Appendix E: Portfolio Risk Reduction Diversification ... · Diversification andDiversification and and Risk ... after spending more than three ... Examining Its Patterns and Determinants

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Appendix E:Portfolio

Diversification andDiversification and and Risk

Risk Reduction

Risk Reduction Strategies for Media Projects

1. Insurance2. Shift risk to

investors/buyers/suppliersi ifi i3. Diversification

4. Breaking up projects into stages, with several go/no go decisions for financing

5. Hedging

How can media firms reduce the riskiness

Media Finance and Risk

of investment?

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• Diversify investment portfolio (ie: conglomerate mergers).

• Choose appropriate debt pp pmaturity structure to reduce liquidity risk.

• Evaluate if the new project fits the firm’s corporate and business level strategy.

How to evaluate if an investment fits the firm

strategy?

-- and therefore minimize investment risk

How can media firms reduce the riskiness

of investment?

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Risk Management

Problem of Risk Estimation

• An average calculated from a given sample of movies will be a poor forecast of the average ina poor forecast of the average in the future. Because the average is unstable, it is a poor estimator of the expected next event.

• De Vany and Walls, “Does Hollywood Make Too Many R-Rated Movies? Risk, Stochastic Dominance, and the Illusion of Expectation” Journal of Business, July 2002, vol. 73, no. 3

• The stable Paretian model is the right model.


Fig. 3. Normal and stable Paretian distributions of revenueN


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• The probability distribution is highly skewed and is not symmetrical. Most of the probability mass is placed on the

f lmost frequent, low-revenue outcomes.


• The mean revenue is much higher than the most probable revenue.


• This is different from a normal distribution where the most probable outcome (the peak of the probability density curve) equals the mean.


• The tails of the distributions are where the important events are located.


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• Risk of potential embarrassment if a rejected project becomes

th t di ’ hitanother studio’s hit.

Epstein, Edward Jay, “The Big Picture, The New Logic of Money and Power in Hollywood,” New York: E.J.E. Publications, Ltd., Inc., 2005

• For example, Universal Pictures, after spending more than three years developing the script ofyears developing the script of Shakespeare in Love, finally decided not to green-light it and instead put it in turnaround.


• Disney’s subsidiary Miramax bought it and produced it, and the fil t t ifilm went on to win seven Academy Awards, including Best Picture of 1998.


• In turning down projects, there is also the risk of alienating

d di t d t llproducers, directors, and stars, all of whom a studio may need for future films.


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• As one Hollywood agent explained, “Whatever the fi i l l l it t k t lfinancial calculus, it takes a truly brave studio head to reject the movies of stars they value.”


Potential Risk Treatments• Risk Transfer• Risk Avoidance• Risk Reduction• Risk Retention

Source: Wikipedia website – “Risk Management” http://en.wikipedia.org/wiki/Risk_management

Risk Transfer

• Causing another party to accept the risk, typically by...

― Contract [ie: insurance]― Hedging [ie: derivatives]


Risk Avoidance• Not performing an activity that

could carry risk.• Might forgo the potential gain.

ie: not buying a property or business to avoid the liabilitySource: Wikipedia website – “Risk Management” http://en.wikipedia.org/wiki/Risk_management

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Risk Reduction• Involves methods that reduce

the severity of the loss.ie: Modern software

development methodologies reduce risk by developing and delivering software incrementally


Risk Retention• Involves accepting the loss when

it occurs.ie: any amounts of potential loss

(risk) over the amount insured


• Risk Retention is acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts isfor greater coverage amounts is so great it would hinder the goals of the organization too much. Source: Wikipedia website – “Risk Management” http://en.wikipedia.org/wiki/Risk_management

Areas of risk management(Basel II framework)

• Market Risk (price risk)Market Risk (price risk)• Credit Risk• Operational Risk

Sources: Bank for International Settlements -http://www.bis.org/publ/bcbs118.htm

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Basel II “three pillars” concept-- to promote greater stability

in the financial system

• Minimum capital requirementsMinimum capital requirements• Supervisory review• Market discipline

Sources: Bank for International Settlements -http://www.bis.org/publ/bcbs118.htm

Hedging and Corporate Ri k M tRisk Management

• What sorts of risks should be hedged?

• Should they be hedged partially of fully?of fully?

• What kind of instruments will best accomplish the hedging objectives?

Building optimal hedging strategy...

• When external finance is more tl th i t ll t dcostly than internally generated

funds, it makes more sense for firms to hedge.Kenneth A. Froot, David S. Scharftein, Jeremy C. Stein, “Risk Management: Coordinating Corporate Investment and Financing Policies” in The Journal of Finance. Vol XLVIII, NO.5 December 1993

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• Optimal hedging strategy does not insulate firm value from marketable sources of risk.

• Optimal hedging strategy will d d b th th t fdepend on both the nature of the product market competition and the strategy adopted by competitors.

Kenneth A. Froot, David S. Scharftein, Jeremy C. Stein, “Risk Management: Coordinating Corporate Investment and Financing Policies” in The Journal of Finance. Vol XLVIII, NO.5 December 1993

• Firms will want to hedge less, the more closely correlated are their cash flows with future investment opportunities.

• Firms will want to hedge more, the gmore closely correlated are their cash flows with collateral values (and hence their ability to raise external finance.)


• Multinational firms will have to take in more considerations when hedging, such as exchange rate.

• Nonlinear hedging instruments (ie: options) allows firms to(ie: options) allows firms to coordinate risk management more precisely than linear ones (ie: futures and forwards).


Fund(2001)

Fund Manager

Net Assets In Top 10Holdings

1-Year Total

Return

Expense Ratio

Least Risky

AIM Global Utilities Fund (AUTLX) Team Managed 22.93% 30.43% 1.06%Gabelli Global Telecom Fund (GABTX)

Mario J. Gabelli and Marc Gabelli 25.67 29.05 1.6

Riskier

Fidelity Select Telecom (FSTCX) Peter Saperstone 49.35 27.04 1.09T. Rowe Price Media& TelecommunicationsFund (PRMTX)

Robert N. Gensler 27.75 43.86 1.03

Montgomery Global Communication Fund (MNGCX)

Oscar Castro and Stephen Parlett 23.61 46.35 1.68

Riskiest

Invesco Telecomm.Fund (ISWCX) Brian B. Hayward 26.77 85.6 1.24Fidelity Select Developing Communications (FSDCX) Rajiv Kaul 47.95 90.95 1.11

Source: Morningstar (Aug 16, 2001)

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• A studio or other media company pools numerous risky projects, making their aggregate cash flow

Risk Reduction Strategy #3:Diversification

making their aggregate cash flow reasonably safe for the lender.

• A venture capital fund pools numerous projects for investments

• Source: Caves, Richard E. Creative Industries: Contracts Between Art and Commerce. Cambridge: Harvard University Press, 2000

• If a company is producing many projects, each project will have an expected return

http://www.amler.com/personal/graphix/Battlefield%20Earth.jpg

• Can Estimate Risk–From the success and failure of the movies in the past

–Need to assume the type of distribution of films (normal, etc.)

Portfolio Diversification in M di C iMedia Companies –

Examples

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Product diversification of leading media conglomerates

Sylvia M. Chan-Olmsted. „Diversification Strategy of Global Media Conglomerates: Examining Its Patterns and Determinants.“JOURNAL OF MEDIA ECONOMICS, Vol. 16, issue 4 (2003): p. 221.


• Sony relied on very few media content businesses (32% from music and 31% f fil d t t i t) d th


from filmed entertainment) and thus was the least diversified. (The other 37% of its revenues being sales of consumer products)


• Sony was followed by News Corp., with 70% of its revenues from media

t t d t (29% f fil d


content products (29% from filmed entertainment and 41% from publishing) and 30% from media distribution.


• AOL Time Warner was overall most diversified in both the content (45 % t t l ith 11% f i 21% f


total with 11% from music, 21% from filmed entertainment, and 13% from publishing) and distribution/outlets (55%).

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• Bertelsmann and Vivendi Universal are similarly diversified

AOL Ti W di


as AOL Time Warner regarding content products.


• Viacom and Disney did not diversify into the cable sector but

li d l h b d i


relied mostly on the broadcasting distribution/outlets.


Summary of the study (2003):1. AOL Time Warner2 B t ltio

n


2. Bertelsmann3. Viacom and Vivendi Universal4. Disney, News Corp.5. SonyD

iver

sific

at



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Diversification - AOL• AOL's takeover of Time Warner in

2000, the largest fusion in the online and media sector at the time.

• AOL has secured attractive content for its online business, while Time Warner is able to market its products via the internet.

Bernd W. Wirtz. “Reconfiguration of Value Chains in Converging Media and Communications Markets.” Long Range Planning, Volume 34, Issue 4 (August 2001): p. 489-506

Diversification - Vivendi• Vivendi has operations in water,

waste management and transport services. This reduces the risk,services. This reduces the risk, when advertising revenues decline.

Robert G. Picard. Media Firms: Structures, Operations, and Performance. 2002, p. 106

Diversification - News Corp• News Corp's is highly diversified by

both medium (newspapers, TV, satellite, books) and geography.

• Combines content provision (e.g., TV series and films) and delivery platforms (e.g., Fox TV stations, cable and satellite TV).

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Diversification - News Corp• The acquisition of DirectTV by

News Corporation is an example of vertical diversification. Through DirectTV News Corp can distribute more of its media content.

Diversification reducing risk• Diversification into different

media does not necessarily reduce risk. Example:reduce risk. Example:Bertelsmann investing heavily into new information and communication technology.

Robert G. Picard. Media Product Portfolios: Issues in Management of Multiple Products and Services. 2005, p. 45

Risk Reduction Strategy #1: Insurance

• 1.3% to 1.5% of a film budget spent on general insurance.

• Film must buy a completion bond, (an insurance policy, cost 3-5% of the budget.)

• The bond commits the guarantor to take over and finance/finish the shooting of a film if it has run over some stated amount date or budget

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• Guarantors typically charge 6% of production budget, with 3 % rebated if the guarantee is not invoked.

• The guarantor rarely steps in, but ensures financial prudence

Completion of film after Natalie Wood–Completion of film after Natalie Wood drowning

• Can require special conditions–Chaperone for Courtney Love

Courtney Lovehttp://images.usatoday.com/life/_photos/2004/2004-03/16-courtney-love-inside.jpg

Natalie Wood

http://asterpro.bizhosting.com/graphic/thumbnails/12_4b_natalie_wood_t.jpg

•The bond enhances the credit quality of a product from subordinated debt (high risk) tosubordinated debt (high risk) to wards investment-grade level (lower risk).

Risk Reduction Strategy #2: Shifting Risk

• Shifting financial risk to investors, performers, distributors

• The main participants typically take combinations of fixed compensation and a share of gross box-office receipts.

Theater: Actors’ Risk Sharing

ece p s.• Investors in a show divide 50% of

net profits among themselves; the other 50% goes to the producer.

Source: Caves, Richard E. Creative Industries: Contracts Between Art and Commerce. Cambridge: Harvard University Press, 2000

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Shortage of risk-sharing resources in Europe

• Few institutions specialize in lending to the audiovisual sector

Th t th f h t f- The sector thus faces a shortage of risk-sharing resources

Closs, Wolfgang, “Analysing Case Studies of European Film Success,” 1 March 2003. European Audiovisual Observatory. 22 July. 2005.

<http://obs.coe.int/online_publication/reports/forum2001_report.html.en>

Riskiness of a Project• Genre

- Action/Romance/Teenage movies have less risk than

i d dserious drama or documentary.• Size of Target audience• Release time• Star Cast

Measure risk with stats not dependent on cash flow

• Debt/contributed capital• Debt/net plant expenditures• Minimum revenue targets• Minimum percentage buildout

targetsWest, Rob, “Competing for Capital,” Telephony, Commerce; ISSN: 0040-2656. Intertec Publishing Corporation, February 28, 2000.

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4th Risk Reduction Strategy:Hedging

• Using derivatives (futures, options, forwards, and swaps)C t l l f ti• Central role of an option structure:–The investing party holds the right to cancel at several defined steps

• Publishing companies purchase options on paper to protect against changes in the prices

• Purchase options to buy paper at p y p pa certain price. If the market price exceeds that price, they exercise them

• With the later additions of options and swaps, derivatives have become recognized as a

Derivatives

very cost-effective way to manage risk and enhance potential returns.

“Bright Future” Financial Times Business Limited. 23 June 2004.<http://web.lexis-nexis.com/universe/document?_m=38d9d884ac294fce4d6af6246c1f1344&_docnum=1&wchp=dGLbVtz-zSkVA&_md5=0b3981e74c9d83dc7c87dc739a78822c>

• Derivatives can re-shape the risk profile, either increasing or decreasing exposure.

• Protected funds provide a perfect

Derivatives

• Protected funds provide a perfect example of how derivatives can help a fund reduce risk to achieve its objectives.


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• They typically combine equity-related instruments and near-cash investments in order to generate returns in proportion to the targeted market whileto the targeted market, while protecting investors' capital.


Limiting Risk to Investors

• Partnership strategies in distribution and production

• Co-production agreements

What is a derivative?What is a derivative?

• Definition: A financial instrument whose characteristics and value depend upon the characteristics and value of one

d l i t Thor more underlying assets. The derivative itself is merely a contract between two or more parties. Source: www.investorwords.com

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• Intuition: Derivatives transfer risk from people who don't want to bear it to speculators who are willing to do so inwho are willing to do so in return for the chance to make a profit.

Typical Underlying Assets• Stocks• Bonds• Commodities• Commodities• Currencies• Interest rates• Market indices

Two Derivative Groups• Over-the-counter (OTC)

derivatives • Exchange-traded derivatives

Common Derivative Contracts

• Futures contracts• forward contracts• Options• Swaps

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Pre-sales• Selling the right to distribute a

film in different territories beforeth fil i d d b d ththe film is produced based on the script and cast.

Source: http://en.wikipedia.org/wiki/Film_finance

• High Costs – Huge salaries paid to movie stars; fees for agents and lawyers (ranging from $10 million to $30from $10 million to $30 million); perks and percentage of the profits paid to agents and lawyers.


German tax shelters• With the favoring German tax

law of instant tax deduction, the film producers can sell the copyright to one of these taxcopyright to one of these tax shelters for the cost of the film’s budget, then have them lease it back for a price around 90% of the original cost.


For instance, on a $100 million film, a producer could make $10 million, minus fees to lawyers and middlemen.lawyers and middlemen.

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• Until then, the financing is up to the producer, who must also pay any additional costs if the film goes over-budget.film goes over budget.

Example: Superman and Never Say Never Again


Conclusion• Financing option can affect the

selection of a film and the film content in different ways.-- Higher costs-- Higher costs-- Tax benefits-- Film shooting location and cast-- TV hits-- Over-budget concern

Are Derivatives D ?Dangerous?

Current Issues in the Derivative Market

• Highly concentrated: Just 7U.S. banks own nearly 96% of h d i i i h b kithe derivatives in the banking

system (from The Office of the Comptroller of the Currency 2003)

Coy, Peter. “Are Derivatives Dangerous?” Business Week, 3/31/2003 Issue 3826, p90-90, 1p, 1c

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• Lack of regulation: Most derivatives are traded directly between the parties and not on exchanges, they are almost entirely unregulated.

Coy, Peter. “Are Derivatives Dangerous?” Business Week, 3/31/2003 Issue 3826, p90-90, 1p, 1c

More about Common Derivative

Contracts

Futures vs. Forwards• Futures are always traded on an

exchange, whereas forwardsl t d OTCalways trade OTC.

• Futures are highly standardized, whereas each forward is unique

• The price at which the contract is finally settled is different:

–Futures are settled at theFutures are settled at the end

–Forwards are settled at the start

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• The credit risk of futures is much lower than that of forwards: –Futures: The profit or loss is

exchanged in cash every day. After this the credit exposure is again zero. p g

–Forward: The profit or loss is only realized at the time of settlement, so the credit exposure can keep increasing.

• In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodicrequirements and periodic margin calls.

Futures vs. Options• A futures contract gives the

holder the right and the obligation to buy or sell.

• An option gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right.

Examples of Common Derivative Contracts

• Futures: Commodities (ie: bandwidth), Foreign Exchange,bandwidth), Foreign Exchange, Equities & etc.

• Forwards: Currency, Commodities (ie: oil) & etc.

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• Options: Commodities, Interest Rates, Bonds & etc.

• Swaps: Interest Rate swap ( ) i(most common swap), Equity swap & etc.

Selected Option Strategies

• Covered call • Straddle

•Bull Spread•Bear Spread

• Strangle •Butterfly•Box Spreads

Examples of derivatives exchange

• The Standard Internet access (PrimeIP) is traded on $22/Mb A f d t t$22/Mbps. A forward contractcan be a price of $25 or $20 in a future date, for instance, for the contract buyer to buy or for the writer to sell.

• A film option is a contractual agreement between a movie studio, or a production company, and a writer, incompany, and a writer, in which the producer obtains the right to buy a screenplay from the writer, before a certain date.

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Example: • Paramount optioned the book

by Philip K. Dick.

• Sony Pictures optioned the book The Da Vinci Code.

• A number of Philip K. Dick’s books have been adapted into movies, such as Minority Report by DreamWorks andReport by DreamWorks and Twentieth Century Fox; Screamers by Columbia TriStar.

Movie studio has the right to buy but not the obligation to produce the screen play of the writer

• In 1974, French film maker Jean-Pierre Gorincommissioned Dick to write a screenplay for a Ubik film. Dickp ycompleted the screenplay but Gorin never filmed the project.

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How to price film options?film options?

Example of Media Derivative:A $400 million, 7-year Eurobond issued in 1992 by Disney.y

• The interest rate was tied to the revenues from a combination of 13 Disney movies released in Europe.

Don M. Chance, Eric Hillebrand, Jimmy E. Hilliard, “Pricing an option on a Non-decreasing Asset Value: An application to Movie Revenue” Dec 16, 2005

• The rate was set at 7% for 18 months.

• Beyond that date, the coupon was set at a formula related towas set at a formula related to the movie revenues.

• The total rate would end up being between 3% and 13.5%.


Difficulties in pricing real option on revenues

1. No observable underlying at the start of the option’s lifethe start of the option s life because the film option is sold before any revenue is generated.


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2. Non-decreasing underlying revenue stream is different from traditional options.

Diffusion models areDiffusion models are inappropriate for valuing options on revenue streams.


3. Uncertainty resolves rapidly in the first few weeks after release

the valuation of movie option has to accommodate the intense concentration of uncertainty at the start of this unique option’s life.


Call Option Value Put Option Value

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a = average ticket price d = max{0,K-N(s)}


Valuing the revenue stream

aN(s) is revenue already receivedam (F(T) – F(s)) is the expected remaining revenue


Equation of the estimation prior to any revenue data


Regression for estimation equation for 244 movies

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(cont.) What does the regression show?

• Suspense/Thriller and Action/Adventure have a i ifi tl t d lisignificantly steeper decline

(higher p) in revenues than other genres.


• Scenes of violent content increased the potential adoption m and decreased attenuation psignificantly, an overall positivesignificantly, an overall positive effect on revenues.


• The most significant influences are the number of initial screensand the budget.Higher number of initialHigher number of initial

screens increases Market potential reduces

VolatilityDon M. Chance, Eric Hillebrand, Jimmy E. Hilliard, “Pricing an option on a Non-decreasing Asset Value: An application to Movie Revenue” Dec 16, 2005

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Higher budgetincreases Market potential slower Decline in revenues

increases VolatilityVolatility• The rating has no significant

influence.• Sequels have a relatively

higher market potential.

An Option Calculation Example:

Film The Others

Assumptions:• Assume the distributor

Miramax wishes to sell a call option on this movie, and that the option is sold the instantthe option is sold the instant before the movie is released.

• The option expire in 6 weeks• Risk-free rate is 3.6%Don M. Chance, Eric Hillebrand, Jimmy E. Hilliard, “Pricing an option on a Non-decreasing Asset Value: An application to Movie Revenue” Dec 16, 2005

Movie Characteristics:• 1,678 initial screens• Production budget $17 million

l $10 illi i d i iplus $10 million in advertising• Average ticket price: a = %5.65


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Plugging data in the regression equation:

= 1.0109e7= 0.2654

92312= 92312Forecast of peak revenue is $57 million the movie is forecast to be profitableDon M. Chance, Eric Hillebrand, Jimmy E. Hilliard, “Pricing an option on a Non-decreasing Asset Value: An application to Movie Revenue” Dec 16, 2005

Set the exercise price at the total budget of $27 million, and insert the obtained parameters into the option pricing formula:

call option value = $18,419,498


Hence, if the distributor sold options on the entire position after 6 weeks, it would collect revenue of $18 419 498 uprevenue of $18,419,498 up front.


• At expiration (6 weeks later), total revenue was $73,422,887 implying attendance of 12,995,201.

The option would haveThe option would have expired with a payoff:Max {0; $73, 422, 877 -$27,000,000} = $46,422,887


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• After the remaining 8 weeks of the movie, the distributor would then be left with net revenue of

$96 471 845 $46 422 887$96,471,845 - $46,422,887 = $50,048,958


• Given production and distribution costs of $27,000,000 and adding the option premium, Miramax would have realized a profit of about $41.5 million.


• Of course, the distributor might not sell the options on the entire movie proceeds. Also, some of the proceeds go to the theaters,the proceeds go to the theaters, largely to cover their costs.


Update of the call option price for The Others using the

updated parameter estimates

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Derivatives in the Media IndustryMedia Industry

Some characteristics of the media derivatives

• “Virtual” derivatives on movies can be traded on the Hollywood Stock Exchange

• All trading is based on fictional money.

Wikipedia: http://en.wikipedia.org/wiki/Hollywood_Stock_Exchange

• Stocks and options on movies can be purchased and sold.

• The exchange also offers “bonds” on actors and actressesbonds on actors and actresses in which value is accrued based on revenue generated by their movies.

Wikipedia: http://en.wikipedia.org/wiki/Hollywood_Stock_Exchange

What types of firms aremore likely to use

currency derivatives?• Firms with greater growthFirms with greater growth

opportunities• Firms with tighter financial

constraintsChristopher Geczy, Bernadette A. Minton, Catherine Schrand, “Why firms use currency derivatives” from The Journal of Finance 1997

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• Firms with extensive foreign exchange-rate exposure

• Firms with economies of scale in hedging activitiesin hedging activities

Christopher Geczy, Bernadette A. Minton, Catherine Schrand, “Why firms use currency derivatives” from The Journal of Finance 1997

Why these firms use currency derivatives?

• Firms use derivatives to reduce cash flow variation that might otherwise preclude firms from investing in valuable growth opportunities.


Frequency of use of derivatives by industry

(372 sample firms from Fortune 500 in 1991)Currency

DerivativesAny

DerivativesConsumer Goods 66.0% 78.7%Electronics 56.3% 63.4% Computers, office equipmentEnergy 34.4% 68.8%Metals 21.9% 50.0%Nondurable consumer products 28.6% 42.8%Paper 17.1% 39.0% Publishing, printingProduction materials 44.0% 62.0%Transportation 40.6% 59.4%

Choice among types of currency derivatives

• LT currency swap: used to manage foreign exchange-rate exposures that extend over multipleexposures that extend over multiple period. It bears a lower level of basis risk than using a series of ST forward contracts. (ie: foreign-denominated debt payments)

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• ST currency forwards:ST forwards is the lower cost alternative for frequent ST transactions that are characterized by uncertainty about their timingby uncertainty about their timing and quantities. (ie: foreign-denominated sales on account)


ISDA 2003 Survey Results:

Derivatives usage by world’sDerivatives usage by world s 500 largest companies

% of World's Top 500 Companies That Use Derivatives

Don’t Use Derivatives

8%Don’t Use DerivativesUse Derivatives

Use Derivatives

92%

www.isda.org “2003 Derivatives Usage Survey” www.isda.org “2003 Derivatives Usage Survey”

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www.isda.org “2003 Derivatives Usage Survey”

• Survey results show that the majority of the companies in the world are engaged in derivative transactions for risk

tmanagement.• Survey also shows the

importance of interest rate and currency derivatives usage.

Typical goals of Derivatives Usage

• Accounting earnings• Cash flows• Cash flows• Balance sheet accounts• Firm value

Gordon M. Bodnar, Gunther Gebhardt, “Derivatives usage in risk management by US and German Non-financial firms: A comparative Survey” from Journal of International Financial Management and Accounting 1999

Company Examples that are using Derivativesusing Derivatives

Source: MAYS Business School at Texas A&M University

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Company Derivative Types

3M (MMM)interest rate swaps, currency swaps, forward and option contracts,

cross-currency interest rate swaps, negotiated supply contracts, price protection swaps, forward physical contracts

Alcoa (AA)

futures contracts for aluminum, fuel, electricity, etc, interest rate swaps (pay floating receive fixed), cross-currency interest rate

swaps, foreigh currency exchange contracts, power supply Alcoa (AA) contracts that contain pricing provisions related to the LME aluminum price. Alcoa has also entered into certain derivatives to

minimize its price risk related to aluminum purchases.

Altria (MO)*forward foreign exchange contracts and foreign currency options, foreign currency swaps, commodity forward contracts (Kraft for

cheese, milk, coffee, and cocoa),

American Express (AXP)

interest rate swaps, interest rate swaptions, foreign currency forward contracts, interest rate caps, and floors, derivatives

embedded in notes, annuities, and investment products

American International Group (AIG)

interest rate, currency, commodity, credit and equity swaps,swaptions, and forward commitments

interest rate swaps, cross currency swaps, foreign currency forward t t d dit h t t Al h d i

Boeing (BA)

contracts, and commodity purchase contracts, Also non-hedging instruments such as interest exchange agreements, interest rate

swaps, warrants, conversion feature of convertible debt and foreign currency forward contracts. Boeing held forward-starting interest rate swap agreements to fix the cost of funding a firmly committed

lease for which payment terms are determined in advance of funding.

Caterpillar (CAT) foreign currency forward and option contracts, interest rate swaps and forward rate agreements,

Citigroup (C)interest rate swaps, futures, forwards, and purchased option

positions such as interest rate caps, floors, and collars as well as foreign exchange contracts

Coca Cola (KO) interest rate swaps, forward exchange contracts and purchase currency options

Interest rate swaps, hedges related to foreign currency risks and Du Pont (DD)

p , g g yforeign commodity price risk, forward exchange contracts,

exchange traded commodity derivitive instruments

Exxon-Mobil (XOM) The Co's size, geographic diversity and nature of the business mitigate risks, so it makes minimal use of derivative instruments.

General Electric (GE) interest rate swaps, currency forwards and options, interest rate forwards, interest caps, floors, collars, equity warrants

General Motors (GM)hedge exposure to foreign currency exchange risk, hedge exposure to commodity price changes, hedge exposure to interest rate risk,

forward contracts and optionsHewlett-Packard

(HPQ) interest rate swaps, forward contracts and options, warrants

Home Depot (HD) interest rate swapsHoneywell (HON) forward and option contracts, interest rate swaps

IBM (IBM)forward contracts, futures contracts,

IBM (IBM), ,

interest rate and currency swaps, options, caps, floors

Intel (INTC)

warrants and equity conversion rights, currency forward contracts, currency options, currency interest rate swaps and currency

investments and borrowings, currency forward contracts, equity options swaps or forward contracts

J.P. Morgan ((JPM)majority are enterred into to make a market, some are used for

enduser purposes. They do everything

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Johnson & Johnson (JNJ) foreign exchange contracts, currency swaps

McDonald’s (MCD)

(1) interest rate exchange agreements to convert a portion of its fixed-rate debt to floating-rate debt and (2) foreign currency

exchange agreements for the exchange of various currencies and interest rates. (1) interest rate exchange agreements that effectively

convert a portion of floatingrate debt to fixed-rate debt and are designed to reduce the impact of interest rate changes on future

i ( ) f d f i h dMcDonald s (MCD) interest expense, (2) forward foreign exchange contracts and foreign currency options that are designed to protect against the

reduction in value of forecasted foreign currency cash flows such as royalties and other payments denominated in foreign currencies, and (3) foreign currency exchange agreements for the exchange of

various currencies and interest rates.

Merck (MRK) local currency put options, forward exchange contracts, interest rate swaps

Microsoft (MSFT)foreign currency options and forwards, options to hedge fair

values on equity securities, options forwards and swaps to hedge interest rate risk, swaps and warrants to hedge credit risks

Pfizer (PFE)short term yen borrowings, forward exchange contracts, foreign

currency swaps, interest rate swaps

Procter & Gamble (PG)

interest rate swaps, foreign exchange contracts, purchased options, borrowing in foreign currency, foreign currency swaps,

commodity futures and optionsSBC Comm. (SBC) interest rate swaps and interest rate forward contractsUnited Technology

(UTX)swaps, forward contracts, and options to manage certain foreign

currency, interest rate and commodity price exposures

Verizon (VZ)foreign currency forwards, equity options, interest rate swap

agreements, interest rate locks and basis swap agreementsWal-Mart (WMT) interest rate swaps, cross-currency interest rate swaps

Walt Disney (DIS)interest rate and cross-currency swap agreements; forward, option

and “swaption” contracts and interest rate caps

US company swap with foreign bank

US company pays a fixed rate of 11%

semiannuallyForeign

BankU.S.

company

Size: $100mill Maturity: 5 yrs

Banks pays a floating rate of 6-month LIBOR

semiannuallyBank pays

10.75% (semiannual

equivalent) on its Eurobond

Us company pays 6-month

LIBOR +.375% semiannually on its credit facility

Transforming floating-rate debt to fixed-rate debt

Counter-partyCompany

Company pays a fixed rate of 14.05%

quarterly

Size: $10mill Maturity: 10 yrs

partyCounter-party pays a

floating rate of 3-month LIBOR quarterly

Liability: $10 million

commercial paper

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Securitization• A process of bundling loans and

assets into securities to enhance th i dit t t th btheir credit status so they may be more readily sold to investors.

Kendall, Leon T., “Securitization: A New Era in American Finance,” in Kendall, Leon T. and Fishman, Michael J., ed., A Primer on Securitization, Cambridge, Mass.: The MIT Press, 1996, pp 1-2

Risk reduction: Diversification • Financial theory shows that a

portfolio of investments, each ith t i i ki hiwith a certain riskiness, achieves

a lower risk by being part of a portfolio.

Product Variation: Advantages• Gives firms a better chance of

hitting a moving target• reduce the risks of concentrating

on the wrong market segmenton the wrong market segment• generates information on

developing market trends

• The expected return on a portfolio is a weighted average of the expected return on the i di id l t b t ti tiindividual assets; but estimating the risk, or standard deviation of a portfolio, is more complicated.

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Portfolio expected rate of return =(fraction of portfolio in first asset *

expected rate of return on the first asset) +

(f ti f tf li i th d(fraction of portfolio in the second asset * expected rate of return on the second asset) + etc.

Variance for Individual Assets• Take N deviations from the

average rate of return for asset a and square each of them:Th

e imq

(average returna – actual returna)2

Then average the products.

age cann

The resulting number is the variance for the asset. The higher the number, the higher the potential risk of the asset.Th

e imthe potential risk of the asset. age cann

• Diversification may not produce efficiencies that improve

Influences on Media Portfolios

pcompany performance. (Jung, 2003; Kolo & Vogt, 2003)

Picard, Robert G. “Media Product Portfolios- Issues in Management of Multiple Products and Services,” The Nature of Media Product Portfolios, London: Lawrence Erlbaum Associates, Publishers, 2005, pp. 7.

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• “broad diversification shows a ‘negative relationship with management effectiveness suchmanagement effectiveness such as ROS, ROA, ROI’.” Jung (2003) (p. 245)

Picard, Robert G. “Media Product Portfolios- Issues in Management of Multiple Products and Services,” The Nature of Media Product Portfolios, London: Lawrence Erlbaum Associates, Publishers, 2005, pp. 7-8.

• Investment to product analysis provided new ways to evaluate d i bilit f tf li

Portfolio Management

desirability of portfolio.


Diversification/ PortfolioIn order to find the standard

deviation for asset a, take the square root of the variance. The closer is to zero the closer thecloser is to zero, the closer the expected outcome is to complete certainty.

The goal of diversification is to reduce the variances of the portfolio as a wholeTh

e importfolio as a whole. age cann

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• In order to estimate the rate at which the two stocks covary, multiply the deviation of asset a by the deviation of asset b in

h f i d heach of N scenarios, and then average the products.

(deviation a1 * deviation b1) + (deviation a2 * deviation b2)…

Eli M. Noam, Media Finance 345

_______________________N

• For the covariant coefficient divide that covariance by the product of the standard deviations of asset A and of


asset B.

Covariant coefficients range between 1 to –1. Values of –1 indicate perfect negative correlation; i.e. elimination of unique risk. Value of 0 means

t th t t


returns on the two assets vary independently, and 1 indicates perfect positive correlation; a poor portfolio match.

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If the returns on two assets in a portfolio varied in perfect lockstep, the standard deviation of the portfolio would be the weighted average of the


weighted average of the standard deviations of both assets:

• The incremental risk of an asset depends on whether its returns tend to vary with or against the returns of other assets held. If it varies against, then it reduces the


overall variability of a portfolio’s returns.

• Focused publishing companies may outperform the more related

Performance and Diversification

may outperform the more related diversified companies.


• Similar for international diversification: more focus leads

Performance and Diversification

to more synergy within product grounds


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Covariant coefficients range between 1 to –1. Values of –1 indicate perfect negative correlation; i.e. elimination of unique risk. Value of 0 means

t th t treturns on the two assets vary independently, and 1 indicates perfect positive correlation; a poor portfolio match.

If the returns on two assets in a portfolio varied in perfect lockstep, the standard deviation of the portfolio would be the weighted average of theweighted average of the standard deviations of both assets:

If the covariance coefficient = 1,let xa = fraction of stock a in the

portfolio, xb= fraction of stock b.Standard deviation of portfolioab =(xa * ) + xb * ).

• The incremental risk of an asset depends on whether its returns tend to vary with or against the returns of other assets held. If it varies against, then it reduces the overall variability of a portfolio’s returns.

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The expected value of a given movie may be high enough to justify its production, but its risk may be high enough to deter y g gproducers who cannot afford to lose or to diversify.

• Expected value of any range of outcomes is the sum of the products of the probability * the result

• Assume a movie costs $10 million to make, may return 10, 5, 4 –1, or -2 million (loss).

• Based on past experience, the b bili f i kiprobability of it making 10

million in net revenues is .3• The other probabilities are .4, .2,

.1 respectively

•Expected Value for movie A

= (.3*10) + (.4*5) + ( 2*4) + ( 1*-1)(.2 4) + (.1 1)

= 5.7

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• Sum of the probabilities of all possible events must equal 100%, because one of q ,them will occur.

• Now that we have determined probability of all possible outcomes, we multiply the probability of each outcome by the dollar value:

The expected value of the project is the sum of probabilities * payoffs.

Advantages of Product Variation:

• Gives studios a better chance of hitting a moving target

• reduces the risks of concentrating on• reduces the risks of concentrating on the wrong market segment

• generates information on developing market trends

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Portfolio rate of return =(fraction of portfolio held in first asset

* rate of return on the first asset) + (fraction of portfolio held in the ( p

second asset * rate of return on the second asset)

• But it also increases the number of flops

• As long as returns on assets are negatively correlated (when one does bad, the other does well) even extremely volatile assets ywill help to decrease the volatility of an overall portfolio.

• Portfolios eliminate unique risk and leave the content company only with marketcompany only with market risks.

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•Assume portfolio of movies that includeMovie Cost Probability & Return

A 10M 30% 10M; 40% 5 M; 20% 4 M; 10% -1M;B 50M 20% -60 M; 20% 50 M; 30% 30 M; 30% 10M;C 100M 35% 200 M; 15% 100 M; 20% 90 M, 30% -2M;D 200M 50% 300M; 25% 250M; 15% 190M; 10% 150M;

What is the portfolio’s expected value?

•Expected Value for movie A

= (.3*10) + (.4*5) + ( 2*4) + ( 1*-1)(.2 4) + (.1 1)

= 5.7

•Expected Value for movie B

= (.2*70) + (.2*60) + (.3*40) + (.3*10)

= 41

•Expected Value for movie C

= (.35*200) + (.15*100) ( ) ( )+ (.2*90) +(.3*2)

= 102.4

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•Expected Value for movie D

= (.5*300) + (.25*250) + (.15*190) + (.10*150) = 256

• So our expected value for the portfolio is 5.7 + 41 + 102.4 + 256 =5.7 + 41 + 102.4 + 256

405.1

Expected Return for Investment

• Movie A (5.7-10) \ 10 = -43%• Movie B (41- 50) \ 50 = -18%• Movie C (102.4-100)\100 = 2.4%• Movie D (256-200)\200= 28%• Overall Portfolio (405.1-360)\360

= 12.5%

The Expected Value of a FilmMay be high enough to justify itsproduction, but its risk may behigh enough to deter producershigh enough to deter producerswho cannot afford to lose, or todiversify risk.

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Expected Value Threshold

• Assume:–Small studio’s threshold isSmall studio s threshold is 90%.

–Big studio’s threshold is 70%.

Studio will decide to produce film if it does not exceed threshold of expected value.

Realistically they will not know the threshold until production starts.

• The incremental risk of an asset depends on whether its returns tend to vary with or against the returns of other assets held. If it varies against, th it d th llthen it reduces the overall variability of a portfolio’s returns.

• As long as returns on assets are negatively correlated (when one does badly, the other does well) even extremely volatile assets ywill help to decrease the volatility of an overall portfolio.

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• Portfolios thus reduce or eliminate unique risk and leave th i t l ith k tthe investor only with market risks.

Diversification and Portfolio Theory

• Adding a new project to a portfolio further diversifies it.

• The ratio of risky assets to risk-free assets determines the overall return of a portfolio.

• Applying the portfolio approach to film production we can view them as assetswe can view them as assets.

Variance• Take 4 deviations from the

average rate of return and square each of them. Then average that. If it’s high, g g ,variance is high. Now, take the square root: that’s the Standard Deviation.

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• The closer the outcome gets to certain, the closer the SD is to zero.

Studio Behavior• Between 1930 and 1960, studio

success correlated with product variety: the more successful studios consistently produced astudios consistently produced a wider variety of films

Risk DiversificationUniversal Pictures in 2001

distributed the following titles:• Josie & the Pussycats

(based on a comic

• Captain Correlli’s Mandolin–(based on a comic

book)• Fast & the Furious

–(action)

–(artsy)• Head over Heels

–(romantic comedy)

Picard, Robert, “The Economics and Financing of Media Companies,” Fordham University Press, 2002.

• The studio system reduces risk. 1. The studio pools many risky

projects, making their aggregate cash flow reasonably safe for the lenders.

2. Studio exercises monitoring of production expenses

• Source: Caves, Richard E. Creative Industries: Contracts Between Art and Commerce. Cambridge: Harvard University Press, 2000

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• Developing too many products will result in diluted support for each and will lower chance for success in the market.

Project Portfolio

• Focus on a few high-potential projects

• But that reduce diversification–There is an optimal balance

Media Companies Spread Their Risk

• Single products face much larger risk.–Books, film, albums, etc.



• A variety of titles attracts a range of audiences and reduces a media fi l bilit t fl ifirms vulnerability to a flop in any one genre



• Some firms will attempt to spread their risk by operating in diff t di i d t idifferent media industries.


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• e.g. Tribune Company–Tribune Publishing–Tribune Broadcasting–Tribune Media Services

http://www.tribune.com/about/index.html


• Oligopoly• Vertical integration• Joint ventures


• Project Portfolio Balances–Among project age (life-cycle)–Among audiences (advertiser

considerations)–Among projects (non-variance, risk

f t )factors)–Among cast (overall budget

constraints)–Among project development stages

(avoid bunching)

• In the creative industries large firms sometimes owe their prevalence not to conventional scale economies, but to the value of large blocks of exposed assetsof large blocks of exposed assets as a collateral for proper performance of obligations


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• The firm with exposed assets has incentive not to cheat in its obligations–The contracting partner, recognizing this has morerecognizing this, has more incentive to sign.


Limiting Risk to Investors• Partnership strategies in

distribution and production• Co-production agreements

Risk Reduction• Diversification is a central element

in a depth-risk environmentRi k hif i l i• Risk shifting also important

Documents

Appendix E: Portfolio Risk Reduction Diversification ... · Diversification andDiversification and and Risk ... after spending more than three ... Examining Its Patterns and Determinants