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Optimal Hedging Strategy

This document provides an explanation and parameters for determining the optimal level of hedging for a firm given its risk aversion and various financial factors. Key inputs include the firm's earnings exposure, volatility of risks, hedging costs, and cost of capital. The model then calculates the optimal percentage of exposure to hedge, which balances the marginal costs and benefits of hedging. It provides the resulting reduction in earnings volatility and estimated net savings from freeing up capital reserves.

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lucnes
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29 views1 page

Optimal Hedging Strategy

This document provides an explanation and parameters for determining the optimal level of hedging for a firm given its risk aversion and various financial factors. Key inputs include the firm's earnings exposure, volatility of risks, hedging costs, and cost of capital. The model then calculates the optimal percentage of exposure to hedge, which balances the marginal costs and benefits of hedging. It provides the resulting reduction in earnings volatility and estimated net savings from freeing up capital reserves.

Uploaded by

lucnes
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLS, PDF, TXT or read online on Scribd
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INPUT

EXPLANATION

Enter parameters into blue cells


Determine Risk Aversion - Sigma

The risk aversion Sigma represents the level of risk the firm is willing to undertake.

Probability firm will experience fiscal distress in a decade =

1.00

The maximum allowable probability of the firm not able to meet financial obligations in 10 years.

hich translates into the probability of distress in any 1 year of

0.10

Translating that quantification to the maximum probablity of financial distress in 1 year.

which translates into a risk aversion Sigma of

3.09

Model Parameters
Total firm earnings ($)

The main input box to enter parameters for the optimal hedging calculation.

Earnings exposed ($)

11.50

Volatility of hedgable risk price (SD as % of mean)

15.0

Volatility of non-hedgable earnings (SD as % of mean)

17.4

More volatile the hedgable risk price, the more useful hedging is. In contrast, the more volatile the nonhedgable earnings, hedging is less useful as more earnings volatility comes from other factors.

Marginal Cost of hedging (cents per $1 hedged)

0.40

The lower the expected cost of hedging, the more the firm should hedge.

11.0

The higher the cost of capital, the more the firm saves by freeing up capital reserves.

Risk free rate (%)

58.60

Translating into a risk aversion parameter. It is a nonlinear function with >3 tending "conservative".

5.0

CoC hurdle rate (%)

Result:
Optimal hedge =

26.7%

or

$3.07

The result gives the optimal proportion of exposure to hedge given all of the parameters.

of earnings exposed,

The proportion represents the equilibrium condition where the marginal cost equals marginal benefit.
The optimal dollar amount to hedge equals the optimal proportion times the earnings exposed.

EVA or Net Savings


SD Earnings prehedge

$8.37

Capital released

$0.24

Gross savings

$0.01

EVA or Savings

$0.002

Higher proportion of earnings exposed, less internally diversified, and a more likely hedging gain.

SD Earnings at hedge

Net savings represent a prehedge capital reserve released (or redeployed).


$8.29

The standard deviation (volatility) of firm earnings before and at the optimal hedge.
The freed-up capital is determined by the reduced volatility and size of reserves held per volatility unit.

Cost of hedging
--> % of exposure

$0.01

Gross savings represent the difference between investing the capital in the firm and keeping reserve.

0.02%

After deducting the hedging cost, the net savings can be set against the exposure for benchmarking.

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