, and control
5. How can you manage risk?
• Lecture 10: Risk management and hedging
1
What Did We Do?
M&A
• Definitions and facts
• Reasons for M&A
• Takeovers
- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?
2
This Lecture
1. What projects should you invest in?
• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options
2. How should you distribute the money you made?
• Lecture 3: Payout Policy
3. How should you raise more money for investments?
• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings
4. Should you agree to a merger?
• Lecture 9: Mergers, corporate governance, and control
5. How can you manage risk?
• Lecture 10: Risk management and hedging
3
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
4
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
5
Common Shocks for Households
• Health problems → health insurance
• Unemployment → unemployment insurance
• Accidents → accident insurance
• Fire → fire insurance
• Theft → theft insurance
• Weather shocks → flood/rainfall insurance
Most household shocks can be covered by insurance companies
6
Common Shocks for Firms
• Accidents → accident insurance
• Fire → fire insurance
• Theft → theft insurance
• Weather shocks → flood/rainfall insurance
Also some firm shocks can be covered by insurance companies
7
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
8
Insurance Companies
• When a firm takes up insurance, it is simply transferring the
risk to the insurance company; it does not reduce the risk itself
• E.g., Hurricanes Katrina, Harvey, and Irma each cost insurance
companies $40b
• Insurance companies have several advantages in bearing risk
1. Experience in insuring risk (estimating probability and loss)
2. Knowledge on how firms can reduce risk
3. Diversified portfolio of risk ("risk pooling") (but can’t
diversify away market or macro-economic risk)
9
Insurance Companies
• Assume you are a farmer and you want to insure your crops
against a drought. Your crops are worth 100,000, and you
estimate that there is a 1-in-10 chance per year that there will be
a drought. A 10,000 premium per year should make insurance a
zero-NPV deal (="break even"). But no insurance company
would offer that deal - why?
1. Administrative cost: variety of costs in arranging insurance
and handling claims (including legal costs)
2. Adverse selection: firms of "bad" type, e.g. farmers that use
less resistant crops, are more eager to use insurance
3. Moral hazard: once risk is insured, firms may be tempted to
take less precautions against damage (e.g. don’t water properly)
10
Common Shocks for Firms
• Accidents → accident insurance
• Fire → fire insurance
• Theft → theft insurance
• Weather shocks → flood/rainfall insurance
But how to insure...?
• Interest rate risk
• Currency risk
• Commodity price risk
11
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
12
Insuring vs Hedging
Insuring
• Shift potential losses to another party
• Does not reduce the risk of loss
Hedging
• Financial transactions that reduce the risk of loss
• When real asset falls in value, hedge makes money
• When real asset increases in value, hedge loses money
• Perfect hedge: gains/losses are perfectly correlated
13
Reasons to Hedge
1. Lower probability of bankruptcy
State 1 (p=0.5) State 2 (p=0.5)
Firm A 50 100
Firm B 100 50
• Suppose firm fails if CF<60 and bankruptcy costs 20% of firm
value. If CF=50, firm fails and its value is 50*0.8=40
• Firm value w/o hedge: 0.5*100+0.5*0.8*50=70
• Hedge: In good state, transfer 25 to other firm. In that case, CF
is always 75 and there is no bankruptcy
• Firm value w hedge: 0.5*75+0.5*75=75 (+5)
14
Reasons to Hedge
2. Lower the risk of being financially constrained
• If cash flows are low and positive NPV opportunity are likely to
arrive ("negatively correlated"), then hedging is beneficial because
you need money to invest
• If cash flows are high and positive NPV opportunity are likely to
arrive ("positively correlated"), then hedging is not beneficial
because you have money to invest
15
Reasons to Hedge
2. Lower the risk of being financially constrained
Example: negatively correlated
• Cash flow ("CF") is either 50 or 100
• Firm A has an investment opportunity that only arises in the bad
state, costs 60, and has a NPV of 30
• Again, firm A can hedge to receive 75 in each period
bad state good state expected
unhedged CF 50 100 75
unhedged CF with NPV 50+0=50 100 75
hedged CF 75 75 75
hedged CF with NPV 75+30=105 75 90
16
Reasons to Hedge
2. Lower the risk of being financially constrained
Example: positively correlated
• Cash flow ("CF") is either 50 or 100
• Firm A has an investment opportunity that only arises in the
good state, costs 60, and has a NPV of 30
• Again, firm A can hedge to receive 75 in each period
bad state good state expected
unhedged CF 50 100 75
unhedged CF with NPV 50 100+30=130 90
hedged CF 75 75 75
hedged CF with NPV 75 75+30=105 90
No gains from hedging!
17
Reasons to Hedge
3. Managers are risk averse
• Shareholders can diversify the risk of one firm, but managers
can’t. Their income is directly linked to how well the firm is
doing (e.g., lose job if bankruptcy)
• Should we hedge the risk for managers? Maybe, but note that if
managers don’t bear the risk, they might extract too many
private benefits
4. Employees are risk averse
• Regular employees can’t diversify either
• Should we hedge the risk for employees? Yes, they often don’t
have the power to extract too many private benefits
18
Who Should Hedge?
1. Firms with high probability/cost of bankruptcy: e.g.,
firms that have high intangible capital, so they have trouble
selling assets to protect from financial distress
2. Firms with high risk of being financially constrained: e.g.,
very opaque firms that experience a strong asymmetric
information problem and can’t raise external capital easy to
invest in positive NPV projects
3. Firms that have well-behaved managers: e.g., where the
risk that managers extract private benefits is not too high
4. Firms that have unprotected workers: e.g., firms in
countries were unemployment insurance is bad
5. Firms in which investors are not diversified: e.g., private
firms in which investors mostly own only this firm
19
Terminology
Hedging
• Financial transaction that reduces the risk of loss in one asset
(e.g. one firm) by taking an offsetting (= opposite) position
Diversification
• Portfolio managing strategy investors use to smooth risk of loss
among all their assets
Speculation
• A trading strategy to make profit from a security’s price change
(not designed to reduce losses)
20
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
21
Hedging with Derivatives
Hedging generally involves use of derivatives: instruments whose
returns are derived from the performance of an underlying asset
(e.g. equity, bonds, currencies, or commodities)
Types
• Options
• Futures
• Forwards
• Swaps
22
Hedging with Derivatives: Options
• How can options be used for hedging? Real-life example: Mexican
government heavily relies of revenues from a state-owned oil
company ("Pemex")
• Government protects itself against fall in oil price by buying put
options (= right to sell 250m barrels at an exercise price of $55)
23
Hedging with Derivatives: Options
24
Hedging with Derivatives: Forwards (and Futures)
Forwards
• Agreement to sell an asset at a future date at a fixed price that is
set today (e.g. sell 30 tons of corn on Jan 1st, 2025 at $250/ton)
Futures
• Same contract as forwards, but traded on an exchange
Underlying assets
• E.g., agricultural commodities (corn, soybeans), non-agricultural
commodities (gold, oil), and financial assets (30y government
bonds, Swiss Francs)
• The actual asset is not usually delivered (and sometimes it is
explicitly forbidden)
25
Hedging with Derivatives: Forwards (and Futures)
Example
• Assume that a solar company wants to sell energy but hedge
against electricity price changes
• 1st of January 2023, they sign a forward contract to sell 1m kWh
solar electricity on 1st of January 2024 at $0.34/kWh
• This is a hedge: If the price of solar electricity goes up, the value
of the forward goes down. If the price of solar electricity goes
down, the value of the forward goes up
26
Hedging with Derivatives: Swaps
Swaps
• A swap is an exchange of one set of cash flows (e.g. a floating rate
loan) for another set of cash flows of equivalent market value (e.g.
a fixed rate loan)
Example
Solar company A took up a loan of 1m with a floating interest rate. It
is worried that interest rates will increase in the future, so it prefers a
fixed interest rate. It can swap with solar company B who also took
up a loan of 1m with a fixed interest rate, but who thinks that
interest rates will decrease in the future, so prefers a floating rate.
27
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
28
Corporate Finance Research Over History
1. The neoclassical world (mid-1960s)
• What effect do capital structure and dividend policy
have on firm value? Modigliani-Miller irrelevance theorem;
models focused on the basics but too simplistic.
2. Breakdown of the neoclassical world (end-1960s)
• Do the MM-assumptions hold? Major efforts were devoted to
refuting the MM theorems empirically. Researchers introduced
new models that relax MM assumptions, e.g. introducing a
separation between owners and managers, information
asymmetries, adverse selection, and signaling.
29
Corporate Finance Research Over History
3. MM frictions for firms (1970s-1990s)
• How to discipline managers? Researchers thought about how
financial contracts can be used to discipline managers, e.g. debt
could prevent them from excessive private benefits. Learned
about non-pecuniary benefits to managers such as reputation
• How do taxes and bankruptcy affect firm value? More
research on frictions was conducted, especially those discussed in
MM: taxes and bankruptcy.
4. M&A (1970s-1990s)
• Research in this period was also inspired by events observed in
the market such as merger waves. Until now, all topics are
predominantly focused on firms
30
Corporate Finance Research Over History
5. Volatility of banks’ credit supply (1990s)
• How does monetary policy affect credit supply to firms?
The central bank (=FED) adjusts interest rates, and research
tries to understand how that affects firms. First support of a
bank lending channel, so banks borrow from FED and then lend
to firms. Also important during 1990s Japan banking crisis.
Additionally, evidence of supply-side volatility in insurance
markets
6. Cross-country: financial development (1990s)
• How does financial development affect firms? Financial
development has substantive support in economic growth,
working partly by reducing cost of external finance to financially
constraint firms
31
Corporate Finance Research Over History
7. Cross-country: law and finance (1990s)
• How do laws affect firms? With globalization and European
integration, researchers started asking how legal rules (e.g. of
corporate shareholder rights) shape firms. Countries with poorer
investor protection have smaller capital markets
8. Entrepreneurship and innovation (1990s)
• What fosters entrepreneurship and innovation? E.g.,
inherited wealth fosters entrepreneurship because in many
(developing) settings it is hard to bring in financiers and keep
employees
32
Corporate Finance Research Over History
9. Firm size and ownerships (1990s)
• What is the optimal firm size? Should firms be private
or public? E.g. research on optimal firm size studying business
groups. Mixed results on whether private or public is better
10. Managerial compensation (1990s)
• How much should managers get paid? Increasingly data on
CEO compensation available
33
Corporate Finance Research Over History
11. Corporate governance (2000s)
• How should companies be governed? Corporate governance
identifies who has power and accountability, and who makes
decisions. It is, in essence, a toolkit that enables management and
the board to deal more effectively with the challenges of running
a company.
12. Information processing (2000s)
• Does distance matter? In large firms, decisions have to be
made by managers who are organizationally or geographically
distant from the site where information is gather; soft info does
not travel well. Test that with bank lending data. Large banks
less willing to lend to difficult borrowers than small banks.
Distance has increased over time, consistent with better
information technology by banks. Physical distance remains
strong barrier.
34
Corporate Finance Research Over History
13. Financial constraints (2000s)
• Are firms financially constrained? First efforts to measure
financial constraints of firms, e.g. by how many cash they hold.
Alternatives to bank credit discussed such as trade credit
14. International finance (2000s)
• How do firms act across boarders? Looked at multinational
firms and how they behave. Effect of debt relief agreements on the
stock market. How is capital attracted to low-income countries?
35
2008 Financial Crisis Shifted Research
36
Corporate Finance After the Financial Crisis
New topics
The 2008 crisis shifted research to role of credit cycles, fragility of
financial institutions, household behavior, and macroeconomic
consequences. Traditional topics receive less attention
New methods
New statistical methods (causal identification) and structural
estimation of theoretical models to tease out macro-economic
implications of micro-empirical insights
Old frictions
Agency and information problems remain central imperfections, but
are now applied between agents (e.g. banks and households) instead of
in firms
37
Corporate Finance After the Financial Crisis
15. Household finance (my field!, post-2008)
• Households: as borrowers (majority of bank loans in form of
mortgages and credit balances), as savers, as investors, as
financial advisers, as corporate managers
• Examples: credit cards have excessive fees, U.S. CARD act
regulated credit cards and reduced borrowing costs. Lot’s of
research on mortgages and misconduct of financial advisors
16. Behavioral finance (post-2008)
• Biases of households, investors, managers, and markets. E.g.
people don’t pay enough attention to credit card fees or don’t
renew their mortgage if interest rates decrease
38
Corporate Finance After the Financial Crisis
17. Banks in the spotlight (post-2008)
• Banks take deposits and invest them. Observations about the
bank balance sheets that explain why regulation is needed; e.g.
bank depositors don’t monitor bank, and they might take
excessive risk. Increasingly regulated after the 2008 financial
crisis
• How do banks screen and monitor borrowers? Do banks price
loans appropriately given a borrower’s risk? Not during the 2008
crisis!
• Emergence of the "shadow banking system" (unregulated)
39
Corporate Finance After the Financial Crisis
18. Corporate bond markets (post-2008)
• Along with the shift from industrial firms to banks, researchers
have shifted their attention from equity to credit markets. Bonds
made up much of the shortfall in bank lending during the 2008
financial crisis
19. From micro to macro (post-2008)
• Understand the effect of micro-observations on macro-trends, e.g.
from households’ taking up mortgages excessively pre-2008 to
aggregate consumption and employment responses
• How crisis/fortune spreads: local contagion of firm bankruptcies,
capital flows through branch networks
40
Corporate Finance Today
20. Social finance (today)
• Peer effects = how your fellow neighbors/colleagues/friends
impact your financial decision-making (e.g. whether how you
invest or which bank you choose)
21. ESG/Green finance (today)
• ESG = environment, social, and governance and green finance.
Do green investments make more returns (doing good by doing
good?), how can banks be regulated to divest from brown
companies?
The 60 largest commercial and investment banks have collectively
financed $3.8 trillion in fossil fuel companies between 2016 and
2020, the five years since the Paris Agreement was signed.
41
Corporate Finance Today
22. Just finance (today)
• What are distributional effects of policies or crisis? Are banks
discriminating against lenders of certain race or income? How can
gender imbalances in boards be addressed? Does the U.S.
paycheck protection program help small businesses?
23. FinTech/crypto finance (today)
• What role do new technologies play in addressing traditional
frictions? E.g. mobile-money reduces transaction fees,
RobinHood allows financial inclusion to the stock market
24. Finance & development (my field!, today)
• More data available, huge return in terms of improving human
welfare if we find out how to reduce frictions here
42
What Did We Do?
1. What projects should you invest in?
• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options
2. How should you distribute the money you made?
• Lecture 3: Payout Policy
3. How should you raise more money for investments?
• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings
4. Should you agree to a merger?
• Lecture 9: Mergers, corporate governance, and control
5. How can you manage risk?
• Lecture 10: Risk management and hedging
43
Lecture Overview (Chapter 27)
• Common shocks
• Insurance
• Hedging
▶ Reasons
▶ Derivatives
Extra: corporate finance research then and now
44
Thank you!
45
