Search

Copyright of FinanzRundschau is the property of De Gruyter and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use. This abstract may be abridged. No warranty is given about the accuracy of the copy. Users should refer to the original published version of the material for the full abstract. (Copyright applies to all Abstracts.)

Copyright of FinanzRundschau is the property of De Gruyter and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use. This abstract may be abridged. No warranty is given about the accuracy of the copy. Users should refer to the original published version of the material for the full abstract. (Copyright applies to all Abstracts.)

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share-as much as 20%-of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough-the authors suggest five years-to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%. [ABSTRACT FROM AUTHOR]

Industrial companies typically face a multitude of risks that could cause significant fluctuations in their cash flow. This is a case study of the hedging strategy adopted by an international air carrier to manage its jet-fuel price exposure. The airline's hedging approach uses 'strips' of monthly collars constructed with Asian options whose payoffs are based on average of 'within-prompt-month' oil prices. Using the carrier's own implicit objective function based on an annual granularity, the authors show how the air carrier could fine-tune its current hedge portfolio by adding tailored exotic options. The article describes annual average-price options, provides an explicit valuation of them, and considers how such instruments may affect corporate liquidity. Consistent with its annual objective function, the airline made this exotic derivative the central tool to hedge across all potential realized values of annual jet-fuel spot prices. The authors believe this modified portfolio is better suited to address the firm's hedging cost and its overall exposure to jet-fuel price fluctuations. [ABSTRACT FROM AUTHOR]

Government-protected banking systems tend to blow up, imposing huge losses on taxpayers. In a recent much-publicized book, The Bankers' New Clothes, Anat Admati and Martin Hellwig propose to fix this problem by forcing banks to maintain 25% of their assets in the form of equity rather than debt. But this author argues, the book overstates the benefits and understates the costs of the proposed reform, while also failing to identify additional necessary reforms. Because bank equity is not true equity, and equity must be evaluated only in relation to risk, increasing required book equity ratios will not necessarily reduce the risk of bank failure significantly. Raising equity requirements is also socially costly because it reduces banks' willingness to lend. When banks need to raise their equity-to-asset ratios, they often choose to do so by cutting back on new loans, rather than paying the high costs of raising new equity. The reduction in loan supply that comes from raising equity ratios can be substantial, and is not just a one-time cost. Balancing the costs and benefits of higher equity implies a much lower required equity ratio than the 25% posited in The Bankers' New Clothes. Finally, because equity ratios relative to risk should be the focus of prudential regulation, additional regulatory policy reforms that strengthen incentives for more effective risk management are needed in addition to higher capital ratios. [ABSTRACT FROM AUTHOR]

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short-sale market to hedge themselves while distributing equity exposure to a large number of well-diversified investors through their short positions. The authors argue that many 'would-be' equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive 'equity-like' financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower. [ABSTRACT FROM AUTHOR]

In this edited transcript of his keynote address at Columbia Business School's Third Annual Financial Studies Conference, the Chairman and CEO of Morgan Stanley begins by tracing the origins of the 2008 financial crisis to the overleveraging of bank balance sheets that were filled with risky and illiquid assets. With the leverage of most large banks rising well above 30 times, reductions in asset values of as little as 3% would have been enough to wipe out their capital. And as the value of the assets began to be questioned, so was the banks' ability to roll over their short-term debt. Contrary to the popular perception, however, the fundamental problem with U.S. banks had almost nothing to with their size, or their complexity. It was in fact the smallest of the large U.S. financial institutions that got into the most trouble-while the largest, JPMorgan Chase, saw the least destruction of value during the crisis. What's more, U.S. banks are relatively small and focused compared to the large universal banks and highly concentrated banking systems that dominate most of the world's developed economies. Complexity itself was not really the culprit either. Some complex banks managed their risks effectively, while many conventional deposit-takers and lenders failed, reflecting significant differences in the quality and judgment of management. The response of the U.S. government to the crisis, mainly in the form of TARP, proved highly effective in limiting the damage to banks and the global economy. And to reduce the probability of a future banking crisis, U.S. regulators are now well along in implementing a new three-part regulatory model that consists of the following: (1) significantly higher capital and liquidity requirements that are designed to keep banks from getting into financial trouble; (2) annual report cards called 'CCARs' (Comprehensive Review and Analysis) for all banks deemed 'systemically important' in which bank balance sheets are subjected to 'stress tests' involving scenarios worse than the recent crisis; and (3) 'resolution plans' for reorganizing banks that get into trouble and whose capital ratios fall below acceptable levels. Thanks to such regulatory changes, and to the response of most financial institutions to them, the U.S. financial system has been restored to stability. In the case of Morgan Stanley, during the post-crisis period in which the firm's total assets have been cut by more than a third (from $1.25 trillion to $800 billion), liquid assets have more than doubled (from $80 billion to $180 billion), capital has doubled (from $30 billion to $62 billion), and leverage has been reduced from 35 times to 12 times. At the same time, the firm has shut down proprietary trading and other risky principal businesses while investing heavily in and expanding its most stable business-wealth management-which is expected to account for over 50% of its revenue and profits going forward. [ABSTRACT FROM AUTHOR]

An asset-driven liability (ADL) structure is analogous to a liability-driven investment (LDI) strategy. In both cases, the intent is to reduce the risk arising from a mismatch of assets and liabilities by aligning the interest rate sensitivity of cash flows on both sides of the balance sheet. Increasingly, defined-benefit pension plans have adopted LDI strategies that reduce their equity assets and increase the average duration of their debt assets to better match the typical long duration of their retirement obligations to its employees. To illustrate the concept of ADL, the authors use the example of a corporate issue of traditional fixed-rate debt that is transformed into synthetic floating-rate debt using an interest rate swap (in which the corporation receives the fixed rate on the swap and pays at money market reference rate like three-month LIBOR). The use of such long-term, floating-rate debt reduces interest rate risk when the firm has operating revenues that are positively correlated to the business cycle. However, a problem arises in that there is limited demand for such debt securities from institutional investors, many of which, because of LDI guidelines, prefer long-term, fixed-rate securities. Derivatives provide a way of resolving this mismatch between issuer and investor interests. In the article, the authors present a detailed example of the cash flows on the 'receive-fixed' interest rate swap (and its valuation for financial reporting) to show how the synthetic ADL debt structure obtains the desired outcome. [ABSTRACT FROM AUTHOR]

The article presents abstracts of articles on topics related to corporate finance including "Navigating the Financial Landscape," by James Morgan, "Reforming Banks Without Destroying Their Productivity and Value," by Charles Calomiris, and "Do Trading and Power Operations Mix?," by John Parsons.

The author investigates the interaction between risk management and capital structure among publicly listed German companies. By surveying executives at these companies, she computes a risk management score for each company indicating the extent of risk management practices. The scores reflect not only the companies' use of derivatives and 'at-risk' ratios, but also the respondents' assessments of how well risk management has been integrated into existing corporate processes. Some results, though not all, are consistent with finance theory. Most important, companies with more extensive risk management activities have higher debt ratios and lower interest coverage ratios. At the same time, such companies also exhibit lower volatility of cash flow, sales, EBIT, and net income, which helps explain their ability to service more debt. And, finally, companies with more extensive-and, according to their responding executives, more effective-risk management also tend to be larger, have longer debt maturities, lower average costs of debt, and have more tangible assets. [ABSTRACT FROM AUTHOR]

The author uses the case of Constellation Energy to show the challenges, and pitfalls, of running an energy and power trading unit as a profit center within a large power company. Sophisticated trading and risk management operations do play important supporting roles in power companies that face competitive wholesale markets. The complicated dynamics of power prices and the complex operations of generation assets and supply obligations require careful assessment of risks and returns. Trading operations can help extract more value from physical assets and supply obligations. But problems are bound to arise when companies attempt to manage the trading function as a stand-alone profit center. Determining the amount of capital required for proprietary trading portfolios and other elements of trading businesses is complicated. It is easy to underestimate the capital required and so exaggerate the profitability of trading. When profit center trading operations share a balance sheet with other business units-especially units with physical assets like generation-the natural tendency is for the trading operation to piggyback on the capital of the other units. The actual amount of capital consumed becomes apparent only in times of crisis. We have seen this mistake made repeatedly in the short history of trading operations in U.S. power companies. Only truly independent trading operations, with their own balance sheets, can be evaluated clearly and held accountable. [ABSTRACT FROM AUTHOR]

Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital. The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long-term strategic and financial priorities. Financial executives should consider the follow pension strategies: Voluntary Pension Contributions: Funding the pension gap by issuing new debt or equity can provide valuation and capital structure benefits-and in many cases is both NPV-positive and EPS-accretive. The authors show that investors have reacted favorably to both debt- and equity-financed contributions., Plan de-risking: Shifting the pension plan's assets from equity to fixed income has become an increasingly popular approach. The primary purpose of pension assets is to fund pension liabilities while limiting risk to the operating company. The pension plan should not be viewed or run as a profit center., Plan Restructuring: Companies should also consider alternatives such as terminating and freezing plans, paying lump sums, and changing accounting reporting. [ABSTRACT FROM AUTHOR]

The authors analyze the economics of natural gas production in the U.S. in light of the government's recent dramatic upward revisions in gas reserve estimates as a result of advances in horizontal drilling and fracturing ('fracking'). While some observers believe the U.S. will enjoy very large supplies of low-priced gas for a long time to come, others are not so sure. Using the data from gas wells completed in the Haynesville shale of northern Louisiana, the authors offer a probabilistic and economic perspective on these newly accessible reserves. Their model and NPV simulations indicate that shale gas exploitation is probably sustainable (with a 60% likelihood), but with some important reservations. NPVs are highly sensitive to gas price assumptions and projected production volumes. The authors' base case assumes the continuation into the foreseeable future of the current gas futures price curve; but the authors also point out that a fall in price of just 17% along that curve would reduce well NPVs to zero. Although it is clear that production from shale wells declines more rapidly than production from conventional wells, engineers have too little history with shale wells to forecast ultimate production with great confidence. Nevertheless, shale gas drilling opportunities also present energy companies with valuable 'follow-on' real options that are not captured in NPV analysis. This additional source of value is inherent in vast shale gas formations in which successful wells tend to lead to more development opportunities. [ABSTRACT FROM AUTHOR]

This article provides a framework for designing and evaluating corporate risk management and hedging programs. Corporate risk management has the potential to create substantial shareholder wealth by protecting companies from unexpected events that could force them to put their strategic investment plans on hold or even endanger their existence. However, assessing the performance of risk management, and how it is expected to increase the value of the enterprise, is a difficult undertaking because the costs of risk management tend to be much easier to quantify-indeed, they often appear directly on the firm's bottom line-than the benefits. The author begins by discussing how to evaluate the benefits and costs of a risk management program in general terms, and then focuses more directly on the assessment of corporate hedging programs, which are generally conducted with derivatives. In practice, there are many obstacles to designing and carrying out a successful hedging program. But one of the most common has been the tendency of top managements to insist that hedging programs be 'costless.' The author argues that just as the purchase of fire insurance is not viewed as waste of funds or a bad investment if the insured house does not burn down, the use of derivatives in a well-designed hedge should not be viewed as a mistake if the derivative position produces losses. To guard against this mistake, the people who design and implement risk management strategies must ensure that their CEOs and boards understand the possible outcomes of the strategy-including losses on derivatives position-and how the strategy itself increases the (expected) value of the firm. Further, management should attempt to communicate the principles underlying its risk management program and the value created by its hedging strategy to the investment community. [ABSTRACT FROM AUTHOR]

An introduction is presented in which the editor discusses various reports within the issue on topics which include hedging, corporate risk management, and bank costs of carrying and raising additional equity.