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

Model Parameters
The main input box to enter parameters for the optimal hedging calculation.
Total firm earnings ($) 58.60 Earnings exposed ($) 11.50 Higher proportion of earnings exposed, less internally diversified, and a more likely hedging gain.
Volatility of hedgable risk price (SD as % of mean) 15.0
More volatile the hedgable risk price, the more useful hedging is. In contrast, the more volatile the non-hedgable earnings, hedging is less
Volatility of non-hedgable earnings (SD as % of mean) 17.4 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.
Risk free rate (%) 5.0 CoC hurdle rate (%) 11.0 The higher the cost of capital, the more the firm saves by freeing up capital reserves.

Result: The result gives the optimal proportion of exposure to hedge given all of the parameters.
Optimal hedge = 26.7% of earnings exposed, The proportion represents the equilibrium condition where the marginal cost equals marginal benefit.
or $3.07 The optimal dollar amount to hedge equals the optimal proportion times the earnings exposed.

EVA or Net Savings Net savings represent a prehedge capital reserve released (or redeployed).
SD Earnings prehedge $8.37 SD Earnings at hedge $8.29 The standard deviation (volatility) of firm earnings before and at the optimal hedge.
Capital released $0.24 The freed-up capital is determined by the reduced volatility and size of reserves held per volatility unit.
Gross savings $0.01 Cost of hedging $0.01 Gross savings represent the difference between investing the capital in the firm and keeping reserve.
EVA or Savings $0.002 --> % of exposure 0.02% After deducting the hedging cost, the net savings can be set against the exposure for benchmarking.